Gilt Fund Blues

On January 1, 2009 as I was reviewing my portfolio or, whatever is left of it, one asset class that looked attractive was Gilt Funds. In the Oct-Dec 2008 quarter when NAVs of equity funds went down in line with the stock markets, the Gilt Funds gave over 10 % return. Seeing that the inflation was coming down rapidly and RBI was making announcements about rate cuts, it appeared logical that bond prices would go up making Gilts attractive.

 Around the same time the banks were also reducing the deposit rates, I decided to invest in a Gilt Fund on Jan 1. Assuming Gilt Funds are steady, I did not look at the NAV regularly. Yesterday, when I looked at the investment I was shocked to see losses on my Gilt Fund investment. 12 % loss in a matter of 2 and a half months. Over 50% drop, if annualised.

A study of what could have been the possible reason, revealed this : I had invested in Gilt Fund at probably the lowest yield in January. Bloomberg says that ” The yield on the note has climbed 1.99 percentage points since reaching a record low of 4.85 percent in January.” Government borrowing is the main culprit. Bloomberg says that ” India plans to sell a record 2.61 trillion rupees ($50.3 billion) of bonds in the fiscal year ending March 31, an increase of 67 percent from the previous 12 months and 80 percent more than initially planned. Sales are estimated at 3.62 trillion rupees for the next fiscal year.”

Mumbai-based Raghavan, a primary dealer who underwrites government debt sales says “Yields should continue to rise in the near term.”

Understanding the yield curve and the factors which affect the bond prices is not as simple as I thought. I am humbled. I’ll continue to hold the Gilt Fund, with the hope that the fund will yield the coupon rate of GoI bonds – 8.25% over a two to three year term.

- G.Mohan

Riding a Tiger Called the Market Capitalization

The valuation of wealth of individuals and companies is no longer done by adding up the value of the physical assets like land, property, jewellery or even bank balance. The valuation is done on the basis of market capitalization. Market capitalization is a simple multiplication of the share price with the number of shares owned by the individual.Forbes prepares its annual lists of the wealthiest businessmen in the world on the basis of market cap of the shares owned by them. They simply ignore all the other assets, because they consider them insignificant in comparison to the market cap of shares. In 2007, four Indian businessmen figured in the top 10 list of world’s wealthiest individuals. In 2008, none of them figure. In fact, Anil Ambani has the dubious distinction of having lost the largest wealth in the world in 2008, about US $ 30 Bn. Thus when the stock prices are high, the wealth is high, when the markets are down, the wealth is low.  If businessmen and companies start basing their identity and targets to the market caps of their companies, they have begun riding a tiger. Market cap is based on the share prices and number of shares. To increase market cap, the share prices have to keep rising constantly and or keep issuing more number of shares. Using the fundamental analysis principles, the share price is a function of earnings per share (EPS) and P/E multiple. Whereas EPS is based on profits, P/E multiple is a function of the perception the investors have about the company’s growth prospects and future margins. In order to get a higher P/E multiple, companies and their managements make a lot of efforts to look progressive, transparent, growth oriented and put their best forward particularly with the analysts. If for some reason, they are unable to get a high P/E multiple with respect to the competitors, in order to keep their share price high, they have to get a higher EPS. Higher EPS is possible only if the business is generating higher profits. If the business is not generating higher profits, then EPS will be low. In effect, the share price will not go up or worse it will go down. That is the point at which, the top managements are faced with the temptation of artificially cooking up the profits, so as to jack up the EPS.  The dilemma is whether to report the EPS honestly and face the prospect of share price going down and thereby personal wealth going down or cook the balance sheets and increase the market cap.Several managements resort to this occasionally, with the hope that they will make it up in future quarters. Even the legendary Jack Welch of GE was accused of smoothening the earnings occasionally. The Chairman of Satyam, Ramalinga Raju.  when faced with such a dilemma, has confessed that he had chosen the path of cooking the balance sheets, not once or twice, but over several years. He mentions in his resignation letter that “It was like riding a tiger not knowing how to get down, without being eaten.”  Businessmen and companies focussing on market cap are like batsmen batting with the eye on the scoreboard rather than the ball. Instead if they focus on their core business and satisfy their customers, they will be better off in the long run. Distributed dividend from profits earned in the core business should be the source of real wealth. The virtual wealth generated by increase in share prices is too fickle and a factor on which the company or the management have very little control. Focussing on controlling this virtual wealth can lead to disasters like Satyam. Satyam might well be the most recent and the most talked about case, but is certainly not the only one who met with this fate, in trying to ride the tiger of market cap.   - G. Mohan

The Dhritarashtra Effect: Lessons from the Satyam-Maytas Fiasco

 

It is more than a week since Satyam announced the proposal to buy into Maytas Properties and Maytas Infra. It took back the proposal after the media and investor community expressed their outrage strongly.

 

 The episode continues to occupy the first page in the newspapers. The Chairman of Satyam, B Ramalinga Raju, must be wondering why despite the next reversal of the decision why the uproar has refused to die. Besides, the fall in reputation, it is hurting the promoters where it hurts most, the stock price. Since the day the Satyam-Maytas proposal was announced, the Satyam stock has fallen from Rs 232 to Rs 134.

 

Satyam is not the first company to merge unrelated businesses of promoters. In fact, even after the Satyam-Maytas episode, JP Associates has announced a large scale merger of several of its promoter companies in unrelated businesses to its public listed company. Yet, Satyam received more flak than the others.

 

Some lessons from the Satyam-Maytas episode are:

 

Ø Foreign Institutional Investors (FIIs), when they smell a rat, vote with their feet immediately. They do not care if it is a loss-making proposition. Immediately, on announcement Satyam ADR, tanked by 58% in NYSE

 

Ø Investors have their own understanding about synergies. The synergies between IT and infrastructure explained by Satyam management, was not bought by the analysts. Even if there was one, it was a complete communication failure. Analysts just could not dissociate the fact that the Maytas twins werecompanies owned by Mr. Raju’s sons companies.

 

Ø Even if the merger was perfectly legal and Satyam was not violating any law, investors have their own perception of what is correct. Even after Satyam backtracked, the stock lost value considerably. The management lost the trust of the shareholders, with this episode.

 

 

Ø A Public Limited Company cannot be treated like a Private Limited company, if promoters have minority stakes.

 

Ø Timing of merger announcements is also important. The same merger deal if it had been announced in December 2007 could have been hailed as a masterstroke. Real-estate and infrastructure were hot sectors then and IT was under rough weather because of the weakening dollar.

 

 

Ø Having a high-profile of Board does not ensure legitimization of such deals, which blatantly favour the family of the promoters. In case of Satyam, the board meeting was chaired by the ISB Dean Prof Rammohan Rao, and the Chairman was not present when the decision was being finalized.

 

Ø Shareholders definitely wish to know how the valuations were arrived at and who has carried out the valuation. Satyam vaguely said, one of the Big Four audit firms had done the Maytas properties valuation. Later each one of them denied individually. This certainly made the whole valuation exercise look dubious.

 

Ø If Satyam had clearly believed that it had synergies with Maytas, it should have stuck it out. By back-tracking immediately, without even convening another board meeting, Mr Raju, gave an impression, that he tried pulling off a fast one, and since it has been seen through, he backtracked. This even made a newspaper give the headline “Raju Ban Gaya Gentleman “, as if he was not one before.

 

Ø The impact of such a gross act of discretion by industry biggie like Satyam can hurt the entire sector (the Indian IT industry in this case).

 

Ø A high-profile board is no guarantee of higher standard of corporate governance

 

Interestingly, Mr. Raju’s fall from grace has a parallel in the Hindu epic – The Mahabharata. Dhritarashtra, otherwise the righteous patriarch of the ruling dynasty of the kingdom of Hastinapur suffered a lapse of his usual sense of propriety, blind sighted by indiscriminate affection for his progeny.  

 

Everything said and done, the hasty retreat notwithstanding, the synergy effect of the Satyam-Maytas (the latter name is formed of the same letters as those of Satyam, in reverse order, let’s say in negative order) deal is now apparent: Satyam + Maytas = 0.

 

- G. Mohan

Sudden Slump in the Steel Industry

The recently concluded Beijing Olympics in August was as much a showcase for China’s sporting abilities, as much as its emergence as an industrial superpower. It was hard to miss the steel structures used in the main Olympics stadium, Bird’s Nest. The Bird’s Nest might not have used more than a few thousand tons of steel, but with the closing ceremony of the Olympics, the light seems to have gone out in the steel industry.

 

The coincidence of the dip in steel demand and Olympics is not just a happenstance. China is by far the biggest producer of steel in the world. In the run-up to the Olympics, it was also a big consumer of steel. It took up huge infrastructure projects, whose completion coincided with the Beijing Olympics. One estimate puts China’s expenditure for Olympics at US $ 42 billion.

 

The sharp dip in demand for steel is reflected by various indicators. The price for steel has witnessed a sharp correction. Although, there is no official exchange for steel like LME for other metals, several newspaper reports indicate the price of steel has fallen by as much as 30-35% from Rs 45,000 per tonne to Rs 30-35,000 per tonne, since August. The Baltic Dry Index (a global indicator for shipping freight, for iron ore and other dry goods) has crashed by 90 % in the last 10 months. The crash in BDI has been attributed to the sharp fall in iron-ore imports by Chinese mills.

 

For the first time since 1981, there has been a decline in steel production in China. Over 85 blast furnaces have been closed down due to the demand slump. The iron ore mines in Goa and Bellary region of Karnataka, who made bumper profits exporting iron ore to China, are facing tough times now. NMDC, the public sector iron ore major, is largely unaffected by the demand slump, because it hardly exports iron ore in the spot trade to China.  

 

Economic Times has reported that over 35 sponge iron units in the Chhattisgarh region have stopped production, in recent months, because of the slump in demand and un-remunerative prices.

 

The steel majors in India. SAIL and Tata Steel reported good quarterly results for the quarter ending September’08. But their outlook is quite gloomy. SAIL has already announced its intention of going slow on its expansion plans by two years. Tata Steel has not made any formal announcement of deferring any of its expansion plans or greenfield projects. But if one extrapolates, the thinking in the Tata group, as expressed by the Group Chairman Ratan Tata is to put all acquisitions and capital expenditure on hold, one can interpret that Tata Steel would also be going slow on its expansions.

 

Global majors like Arcelor Mittal and Corus have reported 20-25% lower production targets, going forward. Arcelor Mittal has already indicated that its India plans will be on hold, until the industry outlook improves.

 

The bleak outlook for the steel industry is reflected in the sharp drop in the stock prices of all steel companies. Tata Steel stock is trading at Rs 165, a far cry from its 52 week high of over Rs 850. The SAIL stock is touching new lows everyday and it is currently trading at Rs 65. The ET Metal index has underperformed the broad-based index considerably in the last six months. The Price-earnings multiple is 3.1 for ET Metal Index against 11 for the broad-based ET 100.

 

My own take on the steel industry is that this slump may continue for a few months, as long as the global housing and automobile slowdown continue.

 

This is a good time to acquire stocks of steel companies like Tata Steel and SAIL in small packets. I prefer SAIL over Tata Steel, because it has no overhang of debt.

 

- G. Mohan

 

ICICI Bank’s Q2 Results: What Lies Behind

 

 Last month, ICICI Bank reported its results for the Q2 ended 30th September 2008.The Bank has been able to maintain its margins by reducing its operating expenses and increasing its share of  CASA  (Current Account and Savings Account) deposits . As CASA  deposits are low cost deposits, they are the darlings of all commercial banks. They reduce the banks’ cost of funds. On savings accounts, they pay a measly 3.5% now and on current accounts they pay no interest.

 

 

ICICI Bank claims to have grown CASA by 30 % over the same period last year How did they achieve this significant increase at a time when the fixed deposit rates were offering an attractive yield? 

 

 

A major shift in policy helped ICICI Bank to increase its CASA deposits. (Mind you, we’re talking about  the increase in deposits here, not the depositors). From July 1, 2008, it mandated all savings bank account holders to maintain a minimum balance of Rs 10,000 in place of Rs 5,000. This was not applicable for salary accounts and no-frill accounts. ICICI Bank sent out a letter to all its savings account holders informing the same and adding that they would levy a Rs 750 + Service Tax, should the accountholders failed to maintain a Quarterly Average Balance (QAB) of Rs 10,000. They also  suggested their customers that should they found the hike in QAB too steep, they were free to switch to a no-frill account with the bank or even close the account. The Rs 10,000 minimum balance is the highest among all banks ( including all public and private sector banks, except Kotak Mahindra Bank, which also requires a Rs 10,000 min QAB). One fails to understand why ICICI Bank is imposing a minimum balance  limit which is at least ten times that of a PSU bank for offering exactly the same range of services?

 

 

While the weeding out of non-remunerative savings accounts may incease operational profits, it may also surge the number of disgruntled customers. I suspect alienating such customers has contributed  to the current problems with perceptions that ICICI Bank seems to be grappling with.

- G. Mohan

Can We Just Fast-forward This Month Please?

This month of festivities (Diwali, Dussehra, Durga Puja, and Id) is bringing anything but cheers to Dalal Street. Not that bourses are faring any better elsewhere. In fact, October, particularly its third week, has ominous rings to it in the annals of Wall Street. Here is why:

 

• October 17, 1907:- The Panic of 1907 began. In this financial crisis the New York Stock Exchange fell close to 50 % from its peak the previous year. There were runs on numerous banks and trusts. This crisis led to the downfall of the Knickerbocker Trust Company – New York City’s third largest trust.
• October 24, 1929 – Black Thursday. The Great Crash of 1929. October 28 and October 29 were worse, leading to widespread panic and the onset of unprecedented consequences for the US. The collapse continued for a month. This led to the Great Depression.
• October 19, 1987- Black Monday. On this day, the Dow Jones fell 22.6 % and the S&P-500, 20.4%. Between Oct 14 -19, the market lost 31 percent. The recovery from this crash was relatively quick.
• October 27, 1997 – Mini-crash caused by the economic crisis in Asia,a.k.a, Asian Flu. On this day, the points lost by Dow Jones still ranks as the sixth in its 112 year existence. The crash halted trading in the NYSE for the first-time ever.

 

In India, on October 24 (Black Friday) 2008, the BSE Sensex shed 1070 points, i.e. it crashed by 10.6 %. In that week on the whole, BSE lost 2400 points.

 

How I wish we had no October in the Gregorian calendar!

 

- G. Mohan

Credit Card Dues Zoom: RBI

As per the latest report from the RBI, the credit card dues have zoomed 86% year-on-year to Rs 29,056 crore as on August 29, 2008. This is higher than the 49% growth recorded last year.

 

 

At a time, when interest rates on credit-card dues have been raised by most issuers to 3.5% per month, from 2.5-3.0% per month, a rise of 86 %  is disconcerting.

 

 

This alarming development could be due to some or all of the following reasons :

 

• The double-digit inflation coupled with the rise in EMI for housing and car loans, the middle class is unable to balance their household budgets, forcing them to spend on their credit-card.
• With stock markets going through a bearish phase since January this year, the day-traders have lost a source of income, forcing them to borrow money on their credit-card for their living expenses.
• With banks like ICICI going slow on unsecured personal loans and two-wheeler loans, it is possible that consumers are using the expensive credit cards to fund their consumer durable purchases

 

- G. Mohan

 

 

 

If Warren Buffet were to Pick Stocks in India Now …

 

Just when the stock markets were tanking all over the world, the Oracle of Omaha, Warren Buffett wrote a article published in the New York Times last Friday, urging people to invest in the equity market. He writes:

 

“I’ve been buying American stocks. Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

 

Chandrakant Sampat, who is often referred to as the Warren Buffett of India, goes by the following cardinal rules for picking stocks of the companies which 

 

• Are in a business that even fools can understand
• Have very little debt
• Have free cash flows
• Don’t have much capital expenditure, which is nothing but deferred cost
• Has a P/E ratio of 13 to 14 based on current year’s earnings
• Has a Dividend yield between 3.5 and 4.0 % 

These are classic rules of value investing for identifying companies which will give returns in times, good and bad. The high dividend yield criterion ensures that the companies give returns even in bear markets.  

Using Chandrakant Sampat’s stock-picking rules, barring the first one, I have created a shortlist of stocks which meet the following criteria: 

 

 

·        P/E ratio less than 13 times based on last year’s earnings (current year’s earnings data are not available easily)

·        Dividend Yield of around 3 %

·        Return on Capital Employed of atleast 25 %

·        Debt/ Equity ratio less than 0.25

·        Companies with market-capitalization higher than Rs. 1000 crore

 

 

Here are the eight stocks which clear all the above filters

 

·        Pfizer

·        Tata Consultancy Services

·        Monsanto India

·        Ambuja Cements

·        ACC

·        Indraprastha Gas

·        Biocon

·        Bharat Electronics Ltd

 

Here are the seven stocks which missed the filters narrowly.

 

·        Praj Industries

·        Voltas

·        Infosys

·        Alfa Laval

·        Opto Circuits

·        Gujarat Gas

·        Jindal Saw

 

 

Disclaimer: Readers are advised to look at company specific news and future earnings outlook before investing, as the above selection has been made on historical data only.

 

 

- G. Mohan

ULIP: Robbery in Broad Daylight

 

Unit Linked Insurance Plan (ULIP) is one of the most popular insurance products being pushed by the private life insurance companies. The attraction about the product is that it offers life cover in addition to providing attractive returns. In addition, investments in ULIP qualify for Income tax rebates.

 

Taken in by the triple-offer and the persuasion of a pesty agent, I took ULIP from Aviva Life Insurance in September 2003. It is a whole-life policy with a life cover for Rs 10 lakh. The annual premium is Rs 21,740. I took the option of investing in the growth fund, which means the units will be invested in the equity markets. In the second year, I opted for the indexation offer, by which the life cover was increased by 5% to Rs 10.50 lakh for a higher premium of Rs 22,828.

 

I have been paying my premiums regularly, as a matter of habit. I receive the policy statements from Aviva every year. I used to casually look at them and file them.

 

Now, after full five years, I have received the policy statement yesterday. After five years, I have paid Rs 1,13,052 as premium but the fund value stands at Rs 87,206 only. I was taken by surprise that even though the equity markets were doing fairly well, except for the last 8 months, the total fund value was much less than the total premiums paid.

 

Aviva claims that the fund is being managed well, as is reflected by the NAV. The NAV of the growth fund has gone up from Rs18.39 in Sept 2004 to Rs 27.21 in Sept 2008, a growth of 50 %.  By conventional logic, when NAV is going up, fund value should also go up. But why the fund value has been going down? I’ve discovered that every year, a significant number of units are being deducted from my account. The statement does not mention any expenditure head for deduction of units.

 

On study of the offer document, I learnt that in the first two years an initial management charge of 5 % was applicable. In the subsequent years an administration charge of Rs 55 per month and a regular management charge of 1% per annum on both initial and accumulation units was applicable.

 

When I realized that the amount being charged was much higher than the above, I thought of surrendering the policy and asked the company about the surrender value for the above policy. I was informed that I would get no more than Rs 30,000. An exit load of nearly 70%, is unheard of in any investment product. I felt trapped.

 

If instead, I had just bought a term insurance policy for Rs 10 lakh, I would have paid an annual premium of Rs 4000 only. For five years, I would have incurred Rs 20,000 as premium and I would have been left with Rs 93,052. If I had invested this amount regularly in a Systematic Investment Plan (SIP) with HDFC Sensex Plus  Fund (a diversified equity fund which invests largely in sensex stocks) , this amount would have become Rs 154,714. HDFC Sensex Plus SIP for the last five years have given a return of 17.6% p.a.  

 

I am convinced that ULIP is a rip-off. AVIVA is not alone. In Deccan Chronicle, Olga Tellis has reported that HDFC Standard Life and Bajaj Allianz charge over 60% as expenses in the first year under their ULIPs and do not disclose the same.

 

The offer documents of ULIPs lack transparency and do not have the requisite disclosures about the charges. The charges are far too high, in comparison with other comparable investment products like Mutual Funds and Bank Deposits. The high agency commissions and large marketing spends are being recovered in a clandestine manner by the insurance companies.

 

It is time the insurance regulator, IRDA, reins in these private insurance companies. In the meanwhile, individuals should stay clear of ULIPs. It is advisable to keep the life insurance needs, investment needs and tax-saving needs separate and handle them accordingly.

 

- G. Mohan

Systematic Investment Plan with a Timely Twist

 

Bharti-AXA, a new kid in the Mutual Fund block has come up with an innovation – Daily Systematic Investment Plan (SIP) as opposed to monthly SIPs offered by other MFs.

 

 Bharti-AXA allows the investor to invest as little as Rs. 300 per day in their equity fund. Investments of higher amounts in multiples of Rs. 100 too are allowed.

 

As the market is witnessing high volatility even within a single trading session, buying a small number of units everyday is a good idea. When the market is up, the number of units bought will be fewer and when the market is down, the number of units bought will be higher. This brings down the average cost of units. The main advantage of SIP is  that  Rupee Cost Averaging is being done on a daily basis instead of  monthly basis.

 

The macro-economic scenario is looking rather uncertain now. Even experts are not able to decide whether the market has bottomed out. Daily SIP looks like a smart idea to take gradual exposure in the equity markets.

 

As the Bharti-AXA is a newbie, their investment performance is unknown. It may be prudent to wait for the older schemes of top MFs to come up with daily SIPs.

 

- G. Mohan