Reliability of the Most Reliabale

Any research, analysis or even a commentary on the economy draws heavily on the macro-economic data.  When it comes to data, analysts all over the world unanimously agree that the most reliable data source is the Government.  They just accept the data provided by the government without even the slightest doubt on its reliability.  The data released by governments has various roles to play.  (a) It indicates the direction and momentum of the economy, which has great influence on the confidence levels of business enterprises; (b) It acts as guiding tool for attracting both domestic and foreign capital; (c) It influences the decisions of Foreign as well as Domestic Institutional Investors, and (d) It sends signals to the financial markets, taking them to new levels.  Such is the importance of data provided by the government, that many people eagerly wait for the release of the most recent data.  Now let us look at some recent headlines:

(a) Govt Admits Subsidy Math has Gone Awry (Economic Times, 8 Dec)
(b) $9B Goof-up in Export Numbers, Admits Govt (Economic Times, 10 Dec)
(c) Export Nos. Gaffe Adds $7.2B Headache to Govt (Economic Times, 15 Dec)
(d) Rangarajan Spots Sampling Errors in IIP Data (The Hindu, 21 Dec)

The first one is an error of forecasting, where the subsidy bill has overshot the budget estimates by a huge margin.  This is very much possible and does happen at times.  But the last three are calculation/estimation errors.  In the second case, "computer and human errors overstated India's export figures", says the report.  It gives further reasons as "wrong data entry, double counting of certain items and computer malfunction".  The difference was to the tune of $8.8Billion.  Within 5 days of revising the export numbers downwards, the government got the next shock.  The export data compiled by RBI for 2011-12 exceeded the government estimates by $7.2Billion.  The RBI data is considered to be more reliable as it is based on the actual payments received.  Then came the big announcement of IIP's contraction by 5.1% during October 2011.  This sent shock waves among the business fraternity and the financial markets alike.  And today, Dr. Rangarajan, Chairperson of the Prime Minister's Economic Advisory Council spots sampling errors in the IIP numbers for Oct 2011.  He had expressed his shock and disbelief when the IIP numbers were released last week.

If one were to make any conclusion on the conditions of the economy based on the data released by the government, the data needs to be compiled properly and computed scientifically without errors.  With the advent of advanced computing technology, we have increased the frequency of reporting by shrinking the reporting interval.  In some cases, this type of increased frequency in reporting can only create unwanted panic in the market.  It looks like a doctor monitoring the temperature of his patient every 15 minutes and reporting the same to the patient.  It only adds to his panic, especially when the news is not good.  What is worse is that the doctors is using a flawed thermometer! 

Series on Financial Markets - V

Continuing with the discussion on raising capital by business entities, unlike what I mentioned in my earlier post, capital can also be raised directly from the savers.  Small businesses borrow money from the friends/relatives of the promoter directly; whereas large corporate houses raise money from public at large.  (There are various reasons why businesses do not fully depend on banks and financial institutions for capital, which is not explained here).  A business enterprise can raise capital in the form of debt or equity (ownership).  When an enterprise raises capital directly from the public, it is said to be raising the money from the 'Primary Market'.  Unlike many other forms of market, primary market is a notional one, with no specific location or office.  However, this market is regulated by the government through appropriate regulatory bodies.

Since there is no specific location; and savers, who would be interested in supplying capital to the firm are geographically scattered throughout the country, the firm has to put in place a complete system to reach the prospective suppliers of capital.  It resorts to the following processes and depends on the respective intermediaries in the process.
(a) Obtaining regulatory approvals (wherever required)
(b) Releasing advertisement inviting public to subscribe to the bonds/shares
(c) Preparing and printing prospectus containing various details of the issue
(d) Printing application forms
(e) Approaching brokers/sub-brokers to promote the issue
(f) Appointing registrars to manage the issue
(g) Appointing bankers to collect the payment etc.

Thus, as against loan from a bank or financial institution, the process of raising capital directly from the public involves lot of money (spent on the above activities) and it is time consuming.  Then why do businesses raise capital directly from public?

Series on Financial Markets - IV

Let us now understand the role of Financial Institutions in an economy.  These institutions act as intermediaries between the suppliers of capital and those in need of it.  It is always possible for the business enterprises to raise capital directly from the individuals who have surplus money.  But there are few problems:
(a) many individuals may have only small amounts of money as surplus
(b) the individual investors do not have the expertise to analyse the business that the firm is engaged in
(c) the individuals find it difficult to understand and assume the risks involved
(d) there is a question of credibility as the business enterprise may cheat the investors

This is where the role financial institutions becomes relevant.  Lets take commercial banks for example.  Banks collect small as well as large amounts of money from those who are willing to invest their surplus, make a big pool of money, which is then used for lending to business enterprises or individuals placing demand for money.  Thus the surplus money that would have directly flowed from the investors to the firm, now takes a detour through the bank.  This solves most of the above concerns.  Lets see how:
(a) individuals can deposit even small amounts as banks pool the funds
(b) banks have the expertise to analyse the business projects
(c) banks can reduce the risk of lending as they lend to many enterprises and thus diversify the risk
(d) banks are regulated by the government which brings in credibility (though not all banks share the same credibility and risk)

Similarly, the financial institutions like insurance companies, mutual funds, pension funds etc. act as financial intermediaries.  They are all regulated, though the extent of regulation differs.  The process of financial institutions bringing suppliers and users of funds together is known as 'Financial Inter-mediation'.  

Inflation, Interest Rates & Growth

Based on Sushma's comment on an earlier post, I thought of elaborating on the relationship between the three basic economic measures - inflation, interest rates and growth rate.  Inflation, as everyone knows, is the rise in prices of goods and services.  There are various factors contributing to inflation, and one among them is the excess supply of money in the economy.  Central banks (RBI in our case) use 'Monetary Policy' to control money supply and thus inflation.  In order to control money supply, RBI can resort to one of (or all of) the following actions: (a) open market operation, where it sells bonds and thus absorbs money from the market; (b) increase in interest rates (the rate at which it lends to banks), thus making the borrowings costlier for banks; and (c) increase in reserve requirements (percentage of deposits the banks are required to maintain with RBI), which leaves lower amounts of loanable funds with banks.  In all the above cases, the excess liquidity is sucked by RBI in order to reduce the inflation.

When banks are asked to pay higher interest while borrowing from RBI and are left with lesser amounts of loanable funds, they start charging higher interest rates on their loans.  This makes bank loans costlier.  On one side the individuals will borrow less amounts of money and thus reduce their demand for goods and services; whereas on the other side, with higher interest rates, they would start investing more in banks/govt bonds etc. 

But every economic action has a flip side.  When the central bank tries to control inflatilon, beyond a point, through tight monetary policy, demand for goods and services comes down heavily as the loans become unaffordable.  For example, when the interest rates are high, demand for housing comes down.  On the other hand, the industry will put its expansion plans on hold as the borrowed capital becomes costlier.  This reduces the overall economic activity of production of goods and services and thus the growth rate of the economy (measured in terms of GDP growth) slides down.  So, beyond a point, you control inflation by compromisng the growth!

IPO Pricing - A Big Puzzle!

Unlike many other products and services, pricing of IPOs is very tricky.  Our age-old Economic theory says that the best price emerges when demand and supply factors are allowed to freely interact.  With all market imperfections, interaction of demand and supply forces determine price in case of most of the products and services.  But when it comes to IPO pricing, what is being sold is not a product or service; but a portion of the ownership of an enterprise.  Thus, the price depends on the value of the enterprise at large.  A fair pricing of IPO is important as the under-pricing deprives capital to the issuer and over-pricing misleads the investor.  There are three popular methods of determining the price at which shares are to be offered by a company.  They are (a) fixed price; (b) book-building and (c) auction.

Until 1999, IPOs were made through fixed price offers in India.  Here, the issuing company, in consultation with its investment banker, decides the price at which the shares are to be issued.  The price and the quantity of shares offered are announced and the investors are asked to apply for the number of shares they would like to buy.  The inherent problem of this method was, 'how could the issuer decide the price?'  In most of the cases, there were huge under-pricing as the issuer, for the fear of the issue failing, was forced to price the shares below its actual value.  (I am ignoring huge over-pricing of issues by few promoters with an intention to cheat investors).  Our basic theory was compromised here as the demand side factors were not given participation in the process of pricing.

In 1999, Hughes Software became the first company in India to make IPO through the book-building route.  Here the issuer, again in consultation with the investment banker, announces a range of price (with a band of 20% or so).  The investors are asked to bid for shares with prices within the range.  The issue price is decided by considering the demand extracted through the bids.  Once the price is determined, all investors who submitted bids for the issue price and above are allotted shares at the issue price.  Here the demand side gets participation in the process of pricing in a limited manner as the price range is fixed by the issuer.

The third method, an auction, allows greater interaction between the demand and supply forces.  It can be a French Auction (tried by REC and NTPC last year) where the floor price is fixed and the bidders are asked to bid at floor price or above.  Or, it can be a Dutch Auction (not prevalent in India, but tried by companies like Google in USA), where the issuer fixes an extremely high price and asks the bidders to bid at lower prices.

Though lot of empirical research has been done on which method of pricing is the most suitable in terms of fair valuation, no conclusive evidence has emerged.  Thus pricing of IPOs remains a big puzzle.

Series on Financial Markets - III

The first post in this series emphasized the significance of transfer of money from the savers (investors) to the borrowers and the second one talked about various instruments (financial assets) available for such transfer.  Now let us look at the system that facilitates the interaction between the two groups.  An economy is divided into three sectors: (a) household sector, comprising of individuals; (b) business sector, comprising of various business enterprises and (c) the government.  Each of these sectors constitute entities who save as well as borrow.  For example some individuals save whereas some others borrow.  Same is the case with business units and the government.  So lending (same as saving) and borrowing happens among the three sectors as well as within the three sectors.  However, household sector is almost always net saver (with savings exceeding the borrowing) and the government almost always net borrower.

In order to have smooth interaction between the lenders and the borrowers, the following becomes necessary:
(a) proper instruments to facilitate the interaction
(b) a platform for them to interact, and
(c) well-defined rules and regulations

We have already discussed about the instruments (financial assets).  Financial markets and various financial institutions provide the platform for interaction among the lenders and borrowers.  Financial markets can be divided into primary market and secondary market.  Financial institutions take various forms like commercial banks, insurance firms, mutual funds etc.  Various regulators like RBI, SEBI, FMC, IRDA etc. are involved in  framing rules and regulations and ensuring their implementation.  Thus the system comprising of financial markets, financial institutions and regulators is known as 'The Financial System'.  Every country has its own financial system, even though the level of development of these systems differ from country to country.  In the absence of a well-developed financial system, the basic economic process of capital formation becomes constrained.  

IPO & Retail Investors

A recent issue of The Financial Express (08-11-2011) reported that SEBI is about to constitute a committee to review various aspects relating to improvement of the Primary market for stocks in the country.  The major issues of concern are (a) bringing back the retail investors to the primary market; (b) reduction of issue costs,  which currently amount to as high as 10%; and (c) reduction of the time gap between closure of issue and listing to 3 days from the current 12 days.

From my experience of participating in the primary market (though in a limited manner) for the last 10 years, I feel the confidence levels of retail (small) investors is now at the rock bottom.  The increased volatility in the market and the poor performance of many IPOs listed recently are responsible for the same.  By looking at the huge discounts at which some issues are listed, one wonders whether there is anything wrong with the way the issues are priced.  I am not denying the fact that small investors should approach equity from a long term perspective; however, the huge listing loss definitely shakes their confidence.  Another area of concern is that the investors are expected to thoroughly study the issuer using the Red Herring Prospectus.  But the size of the prospectus is so large, that no small investor would ever have the expertise or the patience to read the same.  An abridged version of the same is supplied along with the IPO application form.  But, in order to achieve the objective (b) and (c) listed above, SEBI wants majority of the applications to be made through electronic form.  And when one applies through the electronic route, he does not get the abridged prospectus, but the full version.  I feel an abridged prospectus, written in simple language, is what the small investors are looking forward to.

Above all, investor education plays a crucial role.  Retail investors, especially those from the Tier II cities, participate in IPOs based on the recommendations of their friends/relatives or by being attracted by the advertisements and internet.  It is essential for them to clearly understand the risk factors involved in the issue and their future implications.  While making the red herring prospectus more investor friendly, SEBI has to also take initiatives to educate the small investors.  Their behaviour is well described by an old adage: Once bitten, twice shy!
     

Small Saving Schemes - Restructured

If anyone thought that the deregulation of interest rate on savings bank account by RBI a couple of weeks ago was a major step towards aligning interest rates to the market forces, hold on, there is more in the offing.  Ministry of Finance has accepted the recommendations of a Committee headed by Mrs. Shyamala Gopinath on restructuring Small Savings Schemes, namely, PPF, NSC, and all Post Office Deposit Schemes.  In a recent notification, the ministry has suggested implementation of the proposals with effect from December 1st this year.

The most important aspect is that the interest rates on these instruments (except PO Savings Bank Account, which is fixed at 4%) will now be linked to the yields on government securities of comparable maturities.  The interest rates applicable to a particular year will be announced by the Government on 1st of April.  In fact, the interest rates on some of these instruments were aligned to the market rate between 1999 and 2003.  But since then, the rates on these instruments remained constant at 8%.  This created huge inflows and outflows from these instruments depending on the market rate.  For example, when the market rates were below 8%, people rushed to buy these instruments and when the market rates were above 8%, there was net outflow from these funds.

The Committee has also recommended discontinuation of Kisan Vikas Patra (KVP) and reduction in the maturity period of Monthly Income Scheme (MIS) and NSC from 6 years to 5 years.  A new series of NSC with 10 years maturity will be introduced.  Moreover, the accrued interest on NSC will not be eligible for tax benefits under Section 80C.  As far as Public Provident Fund is concerned, the maximum contribution during a financial year has been raised from Rs.75,000 to Rs.1,00,000.

The writing on the wall is clear: Gone are the days of stable/constant interest rates!

Series on Financial Markets - II

After getting a clear idea about what financial assets are, let us now look at some of its characteristics from an investor's (supplier of capital) point of view.  First, they allow individual investors to spread their consumption pattern.  Every individual goes through periods of excess income (young/middle age) as well as deficit income (retirement/old age) during his/her life.  Financial assets help individuals to save/invest during the excess income periods, so that they can meet their consumption needs during periods of deficit income.  Thus financial assets allow investors to spread their consumption.

Second, the financial assets allow individuals to derive income from real assets and allocate the risk.  An individual investor can not invest directly in productive real assets for two reasons: (a) it requires huge capital and (b) it involves huge risks.  For example, as an individual I may not start manufacturing steel, automobiles or even start a retail chain.  But with the help of financial assets, it is possible for me to invest in the businesses engaged in the above activities and enjoy the profits.  Further they allow me to allocate the risk, even if I have limited amount to invest.  So, if I am holding the shares/bonds of five different companies, it is as good as me getting engaged in five different businesses simultaneously.  Again, I can choose to allocate my risks through a combination of high risk instruments like equity and low risk instruments like bonds.

A third characteristic of financial assets is that they allow separation of ownership from management.  When you have large number of individuals contributing capital to a business, it is practically not possible to involve all of them in the day-to-day management.  Moreover, managers need to be professionally qualified and trained.  So, financial assets allow for sourcing capital from various individuals spread all over the country (or the world); whereas the management of the business vests with the professional managers.  They also allow transfer of ownership without any impact on the management of the business.  

Series on Financial Markets - I

Few days ago one of my ex-students, Nisha (who did not specialise in Finance) asked me whether I could write something on the functioning of stock markets through my blog.  Since it requires lot of discussion, I thought of doing so in a series of blogs, this one being the first.  Though some of my readers may find it elementary, I am sure you would enjoy reading the same.

We generally classify assets into two (a) real assets and (b) financial assets.  You might remember that in an earlier blog, I had mentioned that the wealth is always created with the help of real assets.  The real assets represent land, building, machinery, and all other physical resources required for production of goods and services.  All those involved in production of goods and services require capital for investment.  So they represent the demand for capital.  All those entities who have income in excess of their expenditure are looking out for avenues to invest the same; and they represent the supply of capital.  Like any other market, a market is required for the interaction between those who are in need (demand) of capital and those who have surplus capital (supply).  Financial markets provide a platform for the same.

How does the money move from one set of people to the other? Let us take an example from the real market.  When you place demand for a car, the manufacturer supplies the car to you and you pay him cash.  Here two real assets are exchanged.  But when you are providing money as a supplier of capital, what you are getting back is not a tangible asset; but a promise that the other party would return the same to you in future with interest.  So the supplier of capital has a claim on the other party.  The instruments that help us/ or through which we establish this claim are known as Financial Assets.  Bank pass book, Fixed Deposit receipt, NSC, Equity share, Debenture etc. are all examples of financial assets.  I will explain some characteristics of financial assets in my next blog in this series.

'Ratio Analysis' - A re-look

Perhaps one tool for analysing the financial performance of a firm, that we have all been teaching/learning for years together is the 'Ratio Analysis'.  No course on finance is complete without adequate coverage of the above tool.  But off late, I am finding something strange the way we teach this at the MBA programmes.  Our coverage on Ratio Analysis includes liquidity ratios like current ratio; asset efficiency ratios like total assets turnover; profitability ratios like gross margin and, ROI; and long-term solvency ratios like debt-equity ratio.  Most of the standard text books provide in-depth coverage of these ratios.  And, a student goes out of the course believing that these ratios are applicable universally across all types of companies and in all types of sectors.  Nothing can be more misleading!!  We should remember that most of the popular text-books were written at a time when financial performance analysis (in the Indian context) meant analysing firms involved in manufacturing.  That was a time when banks followed a highly conservative accounting system and did not disclose much; there were only public sector insurance companies and they did not disclose their accounts; except UTI, Mutual Funds were non-existing and no-stock broking firm was ever a public limited company.  Hence the scope of financial statement analysis was limited to companies involved in manufacturing.

But, today we are living in a world where we are surrounded by the financial statements of different types of companies engaged in different types of businesses.  Most of the companies upload their entire annual report on their website.  But our text books continue to teach 'Ratio Analysis' from a manufacturing firm's perspective and our curriculum prescribes the same.  So, we teach the same and the students believe that a tool which was developed (or suitable) for analysing firms engaged in manufacturing can be applied universally across industries.  Even-though the industry and industry-analysts have developed various ratios appropriate for analysing their financial statements, they have not found a place in the MBA curriculum.  I strongly believe that the time has come when the focus of a course on Management Accounting should move away from preparation of financial statements (which anyway is the job of an accountant and not that of a manager) to in-depth analysis of the same.  The teachers have to acquaint the students with the financial statements of companies from various industries and teach them appropriate 'Ratios' for analysing these statements. We may not find text books containing this, but that is the challenge that we, the teachers have to take.

Rating of Financial Instruments

Though rating of debt instruments (bonds/debentures) has come of age in India, the rating of equity (IPO/FPO) is relatively new (four years or so).  Investors depend on rating to understand the risks involved in investing.  While rating a debt instrument, the rating agency is looking at only one risk, that is credit risk (or default risk).  This is the risk arising from the possibility of the issuer defaulting on payment of interest or principal or both.  This risk can be understood by analysing the financial position of the issuer.  Letter grades like AAA, AA+ etc. are assigned by the rating agencies.  Higher rating indicates lower risk and, thus higher safety.

As against debt instruments, while rating equity, the risk considered is not default risk.  In fact, there is no default risk involved in an equity instrument as the money once paid to the issuer is never received back, and dividends are not mandatory.  So, what one looks while rating equity is the market risk or the price risk.  That is how safe is the investment from the point of view of generating reasonable rates of returns in the future.  Since this risk is difficult to capture, the equity rating is very tricky.  Here the fundamental factors like the business of the issuer, the competition, quality of management, experience of promoters, corporate governance and financial performance are considered for rating.  Rating agencies assign Grade 1 to 5, with 5 indicating strong fundamentals and 1 indicating weak.  A quick look at the IPOs of 2011 tells us that of the 21 issues carrying grade of 3 or below, 15 are traded currently at prices below the issue price.  Some are traded at huge discounts of 75-85% to the issue price.  Finally a word of caution: The biggest problem in learning investments is that we tend to quickly generalise.  Generalisation is dangerous in Investments as there is no "single theory" that explains all situations.  So, some of the above IPOs may turn-around in future and some issues with grade of 3 and below, which have already generated high positive returns, may go down.

Savings Bank Account – Changing Colours

Last week the Reserve Bank of India deregulated the interest rate payable by commercial banks in India.  Till then all the banks were paying same interest rate on the balance held by the deposit holder in the SB account.  The interest payable on Fixed Deposits (FD) was deregulated few years ago.  During the last one year, two important changes were made by RBI as far as SB accounts are concerned.  The interest payable was earlier calculated by banks on the lowest balance standing in the credit of an account between 10^th and 31^st of a month.  Few months back, the RBI instructed the banks to do away with this practice and calculate interest based on daily balance.  This resulted in marginal increase in the interest received by deposit holders in the SB account.  The second major step was deregulation of interest rates on SB accounts.

With deregulation, we are about to see different banks offering different interest rates on SB accounts.  In fact, this has already started with some banks announcing revised rates with effect from 1^st Nov.  From the bank’s point of view, this has large implications.  Money parked in SB account is highly volatile, unlike the amount locked up in FD.  This amount can be withdrawn by the customer anytime, and hence is not available for the bank for long/medium term lending.  This may create asset-liability mismatch.  In order to bring in some certainty in the balance available, some banks have announced a differential interest rate structure with higher rate of interest for balances above certain level (say Rs.1 lakh) in SB account.  I would also expect some banks to increase the minimum balance requirements in the SB account.  So we can look forward to innovative SB account products rolling out of banks in India to lure the customers.  However, form the customer’s point of view, this move makes only a marginal difference as the rate differences between banks is not going to be very high, and unlike other investments, people are not keen on shifting their SB account from one bank to another for the sake of additional 0.5% or 0.25% interest.  There are many other factors like the convenience, quality of service, net banking, payment services etc. that keep a customer with a bank, even if it pays few basis points less interest on SB.  After all we don’t park our money in SB account as an Investment!

Where is the Wealth created?

Two days ago, while starting my course on Investments to the new batch, I was discussing a point that wealth is always created in the real market and not the financial market.  Let me explain the same.  We many times tend to believe that it is possible to create wealth in the financial market.  But financial market (and the entire financial system itself) is performing the function of mere intermediation.  It helps to bridge the gap between the suppliers of capital and the ones demanding the capital.  The capital has to ultimately flow towards production of goods and services.  Thus the income generated from such production of goods and services is distributed to the suppliers of capital through the financial system/market.  In the absence of demand for capital, the financial system/market looses its importance.

When an individual, who looks at creating wealth through various forms of investments in financial assets, may feel that the wealth creation happens in the financial market.  But, in reality he is participating in the real market (producing goods and services) indirectly and the wealth created in the real market is flowing back to him in the form of interest, dividend, capital gains etc. 

Probability Revisited

On my last post on Probability in Finance, Murali raised a question as to whether the subjective probabilities could be based on past occurrences (relative frequencies).  My answer would be yes, but in Finance the subjective probability can not be based only on relative frequencies.  One needs to combine his/her judgement with the relative frequencies.  Let me explain with the following examples.

A probability distribution of defective parts per 1,000 in a manufacturing process is developed based on repeated observations in the past.  Now if you want to predict the probability of 10 defectives per 1,000 during the next production run, you would immediately refer the distribution that is already developed.  Here your chances of being correct are relatively high.

Now, assume that you develop a probability distribution of rates of return per annum generated by a stock by observing sufficiently long period of time (say last 50 years).  If I ask you what is the probability that the same stock would generate 20-25% returns during the next year, I am sure, you wouldn't feel very comfortable to base your answer completely on the frequency distribution.  You would definitely use the distribution, but add to it your judgement on various other factors that you feel would influence the returns.  This is where the subjectivity creeps in.

Probability in Finance

Today morning I had an interesting discussion with Mr. Muralidhara, one of my close friends and a research scholar at SIT, on the concept of probability in Investments.  We learn/teach the concept of classical (a priori) probability as part of the course on Statistics.  Two important aspects of classical probability are all the outcomes are well-defined; their occurrences are equally-likely and the probability can be stated without conducting the experiment (a priori).  But when it comes to the concept of probability in Investments, if one thinks through the classical point of view, it leads to great misunderstanding as the above aspects are almost not present in most of the Investment/Finance related decisions.  In the world of Finance, what works is not the classical concept of probability, but Subjective Probability.  Richard Levin and David Rubin define subjective probability as “probability based on the beliefs of the person making the assessment.  It is based on whatever evidence is available…..may be in the form of relative frequency of past occurrences or an educated guess”.  This is the reason why we see different investment experts/analysts having different, and sometimes even divergent, views on investments in certain assets (even though the historical data available to all of them are the same).  It is very important for all students of Finance to view probability from this point of view to understand most of the theories and models in Finance.  Prof. Jayanth R Varma of IIMA explains this in detail in a recent working paper titled “Finance Teaching and Research after the Global Financial Crisis”. (available at the website of IIMA and at SSRN)

A note on Tata Steel

Commenting on my blog of 25/8/2011, Suresh raised two questions; one on the falling prices of some of the prominent stocks like Tata Steel, JSW Steel etc. and the second was regarding liquidity in the hands of retail investors.  Since I though these issues need to be elaborated, I decided to make it a fresh post.

Let me take Tata Steel for example, a stock in which I have some interest.  The 52 week high/low for this stock is 737/418.  What is more interesting is that it traded at around Rs.600 during the first week of July then fell to the current level of Rs.422.  This period coincides with the fall in most of the major indices.  The stock is currently trading at a P/E of 5.4, whereas the industry P/E is 7.43.  The sales are growing at 20% and the profit at 30%.  The dividend yield is 2.85%, which is fairly high in Indian markets.  With infrastructure sector expecting a fillip, the steel prices are expected to go up, which would definitely improve the profitability position of Tata Steel.  With all the above facts, I leave the decision on Tata Steel to my readers. 

If somebody picked this stock at 600 levels with an intention of making quick money by selling the same in a couple of weeks, I wouldn’t call him an investor; he is a speculator.  A speculator has no reason to cry when the markets crash, as he must anticipate and be willing to accept huge downside risk.  But if someone bought this stock with an intention of holding it for fairly long term, why is he worried about the current volatility?  Once an investor picks a stock, after making reasonably good analysis of the fundamentals, what he should worry about is not the fall in price, but the reason behind the fall.  If the fall is attributable to an overall fall in the market, that’s alright.  But if the fall is caused by dilution of the fundamental strength of the stock, which prompted him to buy, then he needs to worry (take the case of SKS microfinance).

Let me briefly touch upon the second aspect of retail investors not having sufficient liquidity.  This is where investor education plays a role.  Retail investors can either use MFs or have some systematic investment formula, which results in reduction of average price over a period.  This would bring some discipline, in the sense that he earmarks certain amount for equity investment every month.

Where are we Investing?

Just take a look at Sensex, the most talked about indicator of Indian stock markets, which has fallen from 20561 points in January this year to the current level of 16284 points - a fall of 20.80% (31.20% annualised) in eight months.  What is more interesting is that it lost 2030 points during the last three weeks.  An obvious question is where do we invest during such testing times?

Let me ask a more mundane question?  What did really go wrong with the economy during the last three weeks?  I would say nothing much.  The reaction that we saw in the market is due to two influencing factors: (a) the burgeoning debt crisis of USA and Europe and subsequent downgrading of USA by S&P; and (b) increasing price levels.  Even though inflation is a concern, it would definitely ease in the medium-term.  But are we bothered too much about US debt crisis?  I personally feel that the Indian economy is fundamentally strong and is driven by domestic demand.  What we are witnessing now is only an over-reaction.  Therefore, this is the right time to invest in stocks. 

I normally draw parallels between a super market and stock market.  People rush to super market when the prices are low or during discount sales.  But why do we shy away from stock markets when the prices are falling?  If one picks some fundamentally strong stocks at reasonably low price, it would definitely offer great returns in the long run.  I would like to add a word of caution: Do we buy anything and everything from a super market, just because they are available at throw away prices; or do we also check the quality?  Similarly, it is not advisable to over-indulge and blindly create a portfolio of stocks that are available at very low prices (or low P/E).  Pick good stocks and stay put for a long time: I am sure there will be no regrets!  Happy investing. 

Why this Blog?

In 2009, we organised a Training programme at SIT on Fundamentals of Investments titled 'FINSIGHT'.  The programme evoked good response with about 70 participants from various walks of life.  Subsequently, the idea of starting a blog for sharing thoughts/concepts and ideas relating to finance struck me.  But it took some time for me to actually do so.

This blog - Finsight - aims at sharing thoughts/ideas/concepts/analysis and real life experiences from the world of Finance.  Hence its sub-title is 'Insights from the World of Finance'.  I percieve three types of people interested in this blog.

1. My Students: I would be scribbiling my ideas regularly relating to the concepts taught in the class room.  Sometimes it so happens, that after I complete a session, I feel as an after thought, that the same concept could have been explained in a much better manner; or I feel that there are some more relevant examples/illustrations to make the concept more clear; or there may be some extensions of the concepts.  I would like to scribble all these through this platform.
2. My ex-students: During the last 15 years I had the opportunity of teaching some highly intelligent students.  Today they are occupying various positions in the industry.  I would request them to share their experiences and add their wisdom to the posts that I make.  This would result in a process of collective learning for all of us.
3. My Friends: I am sure many of my friends would like to keep track of some of the basic and latest concepts/practices in Finance.  

 A Warm Welcome to FINSIGHT.