Unlearn the old

“Change is inevitable - except from a vending machine.” – Robert Gallagher

Usually, Geographic texts remain the same across generations. You would not expect your child to learn about one less continent, or one more Sun. But in these changing times, even this is not true. Since 2006, we are now missing a planet. Our solar system now has 8 planets and not nine as we were taught. Something fundamental has changed here.

The same seems to be happening to the rules of investing. For the past many decades – almost since the concept of “fiat money” came into existence, it has always been assumed that earnings determine stock prices – atleast over an unspecified “long term”. Millions of trees have been sacrificed to propagate this thesis, and many investment gurus have made their reputations based on this “style” of investment – not least the great Warren Buffet.

It appears we are now in the midst of a change of tectonic proportions – much like the removal of “Pluto” for the count of planets – where we will take away cash flows and earnings as the primary sources of stock performance and replace them by regulatory and government action.

Two proposals merit attention. The first, originating in the USA, is a proposal by the Financial Accounting Standards Board (FASB), to allow creative accounting (obviously couched in more acceptable language). This will now be discussed and put to vote on April 2. Girdle up for “Ostrich Accounting” from here on – defined as “if I refuse to see it, it ain’t there”. If you assume that most companies already use some variant of this – this report mentions that GE Capital Corp. uses mark-to-market on only 2% of its assets – you understand why most brokerage reports use the words “we believe” so liberally. Whoever claimed that that an analyst was paid to analyse, not believe!

The other report is from our own shores. In an obvious attempt to keep up with the Joneses, in India, the National Advisory Committee on Accounting Standard (NACAS) has recommended a deferment of AS-11. While there is a flicker of hope that this will be rejected – the Ministry of Corporate Affairs has not yet accepted the recommendations, it seems highly unlikely. India will therefore pad along the footsteps of the “most advanced” market in the world.

Key changes – looking at accounting books of companies for clues of financial performance will soon become like reading fairy tales – it already is in many cases – but will now become entrenched policy – not meant for grown-ups. Equity markets will now behave much like debt markets. Debt traders are trained to look at the key market rigger (the Central Bank) for direction on how to trade. Equity traders soon have to look in the same direction – if the Bank prints more green-backs, buy equity, if it prints more bonds, sell equity. Did anyone mention earnings here?

To paraphrase a quote “Every time I find the meaning of investing, they change it”

Regulating the regulators

Imagine a school with a strict teacher in every class. In one such class, are a bunch of kids playing with fire. While the teacher watches, the kids set fire to the window curtains. The fire spreads, and engulfs the school and burns down most of the infrastructure. It then spreads to the neighbourhood and affects the nearby buildings. While trying to bring the fire under control, and examining the cause of the fire, the school principle suggests that one way to prevent another such occurrence would be to appoint the errant teacher as the fire warden for the neighbourhood.

Sounds like a fantasy out of Alice in Wonderland? Welcome to the real world – this is how the financial system of the world operates cica 2009. Gordon Brown, in preparation of the G20 summit on the financial crisis, exported to the world by the USA and UK, writes

“I have learned from this financial crisis that the disciplines we expect of markets cannot be guaranteed without strengthened supervision. “

Uh? Let’s see which part of the financial system that caused the breakdown was unsupervised. The most maligned are the hedge funds. Did these loathed vehicles need a bail-out – not really – for the most part, they just quietly wound down and exited. However, we have had multi-billion (totaling trillions of dollars) of bailout for supervised entities - banks, insurance companies, and investment banks. So don’t you see, the solution to the problem must be more supervision!

Having efficiently “supervised” an excellent problem situation, the regulators in the US have now suggested a Geithner plan to fix it. The plan involves a “put” to investors of banks and distressed asset funds, while transferring the entire risk to the tax payers. As Paul Krugman writes,

"Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard."

Mark Twain could have been speaking about regulators when he wrote

"All you need in this life is ignorance and confidence then success is sure"

especially if success is measured by negating the principles of free markets, and forcible propping up defunct organizations.

What’s with this “political uncertainty”?

Most market commentators. when asked about the possible direction of the market in the near term, hide behind the excuse that “political uncertainty” leading up to the general elections will lead to subdued market performance. Almost as if it was not the job of the market to deal with uncertainty and make decisions in the absence of perfect information.

In any case, it appears that we are headed for another government comprising several political parties. Should an investor worry?



A look at the graph above indicates that the Indian economy left its earlier slower growth trajectory and embarked on a higher growth path somewhere in the decade of the 1980’s. This coincided with a drop in the vote share of the Congress – till then the single largest party with a dominant share of Parliamentary seats. The 1977 experiment at coalition was a miserable failure and led to a resurgence of the Congress. But only for a few years. For the last almost two decades, we have had minority governments ruling India. Over the same period, we have sustained a new and higher growth trajectory.





In fact, it would almost suggest, that the emergence of regional parties helped to increase the growth rate for the nation. A research paper on the “Politics of Infrastructure Spending” by Wilkinson 2006 mentions the following

“Experience since the late 1980s has shown that coalition governments are formed and held together by the judicious spreading around of loans, grants and subsidies, which obviously limits the resources available to be spent on other projects. .. For example from 1999-2002 Andhra Pradesh got $763 million in “additional central assistance for externally aided projects in state plans” because of the influence of its governing Telegu Desam Party, the single most important coalition partner in the national NDA coalition government in new Delhi. The opposition controlled state of Bihar got only a tenth as much, despite a greater population and much worst absolute levels of poverty. However when a Congress-coalition replaced the NDA in 2004, it was Bihar’s turn to benefit from electing large numbers of MPs to a key coalition party, the RJD”

What does this mean for the investor? Clearly, the election process cannot be blamed for uncertainty (it is certain that we will have a coalition government), nor for lower growth. The moot point though is whether growth is in itself needed for stock market performance. A paper by Prof Prabirjit Sarkar of Jadavpur University titled “Stock Market Development, Capital Accumulation and Growth in India since 1950” has this as its abstract:

“This study examines whether there exists a long-term relationship between Indian share price movements and growth through capital accumulation over more than half a century period since 1951. Using the Autoregressive Distributive Lag (ARDL) approach to cointegration developed by Pesaran and Shin, our study shows that no long-term relationship exists between the gross-fixed capital formation (total as well as private) as percentage of GDP and nominal or real share price. There is also no relationship between the growth rate and share prices (both nominal and real). There is also no relationship if we consider the growth rates in share price.”

Now that is a different existential question we need to confront!

Reality check for executive factories

The IIM’s have long justified the rapid and unchecked increase in their fees on the grounds that students are assured of a good placement. Consequently, the institute and its dependents (the teaching staff) should charge “appropriately” to deliver “quality” education. In the case of IIM A, fees have increased from approximately Rs 1.5lakhs in 2004, to Rs 6lakhs in 2009 (CAGR of an astounding 32%). The unstated position appears to be that rather than being non-profit institutes of research and education, IIM’s should now be viewed as glorified placement agencies and finishing schools for graduate students. Incidentally, IIM’s make in excess of Rs2crs per year from placement fees alone.

The recently concluded placement session has been a much needed reality check for the IIM’s. Placement was slow, and students witnessed a salary drop averaging 30% across most IIM’s.

Maybe this will lead to some serious, and much needed soul searching. If the argument is that rising salaries are in some ways related to the “value add” that the institute delivers – then, one has to conclude, that the institute has actually added lower value to the current crop of students. I wonder if the students then entitled for a refund in fees!

The IIM’s seem to suffer from unbridled greed - that has been at the bottom of the current meltdown in the US. No justification can be offered for a 30% increase in fees year-on-year for over a decade (it started well before 2004). Linking fees to salaries ensures that students may need to take loans, and this restricts their ability to explore options of entrepreneurship and of working in socially relevant, but poorly paying jobs. This, when as a public institution, the IIM’s are adequately supported by the State (they have existed for over four decades, and have built their reputations over 3 decades of public support). Operating independence for a public institution cannot be divorced from responsibility to the public and its government. Rather than competing on increasing salaries and costs, it would be more appropriate if the IIM’s focused on creating a management education paradigm suited for the needs of a diverse and uneven economy as India.

The key success factor for the IIM’s has been their ability to draw within their fold, the cream of aspirants – and government ownership, a merit based entrance and low fees have each played a significant role in this. Change one, and the IIM’s will not be the same again. I hope the IIM’s are listening.

Equity Investing – the image of Ganesh

Investing in joint stock companies has a come a long way since a bunch of disparate investors in London, agreed to partake in the risk and return of establishing a permanent settlement in the “New World” and formed “The Virginia Company”. Risk was involved not only in financing a venture that could potentially fail, but also in recovering the upside in case of one.

Settlement risk in investing has, since, been considerably reduced, with counter-party risk significantly reduced through the introduction of clearing house for trades, backed by investor protection funds.

One thing that has not changed, however, is the uncertainty regarding how to approach an investment decision. Investors often are regarded as belonging to one of two (sometimes opposing) groups – one which swears by estimating the future cash flows of companies (fundamental analysis) and another that attempts to predict stock price from past stock price moves (Technical analysis). But these are by no means the only schools of thought. The theorist (capital asset pricing model) would have you believe that price movements are random, therefore unpredictable. Another set of theorist add to the chaos by trying to adopt “chaos theory” (yes – there is a theory for that too!) to the capital markets. A somewhat recent approach which has thrown its metaphorical hat in the ring – is behavioural finance.

Adherents of each school will often go to any lengths to disparage the claims of the other groups. But do any of the approaches single-handedly define the whole “truth” of the investment process? Is it not true that each approach only serves to describe the market only in part, and that over long periods, a particular approach may be unable to offer any significant insight into the investment process.
I have often been struck by the similarity this has to the story of the blind men and the elephant

It does suggest that like with most human attempts to understand the nature of “reality” – the deeper one delves, the more one realizes the limits to the knowledge acquired thus far. As Bertrand Russel stated “I think we ought always to entertain our opinions with some measure of doubt. I shouldn't wish people dogmatically to believe any philosophy, not even mine.”

In the end, I wonder if our ancients were indicating something to us, when they chose Ganesh – the elephant god, as the God who overcomes obstacles (and now the reigning deity of the stock markets) – perhaps reminding us not to behave as the “blind men”? Keep an open mind, and if you feel dogmatic about a particular idea, remember – the only dogma worth falling in love with is to be found in Asterix comics