Moschip Semiconductor (listed on BSE)

My friend had asked me to do some research on this company. I think I finally somewhat understood how off balance sheet activities can make the financials look better or worse than they actually are. For this company, the entire income is off the income statement.. And in the process, I found this section on moneycontrol website where one can search for block deals for any scrip..

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· Company Description: The company is in ASIC (application specific integrated circuits) space. It has a wholly owned subsidiary: Moschip USA. The product design and software development is done by MosChip India. The software is licensed to MosChip USA, which subcontracts the manufacturing and sells the chip through its distribution network. The entire revenue from sale of products is thus in MosChip USA. MosChip USA pays a license fee to MosChip India, which is linked to the gross margin on the products designed and developed by MosChip India.

· Complicated Capital Structure and Reported Financials: The capital structure of the company is complicated. The company acquired Moschip USA and Varsity using its shares. On the balance sheet, these acquisitions are accounted of as investments. The financials on BSE are for Moschip India. As such, the sales, income and share count associated with the investments is not on the BSE reported financials. So we don’t really know the consolidated financials of the company, which is critical, as all the sales are recorded by Moschip US. Economically though, as the subsidiaries were acquired using Moschip shares, any economic benefit from these subsidiaries will accrue to Moschip shareholders at some point of time.

· Critical drivers of stock price: Seems like there are two critical drivers of the company’s performace: (a) How fast does the company topline grow overall? (b) What is the revenue and profit sharing mechanism between the US subsidiary and its Indian counterpart? While this does not impact the financial outlook of the consolidated company, a higher royalty payment to the Indian subsidiary would increase the EPS reported to BSE.

Relied on prospectus filed in Feb 04 to get some of the numbers like cash and debt.

Valuation:
· Share count. Before the offer last year 30.64 million. After the offer, additional 3.34 million. GDR listing, additional 9.5 million shares. Total today should be about 43.5 million shares

· EV: 43.5 mn shares * 45 = Rs. 1957.5 mn market cap. As of 1Q:04 Moschip US has 30 mn. debt. Moschip India had 14 mn cash, Moschip US had 3 mn cash. So Enterprise value = Rs 1970.5 mn.
· Revenues: Don’t know Moschip US revenues. Need to approximate.

Method 1: Consolidated sales for 9 months ended 31/12/03 were Rs 94.6 million. Annualizing the consolidated sales, we come up to Rs 120 million in sales in the year ended 31/03/04. Moschip India sales were 3.8 mn during the 9 month period. (Business Standard article says the company’s revenues were Rs 12.63 crore in 2004 – pretty close).

Between the year ended 31/03/04 and 31/03/05, Moschip India sales went up 5.03 times. If it was all due to increased sales by Moschip US, and not increase in royalty payment rates from Moschip US to Moschip India, then sales companywide grew 5.03 times. This would imply consolidated 31/03/2005 sales were 120*5.03 = Rs 603 million

1Q:06 revenues for Moschip India grew 129%. If this is again companywide, and assuming similar growth throughout the year. FY 2006 sales would be around Rs 1200 million.

So EV/Sales would be 1970.5/1200= 1.64x
Risk: We don’t know whether Moschip India revenues are increasing because of increased sales companywide, or increased payments by Moschip US to Moschip India on the same revenue base.

Method 2: Sales increase in 2004 were 20%. In 2003, it was 25%. If it was 25% for FY2005, sales were 120mn*1.25 = 150 mn. If it is same for FY06E, sales next year would be 150*1.25 = Rs 187.5 mn. On that EV/sales = 1970.5/187.5 = 10.5x

· Conclusion: Blended EV/sales by the two methods is (10.5+1.64)/2 = 6.07x. For a company growing at 25%, this would be steep multiple to pay. For a company growing at 100%, this would be a bargain. I don’ t know what the growth rate is for this company.

Positives:
· Company is saying that they will become cash positive this qtr, and EPS positive by year-end – that is great. It is these kinds of companies whose shares run up.
· The company has survived for a long time, including the telecom bust.
· The commitment of the management seems to be there – same CEO since inception.
· The company is hiring - http://www.assureconsulting.com/indiajobs/showjob.php?id=1426, 4 software engineers and ASIC engineers. Engineering strength in 2004 prospectus is 57.

Negatives:
· This company doesnt seem to have any patent. That is very surprising. Prospectus says – “The company is in product development, initially it was in IP”.
· These type of companies are very order driven – no predictability in revenues. There might be substantial variation in revenues from one quarter to next. Because revenues were so high in 1Q:06, they might be depressed in the next qtr.
· No clue about how good the technology of the company is, and who its customers are. As such, we are clueless really to what might be happening.
· About 100 employees – still a small company. But it has great ambitions. Acquired two companies in last 5 years through stock issuance.

Issues:
· The company issued GDR? Listed at Luxembourg exchange? WHY – This is a very small company? Who bought this GDR?
· What is the profit sharing fundamental between the company and its subsidiary in the US?
· Many bulk deals for Moschip in the last week or so. Why this sudden interest in the scrip? Marshall Wace is a hedge fund – holding period typically less than 7 days – they will sell the stock soon. My former boss (Mike Seargent) is the CEO of its US operations. http://news.moneycontrol.com/stocks/marketstats/blockdeals_query.php

Other:
· Got R RamMohan Rao as director on June 4, 2003 – IIM-B ex Chairman.

China revaluing yuan

The news of the day was definitely China looseining the dollar peg (though not by a lot). This should lead to appreciation of yuan, and cause dollar to depreciate. This shouold help inch the 10 yr bond yields up as Chinese lower their appetite for US treasuries (why keep money in a weaker currency). Housing mousing should start cooling off a little bit...


When I was out of the markets, they went up, despite the London bomb blasts which killed 56 people. When I am back in, markets went down, despite the bomb blasts in London which apparently killed no one.. Microsoft has lowered guidance for next year, Google has missed on EPS.. That should be bad news for the market tomorrow

Earnings going through the roof

I think I made an intelligent decision to move back into the market the other day. Coming into the day, more than 85% of the 104 companies in the S&P 500 that reported earnings either met or beat expectations, according to data compiled by Bloomberg. And finally, it is corporate earnings and price momentum that determine the movement of individual stock prices, and the indices on the aggregate.

GM came in weak today, but that is company specific. While Intel and Yahoo missed analyst expectations, Amgen had an absolutely monstrous quarter. It must be remembered that for Intel and Yahoo, analysts have been ratcheting their expectations up all quarter.

Then Greenspan made positive comments about the economy, and oil inventories came out larger than expected, and the indices ended up positively. After close Washingtom Mutual, Allstate and Qualcom have reported big qtrs - that should be awesome tomorrow...

Indian markets - Cable and satellite.. Zee Telefilms

As I continue learning about the US cable and satellite industry, it looks like these are amongst the best businesses to be out there. While the content business (TV and movies) is very hit-dependent, the distribution business is subscription based. As such, there is a lot more predictability to the revenues. And I think this has implications for India.

Whether the Indian economy is growing or slowing down, consumers who have experienced cable service would continue to subscribe to a pay-tv provider (cable or satellite), as long as they can afford it. Because the alternative - Doordarshan - is so plain awful. So, as consumer incomes increase and video penetration increases in India, the cable and burgeoning satellite providers should see massive subscriber growth.

India currently has a dominant state network - Doordarshan, that is free off the air. That is the only channel that one can get for free. For the other channels, one needs to subscribe - till now mostly to a cable provider. Cable distribution in India has so far been heavily fragmented, controlled in many cases by criminal elements. The only big cable-tv provider in India is Siti Cable, owned by Zee TV. It is only now that satellite companies are starting to roll out plans for the Indian market.

As the cable distribution business has been fragmented, it has had a few implications: (a) Under-investment in cable network. (b) Bad customer service (c) Local monopolies within cities, implying prices that vary sharply in different zip codes. If there were to be an alternative, it might gain significant market share. Two alternatives are beginning to emerge on the Indian horizon: Satellite distribution, and Reliance Infocomm.

Satellite distribution has an obvious advantage over cable - low capital expenditures. Once a satellite is up in the sky, it can cover the entire country. The other major expenditure involved is in subsidizing the equipment (dish, receiver) in each subscribers home. But these equipment costs also follow Moores law (after all most of the equipment costs lie in silicon chips). And when subscriber additions reach a certain volume, equipment costs fall even more rapidly. Thus, this is a business with a high operating leverage, i.e. high margins for the marginal subscriber. And presuming that satellite distributors would be companies with bigger balance sheets (a satellite's cost of build, launch and insurance is roughly $250 million) and superior management than the local cable provider, customer service is where satellite companies can get a big leg up.

But Reliance Infocomm would have an even more powerful weapon, besides strong balance sheet and superior management, if it were to launch video service in India. That is the bundle. Having one bill for the land-line, mobile, Internet access and video servicess is a powerful motivation for a lot of consumers to switch from one company to other. And normally, the consumers would get a discount if they buy all the services from one company than if they purchased the services separately. But as Reliance doesnt seem ready to launch video service for a couple of years, we would focus back our attention on cable vs satellite companies..

There are a few other factors which we should take into account:
(a) Prasar Bharthi has ruled that their cannot be exclusive agreements between distributors and content providers (Star, Sony etc.). That basically reduces pay-tv distributors to a commodity channel. If viewers can see the same content on cable and satellite, the only reason to prefer one over other would be price, and maybe customer service.

What I need to figure out though is that whether Prasar Bharti has regulated the pricing at which content providers can provide their programming to the distributors. Because if it hasn't, distrbutors might be able to squeeze some savings, if they have a sufficiently large reach. This would imply that the bigger the cable or satellite company is (in terms of number of subscriers), the better it is for it.

(b) India is booming in the urban areas, agricultural incomes are stagnant. As such, incremental subscriber growth is more likely to come from urban areas than rural. Cable is dominant here, indicating satellite would have a rough time penetrating this market.

(c) Hyper-competition: There are many satellite companies that are planning to launch service in India. Only a couple will survive. It is important to identify which. Star can leverage NewsCorp expertise in DirecTV, BSkyB and Sky-Italia. Who are Zee's partners?

Zee seems to be betting on distribution - both cable and satellite - which is great. I think I need to study this company more. But the equity has moved from Rs 140 to Rs 175 in the last 10 days, since I thought about it..

The week that confounded everybody..

This was a week when almost nothing could go wrong - inflation remains tame, growth remains robust, consumer confidence remains high, oil drifts lower, and companies beat earnings estimates handidly. S&P now sits at 4 year high. I haved moved back all my cash back into S&P and small cap funds. So, these and emerging market funds are where I am invested in.

Right now I am a momentum person. Trying to time the market perfectly - which apparently no one has been able to do. What is the harm in trying anyway - I would learn something in the process.

Valuation of companies - setting up DCF correctly

There are hundreds of ways a DCF can be constructed - many of which are inaccurate, or don't capture issues like dividends and share repurchases correctly. The most accurate model that I have been able to come up so far, is as follows (the difference is in step c):

a) Calculate Free Cash Flow for each of the forecast years = Cash flow from operations - capex. As this would include cash flow from equity affiliates and cash outflow to minority interests, we do not need to account for them separately.
b) Calculate Unlevered Free Cash Flow = Free Cash Flow + Interest.
c) Calculate Unlevered Free Cash Flow/dil. share for each of the forecast years.
d) Calculate the Present Value, discounting using WACC. This is the Enterprise Value per share. If calculating one year price target, it is the two year out Unlevered FCF from which the forecast series to be discounted should start.
e) Subtract Net Debt/share. If calculating a one year price target, use next year forecasted net debt. Net debt = Long term debt - cash - net debt attributable to minority interests.
f) Add in value of investments accounted to by fair method and cost method/share.

That's it - we have the share price.. Simple!!

The crucial step is step (c) - I haven't seen any analyst do that. But if we don't, then share repurchases in outer years get modeled incorrectly. What is done by other analysts (and hitherto by me) is to go directly from step b to step d. And then subtract net debt, add fair value investments, and divide the resulting number by next year estimated dil. share count to come up with share price.

However, this is incorrect. For if share repurchases are being modeled in outer years, and we use next yr share count to calculate share price in the last step, it doesnt capture the decrease in number of shares that happens in outer years. While unlevered cash flow does go up (because as cash is used to buy back stock, net debt goes up, and so deos the tax shield provided by debt), the full impact of reduced share count doesn't get captured..

Maybe that is why DDM (Dividend discount model) is a better model to value companies.. But then in DDM, you have to make companies that dont pay any dividends to also pay dividends... Which has its own set of problems (what is the payout ratio etc..)

S&P allures?

It was less than 2 weeks back that the markets were fretting about slowing growth in the world, and bond yields had gone below 3.95%. I was then thinking about going into high yield funds. Now, the mood seems upbeat - definitely since the London blasts!! Bond yields are back above 4.1%, and no one expects Fed to pause next time. Most of the companies that have reported numbers have beaten estimates - looks like both Apple and AMD will open up tomorrow after their results after the close today..

Amongst all the madness, there are finally just two drivers of a stock : Earnings revisions and price momentum. That is, the stock should beat consensus EPS numbers consistenly, or it should have wind behind its back. If both happen, we have a winner. If none happen, the stock won't work over the long term. If either one happens, a decision needs to be made.. Does this apply to the broader stock market?

What is the market telling us currently? Is it dangerously complacent, or we are living in one of those times when historical precedents lose their wisdom. Like after 1971, when US went off the gold standard and money supply increased in the system. Now we might be having a similar situation, with easier cross-border capital flows.

Vega Asset Management lost roughly $700 million in June - because the traders there bet on rising US treasury yields. Seems like everyone is being challenged mentally.

Does oil hold as much influence as it did in 1970's? The current rally in oil prices in not OPEC driven, it is market driven. So high oil prices are a result of economic growth in the world - if expectations of growth increase, oil prices would rise, which would temper those growth projections, which should cause oil prices to fall down. But oil has settled at higher and higher prices, which would indicate that markets are able to absorb higher oil prices now, while maintaining the growth..

Inflation numbers are out tomorrow. They should tell something...

S&P Multiple, and stock vs bond yields

So we had a third gain in a row after the London blasts. Briefing.com cites two reasons: (a) S&P is trading at 18.8x earnings, which puts its yield at 5.3% higher than bond yields at 4.1%. (b) Forecast for YoY earnings growth rate for 2Q has come down to 7.5%, below 8.8% at the beginning of quarter in April. And the market is reacting to the fact that reported earnings are always 2-5% higher than consensus.

Questions:
(a) I read somewhere, maybe in "Stocks for the long run", that stocks yielded higher than bonds before World War II, then the relationship inversed. The prevalent thinking was that stocks being a riskier investment should yield higher than bonds. Many investors shorted stocks at that time thinking that they are overpriced, and lost their shirt. Are we again entering an era when stocks would yield higher than bonds? Maybe before World War II, capital movement was more free than it was for the next 50 years (human movement was definitely more free - no passports et al) , are we entering that phase again?

(b) Where is this fact of earnings growth being 2-5% higher than consensus coming from? I though stock analysts either overshoot or undershoot - there cannot be an always statement.

Should I go into the market, should I not? With dollar being as strong as it has been, wouldn't Dell, Intel, Cisco etc get hurt?

Current Asset allocation..

Currently I am invested 60% cash, 40% emerging markets. After the London blasts, markets have moved up approx 2%. Does this point to resilience, or is this the final 10% of a bull market that I shouldn't try to catch? YTD, I am up 3.65%, vs flat for S&P.

What are the reasons I have seen for low interest rates in the US, and other places? Here is a list:

a) China, Japan, Korea et al buying US treasuries. But then why is EU debt yield so low? Somebody is clearly buying EU treasuries too
b) Better cross-border movement of capital has removed ineffeciencies, lowering cost of debt worldwide
c) Increased integration of India and China would keep wage growth and cost of producing goods low worldwide, leading to lower inflation worldwide (and hence lower bond yields)
d) Depression is an offing - this is a classic case of yield curve inversion.

I think it is fair to say that when yield curve gets flatter, retail banks get killed (they borrow on short end of the curve, and lend on long, and make money on the carry trade). To avoid getting killed, they should curail lending, which due to the money multiplier effect would be negative for economic growth. But if the game is on for grabbing market share, the banks might not curtail lending even if it hurts immediate profits.

Excess savings in the world?

Businessweek has on its cover this article on "World is awash in savings glut". What I cant figure out is this - how can there be a net savings glut in the world. If I sell someone something for $50, then my balance increases by $50, and the other person balances decreases by $50. So net savings in the world is 0. Maybe what they are saying is that the world has net positive savings vis-a-vis US. (They do say it at places in article, but still the feeling that one gets is that net savings in world is +ve) I dont know how economists calculate global savings, maybe I should figure it out.

If there is a net savings surplus globally, I strongly suspect that there can be only two reasons:

a) Asset inflation: Do savings include asset price increases? If the price of my home has jumped from $100 to $150, and that $50 unrealized gain is included in savings, then the problem is one of asset inflation. So I need to figure out whether these unrealized gains are included in calculating the savings.

b) Money multiplier effect: We all know the money multiplier effect the banks create. Similarly, there is a money multiplier effect when I borrow from my banks for house loans and credit card company. Are the global savings netted for debt? If not, then the problem is not of high savings, but one of low interest rates.

Now asset inflation can also be linked to low interest rates. Due to removal of ineffeciencies in the world financial markets, cost of money might have gone down globally. Question is: how much?

What exactly is the 2 line conclusion of the 10 page article of businessweek. That Americans are consuming a lot of imports, while the rest of world is not consuming American products. Instead it is investing in America. That is keeping interest rates down in the US. And because the world is not consuming, the interest rates in other countries have been held low by central banks.

I guess the best situation for the world is if Americans reign in their consumption, while the rest of world increases its consumption.

London blasts - Summarizing the risks for the US equity markets...

Before the open, it looked as if the US indices would have steep losses during the day, with S&P futures indicated down 17 points before the open. At close, all the three indices (S&P, DOW, Nasdaq) were up. One would have expected that with oil still at $60 and Hurricane Dennis building up in the Atlantic, the blasts would cause the S&P to have double digit losses and the DOW to have triple digit losses. That was however, not the case.

This resilience by the US markets in the wake of terrorist attacks might indicate that the underlying fundamentals are stronger than thought (by me). Or maybe, there is too much money in the world chasing too few investment opportunities, which jumps at any asset that falls in value. So I thought it would be instructuve to prepare a list of the biggest risk factors that might cause the the US equity markets to move down:

1) Slowing year-on-year earnings growth due to higher 2004 base.
2) Historically high profit margins for corporates - Reversion to the mean would lead to lower profits
3) Market trading at around its long term average of 15-16x (I need to figure out exactly how much, as even a 1x multiple swing indicates 6% swing in values)
4) Interest rate tigheting by Fed, and the narrowing yield curve. Inverted yield curve has historically been a harbinger of depression, though Greenspan thinks that is not the case this time.
5) Huge US budget and trade deficits - with associated long-term implications of dollar weakening
6) Oil prices at $60
7) Housing bubble - the current economic expansion has largely been driven by consumer spending, which in turn has been driven by higher income effect due to appreciation in home values. If the housing market to have a sharp correction, things could become ugly for the broader market.
8) (Now) Terror Risk

Separately, Bank of England kept its benchmark rate unchanged at 4.75%. With Euro weaker to dollar since the beginning of year, some investors have been predicting that the European banks don't need to cut rates to spur growth on the continent. Maybe that is what the Bank of England thought. I should look at the minutes of the meeting when they come out.

Also of news of personal interest, Deutsche Bank decided to sell part of its asset management business, after Citigroup got out of CAM a couple of weeks back by selling it to Legg Mason. Guess it is not a good idea to be employed by an asset management business owned by an investment bank. Lets see what happens to Morgan Asset Management and Merrill Asset Management, Goldman seems to be doing great in its asset management business.

Fed hikes another 25 bps - Not the time to invest in bond funds

As expected, the Fed Open Market Committee (FOMC )raised the Fed fund rate by 25 basis points. More crucially, it signalled continued tightening down the road, and not a relaxation, as some investors were expecting. The result was a loss of over a 100 points for the DOW after the FOMC announcement came out at 2:30 pm.

The Fed indicated that while long-term inflation remains under control, near-term inflation concerns remain elevated. This increase in Fed funds rate might slow housing , which has been an area of concern, if 10 yr and 30 yr yields rise. (See Greenspan's comments: http://gaurav1.blogspot.com/2005/06/alan-greenspans-comments-on-housing.html) 10 yr yield actually fell by 2 bps today after FOMC announcement, indicating further tighetening of yield curve. The current economic expansion has been largely driven by consumer and not by business. Consumer wealth has largely been driven by higher home values, and home equity lines against these values. Any significant decline in home values might thus have a extremely negative impact on overall economic growth. The best hope here, I guess, is to have a soft landing in home prices.

I had discussed a couple of days back whether this is the time to invest in high yield bond funds.
(See http://gaurav1.blogspot.com/2005/06/time-to-move-to-high-yield-bond-funds.html). I think it is better to wait and watch. If Fed keeps increasing the short term-rates, long term-rates might follow suit (so far they haven't).

Markets on June 29, 2005

Morning - 9:20 am

Looks like we would have a second day of +100 points gain for DOW. Oracle beat espectations and raised guidance. Revised GDP numbers for 1Q:05 put growth at 3.8% vs consensus at 3.7% (and earlier reported 3.5%), indicating economy was on solid footing then. More importantly, GDP deflator came in at 2.9%, vs consensus 3.2% (and earlier reported 3.2%). If the oil report out at 10:30 is bearish for oil (i.e. it reports higher inventories of crude and distillates than consensus), then that would be really bullish for equities.

One should remember that the GDP data is retrospective data, i.e. data of the Jan-March quarter. Now we are nearing end of second quarter. So it is a lagging indicator, not a leading indicator. Still, the GDP report indicates inflation was low in 1Q, even though oil prices were in their 50s. If inflation remains low currently, with oil hovering close to $60, the Fed can definitely start loosening interest rates if growth slows. But if growth was and is robust, then Fed might continue to increase rates, just to contain any incipient inflation.

Why are inflation indicators so low when house prices have been jumping up all over. Does this inflation metric exclude housing?
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Evening - 4:20 pm

Guess I was wrong in the morning. Even though oil inventory report was bearish for oil, market has drifted down slightly. Primary reason: Investors are awaiting for the FOMC meeting tomorrow, and what comes out of it on interest rates. FOMC is Fed Open Markets Committee chaired by Alan Greenspan which decides on Fed funds rate.

Alan Greenspan's comments on housing market in June 9 testimony before Congress

The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets. Thus, while investors can arbitrage the price of a commodity such as aluminum between Portland, Maine, and Portland, Oregon, they cannot do that with home prices because they cannot move the houses. As a consequence, unlike the behavior of commodity prices, which varies little from place to place, the behavior of home prices varies widely across the nation.

Speculation in homes is largely local, especially for owner-occupied residences. For homeowners to realize accumulated capital gains on a residence--a precondition of a speculative market--they must move. Another formidable barrier to the emergence of speculative activity in housing markets is that home sales involve significant commissions and closing costs, which average in the neighborhood of 10 percent of the sales price. Where homeowner sales predominate, speculative turnover of homes is difficult.

But in recent years, the pace of turnover of existing homes has quickened. It appears that a substantial part of the acceleration in turnover reflects the purchase of second homes--either for investment or vacation purposes. Transactions in second homes, of course, are not restrained by the same forces that restrict the purchases or sales of primary residences--an individual can sell without having to move. This suggests that speculative activity may have had a greater role in generating the recent price increases than it has customarily had in the past.

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.

The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. In part, this is explained by an underlying uptrend in home prices. Because of the degree of customization of homes, it is difficult to achieve significant productivity gains in residential building despite the ongoing technological advances in other areas of our economy. As a result, productivity gains in residential construction have lagged behind the average productivity increases in the United States for many decades. This shortfall has been one of the reasons that house prices have consistently outpaced the general price level for many decades.

Time to move to high-yield bond funds from S&P?

Could high-yield bond funds the place to be now? There seems to be growing concern that growth is slowing worldwide, with Europe sluggish and high oil prices curbing growth everywhere. This would lead to worldwide lower interest rates, which should make high yield bond funds attractive. How does this impact the US, my primary economy of interest?

If US growth slows (and inflation remains low), Fed might have to pause the interest rate hikes soon (currently fed funds rate is at 3%, and futures indicate a 2005 year end rate of 3.5%-3.75%), and maybe start cutting interest rates again. This should be very positive for the bond funds. However, Fed might not pause the hikes, if inflation creeps up, which it might as oil is now at $60 (vs around $52 when the last inflation numbers came out).

The 10-yr bond is yielding 3.94% today. Is this the time to jump in, or should I wait it to rise to maybe 4.3% before I jump in? If the Fed actually hints at pausing in its rate tightening cycle in the next FOMC meeting in the next 2 days, that would be a boost to the high-yield bonds. On the other hand, that would lead to another boom in the housing market. If there is any blow up there, it might cause the risk-appetite to go down, leading to widening of spreads for everything, including high-yield bonds. So even if Fed funds rate gets cut, high yield bond yields might go up, simply because the spreads (between high yield and treasuries) are so narrow today. Then also, if economic growth slows and corporate cash flows dry up, companies might have a difficult time servicing the high interest coupons on their junk bonds. So this is a very tricky question, to which I have no answer.

There were some equity bulls out there who were happy with the prospect that interest rates hikes would pause. What I don’t understand is that why would equity markets go up if the pause is happening because growth is slowing? What I think should happen is that stock market would drift down as interest rates are cut because of slowing growth, and shoot up only when there is evidence that these interest rate cuts have started invigorating the economy. In the current bull market, the stock market took off only when the Fed funds rate was pushed down to historic lows of 1%. So maybe, it would make sense to wait outside the lines during the first few cuts, and jump in when it seems that the money-easing cycle is nearing its end.

Of course I am assuming here that growth is slowing in the US. It might not, and the second half might be much stronger than expectations, in which equity markets would rally. But I think it is safe to remain on the sidelines in the equity markets right now. This bull market has already outlasted most others in terms of duration.

Best speeches..

So here is a compilation of the best speeches I have found on the web.

Steve Jobs on Life: Given at graduation ceremony at Stanford in 2005. Dots connect - in retrospect. Stay Hungry, Stay Foolish.

Jinnah on Partition: From Rediff.com. Published after the uproar in BJP over Advani's comment that Jinnah was secular. Why should some Indians be so keen to unite and manage another 100 mn odd Pakistan citizens, when the Indian government cannot and has never been able to manage the 1.1 billion already under its control is a deep mystery to me..

Steve Jobs speech

This is the text of the Commencement address by Steve Jobs, CEO of Apple Computer and of Pixar Animation Studios, delivered on June 12, 2005.

I am honored to be with you today at your commencement from one of the finest universities in the world. I never graduated from college. Truth be told, this is the closest I've ever gotten to a college graduation. Today I want to tell you three stories from my life. That's it. No big deal. Just three stories.

The first story is about connecting the dots.

I dropped out of Reed College after the first 6 months, but then stayed around as a drop-in for another 18 months or so before I really quit. So why
did I drop out?

It started before I was born. My biological mother was a young, unwed college graduate student, and she decided to put me up for adoption. She felt very strongly that I should be adopted by college graduates, so everything was all set for me to be adopted at birth by a lawyer and his wife. Except that when I popped out they decided at the last minute that they really wanted a girl. So my parents, who were on a waiting list, got a call in the middle of the night asking: "We have an unexpected baby boy; do you want him?" They said: "Of course." My biological mother later found out that my mother had never graduated from college and that my father had never graduated from high school. She refused to sign the final adoption papers.
She only relented a few months later when my parents promised that I would someday go to college.

And 17 years later I did go to college. But I naively chose a college that was almost as expensive as Stanford, and all of my working-class parents' savings were being spent on my college tuition. After six months, I couldn't see the value in it. I had no idea what I wanted to do with my life and no idea how college was going to help me figure it out. And here I was spending all of the money my parents had saved their entire life. So I decided to drop out and trust that it would all work out OK. It was pretty scary at the time, but looking back it was one of the best decisions I ever made. The minute I dropped out I could stop taking the required classes that didn't interest me, and begin dropping in on the ones that looked interesting.

It wasn't all romantic. I didn't have a dorm room, so I slept on the floor in friends' rooms, I returned coke bottles for the 5¢ deposits to buy food with, and I would walk the 7 miles across town every Sunday night to get one good meal a week at the Hare Krishna temple. I loved it. And much of what I stumbled into by following my curiosity and intuition turned out to be priceless later on. Let me give you one example:

Reed College at that time offered perhaps the best calligraphy instruction in the country. Throughout the campus every poster, every label on every drawer, was beautifully hand calligraphed. Because I had dropped out and didn't have to take the normal classes, I decided to take a calligraphy class to learn how to do this. I learned about serif and san serif typefaces, about varying the amount of space between different letter combinations, about what makes great typography great. It was beautiful, historical, artistically subtle in a way that science can't capture, and I found it fascinating.

None of this had even a hope of any practical application in my life. But ten years later, when we were designing the first Macintosh computer, it all came back to me. And we designed it all into the Mac. It was the first computer with beautiful typography. If I had never dropped in on that single course in college, the Mac would have never had multiple typefaces or proportionally spaced fonts. And since Windows just copied the Mac, its likely that no personal computer would have them. If I had never dropped out, I would have never dropped in on this calligraphy class, and personal computers might not have the wonderful typography that they do. Of course it was impossible to connect the dots looking forward when I was in college.
But it was very, very clear looking backwards ten years later.

Again, you can't connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future. You have to trust in something - your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all the difference in my life.

My second story is about love and loss. I was lucky - I found what I loved to do early in life. Woz and I started. Apple in my parents garage when I was 20. We worked hard, and in 10 years Apple had grown from just the two of us in a garage into a $2 billion company with over 4000 employees. We had just released our finest creation - the Macintosh - a year earlier, and I had just turned 30. And then I got
fired. How can you get fired from a company you started? Well, as Apple grew we hired someone who I thought was very talented to run the company with me, and for the first year or so things went well. But then our visions of the future began to diverge and eventually we had a falling out. When we did, our Board of Directors sided with him. So at 30 I was out. And very publicly out. What had been the focus of my entire adult life was gone, and it was devastating.

I really didn't know what to do for a few months. I felt that I had let the previous generation of entrepreneurs down - that I had dropped the baton as it was being assed to me. I met with David Packard and Bob Noyce and tried to apologize for screwing up so badly. I was a very public failure, and I even thought about running away from the valley. But something slowly began to dawn on me - I still loved what I did. The turn of events at Apple had not changed that one bit. I had been rejected, but I was still in love. And so I decided to start over.

I didn't see it then, but it turned out that getting fired from Apple was the best thing that could have ever happened to me. The heaviness of being successful was replaced by the lightness of being a beginner again, less sure about everything. It freed me to enter one of the most creative periods of my life.

During the next five years, I started a company named NeXT, another company named Pixar, and fell in love with an amazing woman who would become my wife. Pixar went on to create the worlds first computer animated feature film, Toy Story, and is now the most successful animation studio in the world. In a remarkable turn of events, Apple bought NeXT, I retuned to Apple, and the technology we developed at NeXT is at the heart of Apple's current renaissance. And Laurene and I have a wonderful family together.

I'm pretty sure none of this would have happened if I hadn't been fired from Apple. It was awful tasting medicine, but I guess the patient needed it. Sometimes life hits you in the head with a brick. Don't lose faith. I'm convinced that the only thing that kept me going was that I loved what I did. You've got to find what you love. And that is as true for your work as it is for your lovers. Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do. If you haven't found it yet, keep looking. Don't settle. As with all matters of the heart, you'll know when you find it. And, like any great relationship, it
just gets better and better as the years roll on. So keep looking until you
find it. Don't settle.

My third story is about death.

When I was 17, I read a quote that went something like: "If you live each day as if it was your last, someday you'll most certainly be right." It made an impression on me, and since then, for the past 33 years, I have looked in the mirror every morning and asked myself: "If today were the last day of my life, would I want to do what I am about to do today?" And whenever the answer has been "No" for too many days in a row, I know I need to change something.

Remembering that I'll be dead soon is the most important tool I've ever encountered to help me make the big choices in life. Because almost everything - all external expectations, all pride, all fear of embarrassment or failure - these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart.

About a year ago I was diagnosed with cancer. I had a scan at 7:30 in the morning, and it clearly showed a tumor on my pancreas. I didn't even know what a pancreas was. The doctors told me this was almost certainly a type of cancer that is incurable, and that I should expect to live no longer than three to six months. My doctor advised me to go home and get my affairs in order, which is doctor's code for prepare to die. It means to try to tell your kids everything you thought you'd have the next 10 years to tell them in just a few months. It means to make sure everything is buttoned up so that it will be as easy as possible for your family. It means to say your goodbyes.

I lived with that diagnosis all day. Later that evening I had a biopsy, where they stuck an endoscope down my throat, through my stomach and into my intestines, put a needle into my pancreas and got a few cells from the tumor. I was sedated, but my wife, who was there, told me that when they viewed the cells under a microscope the doctors started crying because it turned out to be a very rare form of pancreatic cancer that is curable with surgery. I had the surgery and I'm fine now.

This was the closest I've been to facing death, and I hope its the closest I get for a few more decades. Having lived through it, I can now say this to you with a bit more certainty than when death was a useful but purely intellectual concept:

No one wants to die. Even people who want to go to heaven don't want to die to get there. And yet death is the destination we all share. No one has ever escaped it. And that is as it should be, because Death is very likely the single best invention of Life. It is Life's change agent. It clears out the old to make way for the new. Right now the new is you, but someday not too long from now, you will gradually become the old and be cleared away. Sorry to be so dramatic, but it is quite true.

Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma - which is living with the results of other people's thinking. Don't let the noise of other's opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary.

When I was young, there was an amazing publication called The Whole Earth Catalog, which was one of the bibles of my generation. It was created by a fellow named Stewart Brand not far from here in Menlo Park, and he brought it to life with his poetic touch. This was in the late 1960's, before personal computers and desktop publishing, so it was all made with typewriters, scissors, and polaroid cameras. It was sort of like Google in paperback form, 35 years before Google came along: it was idealistic, and overflowing with neat tools and great notions.

Stewart and his team put out several issues of The Whole Earth Catalog, and then when it had run its course, they put out a final issue. It was the mid-1970s, and I was your age. On the back cover of their final issue was a photograph of an early morning country road, the kind you might find yourself hitchhiking on if you were so adventurous. Beneath it were the words: "Stay Hungry. Stay Foolish." It was their farewell message as they signed off. Stay Hungry. Stay Foolish. And I have always wished that for myself. And now, as you graduate to begin anew, I wish that for you.

Stay Hungry. Stay Foolish.

Thank you all very much.

Interest rates, inflation and oil

In April, stocks went down because of concerns of a soft-patch. Since then, as inflation indicators have come below consensus, market has started thinking that Fed interest rate tightening cycle will end soon, sending stocks higher. There seems to be a growing consensus that the Fed is going to stop raising rates sometime this year, to end the year at 3.5% to 3.75%.

Oil prices continue to rise, today it is above $56. Oil prices have spiked up again recently, which can lead to inflation concerns again being ignited in the second half of the year.. This would imply that Fed continues increasing rates. This would continue to make US treasuries attractive for foreign banks and investors, keeping the 10-yr bond yields at low levels. The result - a flattening yield curve, which has histroically been a harbinger of recession. Maybe, as Greenspan thinks, it is not the case this time. But then, banks get killed in a flattening yield curve environment, as they stop making money in the carry trade business (borrowing on the short end of the curve and lending on the long-end). And so they curtail lending, which impacts the economy as a whole. Lets see if it is different this time.

On a separate note, on the question I raised the other day (Do monsoons really impact Indian auto companies bottomline) Smith Barney wrote a report recently. It suggested that while monsoons have had an actual less impact on performance of the Indian auto companies, they did have an impact on the stock performance. The key drivers seem to be consumer finance and level of competitive intensity.

Oil - What is happening?

BSE closed at 6906 today. As Edwin Lefevre wrote “More money has been lost during the last 10% and first 10% of a bull market than has been made in the middle”. And maybe that is the case now in the Indian markets.

Oil closed up again today at $55.60. The reason is that Department Of Energy (DOE) report in the morning showed a worse than consensus drawdown in inventories. OPEC raised its production ceiling by 500K, but they were already producing at this increased level of 28 million barrels/day, so effectively that means no new production is coming on-stream.

Why are oil prices going up? My guess is because of demand from US, China and India. US consumer demand remains strong amongst a sharp increase in wealth due to high real-estate prices and good returns from the stock market in the last two years. Americans continue to buy cars and gas-guzzling SUVs, and continue to drive across the nation on weekends. Why is that? Because of low-interest rates. If interest rates went up slightly to calm down the real estate market and also make car financing less attractive, consumers would start taking notice of the high gasoline prices and maybe cut down on oil consumption.

But why are interest rates in the US so low? Bulls say that even though they are low if seen historically, they are higher than the rest of the world currently, and so investors outside are investing in US to take advantage of the relatively high yields. Add to that the current uncertainity in the Euro area (France and Netherlands rejected EU constitution), where there might be interest rate cuts to stimulate economy, and that makes US Treasuries attractive.

However, we shouldn’t forget the huge US trade deficit, at around $55billion/month. Economic theory indicates that $ should weaken as a result. It hasn’t. And that is because foreigners (China) are lending back to the US (by buying treasuries) the surplus they get through trade. Why? Because, as I pointed out in the last paragraph, there is no other place to invest. If EU had been growing faster, then some investments might have gone in Euro. Unfortunately, that is not the case. It is sort of vendor financing that is going on here. Which brings us to China.

China has the biggest trade surplus with US. Till yuan is pegged to dollar, logic would dictate this trade surplus would exist and keep on growing. US wants the yuan to appreciate and dollar to depreciate. This would lower the overall economic growth in China (due to lower exports due to stronger Yuan), which would arguably curtail consumption of oil in China. At the same time, China would reduce its problem of investing all its trade surplus, which it currently does in US treasuries. This would inch US bond yields up. And as we discussed above, this would be a double whammy for oil.

Where does India fit in here? By keeping the lid on retail prices, Indian government has its own hand in keeping demand for oil artificially high in India (i.e. artificial to current oil prices). By bringing oil prices in line with global prices, Indian government would temper the demand of oil a little bit, and prevent unsubstainable economic forces from building up in the economy

Who benefits if oil prices increase? HPCL, BPCL. Who loses - maybe everything else. High energy prices are not good. Is it time to short Pantaloon?

A way to play coal shortage (see yesterday's post) might be to buy Cement companies -some people are arguing that coal shortage would imply that only small incremental capacity comes online, and with utilization rates tight and demand booming, this could lead to a jump up in cement prices. However, I haven't seen any numbers associated with the analysis, so I would just hold off.

Indian equity markets - Ideas

The BSE Sensex is at 6860 currently. Smith Barney issued a report today suggesting caution for H2. It is overweight Capital Goods, IT and banks. Automobiles has been cut to neutral. Underweight on Pharmaceuticals.

Auto stocks have gone down in the past few days, due to (a) Concerns over monsoons (b) high steel and oil prices, which depress margins (c) Maruti cut the price of Maruti 800 to compete with Hyundai, which had earlier lowered the prices on one of its models.

Issues:
1) While Monsoons do have an impact on the automobile sector, it would be better if we could quantify the mix of cars sold between urban and rural centers.
2) Looking out 4 months ahead, when Diwali comes on, I guess there would be many financing schemes that should bode well for the automobile makers. So it might be a good time to position oneself in case stocks move down meaningfully on Monsoon concerns.

IT sector:
1) Strong dollar – augurs well for IT? Wipro says 1% appreciation in rupee hurts margins by 35-40 bps.
2)Infosys has appreciated YTD, but not TCS. Why? Residual reversion for TCS?

Diwali:
1) Pantaloon is overvalued, any other retail play in Indian retail market?

Coal shortage in India:
1) How to play it? Generator manufacturers, suppliers to infrastructure in Indian coal mines, shipping companies who ship coal to India? High oil prices might have a really big impact on India here. Who would be least impacted – services sector => IT? Maybe cost of power is going to go up, and if it can’t be passed on to consumers, Reliance Energy, NTPC might get hurt. If it can be, they are great stocks..