Wednesday, August 15, 2012

What to expect from the new CEA

I have a new blogpost on CNN-IBN's India Blog site. The link is here. I am also copying the blogpost below:

Last week, the Indian government appointed Dr Raghuram Rajan, a distinguished economist, as its chief economic adviser (CEA). The CEA advises the government on possible policy options and priorities. There are no executive responsibilities other than to prepare the various economic reports that are presented to Parliament - including the Economic Survey. In this context, it may be useful to look at the policy preferences of the new CEA.

In April, Rajan made a speech in New Delhi in the presence of the PM where he signed off with "I have been frank as an academic, that is the only value I bring". This suggests that perhaps he thought that his speech would not be to the liking of his listeners. But was it really that radical?

The speech (along with my somewhat liberal translation for the non-economists) identifies some issues with recent economic policy:

"Rent, patronage, or entitlement enhancing measures have sailed through."
"Private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth and continuing government transfers and subsidies. The result: The gap between our spending and our saving is making us dependent on short term foreign inflows to a dangerously high extent."

My translation:
Policy paralysis led to bureaucratic/political adhocism, encouraging corruption. India's unwashed masses have been satisfied through hand-outs in the form of subsidies for which there is no apparent way to fund.

The Government has raised minimum support prices for agri commodities at much higher rates than the rate of inflation. Along with free hand-outs (referred above), and forced lending to rural sector through compulsory priority sector lending, we are consuming well over what we save. Soon we will need China to fund us!

So far, I see no problems with the diagnosis. The problem starts now!

Rajan says: "We need a common minimum programme across all sensible political parties to ensure that we stabilise the economy and foreign investor perceptions quickly."

Here we have it. By implication, democracy in India is a problem. If you don't agree with policy wonks of the government, you are not "sensible", and foreign investors are more important than local.

In reality, democracy is good for the economy as are policy disagreements. Enough data exists to prove it. One example is that India's growth rate has gone UP significantly in the period since we have had coalitions ruling the country.

Additionally, most large Indian houses have been investing overseas (perhaps in quanta at least as large as inflows) over the past few years. That should cause policy makers to pause and see why domestic industry does not see the potential in India while we are supposed to invite foreigners.

Rajan goes on to suggest that by 2000's, "powerful elements of the political class which had never been fully convinced about giving up rents from the License Raj ..., had by then formed an unholy coalition with aggressive business people ..... The new post-License Raj equilibrium became the Resource Raj."

The statement is misleading seeming as it does to suggest that the unholy politician/industry alliance is new. When did India ever have a strategy to offer national resources in a transparent manner? It was always through licensing which is by its nature open to corruption. Only difference this time the scale of corruption is unprecedented under the current dispensation.

So what is the solution that Rajan prescribes? He says, "simply moving our millions from low productivity agriculture to rural industry or services will give us growth for years to come, provided we are willing to do the minimum necessary to collect the low hanging fruit."

How do we do this? "We need to liberalise sectors like education, retail and the press, freeing entry and improving customer choice. We need to transform more government-owned firms into well-managed publicly owned firms which are free from political influence or government support. And we need to evolve transparent means of pricing and allocating the bountiful natural resources in our country."

Get the connection? Huh? Well I don't too. How does letting foreign investment in the press, retail or higher education (he speaks of higher education, not primary, when he speaks of liberalisation somewhere else in the speech) help in increasing rural industry or services? Privatisation of government-owned companies has already been ruled out of the policy tool box of the current government and is unlikely to find its way back.

Unfortunately, the rest of the prescriptions too don't offer anything new: increase fuel prices (instead of curtailing wasteful government expenditure), find a policy for allocation of natural resources (non contestable except that no format has been suggested, so this is a motherhood statement and no more) and look out for foreign investors (I fail to see why it is not necessary to be kind to Indian investors as well).

So far, what one sees of the new CEA seems to be only old wine in new bottle. Worse, it does not seem to be based on fact or cogency of argument. Hopefully the reality will be better for India's economic future.

Thursday, August 9, 2012

A surreal experience


An early morning ballon flight over rose valley Cappadocia, Turkey. You can see from the colors of the mountains why it is so named. This is as close to gnome valley as one can get - have not seen this kind of landscape ever before. I broke my long-held self-imposed rule of never riding any vehicle or animal that did not have an ENGINE - can't say I have any regrets. Not going to make it a habit though - markets are behaving in an engine-less manner anyway.

Sunday, August 5, 2012

After 5 days in Istanbul, awaiting the flight to Cappadocia.

Istanbul is all it is made out to be - great historical monuments, wonderful energy, and a very modern outlook.

Watch out for weak air conditioning (even in the best hotels), and nasty taxi drivers.

Language is interesting - many common words with Hindi. Kofta, kebabs, shorba (I'm using hindi spellings, though the turkish words are the same with the same meaning). Shakkar(sugar) shakarpara are other examples. Dikkat (danger), and meydani (maidan) are close - and this is only a sample. The slave dynasty left more than a few monuments in India. 

Sunday, July 22, 2012

Latest market obsession - reforms post Presidential elections

Post the announcement that Pranab Mukherjee was standing down as the finance minister, the equity markets again started factoring in "reform initiatives" by the PM. That this would imply the PM's inability to push his senior colleagues to accept  his recommendations vis a vis their ministries, does not seem to bother the markets. In this context, Swaminathan Anklesaria's column

Don’t expect major reforms from Manmohan as FM


is worth a read.

For those interested in the context of the "reforms" initiated by Dr. Singh in 1991, the video below is a must-watch. Though it features the finance minister of the "other" side, it does give a ring side view of what the situation was in those days. When will the market participants learn? Being bullish is great, but ignoring history ensures that errors are repeated


Congratulations President Mukherjee

First, heartiest congratulations to Mr. Pranab Mukherjee on his appointment as the 13th President of India. Compared to the incumbent, whose nomination had raised many an eyebrow given the somewhat less than salubrious past of her immediate family, Mr Mukherjee's accession to the Presidency is likely to be welcomed by most.
 
I visited the website of the new President elect just a few moment ago. The link is below - but since it is likely to get updated (hopefully soon), I have cut and paste a small part of the right column. The election results are updated, so the site is live and the webmaster is awake. However, he seems to see no contradiction on sending a message thanking the electorate for their support - while continuing to request the electorate to vote for the Congress. 
 
Results
Shri Pranab Mukherjee has defeated his opponent by128252votes
We are immensely grateful to all the people who directly & indirectly supported us.
I hope that Pranab da will quickly forget that he was a part of the Congress over the past few decades - and accept the role of a President who represents the Constitution - and not some political affiliation. The President's post is meant to be above party affiliations. The President is NOT a member of any party. As chance would have it, one of India's most senior politician now occupies that post.

The Prime Minister's post on the other hand, IS the most important Political post in the executive - and is meant to be held by the most senior politician with the ability to lead his party to power in an election. Here, we have someone who has not won ANY election where the people have voted directly - nor would he have been able to win a party election if one were to be held.  Instead, he holds his position as a nominee. I hope, for the sake of India, that this changes quickly too. Jai Ho.

Sunday, June 24, 2012

Companies “guide” earnings – should you listen?!




One more earnings season closes with TV channels getting analysts and other talking heads to discuss earnings “hits and misses”. Companies that have delivered results better than “expectations” are immediately rewarded by higher share prices e.g SBI, while those that have disappointed are sold by investors e.g Infosys. Setting expectations – and then beating them - seems to have become essential strategy for a CFO/CEO seeking to maximise near-term shareholder value. What role does “management guidance” play and should companies seek to set investor expectations through frequent earnings guidance?

Forward looking statements and earning guidance
Forward looking statements are meant to help the investor community, especially analysts, take a considered view on the earnings outlook of a company. Earnings guidance is more specific – it usually relates to making a forecast of the EPS (earning per share) of the company.

The case for management making earnings forecasts is to lower information asymmetry – where a more informed investor is able to make better investment decisions as opposed to the lay investor. It is supposed to help lower stock price volatility because investors are more informed of the management’s view and can presumably invest with greater confidence – or so the theory goes.

The counter- argument is equally powerful. Paradoxically, frequent management guidance makes the investor community heavily dependent on management input. Variations in performance from stated targets leads to violent market reactions – making the stock price more, not less, volatile.

When combined with a company that tries to “game” the investor, by first guiding for a lower performance, and then delivering better, it leads to generation of “whisper number”. Much like a dog chasing its tail, it then becomes difficult to predict if the performance measure that the market is using as “benchmark” is the official (lower) forecast or the higher “whisper number”. In either case, the credibility of management guidance is suspect.   

Management Myopia
A research conducted in 2007 by Mei Cheng et al explains the problem through this interesting diagram below. Their conclusions are even more interesting – “dedicated guiders invest less in R&D, meet or beat analyst consensus forecasts more frequently and have significantly lower long-term RoA growth than occasional guiders.” They term this “myopic” managerial behaviour – sacrificing long term growth for the purpose of meeting short-term ones.

Endogenous nature of earnings guidance
 

Does management have predictive capability?
Another issue with guidance is the limited ability of management to be accurate. In my experience, I have seen three scenarios where management guidance is reliable:

The first scenario is where the industry outlook is so good that even mediocre companies are able to deliver high growth. The IT industry in the mid nineties is a case in point. Here, companies manage to beat guidance regularly, and, usually have a “buffer” of earnings which is carried forward to the next quarter. Predictable earnings growth quarter on quarter in a high-growth backdrop makes for very “prescient” managements. The crystal ball becomes a lot murkier when the industry becomes more competitive. In my view, Infosys currently suffers from this malaise.

The next scenario is when the company operates in a sector where product changes are slow, and consumer behaviour is the dominant variable. Fast moving consumer goods is a suitable example. Consumer behaviour for low involvement products changes slowly, and this reduces performance variability. As with all generalizations, this too is prone to challenge – the story of Hind Unilever vs Colgate, or Nirma vs HUL is too well known. But the exceptions prove the rule – when the road is straight, the rear view mirror can be used to drive the car – bar the accidents! And managements are great at looking at the rear-view.

The last scenario is when we deal with banks and financial institutions. Looking at the annual report of a bank always reminds me of a painting of Pablo Picasso! It’s what you imagine it to be. No other industry allows such creative accounting –the management’s ability to predict earnings 5 years out to the second decimal is a given!

In most cases, the ability of management or forecasters to spot a change of trend before it happens is almost non-existent. Crompton Greaves was projecting great exports to European countries well after the collapse of demand in these areas. In Apr 2011, World Steel Association (WSA) was predicting steel consumption in India to grow 13.3%. By Oct 2011, the estimate was lowered to 4.3%. WSA members produce 85% of the world steel output. The list is endless. In the current environment of extreme macro-economic volatility, this predictive capability is even lower.

Interpret guidance- use the data, ditch the prediction
The best use of a management commentary is to take note of the details. In between results, only the management can tell investors how the business is faring. Details on deals done, those underway, and the performance till the day can be informative to the investor. However, when it comes to making forecast, a dose of healthy scepticism coupled with an overarching macro viewpoint will be a more reliable aid.
Investors tend to believe that managements have some special insights on the business. While this may be true about technology, competition, and market dynamics – it rarely extends to a greater predictive capability. When it comes to the future, trust your own judgement. It has as much a chance of being correct as that of the management.

Friday, June 15, 2012

Forecasting Market Direction II

Second part of my column on forecasting market direction. The article is reproduced below.

The author takes a macro look at liquidity & interest rates, two key market direction components

In my previous column, I had discussed growth and valuation as two components of my four factor model for determining market direction over the medium term. In this column, I discuss the other two macro components – liquidity and interest rates, and how to tie up all the factors to estimate market direction.

Liquidity

Liquidity can be interpreted in various ways. In simple terms it determines the extent of mismatch between demand and supply of money. Since monetary authorities often attempt to “manage” liquidity through market operations, a market driven measure is difficult to find. We often have to do with proxies.

At a macro level, liquidity can be measured through money supply (called M3 by economists). As the graphs demonstrate, M3 as a forecaster of market direction worked well for most of the decade of 2000. Post 2008, the correlation between market direction and M3 apparently broke down – central bank interference has, since, become the norm.

Other measures of liquidity can be FII flows, the liquidity adjustment facility of the RBI or measures such as TED spread (price difference between three month futures on US treasuries, and the identical contract in Euro).

At the level of the market, liquidity is easier to measure. Volatility can be taken as a proxy – lower the volatility, higher the liquidity. Other measures include impact cost of trades (difference between the buying and selling price) or intra-day high-low of stock prices.

Whatever the measure, the impact is likely to be the same. Easing of liquidity conditions helps in taking the market up. The reverse is true when money becomes tight.

An interesting outcome of this is the impact on “mid-cap” or less-traded companies. Smaller companies usually trade at a valuation discount to the larger, well-traded companies. This often leads “value investors” to invest in these companies. While this may be a valid strategy for someone having an investment horizon exceeding 5 years, it can be painful for investors (or fund managers) who look for near term performance.

When liquidity dries up, the smaller companies are the first to feel the impact of tight liquidity and fall in stock prices of such companies is usually steeper than their larger (more liquid) counterparts. In other words, invest in mid-cap value only when liquidity conditions are benign, and are likely to remain so. Value investing can easily become a value trap for the unwary.

Interest rates

Interest rates are fundamental to valuing any asset – financial or real. At the heart of investing is the desire to earn a return that preserves or grows the value of money. Interest is the benchmark for measuring the effectiveness of any investment. Since the concept of interest is relatively simple, I will not attempt to explain it. However, I have often observed that most people do not realize that value of all investments fall when interest rates rise – equity, debt or real estate. A simple way to understand this is to see all assets as generators of cash flow – dividend, coupon rates or rent. We use present value of these cash-flows to measure the value of each investment and that uses interest in the denominator. In other words, unless the cash flow from investment increases when interest rates rise (for example, in the case of inflation adjusted bonds), asset prices will fall when rates rise.





Another point worth mentioning is that liquidity and interest rates do not need to move in the same direction, though they may. It is therefore necessary to examine each separately.

In the market, all interest rates are not equal. I had earlier referred to a study by the RBI where it postulated that inflation rate below 6 per cent may help growth while above it, it is likely to harm. Likewise, when interest rates rise above 7-8 per cent (from lower rates) impact on markets is more adverse. Increase in rate from say 4 to 5 per cent is less likely to impact. This is explained by the assumption that at lower levels, the differential interest rates can be passed on to consumers – without impacting corporate margins and therefore protecting (enhancing in nominal terms) the cash flow. However, higher rates meet consumer resistance forcing companies to absorb the rate increases with consequent lower margins. Likewise, on the way down, a drop from 8 to 7 per cent is more likely to have a positive impact than one from 10 to 9 per cent.

The last question to consider is what interest rate we are referring to. For the purpose of the stock market, we should look at the borrowing cost of companies. Since this varies from bank to bank and company to company, it is normal to consider the base rate of banks. Even simpler is to track the repo rate: the rate at which banks borrow from the reserve bank.

Putting it together

In the very short term, liquidity overwhelmingly determines the direction of the market – higher liquidity leads to higher market levels and vice versa. However, over the medium term, say 3 to 6 months, the dominant factor is the earnings and its growth. Higher growth will support higher levels. In a benign interest rate scenario, or one where interest rates are expected to fall, valuations will rise.

In all this, change in levels is more important than the level of each variable. However, when variables cross thresholds (for example, interest rates go beyond 8 per cent, or earnings rate falls below 15 per cent) the impact is greater.

In the current context, as we mentioned earlier, earnings growth is expected at 12 per cent (anaemic but better than last year: positive), interest rates may fall further (they are at the threshold of 8 per cent: a further cut can have a large upward impact on markets: positive). Liquidity is poor (M3 is falling: short term negative), but valuations (at around 13-14x: positive) are at the lower end of the 12x to 18x band. Downside in the market can therefore come from liquidity shocks. Otherwise, potential upside to downside risk is in favour of the equity investor. Buying dips may work well for the patient investor.

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