Flying Donkey

Monday, October 13, 2008

The Oscillating Market: Crash and Boom

The last few weeks have been heck of a roller coaster ride. Just as the stratospheric rise of the stock market in the late 90s and the 2000s was a deviation from fundamentals, I suspect, so is this massive retreat from the markets.

The heady days of the stock boom resulted in irrational valuations in excess of 20 times P/E. Essentially what it means is that investors were either so patient that they were willing to wait 20+ years to realize any profit on their investments or they were expecting markets to grow at an annual rate of 7% annually. The US had a market cap of about $58 trillion at its peak in May 2008. Therefore, it means that the market was expected to add $4.1 trillion to its value in year 1 with a build in growth of 7%. Put it another way, on an average, each publicly listed company was expected to grow by a whopping $241M in Year 1 and increase by 7% perpetually. From a purely quantitative viewpoint, this 7% growth is almost 50% higher than the sustainable growth rate, given the historical retention rates and returns.

We can also look at it from the viewpoint of risk. The market was demanding a spread of only 163 basis points over the risk free yields. Consider this… the average spreads over the last 80 years have been close to 600 basis points. So, the market had been telling us that the risks of investing in the stock market have been reduced by more than 350%. Now, I know that investors have been searching for the zero-beta portfolio, but this is ridiculous…the stock market had effectively given itself a AAA bond rating…I repeat BOND rating.

So, where are we now and where could we be headed. Last week, the average P/E had fallen to 11.42x. This has been a precipitous fall, but if we continue to ignore the fundamentals and rely purely on quantitative strategies, we are nowhere near the bottom. If we look at the current market data regarding risk, growth etc, the models would suggest a fair value of less than 5x P/E. That’s another 50% drop in the indices.

However, another approach is to look at the fundamentals. It includes taking a long term view of the market both prospectively as well as historically. Despite the ups and downs, the market has, on an average, returned more than 9% to the investors and has grown at a rate of over 5.5%. If we continue to believe in the long term viability of the free markets then there is no reason why the markets should not recover. In fact, there is no reason the markets should not recover by more than 20%, which would be indicated by an intrinsic P/E of about 14x. It does not mean that companies above 14x are overvalued or the ones below that are undervalued. It just means that, given the long term growth rates and returns, 14x is the valuation level that is sustainable over the long term.

In the end, the market is the sum total of the fundamentals (people, capital and technology) and the collective expectations of the people. Any mismatch between fundamentals and expectations is not sustainable over the long term. We have had a decade of expectations induced growth, and now we are having a dose of expectations induced decline… a clockwork oscillation of the market pendulum between optimism and pessimism.

Saturday, November 03, 2007

Hole In The Middle

Today’s corporation can be compared to the old feudal system. At the very top sits the senior management, responsible for analyzing the landscape and defining the strategy of the firm. Below this level is the middle management whose main job is reporting to the senior management.

This analogy can be compared to the King and his cabinet of old, whose main task was to evaluate threats, form alliances and wage war. This role is not all that different from the feudal lords who held fiefdoms. Their primary task was to manage a territory in the name of the King. This is not unlike the modern middle managers who might manage a department.

The primary goal is the same – helping the King/CEO manage the larger entity by carving it out into simpler manageable segments. Unfortunately, the end result is also the same – power plays and jockeying for position to the detriment of the larger entity.

The solution to this structural issue within a corporation can be found in the political solution to fiefdoms. Just as fiefdoms were replaced by a cadre of mercenary civil servants who had no loyalty to a particular Lord, King or territory, so should the middle management be replaced by knowledge networks. The key to eliminating territorial tendencies is to eliminate territories.

The problem is not that the middle management is incompetent or not hardworking. Quite the contrary, over the last two decades there has been a steady increase in the hours per week put in by the management as well as in the qualifications they bring to the table. In addition, there is a plethora of management tools in the market, all geared to help the management process.

The trouble lies in a primeval human instinct that no amount of coaching or education can overcome – survival instinct. As managers rise within an organization, they create a personal eco-system around themselves. This consists of people, tools, and mind-set. This eco-system results from past experiences and comfort level of the manager. Advancing within an organization also results in an increasing desire to maintain the status quo.

This combination of experiential eco-system and desire to maintain the status quo results in the general malaise that plagues middle management. The general symptoms are sluggish decision-making and failure to adapt to the marketplace. The end result is poor corporate performance poor shareholder returns.

The key to solving this quandary is to realize that a leopard cannot change its spot. To fight the basic human tendency of self preservation and turf protection is a losing battle that no organization will win. It is much smarter to recognize this fact and work on a management model that bypasses it.

Wednesday, August 09, 2006

Investment Banking - Sociopaths Wanted

Over the last few years I've had the (dis)pleasure of working with a lot of investment bankers. It seems to me there is one quality that is predominant in most of the bankers I've met - Sociopathic behaviour.

Wait...wait....before you start pounding on me, lets consider the psychology of a psychopath and some of the clearly visible behaviour exhibited by your friendly neighborhood investment banker.

1. SUPERFICIAL CHARM -- a tendency to be smooth, engaging, charming, and slick. Not in the least shy, self-conscious, or afraid to say anything. Indeed this trait is shared with salesmen and consultants...but read on.

2. GRANDIOSE SELF-WORTH -- a grossly inflated view of one's abilities and self-worth, self-assured, opinionated, cocky, a braggart. Bankers have the biggest egos of any professional on the planet. Consider this...they fight over the font size of their names on business correspondence. In US, a company filing for an IPO has to do a Red Herring(RH). The RH has the names of all the banks whether they be in a lead or co-manager or syndicate capacity. One of the biggest fights in the IPO process happens because the bankers can't agree on the font size and the placement of their banks name. No wonder they work 90 hours a week...they spend hours deciding the font size.

3. NEED FOR STIMULATION (PRONENESS TO BOREDOM) -- an excessive need for novel, thrilling, and exciting stimulation; taking chances and doing things that are risky. Often has low self-discipline in carrying tasks through to completion because he gets bored easily. In every roadshow meeting I've ever been to, the banker is always playing with his blackberry as opposed to paying attention to the meeting.

4. PATHOLOGICAL LYING -- can be moderate or high; in moderate form, and will be shrewd, crafty, cunning, sly, and clever (in extreme form, he will be deceptive, deceitful, underhanded, unscrupulous, manipulative, and dishonest). Never take a banker on his word. They will say just about anything to get you "pregnant'. Once you are far along in the process, there's not much you can do but play along with the bankers. We had our bankers tell us about market conditions and their pre-marketing of our IPO with investors, based on which we signed them on. Guess what...2 weeks after we signed, they came back with totally different terms from what we agreed on because "the market had changed." Make sure you communicate clear break-off points with the bankers before you sign them on. Most bankers will be difficult to peg down clearly, but if they say things like "market will tell us"...dump 'em.

5. CONNING AND MANIPULATIVENESS -- the use of deceit and deception to cheat, con, or defraud others for personal gain; distinguished from Item #4 in the degree to which exploitation and callous ruthlessness is present, as reflected in a lack of concern for the feelings and suffering of one's victims. Again, read the previous point. When I say thay will get you "pregnant"...I mean really pregnant. We spent a lot of money on the IPO filing and the roadshow etc, before the bankers started squeezing us on terms etc.

6. LACK OF REMORSE OR GUILT -- a lack of feelings or concern for the losses, pain, and suffering of victims; a tendency to be unconcerned, dispassionate, coldhearted, and unempathic. This item is usually demonstrated by a disdain for one's victims. Make sure you have two or more people on the call or whenever you talk to the bankers. One key word they like to use is "mis-communication". Keep notes of the conversations and send follow-up emails to clarify everything that was said. We had a banker promising us his participation in the IPO by committing to buy our shares (called market making in banking). When push came to shove, he claimed ignorance, but there had been 5 people in the meeting in which he made the promise, and so he took refuge behind "mis-communication" defence.

7. SHALLOW AFFECT -- emotional poverty or a limited range or depth of feelings; interpersonal coldness in spite of signs of open gregariousness. Investment bankers are the most fun people to hang out with when they want something out of you. Their expenses paid dinners are notorious in the business community. You'll be surprised how long it takes them to return calls once they have what they want. Again this trait is not uncommon in corporate world...bankers have simply perfected it.

8. CALLOUSNESS and LACK OF EMPATHY -- a lack of feelings toward people in general; cold, contemptuous, and inconsiderate. Read the previous point.

9. IMPULSIVITY -- the occurrence of behaviors that are unpremeditated and lack reflection or planning; inability to resist temptation, frustrations, and urges; a lack of deliberation without considering the consequences; foolhardy, rash, unpredictable, erratic, and reckless. Unlike almost every other professional in the corporate world, bankers have absolutely no planning skills. They are primarily "deal sharks" and are geared towards deal generation and consummation. Planning is of secondary importance to them and for the most part they are not too good at it. Time and time again we made changes to our SEC filing based on banker recommendations only to realize that the bankers had not really thought through things, making our job more difficult. Make sure you go through the thought process behind each recommendation and you evaluate the consequences.

10. IRRESPONSIBILITY -- repeated failure to fulfill or honor obligations and commitments; such as not paying bills, defaulting on loans, performing sloppy work, being absent or late to work, failing to honor contractual agreements. One thing we realized was that there is no contract out there worth the paper its written on when it comes to bankers. The agreements they sign with you are notoriously vague with tons of loopholes that allow them to escape without any liability. They simply will not sign an airtight agreement. So the most important thing in picking bankers is referrals. Try get referrals through people who the bankers can't afford to antagonize.

11. FAILURE TO ACCEPT RESPONSIBILITY FOR OWN ACTIONS -- a failure to accept responsibility for one's actions reflected in low conscientiousness, an absence of dutifulness, antagonistic manipulation, denial of responsibility, and an effort to manipulate others through this denial. Tough luck trying to point out the mistakes made by bankers. Its always the market conditions that are the fault or the lawyers or the management itself.

*Note: The traits of a sociopath were taken from a pyschology journal and also a website that I can't seem to recall. If you find these characteristics on some other website...consider that to be the original source.

Sunday, April 02, 2006

Long Live Pakistan!

Everyday bad news trickles in from Pakistan. Balochistan is up in arms and the North West Frontier Province is witnessing intense fighting on a daily basis. To the east, Sindh is increasingly disaffected.

This cannot be good news for India. We don't want a strong and belligerent enemy on our western borders, but we don't want a fragmented and crumbling state either.

The repurcussions of a failed state could be horrendous for India. We would be looking at 162 million people, majority of them poor and uneducated, looking for stability and possible assimilation into India or the same people in constant strife and possibly an endless resource for terrorist movements.

Manmohan Singh recently spoke about the future of the subcontinent in which the borders would be irrelevant. This cannot be allowed to happen. A borderless subcontinent would give the greenlight to about half a billion people from neighbouring countries to ride piggyback on the success brought about by the hard work of the Indian people.

India was cleaved into two and there are still people (I used to be one of them) who dream about a united India. But the geopolitical and socio-economic realities do not permit us to be romanticists anymore.

Assimilating a population almost half the size of the current one will throw India into disarray. On one hand is the volatile issue of the fundamentalist and feudal mindset of our neighbors, and on the other hand is the issue of the massive economic shocks that would result from a re-unification or federalization of the subcontinent.

On an aggregate basis, the per capita GDP of Pakistan in PPP terms is about $2,400 compared to $3,600 of India. The GDP of Pakistan is obviously inflated by the fact that it receives substantial foreign aid (including $1 billion/year from US). This aid will no doubt stop once the two economies assimilate. The combination of the two economies results in an immediate dilution of about 5% for India (If you factor-in the aid factor, the dilution is higher). This is important as India is fast approaching the theoretical inflection point of per capita GDP that will allow India to achieve the critical mass for long term growth. Any dilution in per capita GDP will only push back the timeline.

According to various estimates 32%-40% of the Pakistani population lives below the poverty line. That translates into 52-65 million destitutes on top of the approximately 250 million that already exist in India. And this does not even take into consideration Bangladesh, which is considerably worse off.

Pakistan's literacy rate is 49% with about 40% of the population less than 14 years of age. This influx of an illiterate young population will put tremendous pressure on the Indian educational infrastructure which is already at capacity. The law & order implications of this influx are even more significant.

In short, the boundaries that were created in 1947 have to stay. We talk of federalization or re-unification only at our own peril. Germany presents a clear example of what happens when two disparate economies combine. Lets work towards peace and collaboration, but lets stay away from re-drawing the geographic or monetary borders. Lets also pray for a stable Pakistan.

Friday, March 17, 2006

The Great Indian Market Crash of 2006

The BSE is trading at more than 21 times its Price to Earning ratio. In simple terms, it will take an investor more than 21 years to recover the cost of his investment, not taking growth into account. This is obviously very simplistic argument, but you get the drift. To give you a perspective, the Dow Jones Industrial Average (DJIA) is trading around 22 times.

Yes, Indian stock market is now at the same price point as the US. This, despite the fact that there is about 250-550 basis point country risk premium attached to the Indian stock discount rate. This is nothing short of hyper-irrational exuberance. These kind of valuations are not justified even on a growth adjusted basis. Even considering a generous 11% growth rate for non agriculatural sectors, this translates into a PEG of 1.91. This compares unfavorably with the PEG of DJIA, which stands at 1.6.

A brief, and informal, survey done by yours truly of ordinary Indian seems to suggest that most of them have stopped pumping-in more money into stocks for now. There is a general feeling that the market is overvalued.

Then why is the market not correcting? The answer seems to be the FIIs. More than 20% of the money invested in the market is by these institutions. Why are they still in the market if it is overvalued? The answer is twofold: i) Lack of alternatives; and ii) Fear of market impact.

i) Over the last few years, hundreds of Indians have taken advantage of the buzz surrounding India and gained a foothold in the foreign financial markets as India experts. These guys are now caught in the spin cycle that they created. For them to pull out of the Indian market means losing their sway in their firms. If Indian market goes down, they go down with it. This escalation of committment is like playing the Russian Roullette - You keep pressing the trigger and if the market goes up, you win. But eventually, they will have to come to the loaded chamber...just a matter of time.

ii) Some of the saner money managers are stuck in the market for another reason. There is no one to buy from them. And if they unload their holdings, the market will not be able support the supply and they will drive down the prices.

Either way, the result is not pretty. So what do they do? One word - PROPAGANDA. They organize investor conferences, bring out pie-charts and spreadsheets and convince each other that the market is solid. They do all this in air-conditioned hotels and sanitized campuses of major companies. What they try to forget about is the woefully lagging infrastructure - shortfall in energy, crumbling roads, slow judicial process.

In short, they are loading-up the table with heavy goods, but not reinforcing the weak legs of the table. Eventually, the table has to fall under its own weight.

So what is going to happen? A rudimentary analysis seems to indicate that we are looking at about a 25-50% correction. This range was calculated by rationalizing the P/E as well as the PEG ratios.

For a healthy and growing developing country, P/E in the range of about 16 is what one would expect. This P/E is 25% less than the the P/E of 21 that we are seeing in the market. This is how I got the lower range of the correction.

PEG of BSE is close to 2 right now. An ideal PEG is around 1. This supplies the upper range of our correction, which is 50%.

The current optimistic estimates of Indian market capitalization place it around $900 billion. So, based on my analysis, it would seem that the market stands to lose between $225-$450 billion over the short term.

Monday, March 13, 2006

Pervert Nation

Hindustan Times had another article on eve-teasing today. Apparently, the studs of Delhi are so macho that they have to demonstrate their virility by grabbing breasts of random girls, in front of the girls' parents.

Oh my wonderous nation...the superpower in waiting. How glorious will be your future now that you have spawned such fine male specimens. The world stands in awe of the 8% GDP growth. But little does it realize that this is just a ploy to attract gori kudis so that the virile progeny of Mother India can warm their hands on their unresponsive breasts.

Girls in India can rest assured that all their sexual fantasies will be fulfilled as soon as they step out of the house, thanks to our desh ke laal. These mini Chunkey Pandeys know what the ladies want...even if the ladies themselves don't know it.

Afterall, why go to Bangkok when you can park your cock in some aunty's behind in a jam-packed bus. She wants know it. Which girl doesn't like randoms penises pushing against her body.

Also, why deprive the elederly of the pleasure? If some old woman is waiting for a bus at the end of a busy day, all she really wants is to get in your Mercedes and get raped by you. Hell...nobody can accuse the Indian male of age discrimination.

Somewhere up there is a happy mom, her eyes tearing up...her little boy is all grown up.

India: Miles to Go

Over the last few years, there has been a new found confidence in India, and rightly so. Indian economy has grown at an average rate of 6%+ over the last five years, the per capita is approaching the inflection point of $600, and the world is finally waking up to the Indian economic juggernaut.

In short, in the marathon race of global commerce, India has been running like a true sprinter. Compared to the 70s and the 80s, this is truly amazing. At this rate, India will double its economy about every decade.

But there are some sobering facts that need to be looked at before we start dreaming of the second coming of the golden age of India. The question one should be asking this growth sustainable?

India needs massive investments in infrastructure and some additional help from the gods to sustain this level of growth. Critical areas of development exist that will need to suck up the next wave of investments.

India is woefully lagging in meeting its energy needs. It has about 110 GW of installed capacity. This is about quarter that of China and about tenth that of the US. Indians have 13 MMBTUs of energy available per capita as opposed to 35 of the Chinese. It needs dedicated electricity to power its manufacturing and service industry.

The drinking water availability of India remains a big concern. By 2010, India would have approached the UN defined stress line of per capita availability of water. History tells us that rise and fall of civilazations has been predicated on the availability of water. This is a big concern and has the potential of derailing the economy.

Despite these elephants in the room, the Indian stock market has been behaving like it was the developed market. Indian valuations on a relative basis are approaching all time highs. At the current valuations, Indian companies are starting to become more expensive than companies almost anywhere else in the world.

Whats the drawback you ask? Outflow of investments!

Currently, more than 20% of the capital in the stock markets is from Foreign Institutional Investors (FIIs). There is a surprising unanimity in the the foreign capital markets that India is overpriced. We are looking at a significant pullback of investments and profit-taking. Thus, just when we need the billions and billions of dollars to fund the infrastructure spending, we will be seeing a net outflow of funds.

Thursday, March 02, 2006

Hijacking of India

New York Times published a less than enthusiastic article today about Bush's trip to India. I'm sure this article is well balanced and well researched (unless Jason Blair is the ghost writer), but the only lasting impression that remained with me is the threat of suicide bombing by a Mumbai Muslim youth. I'm not sure how credible this statement is, or if it was even made, but it left me feeling angry and frustrated.

A nation of 1.1 billion people, 66% of whom admire USA (according to Pew Research), and the one thing that people take away from this article is that Indians want to suicide bomb America, and yes, they will even get visas to do that. I am disappointed by the biased reporting of NYT, but I am even more disappointed by what's happening in India.

Everyone I know supports and loves America, yet a minority opinion is being presented as the opinion of India. The people demonstrating in Delhi, Mumbai and Hyderabad have shown a reckless disregard for the majority by their demagoguery.

Why is it that these people hate Bush so much...because he invaded Iraq? I'm sure a lot of Indians share that opinion, but they still welcome Bush's visit and US-India ties as they believe that it will benefit India. Are these demonstrators suggesting that they are more concerned about some distant middle-eastern country than their own country?

The majority has allowed madrassa-educated fanatics to control the message that goes out of India. In US and worldwide media, the message is that Indians are burning US flags and cursing Bush. The same Indians who are taking away US jobs are wishing ill of them.

The majority has allowed the very perception of India to be hijacked. We worked so hard to change the perception from snake charmers to IT wizards. Now, these guys are trying to paint us as reactionary jehadists.

As a democracy, it is important that all viewpoints be allowed. The key here is 'ALL'. In this case, a narrow fanatical viewpoint that is antithetical to India is being presented. If Indians don't wake up and respond to it, we'll soon wake up under the crescent moon.