Planning - the way to reduce Pain

A recent news item regrading the wife of an airlines employee committing suicide due to financial distress created lot of noise.  She claimed that her husband was not paid salary for 4-5 months and that created lot of financial problems.  The story of suicide by farmers has become a regular one.  But the heat of financial distress pushing the middle income families to take such drastic steps is a recent phenomenon, at least in India.

This brings to light the ignorance of 'personal financial planning' among most of the middle class families.  During the last decade or so the spurt in new-age technology related jobs, where the average salary of an individual was far above the other sectors, created a new section of middle class people.  When a young boy or a girl, in early twenties, is offered a fat salary, they tend to forget the importance of 'financial prudence' and indulge in acquiring assets like luxury apartments, high-end vehicles and develop a life style that demands lot of cash.  Most of these assets are acquired by taking loans against the fat salary.  As long as the salary keeps flowing in, the pinch of EMIs is not know.  But what they fail to realise is that these EMIs are here to stay, even if the salary moves downwards or even stops for a couple of months.  Debt is like a knife with sharpness on both sides.  When the fruit that is being cut is ripe and soft (read, good flow of income), it cuts the fruit easily; but when the fruit is hard (read, fall in income), it cuts your finger.   This is where the importance of financial planning lies.  The most important aspects of financial planning are:
(a) Investment planning
(b) Tax planning
(c) Risk Management & Insurance planning
(d) Retirement planning
(e) Estate planning

Today, there is no dearth for literature on financial planning.  There are many books, websites and even agencies offering this wisdom.  But what is more important is to take the advise from them and use one's own wisdom to plan the finances properly.  A step-by-step approach to financial planning is given below, which is taken from the book, 'Personal Finance' by Jack R Kapoor, Les R Dlabay and Robert J Hughes.

In the first look, this might appear cumbersome, but it is not so.  And moreover, it is not necessary that an individual goes through each step.  What is expected is that each individual is at least aware of these aspects and spends some quality time planning his/her finances.  This would make him/her better prepared to face financial adversities in future; and thus reduce the pain.

IPOs - Issues & Alternatives

In a recent blog Prof. J R Varma, quoting a research paper by Adam Pritchard, argues that it is high time we abolish IPOs!  Weird, as it may look, but when one reads Prof. Varma's blog (http://jrvarma.wordpress.com/) as well as the paper by Pritchard (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246), one is forced to believe their argument.  Pritchard explains that an IPO does not add value to any stakeholder including the issuer and the investor; and those who make money from IPOs are the people who manage the issue.  These people/agencies are paid a specific percentage of the issue size, which is known as 'floatation costs'.  Pritchard suggests a two-tier market system, where the companies would be first allowed to trade in a market where the participants would be Qualified Institutional Buyers.  Once a company matures in the Tier I market, it would be allowed to move to Tier II, which would be open to retail investors.

Way back in 1997, I was involved in a project to analyse the post-issue performance of the IPOs that flooded Indian markets during 1993-94.  (Incidentally, Indian markets witnessed maximum number of IPOs during this period).  We found that majority of the issues were trading below the issue price and many companies had vanished into thin air.  Compared to 1994, today, Indian markets have matured a lot in terms of regulation, disclosures and compliance.  However, the IPO market continues to be a gambling zone.  On one side we have issues like Vaswani Industries (October 2011-Issue Price Rs.49 & Current Price Rs.4.76) and Indo Thai Securities (July 2011-Issue Price Rs.74 & Current Price Rs.9.75); and on the other side, we also have Onelife Capital (October 2011- Issue Price Rs.110 & Current Price Rs.648.10).  The story is not different in developed countries either.  Take for example the much-hyped IPO of Facebook.  The shares issued at $38 in May this year are currently trading at $18.80 in Nasdaq and the firm is embroiled with more than 40 lawsuits.  If a firm trades at huge discount or at huge premium on listing, it reflects the inefficiency of the primary market.

In the wake of the above, I pray that the Government appoints a committee headed by Prof. J R Varma (who has already been a member as well as Chairman of several committees) to restructure the IPO market; the committee comes up with revolutionary suggestions; and above all, the Government accepts and implements these suggestions.  Are the bosses at the Finance Ministry and SEBI listening....?

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.

'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.

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.