In the second half of 2000, Bangalore was splashed with billboard advertisements about the next new thing, the software company anyone should want to work for. Aztec, it called itself, and the pedigree was impeccable.

Started, by J. Parthasarathy with funding from Exodus founder K.B. Chandrashekar (through e4e), the company became this hot-shot to-be-competition for the likes of Infy and TCS.

The IPO went through at Rs. 80 per share. It listed around Rs. 100, and soon collapsed with the .com bust. It hit lows of Rs. 13.35 in 2003, and rose with the general bull run to hit highs of 228 in 2006. Then it was all the way down to the current price of Rs. 74.

And now Mindtree acquires e4e's stake in Aztec at Rs. 80 per share. Mindtree already has bought nearly 30% in the market. There will be an open offer for another 20%, and eventually a merger into Mindtree.

This is the culmination of a 7.5 year saga of Aztec. From Rs. 80, back to Rs. 80 - no splits, bonuses, and a total dividend of Rs. 2.1 added up in all these years. The company shuttled from profits to losses and back a number of times.

What does Mindtree get out of this? Software companies usually don't have too many assets, but it could be the people. Looks like the management and employees are starting to sell their holdings - V. Chandrashekharan, the CEO and other key employees such as CIO, Director etc. have dramatically cut down their stake. Will they stay? If they don't, will Mindtree be able to retain their client relationships? Only time will tell.

But it's the age of consolidation for the next tier of IT service companies. To compete they need the size, so expect a lot more mergers.

Labels: Aztecsoft, Mindtree

On Feb 11, I'd written that Nifty's yearly EPS growth was only 13%.

The story gets worse.

As of May 16, EPS growth has been just 11%, from 211.72 last year same time to 235.08. And the current P/E: 22.

But this time there are 15 companies that haven't announced results yet, some of them being very high EPS growth ones (Unitech, L&T, NPTC, Sunpharma). But there are laggards too (BPCL, ONGC, Tisco, ITC) who are expected to show 10% growth or less. The weightage of all the not-yet-announced result companies is 23% of the index, and if they do well the EPS growth may change substantially.

The picture will get clearer in June, but this is not looking good at all. We are literally at the same Nifty value as of Feb 2008 and the P/E hasn't changed - means that despite these quarterly results, we have gained ZERO percent quarter on quarter.

Good news, though, on the technical front is that life looks good till May end. There is a lot of put buildup at 5,000 and new institutional buying is being seen in the last week. Things are likely to get better before they get worse. But they are going to get worse, unless we see stellar results in the next two weeks.

Labels: Commentary

Inflation is at 7.85%, a 44 month high. And oil hits $128 for reasons unknown, but everyone speculates on the causes.

With the INR-USD rate at Rs. 42.5+, the cause is said to be oil refineries increasing buys. But why isn't RBI selling dollars like crazy and keeping the exchange rate stable? It's silly to say at one end that they won't use the exchange rate to control inflation, but then watch the exchange rate go the other way and hurt inflation MUCH MUCH more.

There is literally no interest-rate arbitrage happening - otherwise we would have hugely balancing funds coming in to take advantage. In fact the dollar rising removes the arbitrage completely - as the 5% differential in interest rates is taken away by the 5% fall in the rupee.

There is a need, to get the exchange rate to Rs. 38 or lesser immediately. If they really want to control inflation, that is. But if they really do not interfere, I believe the markets will take it down to there - or even to levels of 35 very soon.

Interest rates are going to have to rise eventually as governments increasingly see a need to demonstrate some action, even if that action does not amount to any real change. See what they did with commodity futures - banning trading in potatoes, which has actually DECLINED in value this year.

It's not the result, but the action that counts. Our country is doomed to behave, financially, like a Balaji Telefilms TV serial - all emotion and no substance.

Labels: Commentary

From FT:

The rating agency CRISIL has downgraded ICICI Bank's securitised commercial vehicle loan pool worth over Rs 82 crore due to a drop in collections from repayments. The rating has been revised from "AA- (so)" to "BBB+ (so)".

This is the second instance of downgrade for ICICI Bank in a span of 30 days. Last month, the private sector bank's securitised car and personal loan pool worth over Rs 203 crore was revised downward from "AAA (so)" to "AA (so)" due to rising defaults on payments by borrowers.

Commenting on the downgrade, CRISIL said the performance of the pool has been marked by a higher-than-expected use of cash collateral. The cash collateral is an arrangement (cushion) for making payments to those who have invested in securitised paper when the collections for borrowers show a decline.

...

This pool was securitised in December 2005 and 27 months after securitisation, the pool amortised by about 78 per cent. The credit collateral stipulated at the time of rating was Rs 6.8 crore, of which around 79 per cent has been utilised. This level of utilisation is much higher than the rating agency's expectations.

The delinquencies, including repossession losses in the loan pool, are also high at 8.6 per cent for 90-plus days.

SO ICICI Bank securitised some loans by pooling them together (I didn't even know this was happening - but it's good). The investors in this pool get a fixed rate of return as borrowers on the loans pay up their interest payments. When interest payments are lower than expected due to defaults, ICICI bank pays out of the cash collateral it has included in the pool. When that cash also runs out, the investors start to lose money (in order of the seniority of the tranches they purchased)

There must be other loans that are delinquent for less than 90 days, and that is likely to make the default hit higher than 8.6%.

This has a lower impact on ICICI bank - because it has sold the risk to other investors - but it takes a hit on the cash collateral and also on any tranches it still owns (the most junior are likely to be retained by the originating bank).

But the impact can be for the other such securitised loans or for future securitisations - as investors (most likely mutual funds and other institutions) will demand higher returns for the higher risk involved.

Are we getting into phase I of India-Subprime? Securitised loan downgrades are first signs of visibility - the loans that banks DON'T securitise are extremely opaque and delingquencies there are not revealed this publicly. But if this trend continues, defaults are going to be a serious issue going forward.

Some more: Citi sees rising NPAs

Citigroup on Thursday said it was not exiting the consumer finance business in India, but had decided to reposition its products due to a rise in defaults in recent months.

Refusing to disclose details, Citi India Chief Executive Officer Sanjay Nayar told reporters that non-performing assets (NPAs) in the consumer finance segment were much larger than expected, but added that business remained "satisfactory".

Also read: Co-op bank NPAs rise, SBI credit card defaults cause concern, Banking sector shows good numbers in Q4.

Labels: Commentary, ICICI Bank

From Fundoo Professor:

Mastek published an important notice in The Financial Express (page 11, New Delhi edition dated may 16, 2008). The company disclosed that SEBI has directed it to:

1. place orders for buying back shares from the market "at least once a week at market related prices during the periods when the market price is lower than the maximum buy-back price such that the amount of buy-back is exhausted expeditiously"; and

2. not to close the buyback without completing it except under exceptional circumstances, with prior approval of SEBI.

In the Corrigendum to Public Announcement, Mastek has also said that:

"The Company does not intend to close the Buy-back before the maximum limit for the Buy-back is reached except in case of circumstances detrimental to the interest of the Company or the Buy-back such as adverse unforeseen circumstances, the market price being above the maximum price for a sustained period of time, political and other uncertainties and occurrence of any force majeure events, in which events the Company may close the Buy-back with the approval of SEBI."

Uhem. This is a weasel clause. But since SEBI approval is needed, it makes things a lot better.

The other clause - where they should place orders at least once a week is also good for investors. The buyback price of Rs. 750 maximum is WAY above current prices (though the stock has shot up 25% since the announcement)

Other such transactions in the pipeline are Sasken's buyback (max price 180 I think), SRF (max price 160) and a few others. It will be interesting to see how shares perform in buybacks.

Labels: Commentary, Stocks

Hindustan Times: 'No pooling' norm to hit PMS hard:

As per industry estimates, close to Rs 10,000 crore is housed in portfolio management schemes, of which more than three-fourths is operated in the pool format. SEBI has given a time frame of six months for PMS houses to fall in line with changed regulations.

“They (portfolio managers) would be required to keep assets of each client separately and not in a pooled manner,” SEBI said in a release on Tuesday.

Over past few years, brokerages and PMS players had been pushing pool PMS to retail investors, eager for a slice of action in the booming stock market. As per the agreement signed, customers who had similar investment preferences could join in, without even having to open a demat account.

Pool account, in spirit, operate on the lines of asset management companies. Brokerages open ‘pool PMS’ as a common account, under one head. Fund managers pool-in investments received from clients and start investing on behalf of the whole group. The purchased bouquet of stocks are allotted pro-rata to the clients’ portfolio as per their investments into the PMS.

This ensured minimal documentation procedures for the investors and easier operations for the PMS provider. With SEBI clamping down on these pool PMS, investors who have been availing of this facility will have to open separate demat accounts. Each of these accounts will contain shares purchased specifically for the investor by the fund manager.

PMS managers also say that managing individual accounts and execute trades separately will lead to enormous strain on the brokerages. Under pool PMS, brokerages could execute trades for hundreds of clients at one go. Now with new guidelines on, brokerages will be forced to execute trades for each and every client separately. Brokerages will be forced to pass on additional transaction costs (by way of more trades and more dealers involved) to customers, they warn.

“If SEBI had intended to apply brakes on pool PMS, it would have done well by raising the threshold limit,” said a PMS fund manager. What he means is SEBI could have put a limit (say Rs 25 lakh ) over which no pool PMS could be permitted.

Broking houses usually find it easier (and economical) to manage investors with lower absolute investments in the pool format. One needs at least Rs 5 lakh to invest in PMS, as per current regulations. However, according to PMS fund managers, most brokerages will find non-pool PMSs an unviable proposition as broker’s commission on a Rs 5-6 lakh PMS account is less than Rs 1,000 every month.

Such bull, no?

If 1 Pool account produces commissions of Rs. 10,000 per month, and is split into 10 accounts for which they get 1,000 per month each, what's the difference? Of course such math is just for show, the real problem is that they can't hide their prop account losses in non-pooled accounts. (Read: Stopping the PMS Abuse)

The technology problem is also ridiculous to mention - they no doubt have software to automatically assign trades to accounts, and divide trades into appropriate accounts. They do this anyhow, because at some point trades do get assigned to accounts, so what's the big deal in doing that at the time the trade is taken? That's just an excuse.

Another issue, I think is the size of trades. Let us assume 10 accounts of Rs. 5 lakhs each, giving you a 50 lakh pool. In that pool the brokerage can take all sorts of trades, including futures trades which can add up to 50 lakhs. PMS accounts are not allowed any leverage. (A norm that surely is flouted, but I have no proof) So for 50 lakhs you can only buy 50 lakhs worth of futures. Take an RPL contract. The futures contract size is Rs. 3.2 lakhs. For a 50 lakh pool, the brokerage could technically take up 15 futures contracts. But at each account level they can take only 1 (since the size of the account is 5 lakhs each) - so for 10 accounts, they can only take 10 trades. [Note: this is just illustrative]

Now obviously they would assign trades to accounts then too, right? What happens to the remaining 5 trades? Answer: if they are profitable, they go into the PMS providers pocket - only the profits of 10 trades are allocated to customers. If they are not profitable, the loss is divided into 10 contracts, and the five are stashed away as "squared off even". Heads they win, Tails you lose.

With the removal of pooling, such blatant manipulation is disallowed. Which is also why some PMS providers are sulking.

Lastly, the creation of individual accounts for each account gives every user the ability to cross check trades - with the depository or the exchange. That is not something the PMS provider will like because it is a trail - and anything that was "hidden" earlier will come out in a surveillance operation by the exchange or courts.

But since they have six months, expect the maximum churn to happen from now till then. If you have a PMS account and suspect such activity, I'd say simply pull it out before this happens to you.

Labels: Commentary

So the dollar has risen like crazy. From 39.9 a couple weeks back, to 42.5 today. And getting stronger. Is this FII profit booking?

Heavy dollar buying by foreign banks on behalf of their custodian clients in the non-deliverable forward market (NDF) along with continued dollar demand from oil companies led the spot rupee to breach 42 and reach a 13-month low of 42.2150 on Tuesday.

According to dealers, the spot rupee opened a tad stronger at 41.98 after closing on Monday at 42 to a dollar. Demand from foreign banks to buy one-month dollars in the NDF market triggered the fall, which was further enhanced by dollar buying by oil companies.

Dealers explained that most of the custodian clients (foreign institutional investors) were booking profits on their investments in India but phasing out the repatriation of funds through NDF dollar purchases in forward market.

FIIs definitely have been selling recently, according to SEBI stats. A theory is that this selling is due to lowered leverage offered to hedge funds after the credit crisis worldwide. Another is that this is simply profit-booking, to counter huge losses in the credit markets.

Either ways, this adds on to oil buying by the oil companies, which requires a lot of dollars, obviously.

A lousy rupee is bad for inflation because imports get costly, and international prices of commodities are high. Double whammy there.

And my new conspiracy theory is the dollar is propped up to keep the exporters really happy so that the Karnataka elections can be won.

So how bad can the dollar get? Technically speaking, the charts show no resistance till 44. But being purely technical in a market like this is stupid. SO obviously it will stump all the technicals and go topsy turvy and confuse the hell out of hedgers.

But there is hope, I think. This is likely to be part of a huge pullback rally on the dollar worldwide, and in the US markets. The credit crisis will soon slip into phase 2 - post July , I think - and the subsequent drop in all sorts of asset prices should push the dollar to much much lower levels. So this is a chance for those that didn't get a chance to hedge - eventually they'll remember these levels fondly.

But note carefully that I have been wrong so often it's worth taking anything I write with a lot of salty. Salty advice. That's what I should call this blog really.

Labels: Commentary

Portfolio management services (PMS) have been told to change the way they operate. (From DNA)

Sebi asked PMS houses not to pool assets of investors the way mutual funds do and also increased the minimum networth requirement for floating a PMS house.

The networth required to float a PMS scheme has been increased to Rs 2 crore from Rs 50 lakh earlier, purportedly to weed out the smaller players.

The number of PMS players has shot up to 205 as on March 31, 2008, from just 18 in 1999. These include several small and mid-size brokerage firms. This is unlike in the markets abroad, where PMS is run primarily by asset management companies.

The second part - of having a higher net worth - is just to weed out the smaller players.

The first part is important. But before I say why, a little history is worth looking at.

PMS schemes were badly abused in the 80s and early 90s, and were at the time only for institutions (who would give money to banks to invest in bonds/shares). Banks used traders and brokers to freely move money around, but the abuse was in how the banks actually made it take all their losses. Banks had their proprietary trading going as well, and they would take on huge trades. Some of these trades in their prop accounts made losses, and sometimes, large losses.

Banks routinely transferred the losses to their PMS client accounts, essentially saying that these trades happened from the client's money, not their own. With no system to check them, this happened for years and years, even with RBI's knowledge. Why did the clients stand for it? For two reasons - a) some of them were public sector companies where palms were greased. For instance, Sucheta Dalal and Debashis Basu found that Power Finance Corporation had taken a loss of 90 lakh in 1991, and the beneficiary were Aditya Birla's daughter and daughter-in-law. Citibank was the PMS account manager, and presumably this deal was done to please the Birlas and the intermediary brokers. Why PFC stood for it is anyone's guess, and that guess might include some money moved hither to thither.

Another reason was unsaid guarantees. Banks weren't allowed to guarantee PMS returns, but they did, unofficially. Some even to the extent of 25% a year. Then, any profits made above the guaranteed rate, could be offset by any losses, the client wouldn't care.

This kind of abuse went on for years and years until the 1992 scam was unearthed, and many banks simply stopped their PMS services.

Now PMS is back for the individuals, and banks and brokers have lined up for your money. Except, we've heard millions of stories where despite a strong market, PMS products have returned negligible profits. A person I know got exactly 25 lakhs back, on a 25 lakh investment, after two years of investment. Only the Sensex had gone up 2.5 times in the same period. Hundreds of others have written in blogs, comments and sites about pathetic PMS performance.

I can surmise now that the way PMS has operated, with brokerage houses at least, is that they take all this money and put it into a single account. They put their own "prop" money in the same pool. Then they go and trade. Now they must allocate trades to individual accounts, because that's how PMS is supposed to work. So they take all the profitable trades and put it in their account. If any good trades are left, they assign it to the highest valued PMS accounts. The remaining simply take the losses. Abuse, you say? But what can you do to stop it?

With SEBI's new rule, some of this MIGHT be plugged, you think. Since no "pooling" is allowed, each trade has to reflect the owned account, and therefore this abuse is lesser. That may be true - and this will reflect in brokerage results. The recent results have been good, but that could have been because of this kind of abuse - with no allowance to do PMS gotchas, there is likely to be a slide next Q and onwards. But the guys in there are smart enough to figure out other ways to con clients - like assigning day trades to PMS clients (client accounts can be tacked on later), not disclosing client account trades for three months, and such.

So what can you do?

• If your PMS account shows day trades, and the profits generated are not beating the index, then get out of the account. Potentially some kind of shady stuff is going on.
• If your brokerage tells you they won't show you your account transactions for even five days, and the average holding period of a stock is less than five days then exit. You should be able to see transactions literally on an end-of-day basis, or at least while they are open (i.e. bought but not yet sold etc.)
• Don't believe your brokerage if they tell you they don't do prop trading. Prop trading can be a special client account.
• Track your PMS account regularly. They have been sources of fraud for ages, and you don't want to leave it unguarded.

What you want is good disclosure and top quality returns. SEBI's rules are well intentioned but they must audit the PMS accounts and ensure this is being followed - and make a 10 crore fine per incident of fraud. And do this to particularly to the big brokerage houses.

Does SEBI have it in them?

Labels: Commentary

So Oil Prices are reaching $124 and showing no signs of stopping. Means they will stop pretty soon, and reverse direction, because everyone and his uncle is predicting that the price will hit $200. That's my theory of market versus people who make a lot of noise.

Anyhow, assuming the oil price stays this high, what happens?

• Will etrol and diesel prices increase - remember the last increase was when the price was below $90 a barrel. But who cares really - the oil companies that market fuel are government controlled and can bleed enormously. The government will fight fuel rises to the very last breath, because it's the last year before general elections. Private players like Shell and Reliance have already cut down retail operations massively. SO I wouldn't expect retail prices to increase right now.
• If they do increase, however, inflation will hit new highs as literally everything depends on such prices.
• The price of flying goes up, as jet fuel prices aren't subsidised. Less people fly and overall, we should see an impact on companies like Air Deccan and Jet. Airport providers like GVK and GMR will also be hit if oil prices stays this high.
• Refiners like RIL and RPL should benefit as the heavy-light crude differentials remain high. Yet, with more refineries coming along, this may not be a very sustainable advantage in the long run.
• The rising cost of fuel is funded partly by a falling dollar. But in India the rupee is falling against the dollar, so that's a double whammy for us. Still, I believe the dollar reversal is a short term thing, and I hope Mr. Big Shot IT companies and Textile companies are setting up more hedges now - this is going to look very attractive a while from now.

High oil prices should usually mean higher gold prices. Yet, gold is benign. So some kind of a major trend change is happening, and I think we're in an inflexion point yet again in the financial markets. All old links are out, new links are being formed, and the wisest person is someone who doesn't try to predict, but follows.

Labels: Commentary

From Business Standard:

Chennai-based Indian Overseas Bank is planning to sell its properties to self-promoted special purpose vehicle, thus realising the entire profit and then ploughing it back to its Tier-I capital. IOB will do a leaseback deal of properties that it had sold to the SPV.

Fantastic. This is like me selling my house to a company owned by, er, Me. Then renting it back from me. And saying that since I sold, I made humongous profits.

Very interesting, this. Why will IOB do it? Simple - its real estate assets are on the books as the value they were acquired at. They can't simply revalue them (would probably go into a different account, not profit, but I'm not sure about this).

Who benefits? The government. The sale involves payment of registration fees. The leaseback has service tax on it. So the government should be happy to do this deal. The bank shows a 600 cr. profit so technically shareholders will seem to be quite happy too.

The difference between selling the land to an uninvolved party and this, is that there you lose the ownership, and the leaseback may not be at your terms. Here IOB gets the best of both worlds.

If you're screaming "unfair!" then consider this: So many people bought all these companies saying "land bank". This is just like valuing a land bank. If you think that selling to a third party and leasing would be better - think about a scenario today where hajaar companies and banks have land banks at cost. SBI, for instance, has huge tracts of very prime land.

So let's say SBI sells land to an IOB Special Purpose Vehicle (SPV), and IOB sells its land to an SBI SPV, and they both do leaseback agreements. This will be "above board" to nearly everyone and raise everyone's profits, and the governments revenues through taxes. Fantastic, no?

Real estate companies do this routinely. Recently DLF announced that it's revenues were lower by 800 cr. because they cancelled a sale of land to a company named "DLF assets". Uhem.

If it's legal for real estate, it should be ok for banks. But what it's teaching me is: reported financial results cannot be taken at face value.

Labels: Commentary

A quick note to tell you I've been interviewed by Kamla Bhatt about Moneyoga.

Here's a link to the interview:
Deepak Shenoy: Entrepreneurship Is Overrated. Is It Really?

The interview is about Moneyoga, what we are, how we're different, what we want to be, and some of my views on entrepreneurship. Do have a read and let me know what you think.

Kamla's site has been featured by LiveMint in their online article on 10 popular blogs for Indian ventures.

Labels: Moneyoga

...is that the RBI will not let the dollar devalue against the rupee, regardless of inflation figures, until May 22.

Because that's the day the Karnataka elections are over. Karnataka has a lot of exports - not just IT, which is what makes it famous, but also textiles, granite, lots of different types of ore etc. A dropping dollar will threaten all these people's jobs, and something done today may adversely impact elections, no?

At least it will ensure that the Congress stays out of power. And that is a no-no. The problem is what to do when prices of food items are so high? I think that will require a lot of scratching of heads, but I don't think there's any solution except to let the dollar go, eventually. The FM routinely gives excuses about how they will stabilize, but they will not, as long as we have this ridiculous dollar-rupee equation.

Of course, my theory goes further. Not only will the dollar slide after the 22nd of May, it will do so without warning from the RBI or anyone else. The reason will be some international reason like too much money coming in, or that our markets are buoyant (which they will be). Warning means too much explanation and too many people trying to do stupid things like speculating on derivatives which they don't understand. But this isn't just no-warning. This is actually going to be saying "we'll protect the dollar at any cost" and not doing so, stating reasons for the lack of protection as something else. The CNBC commentators will be having wet dreams about this kind of day.

That's also the reason why there should not be a stock market crash before then. But Karnataka is not so stock-market-dependant so that cannot be inferred...still, a party does not want any negative news during elections, and the Congress will do whatever it can.

That's me getting off the political pedestal, and going back to reality. Please note that this is a random conspiracy theory, and should not be taken seriously, but it does refer to people dead or alive. It's just me having some fun.

Labels: Commentary

I often hear people quoting Warren Buffett saying "Derivatives are weapons of mass destruction", and thus, that derivatives are ultra-horrible, a bad thing, a sin, and what not.

What Buffett says is not what Buffett always does. Berkshire Hathaway, the company he runs, had it's net income falls64 percent because of derivatives.

Berkshire Hathaway Inc. said Friday its first-quarter profit fell 64 percent because it recorded an unrealized $1.6 billion pretax loss on its derivative contracts, and its insurance businesses generated lower profits.

Berkshire reported net income of $940 million, or $607 per share, in the quarter ended March 31. That's down significantly from the net income of $2.6 billion Berkshire generated a year ago.

Berkshire's chairman and CEO Warren Buffett warned shareholders in his annual letter that the derivatives could make the company's earnings volatile. But he predicted the derivatives will ultimately be profitable.

...

Including the derivative losses, Berkshire's net investment losses in the quarter totaled $991 million. A year ago, the Omaha-based company recorded a $382 million investment gain.

Berkshire's derivatives fit into two major categories. Berkshire will have to pay on some of the contracts if certain U.S. entities default on their credit. Most of the other derivatives will only be paid if the certain stock indices are lower in 15 or 20 years than they were when the contract was written.

Berkshire has received $2.9 billion in premiums on the credit-default derivatives and $4.9 billion on the stock index derivatives.

Berkshire said its operating earnings are a better measure of how the company is performing in any given period because those figures exclude derivatives and investment gains or losses. Berkshire reported $1.93 billion in operating earnings during the first quarter, which was down from $2.21 billion in operating earnings a year earlier.

Berkshire's insurance group, which includes Geico, reinsurance giant General Re and several other firms, contributed $181 million to net income from underwriting new policies. A year ago, Berkshire's insurance companies generated a $601 million underwriting profit.

Buffett has said he expects insurance profits to fall during 2008 because increased competition has driven premium prices down, and a catastrophic loss could further hurt insurance profits.

Emphasis mine.

Now I don't think you should hold Buffett to his word. This is a business where being fickle is a good thing. When circumstances change, you change. Buffett probably meant his mass destruction statement when derivatives were being sold with no idea about risk. But today when risk is priced in, derivatives are much more attractive for a value investor.

Berkshire's business itself is partly insurance. Insurance, I believe, is like a derivative, and that is in effect what Buffett has done - insurance on certain credit not defaulting, and insurance on the index not falling over twenty years.

Not that it is a good idea because I have no idea what twenty years will do and would never write the insurance. You can only come out in two ways - looking like a hero, or totally bankrupt. There's no "in-between". And the number of events, or "black swans" that can happen are ridiculously high - high enough to bankrupt you.

Take the put option Buffett has written on stock indices. Assume a 50% fall from here. He has received about $4.9 billion in premiums. For example a Dow Jones Index put at 12,000, over 20 years, he might get around $1165 per unit, and since they've said around $4.6 billion total premium received, means around 4 million shares which translates to a strike value of $48 billion. Margin requirements for such options are typically $2.5 billion (at 5% margin). That means for an equivalent put option, the margin required is $2.5 billion, for an exposure of $48 billion. If the index falls 50% anytime in the next 20 years, there will be a mark to market loss of $24 billion (though the option cannot be exercised until 20 years later). This $24 billion will be required as a maintenance margin, cash that the company can't technically use. Right now the company has around $36 billion, but if the stock markets hit lows, the cash may be required to purchase or bail out companies - the way Buffett has traditionally grown. Not having that avenue is horrendous - and this is just one index option written - there are other things that require margins (insurance, CDS etc.)

It may sound like a 50% loss is not quite forthcoming or in the horizon, but who can ever see these things? I would want to be on the buy side of that equation, using short term puts as a hedge instead. Far more predictable, and controllable and loss protected.

And that's just the index puts. There are credit derivatives, which assume no credit defaults by the underlying companies. What if that doesn't pan out?

Coming to the rest of the highlighted items. Note carefully - operating income has gone down. Insurance business has gone down in 2007, and is expected to be worse in 2008. Businesses like Amex, Wells Fargo et. al. are due for a subprime hit, and the residential problems will hit the furniture/carpeting businesses. Life isn't going to be easy the next few years.

In a lot of ways, this is huge change in outlook for one of the world's most admired investors. We must wait and see how well he reacts. One lesson though: Do not believe what Buffett says is what Buffett will always do. Because in this business, people change - and for good reason.

Labels: Commentary

From Moneycontrol: (Hat tip: Samarth)

Reliance Power Ltd, which raised Rs 11,562 crore in its IPO in January last, has temporarily parked almost the entire money in mutual funds. The 2007-08 financial results declared by the company on Monday show that Rs 11,412.81 crore is invested in mutual funds. The company has not disclosed either the funds or the schemes where the money has been invested.

The IPO offer document says that the company “intends to invest the funds from the issue in interest bearing liquid instruments including deposits with banks and investments in mutual funds. These investments may include investments in mutual funds managed or financial products sold by one of our affiliates, RCL (Reliance Capital)”

The company has spent only Rs 25.83 crore as of March 31, 2008 in construction and development of its various projects.

The temporary parking of the IPO money in mutual funds has helped the company report a net profit of Rs 94.6 crore for 2007-08. Total income for year stands at Rs 132.8 crore, of which dividend income is Rs 112.7 crore.

Reliance capital benefits from Reliance Power's parking of funds, surely - they're just crossed an AUM of 100,000 cr. and this sorta helps, I guess.

And now, without using ANY money they can get around 900 to 1000 cr. in "dividend income" - nearly 9% of the collected money - as practically risk free money. If they don't spend a lot that indicates a huge part of it as profit - heck, they could grow revenues and profit 8 times (800% growth) without moving a finger!

Well, this makes no sense fundamentally of course, but things will change as we move on - surely they will deploy this money into projects and those should get you a much better profit than the risk-free return. Still, the share issuance is very large - nearly 236 cr. shares are out there, and some more with the bonus issue. So it's all going to be about how they churn out profit. At current prices of 400+, they need to make profits of some 10,000 cr. within five years to get a good return. That will be something to see.

Disclosure: No positions.

Labels: ReliancePower, Stocks

From Bloomberg:

Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn't understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn't understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Three months later, Mehta, then chief finance officer of Sundaram Multi Pap Ltd., told his chairman that two of the contracts had turned sour, incurring losses of 60 million rupees ($1.5 million). ICICI has served a bankruptcy notice to collect the money, Sundaram says.

"I was made to believe these bets don't go wrong," says Mehta, 33, a commerce graduate from Mumbai's Dalmia College. "It was all about making profit, no mention of losses." ICICI, India's second-biggest bank, denies misleading its customers.

Indian companies may lose $4 billion on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Sundaram is among a dozen firms that have filed lawsuits against banks including ICICI, Kotak Mahindra Bank Ltd. and Axis Bank Ltd., accusing them of hiding risks to lure small businesses into contracts they didn't understand. No rulings have been issued.

"There's a lack of transparency at banks," says Gautam Rao, director of Business Risk & Hedge Management, a Chennai- based consulting firm. "They don't explain the various legs of the transaction. The companies have no clue what they're doing."

Looks like the companies are claiming they weren't advised right.

The banks say clients were fully aware of the risks.

"We maintain records to show that companies knew what they were getting into," says Madhabi Puri Buch, an executive director at ICICI who declined to comment on specific cases. "There were no complaints when they were making profits."

In Sundaram's case, ICICI has a signed contract and the recording of an Oct. 24 phone call in which Mehta says, "Yes, yes, yes, I agree," according to papers filed at Bombay High Court.

Indian banks may lose 16 billion rupees if they can't enforce the contracts with smaller companies, according to CLSA, the Asian brokerage arm of French investment bank Calyon. The estimate is based on the assumption that 10 percent of companies may renege on the agreements.

ICICI declined to comment on potential losses for its clients on April 26, when the bank reported earnings. Axis Bank, India's fourth-largest by market value, set aside 719.7 million rupees for possible losses April 21.

Two things work in favour of the corporates. One, that they may be able to prove that the banks sold them products they did not understand. The usual statement is "caveat emptor" - buyer beware - which means if a buyer agrees to buy a product he is responsible for the risk. But in banking circles, a new term - caveat venditor, or seller beware - is doing the rounds. Given that financial derivatives are horrendously complex, understanding them can sometimes be beyond the ability of small companies. And then, some products are disguised lose-lose situations for the corporates, because the banks have access to far more information that the corporates. When this comes out, it is likely that an authority - either the RBI or the courts - may rule in favour of the corporate. (They have done so many a time, telling brokers to return clients money even after having a power-of-attorney to trade)

Second, ICICI bank can't sell them a derivative if it's a speculatory hedge - because the RBI bans those if not traded on an exchange. Most of these contracts are OTC - over the counter - products, which are ok for a hedge, but not really for the kind of contracts that have been taken which are simply speculation. If the corporates prove that the contract was illegal, they cannot be enforced and the banks are left holding the loss.

So two things work against banks - that the contract may be deemed invalid because it's illegal, or that they missold the product. If the court ruling is for Sundaram, expect a huge number of cases against the banks.

What are the other options? Out of court settlement. This will necessarily be in favour of the corporate - as obviously the payment will be much lesser than the demand (why settle otherwise?) Even there, there will be more such cases by other corporates who know they can get away with paying less.

Lastly, what if ICICI wins? They may not get the full money - in this case, the company may be bankrupt and only part of the money may be recovered. But after this, no one will deal with ICICI for derivatives; that means a huge reduction in fee and treasury income. With credit growth slowing and now fee/treasury income also impacted, the net impact on banks is negative.

This is very bad for the big P/E banks. If anything it is good for the traditional, conservative banks, who are likely to get the business. They're all at P/Es of 6 and 7 and such, and growing reasonably - like Corporation Bank. (But these PSUs suffer on account of the government's policies so risk isn't small)

(Note: Canara Bank just announced bad results. Will cover that separately.)

Labels: Commentary, ICICI Bank

ICICI Bank reveals it's Q4 results and annual results for FY 08.

What I'm concerned with is the EPS contraction in the fourth quarter. In Q3, I'd noted that EPS growth was only 2%. In Q4, EPS was Rs. 5.68 versus Rs. 6.2 in Q4 FY07. This is an EPS contraction of 52 paise, or nearly 9%.

Note that again, carefully: EPS growth in Q3 was 2%, and in Q4, EPS growth was a NEGATIVE 9%. Slowdown, anyone?

Now for the financial year, diluted EPS was Rs. 32 versus Rs. 30.75 last year. That's a 4% growth. At current price of Rs. 916, you are paying a P/E of 28 for this company. Now 28 P/E for slowing growth is a tad high, huh?

(Note that the official result statements show some 39% growth in profits. But that is an absolute number - they raised 20,000 cr. last year, which diluted the capital severely. If growth can only come from capital expansions, then we shouldn't be paying this kind of P/E.)

Having said that - let's conider the "weighted average EPS", which has grown to 39.4 from 34.8, which is a 13.2% increase. Again, way lower than P/E. What's more scary is that EPS growth is really slowing down in a quarterly manner.

Other points:

• Growth from UK and Canada is huge. Is this subject to a slowdown in those countries? Time will tell.
• Impressive growth on the Mutual fund and Brokerage subsediaries.
• Insurance is unimpressive. The numbers don't seem to provide too much confidence in the businesses. Insurance actually lost a heck of a lot of money (1500 cr.) which may be good to demerge.
• Coming to demergers, there wasn't much that was heard of the demerging of the mutual fund, insurance and brokerage subsediaries. Any news?
• Retail credit growth may be suspect because of the home loan squeeze and generally high asset prices.
• ICICI Bank has provisioned a further Rs. 400 cr. for this quarter's mark-to-market losses. In my earlier post we had seen this figure being switched back and forth. But now they are clear - 280 cr. earlier to this quarter, and another 400 cr. now.
• ICICI refuses to mention what derivative losses it's clients have. That's ok, they don't have to. It's their clients that lost money.
• What's weird is that they mention that they have some customers who have filed legal cases against them. And they have provisioned some money against such cases. They have specifically not mentioned how much the provision was, and the potential impact of these cases. Beware the unsaid words - they will come back and bite.

Disclosure: No positions. Was short, but am out of that position now. I wouldn't short this stock on Monday - the technicals look very strong. But the fundamentals are weak, and I think now it's a matter of time before this stock goes down.

Note: This is not a bad company - it's not going to be bankrupt. It has a lot of assets, and capital to support itself. But it cannot command such valuations with obvious growth pressure. The company is consolidating and the stock needs to do so as well. At the current price, there's not much more left to go - but take 1/3rd off and maybe there's a story.

Update 27/4/08: ICICI Bank's 1 hour conf call provided more details.

• IPOs not planned until they get a "fair value" for the subsediaries.
• There was some difference between the way Prudential valued the exposure in insurance to the way ICICI did it. The reason mentioned was that the actuarial fundas were different (we are a growing economy etc.) for the two players. I am not very convinced. This is going to be an Achilles heel unless ICICI gets rid of it through an IPO.

Labels: ICICI Bank, Results, Stocks

From FT (tip: Marc's blog):

Rules regarding how banks account for off-balance sheet interests are “irretrievably broken”, a senior group of international rulemakers has warned.

The rules, which have allowed trillions [note the "t" -- not "m" or "b" but "t"] in assets to escape close scrutiny, have come under attack in the wake of the credit crisis as banks have been forced to disclose huge losses on these holdings.

But a report by a high-level group of accountants has warned that completion of the current overhaul of the rules would not be possible in the near future.

“Completing a final standard by mid-2011 will be extremely difficult, perhaps impossible,” says the report seen by the Financial Times and prepared by board members of the US-based Financial Accounting Standards Board and the International Accounting Standards Board.

While the report does not yet represent the official view of the accounting bodies, it is a sign of the turmoil within the industry in grappling with the off-balance sheet issue. [By "grappling", they mean, "Holy s---, are we in trouble now."]

Accounting standard setters are already under pressure for their support of marking assets to current market prices – a practice that has resulted in billions in writedowns and affected banks’ profitability seriously. [That's not the issue with mark-to-market -- the issue with mark-to-market is that it leads to a death spiral by which new downward marks lead to loan calls and fund redemptions which lead to panic selling which leads to new downward marks which leads to... you guessed it, banks' off-balance-sheet entities going kablooey and suddenly showing up at the door like your unwanted uncle.]

The Financial Stability [ha!] Forum, a global body of regulators and central bankers, has asked the IASB and its US counterpart to consider the issue as a matter of urgency. Accounting standard setters are in the throes of discussing how to respond.

However, the report by the high-level group of accountants says the project to overhaul current rules on off-balance sheet interests has lost momentum because of staff turnover and “relative inexperience”.

We would do well to heed this in India as well, where accounting standards are much more lax. Banks don't have to reveal a lot of details on underlying data, companies don't need to release balance sheets (only P&L accounts) every quarter, and there are enough ways to hide or toss around revenue.

We have all the more reasons to mistrust management and indeed, even auditors. I would not make a huge decision based on reported growth numbers - discount the upside, and amplify the downside.

Labels: Commentary

A number of you are searching for the record date of the Reliance Power Bonus issue and then hitting my blog. Note now that the management has announced it - Bonus shares will be issued to all those that own shares as of June 2, 2008. That means you must purchase the share on or before 29 May 2008. On the opening of the 30th, the share will go "ex-bonus" meaning any purchases from then on will not give the owner any bonus shares.

Labels: ReliancePower, Stocks

From Airtel's auditor's report:

Note 7 to these financial results, regarding the revaluation of investments in Bharti Infratel Limited (' BIL') at fair value, recognition of the difference between its book value and fair value as Reserve for Business Restructuring in the books of the Company and utilization of this Reserve for write off of losses on transfer of Telecom Infrastructure Undertaking, where the Company has followed such treatment prescribed in the Scheme of Arrangement as sanctioned by Hon'ble High Court of Delhi vide order dated November 26,2007, effective from January 1, 2008, in preference to relevant Indian Generally Accepted Accounting Principles, which, in the absence of such Scheme would not permit this fair valuation or utilization of Reserves for Business Restructuring.

I honestly do not know what this means. Airtel, when it put its tower assets into BIL - a different company - should have taken the assets off the books. It decided to "revalue" the assets at the time of transfer, and presumably this value was higher than book value (which is cost minus depreciation). The difference was a positive number, which was used to offset losses on the transfer.

I don't know what losses can happen when they demerge a unit into a subsediary company. Unless they decided that they can transition some loss into the subsediary and declare a higher profit in the main company. Is that what's happening? Need more clarity.

If a demerger to an unlisted subsediary is a way to increase profits in the core company, a lot of demergers are going to happen. Wait. They are already happening, in a number of companies.

And there is more in the auditor's report.

Note 11 to these financial results, where based on a legal opinion, the Company has continued with its accounting policy to adjust foreign exchange fluctuations related to purchase of fixed assets to the cost of fixed assets as per the requirement of Schedule VI of the Companies Act, 1956, which is at variance to the requirements of Companies (Accounting Standard) Rules 2006 dated December 7,2006.

Again, I think the implication of this is negative. (If it had been positive, the auditors would have said that should the real accounting standard been followed, the net profit would be higher by XX cr.) This means that some legal loophole exists that allows Bharti to have a lower forex loss from dollar appreciation by doing some accounting magic.

Note that there seems to be no evidence of any wrongdoign here. They are likely to be using the right legal and accounting methods to maintain fantastic topline and bottomline growth.

But I am wary of such reports in seemingly bad times - and if we start seeing more auditor warnings, chances are that growth has to be "created" by moving numbers around. I expect a lot of excellent bank results going forward - we've already seen excellent numbers from Axis Bank, Yes bank and HDFC Bank, and are likely to see phenomenal numbers from ICICI too. Because we will never understand the accounting, and we have to trust the management.

My feeling is that this quarter and the next will see all sorts of funny-money accounting, and then we will not be able to deny growth slowdown any longer. Already we have seen EPS growth of 13% on the Nifty, and in a few days we'll know if the last quarter was any better. (All results of Nifty stocks are not out). Fun times.

Labels: Airtel, Stocks

From Calculated Risk:

Homebuyer's were speculating with no money down. Mortgage brokers didn't care because they would sell the loans immediately and collect their fees. Wall Street didn't care because they could package the loans and sell them to investors. Investors would have cared, except they trusted the rating agencies. And as this article describes, the rating agencies weren't evaluating the underlying loans - they were performing statistical analysis using models based on lenders that cared if the borrower would repay the loan.

Who takes the blame? Rating agencies (the article referred to is here) seem to be the focus now.

What this entire business is is a loss of trust. Investors trusted the hedge and pension funds. Hedge funds trusted the rating agencies. Rating agencies trusted the banks. Banks trusted the borrowers. But if the trust was all ok, why was there a need to charge fees and high interest rates?

That means there is somewhere a small tiny possibility that someone will betray you. Currently it's all being pinned on the borrowers. They lied, so we all suffer. But who asked the rating agencies to trust the banks? What kind of idiotic person decides that homeowners can lie, but a bank will not? In the history of mankind, more banks have lied as a percentage of their population, than home-loan-borrowers. [Note: I'm making this up, but I think the data will prove me right] But we will still trust them over the latter?

So rating agencies were stupid. And why then were investors trusting rating agencies? Especially since they hadn't even paid for their (obviously laughably wrong) opinion?

Trust was breached at every level, and history will show us it has always been that way. You can fix the banks by forcing them to take on a lot more of the risk they offloaded. That fixes the borrowers - who will lie if they can, but banks will catch them if they have so much to lose. Then suddenly no one wants to lend anymore, which is more a political problem than an economic one. No loans, no lucrative jobs, and no risk taking - not signs of good capitalism.

You can fix the rating agencies by open-sourcing their business and providing no government protection. (i.e. public funds should not be required to have AAA or even rated securities). That will kill the rating business, a much lesser political problem.

But then it increases the burden on hedge and pension funds. Or does it? Such money comes with little accountability and in some cases a mongoose can do better investing; but investors persist because they do not want to become mongooses, or don't really know what being a mongoose involves. (What will I eat? Snakes? Yuck.)

Investors, we know, are the stupidest of the lot anyway and will trust anything even if it is only etched on telephone poles. Some of them are rich sods that understood the risk. Most of them are funds that didn't deserve to even think of the risk. Towns in Norway. School funds. Pension funds.

The trust is gone, and now all of the investing will unwind. Do whatever regulation you want, the trust is not coming back that easy. It will take a long time for us to realise that while there may be a lot of money in the "sidelines", it will not come easy to those that need it, because they can't trust anyone anymore.

Labels: Commentary