Improving the odds in equity investing - I

Erudite books and articles on investing gloss over or ignore one of the most important investment rules - alignment of interest of the company managers/major shareholders with the minority shareholders. It is assumed that an independent board, shareholder activism, stock options to managers, or good old greed will ensure this. Not so.

First, let me give some examples of what I mean - and why this is not the same as "management quality". Till the early nineties, it was assumed that investing in multi-national corporations was a sure fire way to make money. Post liberalization (early 1990's), this changed. Dividends fell, splits reduced, and profit growth slowed. While this could partly be attributed to greater competition from domestic companies, it was largely because liberalization allowed the overseas (majority) shareholders alternate mechanisms to reward themselves at the expense of domestic shareholders. Unfair transfer pricing was regularly resorted to (foreign owned pharma companies are a prime example). As was the setting up of wholly owned subsidiaries (e.g. P&G) by the overseas parent to the detriment of the prospects of the listed company (the list of such companies is long and illustrious !). Clearly, the management quality had not changed, only the incentives had.

It does not even have to be the machinations of some evil, greedy "promoter" with his grubby fingers in the cookie jar. The Gujarat governments recent diktat to state owned enterprises to pay 30% of pre-tax profits to the government in the form of a donation (?!) is a case in point. Similarly, the Central governments' use of the state owned oil companies to subsidise consumers while paying absurdly high taxes, penalises the minority shareholder.

Strangely, high shareholding by the principal shareholder does not seem to generate alignment. This is particularly true when the company has assets (say land) which are not being priced at prevailing market value -  if the asset value (notwithstanding its current income generation) is more than the enterprise value. There is, almost invariably, an attempt by the principal shareholder to either take the asset out of the books of the public company, or to increase shareholding - usually through an merger with an over-valued, privately owned, company. Alembic and Cadilla have both tried/done this. 

Even if the majority shareholder does not try to "strip" the assets, the market will surprisingly refuse to recognise the value in the company - till there is a requirement to raise capital in such a company. All "holding" companies come in this category. Many tend to be illiquid - which is taken as a reason for the dis-interest of the market (or, it is the other way around?). Holding companies often trade at 60% discount to holding value, for long periods of time. Here, it is not in the interest of the principle shareholder to "unlock" value and therefore it will not happen. Minority shareholders can wait till their patience runs out, and the current holder sells to another unsuspecting soul in search for a "value" stock.  

On the other hand, an alignment of interest can work wonders. This, ofcourse, will not make a bad business good. Nor will it change the business profitability (though sometimes I have seen this magic happen). However, what it will do, is that it will increase the chances to make money when the going is good. Average businesses will deliver superior returns. Lets take a few examples:

United Breweries group has had a stranglehold on the liquor/beer business in India for decades. However, only when it became necessary to increase market capitalization to (a) ward off the threat of take-over by overseas corporates (b) raise capital for acquisition, and di-worsification (I borrow from Peter Lynch) - that a group restructuring was initiated and the stock price multiplied. 

State owned company shares move up as soon as the government announces a dis-investment program. Logically, an increase in supply of stock, without any change in the outlook of the company, should have the reverse effect.

Decoding managment motivations is perhaps as important as poring over the notes to accounts.

Satyam's Shenanigans and related issues

Its been said that truth is stranger than fiction. Satyam Computer demonstrated it aptly this week - first, announcing the purchase of a company owned by a relative of its promoters, and then, withdrawing the proposal in the face of a falling share price. Several issues emerge - not the least, one of corporate governance.

The presence of external directors is supposed to mean that minority shareholder interest will be looked after. When you have as an independent Board Member, Prof Palepu of Harward Business School, who claims to research "corporate governance" and has, to his credit, a presentation made to Nasscom on "How to make corporate board more effective", you expect that some basic application of mind would take place. As events proved, you would be wrong.

Another worthy, Mr. T R. Prasad, a former Cabinet Secretary to the Government of India, the highest post a bureaucrat can reach in India, and another independent director had this to say “Even your uncle will not sell you the land at the price Maytas was selling it to Satyam". This, post the protest that shareholders registered at the conference call announcing the deal. Clearly, providence has awarded the man a particularly nasty set of uncles. It may be worth checking if he too had bought land along with Maytas and was therefore miffed if the transfer value eroded the value of this investment.

This well written article raises many pertinent questions. Not least, one of conflict of interest of the nature that required audit firms and consulting companies to be different entities in the US. When Prof Palepu generates close to $200,000 as revenues from Satyam, one cannot truely expect that he will be fair to minority shareholders. So is there just cause for a class action suit? After all, Satyam is a US listed entity !

Another, albiet somewhat peripheral point I would make is, that once again, it proves that education is no guarantee for integrity - a point most forget when we plead for "educated" politician. The most academically qualified PM currently runs the country, and has had the ignominy of presiding over an alleged case of cash-for-votes while facing a no-confidence motion. Human values and education qualifications do not have a high correlation!

But is it all the fault of the company, or are investors to blame for mixed signals? If corporate governance was such a big requirement for stock price performance, how do you explain that the highest "wealth generator" (where the criteria is market cap increase) for the past few years has been Reliance - not perhaps the epitome of corporate governance.

If the objection was to unrelated diversification, not too long ago, we had analysts suggesting that Unitech would "unlock value" by setting up a JV for its telecom business. Why on earth was the Unitech stock not hammered for attempting to get into telecom in the first place? It fell sharply only when it got into a liquidity crunch. If it is okay for a real estate company to attempt a telecom business foray, what is wrong with an IT services company getting into real estate - that too, when the promoters of the IT company are, incidentally, in the IT business, and their roots are in the construction business?

So is not corporate governance, and not unrelated diversification. It is really that Satyam's proposal would take out the cash from the company and give it to the promoters (largely). The mistake the company made was that they should have proposed a merger / share swap rather than a sale of shares. Maytas Infra share price had actually risen 15% between July to Nov 2008 when peer group shares fell 60% or more. Would this have been enough to satisfy promoter greed? As it turned out, clearly not. But I wonder if a merger would have generated significantly lower heat and dust.

Lastly, how have the institutional investors (and the investor in their funds) benefited. The deal has fallen through, but the stock price is down 25%. And the company is now suggesting a buy-back, while all analysts have changed their ratings to a "Sell". In the end, the promoters would have increased their stake (by reducing the outstanding shares through a buy-back) at a significantly lower cost than that prevailing a week ago. A few weeks later, once the dust has settled, this issue too will be forgotten. Who is the loser in this - it does not appear to be the promoter group. They should pay some royalty to Pakistan for stealing this terror of an idea!

Common man, uncommon expectations

Rab ne bana de jodi – Aditya Chopra latest directorial venture, is the story of a “common man”, a Clarke Kent, who seeks to induce his wife-by-accident to love him. In the process, he creates a persona of a boisterous and flashy, yet sensitive, Raj who almost wins his wife’s heart – but loses out in the end.

Aside from an excruciating three hour length, gaping improbabilities in the plot (a moustache can hide the identity of a man from the woman he lives with?!) and a Shahrukh Khan who thinks that an “ordinary man” has drooping shoulders and simpers, the story throws up an interesting view point. 

If Sahni – the “ordinary man” has it in him to be dashing, and amusing, why does he go through life as a repressed soul. Indeed, why is it important that the girl love his boring personality and ignore the advances of his attractive alter ego?

Some years back, I had the opportunity to consult with Mrs Rama Bijapurkar – a leading marketing consultant. We were, at the time, doing some research on the economics of film making and I asked Mrs Bijapurkar if it were possible to use market forecasting tools to select a script for a movie. Her insight, which I think is extremely meaningful, was that successful movies were a lead indicator to consumer behaviour and could be used to forecast shifts in consumer preferences – and not the other way around.

If RNBDJ – the alphabet soup the movie name resolves to – becomes successful, is there a message in it for marketers and society? That too a perverse one – that hard working, ordinary people, had best retain their anonymity. That aspiring for greater success and recognition is best left to others – perhaps even a hint, that with a bit of piety thrown in, you may even achieve the “impossible” – in the movie, the love of the protagonist’s otherwise uneventful life – if you do not aspire for more?

Over the weekend, the newpapers carried articles suggesting that Mr Ratan Tata was annoyed that a police officer who had risked his life for 6 hours in the Taj while waiting for the commandos to arrive, had released a CCTV recording to the media which showed him in action. Usually, most societies celebrate bravery. More so, when a poorly armed officer faced up to the challenge of heavily armed and well trained terrorists – and risked his life in the process. If it were a set-up, or the action pre-meditated, one could understand the reason for displeasure. With neither being the case, what can be the reason for feeling that the recording was “misused”? Though I am perhaps being uncharitable here – does it reflect the bias of society leaders that an “ordinary man” has attempted to reach beyond his station in life. It appears that stories of extraordinary courage of ordinary people, can be celebrated only in death, and if still alive, such persons should rapidly recede back into anonymity. Life imitating art?

 

Why does Reliance need money?

Recent news reports of Reliance Industries (RIL) seeking to raise money are puzzling. Especially the quantum - in excess of Rs15,000 crs ($3bn). The report points out that Crisil, the rating agency that rates these bonds, has justified a AAA rating because it claims that RIL has Rs22,600crs of net cash accrual. - 44% of the net debt of RIL, and an interest cover of 22.

The petrochem cycle is currently down, as are the refining margins that RIL must be making. However, to require such a massive raising of capital indicates a financial requirement far in excess of what the known capex of the company indicates.

Other reports are telling : The Central Government has withdrawn its affidavit in the case of RIL-RNRL, which will now allow a settlement to proceed between the two companies. The Oil ministry is contemplating a move to float the market price of petrol and diesel - a laudable objective in general, but completely counter-trend in pre-election behaviour. Incidentally, both these moves will be beneficial to RIL - which is reflected in the recent share price upmove.

So what explains the capital raising? Given the sharp fall in crude price over the past couple of months, inventory losses may be a possible explanation. However, normal operations will not result in losses to require the scale of capital raising. Possible scenarios are (a) the scale of inventory losses are huge - suggesting speculative trading (b) the cost of development of the KG basin has suddenly gone up - which is either great news (more gas has been found), or terrible news (the project cost has inexplicably gone up), (c) the retail plans of RIL have been put on the fast track

Take your pick.

Public - Private partnership - what happened to private risk taking?

The US Senate refused to bail out the US car manufacturers. Closer home, as if on cue, the demand for government guarantees for infrastructure projects seems to be rising. On a show on a business channel last evening, I was asked to comment on whether the government should provide such support, in the context of the increasing difficulty in reaching financial closure for long gestation, and low return infrastructure projects. A similar demand was voiced by the Chairman of one of India's largest construction companies a few days ago on a rival channel.

Lets look at the merit of case - long gestation infrastructure projects are currently difficult to finance because lenders - predominantly bankers - see them as risky. The risk for road projects for example - arises either out of estimation of "tollable" traffic, or the duration of loan - typically in excess of 20 years. Government guarantees will doubtless make these projects bankable. The question then is "what is the role of the private sector?"

To me, it appears that once again, the private sector wants to pass on legitimate commercial risk to the public while keeping the profits involved in the construction of the project in private hands! The moot point is, why should the public sector not do it all itself? Which brings us back to a government controlled "planned" economy - a model which was supposedly given up for dead just a few months back.

The logical work-around would be to look at measure to develop a vibrant and functioning debt market, which India sorely lacks. Simultaneously, we need to develop a long term bond market to allow intermediaries to match tenure risk. There are several studies which point to the steps that need to be taken in this regard - which I will discuss in another post. What we definitely do not need is another form of crony capitalism!

Defamation of Religion... huh???

While browsing the net in search of coverage and viewpoints on the Mumbai attacks, I came across a concept I had never heard of before - that of "Defamation of Religion". It all started when I stumbled across the views of an American lawyer with regard to a UN (no less..) committee which has apparently recommended that the General Assembly adopt this. Initially, I thought this was some sort of scam, not the Orwellian piece of legislation it seems to be. However, people, this is very much a reality. Incidentally, India abstained ! The reason, given before the vote was :

"the representative of India said his delegation condemned any attempts to associate Islam, which was a peaceful religion like any other, with terrorism and violence. India also stood against negative stereotyping of any religion. But it was nevertheless concerned that the text under consideration spoke about only one religion, when in fact, all religions faced similar problems."

Here is another view on this.

Problems of being "close to the ground"

How many times as an analyst, I have seen business leaders in a state of denial. The steel sector was a beautiful case in point in the current year. While the world economy was going in a tail spin, steel magnates kept insisting that prices would not fall "because raw material prices were up". It never ceases to amaze me how many times even very senior and experienced managers will talk in this way - almost as if someone has mandated that their business should make money, and therefore cost escalation will always be absorbed by their customers. I see this as a problem of being too close to the day to day business of the company. This creates a myopic vision - where anyone with a 50,000 feet view will tell you that a business decision is silly, while the "expert" who lives and breathes the business, will continue to justify his following the most recent trend. My conclusion - speak to corporates to understand their business model and the current business situation, but DO NOT make the mistake of assuming that they have the ability to forecast beyond the next week. The analyst ought to know more! (which is also the reason of the existence of the likes of Mckinsey and other strategy consultants).

We see this now in the response to the recent Mumbai terror attacks. Most "experts" are focused on providing guns and armour to the domestic police force. As if this would in anyway reduce or protect India from these attacks - the problem is external and will remain so. Body armour for all police will come at a cost of medicine, school education or such alternate use of money - a problem we do not wish to address. Luckily, no one in India asks for where budgetary provisions will come from. I find that even responsible journalists with demonstrably developed strategic sense get into this loop.

Vardarajan, of The Hindu, someone whose coverage of the noxious India US nuclear deal was exemplary, seems to have fallen in this trap - excerpts from his recent post

The Pakistani Army would very much like a military crisis on the border with India because that would relieve the pressures it was facing on the Afghan front. “Our dilemma is that we don’t want to play their game — we want them to continue being engaged in the fight against terrorism in the west because that’s also our war. But we can’t give them a pass either. The perpetrators have to be fixed.”

It was because of this complexity, the sources added, that India’s public response has been very limited.

This has to rank amongst the most hilarious justification of pussilanimity anywhere - the bully has just slapped me, but you know he is also doing that to a few others, so we should not distract him.

What can I say - I guess I am a war monger and not to be taken seriously!

Pakistan's dodge seem to be working

Yet again it seems that India is going to miss the wood for the trees. I am watching a vocal but to my mind, meaningless debate, on TV on whether we should free up some police personnel from guarding politicians and move them to guarding train stations.

What happened to the need to take action against Pakistan?

Any strategy novice will realise that the ISI has just executed a fantastically planned and timed operation.

The situation was slipping : the Kashmir election was proving a great success, with more than 60% voter turnout. The LeT was losing morale, and the Pak army was being forced by the US to fight against their kin in the Al Queda.

At one go, the tables have turned. India is seething, but a toothless PM is not in a position to respond. Elections are round the corner, and with the ruling party on the back foot, the willingness to go on the offensive is low. The typical response of the Indian leadership is to "put Pak on the mat" by offering proof to the US authorities of Pak's involvement and hope that the US will force Pak to take action. Unfortunately, it misses the point completely. The USA is NOT going to do anything for India, only what is in its own interest. They have only partially de-hyphenated India-Pak relations. Incident such as the mumbai attacks help to strengthen this hyphenation to the detriment of India. The US Secretary of States statements in her visit to India, and subsequently Pak, make this clear to any but the blind. Zardari threatened to pull troops from the Afghan border, and that was enough for the USA to stop its sabre rattling.

India is therefore left with some exhortations to act "responsibly". The Pak government is busily repeating the line that our beloved PM gave them - that Pak is also a victim of terrorism - and therefore cannot be blamed for the attack.

So what happens next - we act "responsibly", do nothing and wait for the next attack. Musharraf has gone so far as to suggest that India should be sympathetic towards Pakistan, should appreciate the problems of Pakistan!

So is there an alternate plan?

There are some key issues we need to understand:
1. A country like India with a long border and unfriendly/non-cooperative neighours cannot be converted into a fortress. The only way to defend its citizens is to ensure that the cost of attack is unacceptably high for its enemies. This means that ALL attacks MUST be met with overwhelming force as a response
2. Pakistan, in its current political form and geography, is not going to allow peace with India. As has been pointed out in one of the article I have earlier bookmarked, the economic power (70% of market cap) and the military power (the N-bomb) is in the control of the Pak army, NOT its civilian government. We cannot therefore deal with the Pak govt. as if they are driven by the same factors as a govt. in India. They are powerless to decide anything. The Army, on the other hand, derives its power from its unceasing animosity towards India.
3. The Indian government has to tune its foreign policy and its list of "friends" to suit its own needs, not that of others. If that means that some are upset, so be it.

Once these are accepted, the only clear path is to figure out a way to put pressure on Pakistan to clean up its act. This requires a two pronged approach.
1. Economic - India needs to impose an unacceptable economic cost on Pakistan of continuing its proxy war. Ideally, this can be in the form of UN sanctions. However, given the presence of China in the UN Security Council, such a resolution cannot be passed. The next alternative is to try and enforce and economic blockade by itself. An interesting suggestion made in an article I read on this subject, was that India should insist on all products carrying a notice that they werre being made by a company having associates operating in Pakistan, and then build Indian public opinion to boycott those goods. The idea was that this may force these companies to withdraw from Pakistan rather than give up the Indian market, and this would put enormous pressure on the Pak industry. I am not sure how much this would effect Pakistan, but it is definitely an interesting idea.
2. Military - here the options are few. The first would be to take out the terrorist camps through air strikes and commando operations. The next would be a bigger operation - barricade the sea route to the Pakistan ports, and involve Israel and US - the first to help with taking out the nuclear assets of the Pak army, and the latter to help with the intelligence. (Why should they help - we are solving their problem as well, and are supplying the foot soldiers. Otherwise, the nuclear deal with the US need not be activated i.e we do not buy their military hardware). The second step would be to move in physically, and divide the country into Baluchistan, NWFP and Punjab-Sindh. The exit option would be to dismantle the financing structures of the ISI and then allow elections etc.

If either of these seem to radical, then we should hunker down and prepare for the next bomb blast - because that is what we will get.

US Economy - Doomsday voices become louder

A friend pointed me to an interview of Gerald Celente in FoxBusiness.com - where he predicts that the USA would face problems of tax, homelessness, and low consumer demand over the next 4 years. A bit of googling revealed that Gerald Celente is a Futurist with a seemingly high strike rate of forecasting major trends. He runs Trends Research Institute. The video is worth a watch.

Others too are worried - in varying degrees. Paul Krugman worries about the next year , while other feel that that the present monetary system is suspect.

Not pleasant reading going into the weekend. In India, we will get a "fiscal stimulus" package from the new FM this weekend - around noon tomorrow. Today's market action of a 2.5% drop seems to suggest that traders have already decided that the measures to be announced will be inadequate. Retail price for petrol and diesel has been dropped from midnight today.... the bad news does not stop for the oil marketing companies.

The power of alternate media

At last some voices offering a view not heard on the loud-but-unthinking english TV channels. I was forwarded this write up by a friend. Thanks Ashok.

Hotel Taj : icon of whose India ?

Bhanu Pratap Mehta's Managing the Rage in the Indian express offers a sensible approach for India to up the ante on Pak. While all the media debate focuses on how we can improve security in India, it is time we got to the "root cause" (to borrow a term from the Pakistanis) - i.e. how to resolve the threat from Pakistan

Lunch over.. need to go back to work !

Not for the BHL's

Despite almost a week elapsing, the events in Mumbai do not seem to have triggered serious, publicly available analysis from the people who should know their job - the defence and strategic affairs analysts. Read Strategic motivations for the Mumbai attack by George Friedman of Stratfor for a view which expounds in detail what I had hinted at in my earlier post The cost of Attack.

In It’s time Pakistan got slammed for harbouring terrorists R Vaidyanathan of IIM Bangalore advocates a response that I symphatise with, but its not for bleeding heart liberals (BHL's) as he says !

ZIRP and QE

At last a post from me on matters related to economics - but on a subject I claim no expertise on - the US markets. I follow the time honoured principle of research - what is copied from one source is plagiarism, from many sources, is research.

So here goes:
A primer on quantative easing and inflationary expectations
The mystery behind how "helicopter Ben" got his name

If this confuses you on whether we are headed for deflation or inflation, well, join the gang!

A "must view" for Pak Apologists

A popular (hate the thought !) English language TV news channel of India had, on its show this evening, an actress of yester years suggesting that the Indian public should not accuse Pakistan for its action (or inaction depending on the camp you belong to) vis a vis the recent terrorist action in Mumbai. Below is a link purporting to be a telecast of a Pak TV news channel. Do watch to figure out how far we are in our thinking as neighbours!

http://in.youtube.com/watch?v=5F4_qwtM5yY

Post-nuclear deal - can we use USA help

The rebuff that the government of Pak and India received from the Pak Army establishment on the demand to send the ISI chief to India, has presumably gotten the US secretary of state to head towards India to cool tempers. Unfortunately, at present there seems to be no tempers to cool - atleast among the political leadership.

India is at present in a position to demand the highest possible help from the USA in terms of both, equipment and intelligence to plan its rejoinder to the ISI threat. Bruce Reidel, the incoming President's South Asia advisor is no sympathiser of Pakistan. However, the ability of the currently, leaden-feet leadership of the India to turn this to India's advantage is in doubt.

If ever there was a need for a popularly elected (not nominated) political leadership in India, it is NOW.

Yet another instance of shirking a tough job

The hapless home minister had to make way for his handling of the security situation. Completely ignoring the concept of collective responsibility, the PM let the home minister go, as if the man had made some policies on his own. When it came to reallocating the tough portfolio, the PM chose to hand it to Chidambaram.

The key ability of a leader is to be able to lead from the front. At the current moment, the most important need was to provide the country and the security apparatus, a clear and focused direction, with authority flowing from the highest political office - that of the PM. Instead, the PM, yet again, elected to hide behind his colleagues and revert to a job which he is comfortable with - that of the FM !

Just goes to show that there is a difference between a leader and a bureaucrat !