Against the herd

Bubbles develop and declines manifest in a certain manner. Knowing this pattern, you can book profits and curtail losses

Jojo Puthuparampil

History's first bubble is unrecorded. Perhaps it might have been triggered by Caveman A who traded a lump of brontosaurus flesh to Caveman B in exchange for hunting rights. In modern stock market terminology, a bubble refers to the run-up in share pieces until they reach so high a level that there is no one left who is foolish enough to buy. No one can predict when the bubble is going to burst or when the market is hitting its bottom. However, knowing the way bubbles develop and declines manifest you can book your profits and curtail losses. Allan Campbell’s book charts the pattern booms and panics follow.

Most bubbles tend to develop in a similar manner. Stocks start to rise in value for sound fundamental reasons. However, at some point people no longer buy stocks for their growth potential. They buy simply because stocks are going up. At that point, rational investing turns into 'irrational exuberance', and the bubble begins to inflate. Though we are foolish to buy stocks at this level despite knowing that they are overpriced, someone will be an even greater fool to buy them from us at an even higher price. To hear the bell at the top, turn your TV. "If pundits are talking about a new era for investors, it's time to sell," Campbell says.

Panic also follows a similar irrational logic. As stocks descent from their peaks, the dominant sentiment is to take advantage of the price dips and buy more stocks. This sentiment is especially prevalent if the bubble has been building for a long time, because the longer it has been since the last bear market, the less investors remember that stocks go down as well as up. As a result, there is often the bear-market rally. But when the rally stalls at prices below the previous high, some investors decide to use it as an opportunity to lock in whatever profits they still have. Thus, they sell, sending prices tumbling again. During this second tumble, panic often sets in as investors realise they have missed two opportunities to sell high. Now the concern is no longer about maximising gains, but about minimising losses. And selling is the only way to minimise losses. Every piece of news is interpreted negatively by investors who look for a reason to sell. As stocks go down, panic to sell begets more panic until everyone who wants to sell has sold.

At this point the market is at its bottom. Fortunately, panic, too, wouldn't last for ever. "When pundits start talking about an 'irrational depression' that will not easily be turned around, it's time to buy," Campbell counsels.

Contrarian signals work better in stock markets. That's why listening to conventional wisdom and doing just the opposite of what it suggests is a sound investment strategy. "You would ignore the voice of sentiment only if you are able to quantify whether the market is irrationally undervalued or exuberantly overvalued," Campbell reasons. And there are ample reasons why the market is not efficient but irrational.

The efficient market theory proclaims that the decisions of the well-informed buyers and sellers lead to fair prices. But if the theory is true, then stocks are always fairly priced and it makes as much sense to by them when they are trading at 50 times their earnings as when they are trading at five times. According to behavioural finance, humans possess ample traits that prevent rational stock market behaviour. The most decisive among these traits are: greed and fear (if humans are rational about money, casinos wouldn't exist), self confidence (this trait makes us believe stock market success is a result of skill, when often it is a result of luck), herd instinct (this mentality forces us to believe that the market, or herd, is right and we are wrong when the truth is the other way around), pattern recognition (we tend to see patterns when only randomness exists), myopia or lack of historical vision (we tend to consider recent events more seriously than earlier ones which actually bear more significance), and vanity (instead of admitting we are wrong, we keep on holding and stocks keep going down).

Studies have found that buying stocks when most strategists are bearish and selling them when most are bullish produced better results than buying when P/E ratios are low and selling when they are high.

The reason for this disconnect is simple: strategists tend to be bullish when economic and political conditions are good for stocks. But when conditions are good everyone is buying. By the time you read their recommendations, stocks already reflect the good news and are fully valued or overvalued. Conversely, the strategists are bearish when conditions are bad. But under those conditions, most folks have already sold; so stocks are cheap.

Conventional wisdom tells you not to act until you have all the information you need ('better safe than sorry'; 'look before you leap'). But with the stock market, you never have enough information. You never know what the economy will do or what political surprises are around the bend. But neither does anyone else, which is why stocks are always cheap during times of uncertainty.

When you begin to invest in stock markets, it is better not to listen to self-made pundits who flaunt terms like 'market timing', 'charting' and 'day trading'. These practices contain pitfalls that you might fail to spot. Market timing refers to the strategy of frequently increasing or decreasing your stock holdings in response to expected short-term stock market movements. This strategy doesn't seem to work because no one can predict market movements in the short term when trends appear random.

Technical analysis tells you the prices at which a stock attracted buyers or sellers in the past and indicates at what price it will attract them in future. But the future price of the stock will be determined by events that cannot be known in advance.

Day traders buy and sell stocks throughout the day to capture gains from small price movements. "Don't indulge in this exercise unless spending daytime in front of a computer screen watching your wealth fluctuate from second to second is your idea of fun", cautions Campbell. Beware!

Conquering Stock Market Hype

Author: Allan Campbell

Publisher: McGraw-Hill

Edition: 2004, paperback

Price: Rs725

The road to investing

The way of the successful investor is to do nothing—until you see money lying somewhere around the corner, and all that is left for you to do is go over and pick it up, says legendary investor Jim Rogers

Jojo Puthuparampil

"While I have never patronised a prostitute," writes legendary American investor Jim Rogers, "I know  that one can learn more about a country from speaking to the madam of a brothel or a black marketer than from meeting a foreign minister." Seeing and assessing markets across the globe from ground zero has been Roger's style. "The best way to profit from the global situation is to see the world mile by mile," he says. Adventure Capitalist is the mile-by-mile account of Roger's latest road trip across 116 countries, analysing regional markets and evaluating investment opportunities.

Behind the wheel of a sunburst-yellow custom-built convertible Mercedes, Rogers and his fiancé Paige Parker began their 'millennium adventure' on January 1, 1999, from Iceland. The journey—which ended three years later on January 5, 2002, in New York—took Rogers and Parker through 152,000 miles and half of the world's 30 civil wars, and resulted in the Guinness World Record for the longest continuous car journey. The couple traversed many countries where most rarely ventured such as Angola, Sudan, Congo, East Timor, and drove through deserts, jungles and epidemics. They marveled world's wonders like Grand Canyon, Victoria Falls and Taj Mahal, ran into deadly blizzards in Iceland, descended eight stories down ground level to visit an ancient subterranean city in suburban Istanbul, purchased diamonds from Namibia (which later turned out to be polished glass), camped with nomads and camels in western Sahara, witnessed 'butt dance' near the Senegal Mali border, moved past Bulgarian sex workers who raised their skirts to advertise their wares, drank salt-tea in Mongolia, gulped snake's gallbladder in China, and ate worms, termites and grasshoppers. Best of all, they saw the real world from the ground up – the only vantage point from which it can be truly understood – economically, politically and socially.

Rogers entered the investment business in 1968 with $600 in his pocket, and he left it in 1980, at the age of 37, with enough money to satisfy a lifelong yearning for adventure. He began globe-trotting with an around-the-world motorcycle trip 15 years ago, covering more than 100,000 miles across six continents (that journey became the subject of his first book, Investment Biker).

Rogers is a contrarian. His success in the market has been predicated on viewing the world from a different perspective. He dismisses the majority world view as bilge and counters much of what the glib Street savants say. His take on Iran, one of the so-called rogue countries, captures his approach. "Forget what Washington tells you; there is a lot of positive changes coming in Iran. Demographically, it is a very young country. And it is ripe for investment. I am very optimistic about its future." Rogers became a China enthusiast much before the world reckoned the communist country's capitalist credentials. “Twenty-first century belongs to China the way 20^th and 19^th centuries belonged to the US and Europe, respectively," he asserts.

According to Rogers, 'new economy' is not as hot as it made out to be. "Everyone talks about new economy. Well we have heard that before. The railroad and radio changed the world much more than information technology is said to be changing the world now. Radio Corporation of America (RCA) became one of the largest corporations in American history and made huge profits. But if you had bought shares in the RCA in the late 1920s, you would never have made any money because the shares never again got as high as they got during the mania. It wouldn't have been any different had you bought shares in the railroads in the 1840s. By the time the mania hits everyone is getting involved: banana salesmen, hairdressers and dentists. By the time the bubble has grown really big, the smart money is usually on the run," he says.

Rogers differentiates between trading and investing. "Traders are the short-term guys, and some of them are spectacular at it. I am hopeless at it—perhaps the world's worst trader. I see myself as an investor. I like to buy things and own them forever. And what success I have had in investing has come from buying stock that is very cheap. Even if you are wrong, when you are buying cheap you are not going to lose a lot of money. But buying something simply because it is cheap is not enough—it could stay cheap forever. You have to see a positive change coming, something that within the next two, three years everyone else will recognise as a positive change."

Risks never deterred Rogers in real life. But when it comes to investing he is surprisingly cautious. "I don't ever take risk with my money," asserts the adventurer who considers being the father of his daughter as his greatest escapade in life. "The way of the successful investor is to do nothing—not until you see money lying there, somewhere around the corner; and all that is left for you to do is go over and pick it up. You wait until you see something you think is a sure thing."

According to this adventure capitalist, the mistake that many people make in the stock market is buying something, watching it go up and thinking they are smart. "They take a big profit and immediately go looking for something else. That's the time when you should put the money in the bank and go to the beach for a while until you calm down. Because there are not many opportunities that are ever going to come along. But you do not need many if you do not make many mistakes."

Rogers' predictions are as startling as his perceptions: he insists it is time to dump shares and buy commodities (the commodity bull market has already begun), remains bullish on Angola and Bolivia (the transition of these countries from conflict to peace is positive), and foretells that the dollar, euro and yen will be doomed (he is yet to find a substitute for these currencies). He reserves the heaviest jab for desi pundits who position India along with China: India, he predicts, will soon break into several small countries.

India is not the only country that Rogers expects to disintegrate. "One of the more visible changes the world is undergoing right now is the end of the age of empire builders," he writes. "Over the past 300 years, thanks to technological advance, countries tended to grow bigger and bigger. That tendency is reversing. There are about 200 countries in the world today. Over the next three to five decades, there will be 300 or 400."

Born in 1942, Rogers had his first job at the age of five, picking up bottles at baseball games. Decades later, he co-founded the Quantum Fund, a global investment partnership, towards the end of 1960s. During the next 10 years, the portfolio gained more than 4,000 per cent, while the S&P rose less than 50 per cent.

Adventure Capitalist is the most adventurous journey one is likely to take within the pages of a book—the perfect read to armchair adventurers, global investors, car enthusiasts and anyone interested in seeing the world and understanding the markets as they really are.

Adventure Capitalist

Author: Jim Rogers

Publisher: Random House

Edition: 2003, hardcover

Price: Rs1,060

As hedge funds grow, so does risk

From fraud to exotic instruments, funds face varied risk management challenges

Jojo Puthuparampil

As hedge funds manage increasingly vast, complex and exotic portfolios, there is a growing concern about portfolio managers' risk and compliance officers' understanding of their risk exposures.

Over the past five years, the number of hedge funds has doubled, to more than 8,000, and total assets under management are approaching $2 trillion. This creates stiffer competition, which puts pressure on managers to take bigger risks or skate toward the edge of fraud or other malfeasance. According to Mark Sunshine, president of West Palm Beach, Fla.-based First Capital, which provides credit services for hedge funds, potential areas for fraud include misreporting assets, inflating returns, violating laws and regulations, ignoring disclose liabilities, and failing to follow the fund’s investment thesis and guidelines.

"Fund manager fraud is the number-one reason for serious loss—defined as greater than 50 percent—in a hedge fund," says Sunshine. "Because this is essentially an unregulated industry, there is little timely oversight of the managers."

There are also risks associated with self-dealing, which happens "when fund managers make investments with their personal money or the money of the fund management company," instead of the fund's money, explains Sunshine. "They then favor their personal investment over the investment  of the fund."

Managers can also hurt their funds by deliberately misstating the value of their portfolios or taking unacceptable risks. Anna Pinedo, partner at law firm Morrison & Foerster in New York, says that insider trading can also result in legal repercussions for hedge funds. "There have been a number of enforcement actions [by the Securities and Exchange Commission] against hedge funds and their principals for insider trading and market manipulation issues," she notes. "These actions are a good reminder to the hedge fund community that it is very important to have internal compliance procedures and for personnel within hedge funds to monitor internal adherence to the compliance procedures."

Exotic Investments

As the hedge fund landscape gets more crowded, funds look further afield for investment opportunities, pushing into areas such as credit derivatives and structured products. These highly customized, non-standard instruments can add risks that a manager might not even be aware of.

"Often, derivatives and structured products have a built-in leverage or gearing effect, which may make the effect of a change in an underlying or reference asset more severe than otherwise," says Pinedo. She stresses: "A thorough understanding and careful review of each product is required in order to be certain that the people at the hedge fund who are monitoring the portfolio understand the risk exposure under each derivative contract or structured product."

If hedge funds enter into back-to-back swaps or other derivatives contracts, there may be legal and business risks if the terms of the back-to-back agreements do not line up perfectly, she adds. "This is particularly true in the credit derivatives area where default and triggering events may not align," says Pinedo.

Lack of understanding is also an issue when it comes to correlating risks across asset classes and geographies, says Sunil Pai, chief information officer of Palm Beach Gardens, Fla.-based hedge fund ST Capital Partners. "The world has become much smaller in recent years, and there are a number of risks that have become or have the potential to become very correlated," he says. "Many newer hedge funds are run by inexperienced individuals—many coming out of big Wall Street firms—who have not lived through an event such as the hedge fund crisis in 1998 or the stock market crash in 1987. "These individuals may not be asking the what-if questions that are essential for adequate risk management," notes Pai.

Counterparty Risk

"Investment banks with large prime brokerage operations and commercial banks act as counterparties and creditors to hedge funds. They facilitate the implementation of many of the hedge fund managers' strategies and provide the capital that enables managers to leverage their exposures.  Concerns about counterparty risk management have become more pronounced with the increasing complexity of financial products," said Federal Reserve Board chairman Ben Bernanke at the Federal Reserve Bank of Atlanta's Financial Markets Conference in Sea Island, Ga. on May 15. "Complexity—especially when combined with illiquidity—amplifies the difficulty of measuring market and counterparty credit risks," said Bernanke. "The problems of valuation and of risk measurement faced by investors in tranches of bespoke collateralized debt obligations [CDOs] are a good example. Similar problems are faced by the core financial intermediaries that often act as counterparties to hedge funds in complex synthetic CDO transactions."

Given increasingly risky investments by hedge funds, banks may have the most to worry about, but hedge funds need to keep an eye on their counterparties as well, especially if the funds are straying far from their home territories.

"Funds must evaluate the creditworthiness of their counterparties," says Steve Howard, an attorney in the New York office of Thacher Proffitt & Wood. "If the counterparty goes bankrupt, the fund may not be able to recover its investment."

According to Sunshine of First Capital, some funds are producing high returns through excessive leverage. The higher the leverage, the greater the potential returns and the higher the risks. With ordinary borrowing, it is relatively straightforward to assess the degree of risk associated with an investment, but leverage can take many forms.

"It's much more than just debt," says Sunshine. "It includes derivative contracts, delayed settlements, swaps and options, and other synthetic instruments."

Morrison & Foerster's Pinedo notes that many complex financial instruments include embedded leverage as a feature. The embedded leverage not only increases risk in a hard-to-quantify way, but can also make the investment less liquid. As hedge funds come under increasing pressure to shorten lock-up periods, these instruments can create problems. "It may become more difficult to meet the short-term demands on the part of investors for redemptions," says Pinedo.

Valuation Difficulties

Hedge funds with investments in complex and illiquid securities may fail to accurately assess the value of their assets. The more complex the investment, the trickier the valuation process. For example, hedge funds need a more accurate means of valuing over-the-counter derivatives, Pinedo says.

There are inherent conflicts of interest in valuation, Pinedo points out, such as the strong economic incentive for hedge fund managers to overstate the value of a portfolio, since their fees are tied to returns. Valuation of positions for which market prices are not available also poses severe risks. It's important for a hedge fund to have standardized procedures and adequate oversight when it comes to valuation, she says.

According to Sunshine, lack of systems and infrastructure causes problems for many hedge funds. Technology costs money—which cuts into the bottom line. And so does management oversight. "Many fund management companies do not have adequate staff to manage their assets during an economic slowdown and are at risk of losing control of their investments if the economic tide starts to go out," Sunshine says.

Hedge funds must have appropriate systems to monitor and limit exposures and provide disaster recovery capabilities, says Pinedo. They must also have compliance policies to limit exposure and to segregate functions and activities among the front, back and middle offices.

"Operational risks are quite serious," she says. "Many hedge funds have grown very quickly and have not developed the systems and controls and procedures to keep up with their growth. Moreover, hedge funds generally are led by traders, who may not be accustomed to functioning in an environment where there are rigid internal controls and procedures."

Inadequate staffing creates other problems. "Fund performance in many cases is determined by the performance of a small group of people—in some cases one key individual," says Howard of Thacher Proffitt. "The fund could be harmed if key individuals leave or otherwise no longer manage the fund."

In this and other areas, size can be an advantage, says ST Capital's Pai. "Costs for regulatory compliance are going up while operational and debt funding costs are generally going down," he says. "Larger hedge funds have an edge in obtaining the best trading and fund-administration cost levels."

(This report was written for a New York-based news syndicate after speaking with US-based financial analysts)

When exchanges embrace and eat one another

When exchanges embrace and eat one another

Like their corporate counterparts, bourses world over, too, think being big is the only way to remain competitive

Jojo Puthuparampil

As traditional trading floors are becoming a distant memory, stock exchanges world over are trying to embrace and eat one another in order to expand reach and operations. The recent purchase of a 6 percent stake in the National Stock Exchange (NSE) by Morgan Stanley, Citigroup and private equity fund Actis is a brief act in a long consolidation drama being staged on the global financial markets, featuring leading bourses. The move by Morgan Stanley and others followed purchases of 20 percent in NSE by NYSE Group, Goldman Sachs, General Atlantic and Softbank Asian Infrastructure Fund (SAIF); as well as 5 percent in India's Bombay Stock Exchange (BSE) by German Deutsche Boerse for $910 million, and another 5 percent in BSE by the Singapore Exchange (SGX) for $42.6 million.

Against the backdrop of similar developments involving exchanges across the globe—NYSE's acquisition of Euronext, which runs exchanges in Paris, Amsterdam, Brussels and Lisbon; the Nasdaq Stock Market's pursuit of the London Stock Exchange (LSE), and attempts by NYSE and Nasdaq to form partnerships in Asia—these deals signal that the ongoing consolidation of global capital markets will gain momentum.

Bourses in India, whose gross domestic product grew 9.2 percent in the three months through December, second only to China among the world's major economies, are emerging active participants in the consolidation process. By picking up a stake in NSE after paying $115 million in cash, NYSE, the world's biggest exchange, made its first investment in Asia through the Indian market where the combined worth of stocks has risen 50 percent over the past two years to $820 billion.

What is happening in India is only a stray whiff emanating from a storm brewing elsewhere—almost all the world’s leading exchanges seem to be affected by the feverish consolidation contagion. LSE recently rejected a $4.2 billion take-over bid by Nasdaq. This was preceded by an unsuccessful bid for the London exchange by OMX, the Swedish Stock Exchange, in 2000. In recent years, LSE also rejected bids by Euronext by Deutsche Boerse, which runs the Frankfurt exchange, and by Macquarie Bank of Australia. In addition to the purchase of Euronext for $20 billion in June 2006, NYSE bought Chicago's Archipelago Holdings, a nine-year-old, all-electronic trading system, for $10 billion, in an effort to compete with all-electronic operations.

NSE, based in Mumbai and twice as big as BSE in terms of volume and value of the trade it carries out, handled a daily average of $2 billion in 2006. The 14-year-old exchange also dominates trading in equity-based futures contracts and owns stakes in the Indian National Commodity Derivatives Exchange and the Multi-Commodity Exchange. The transaction between NSE and the group led by NYSE and Goldman valued the Indian exchange at $2.3 billion. The deals involving the group led by Morgan Stanley and Citigroup will take foreign ownership of the NSE to 26 percent, the maximum allowed by Indian law. Morgan Stanley will buy 3 percent, while Citigroup will take 2 percent and Actis 1 percent.

"In a rapidly integrating world of financial markets, the partnership (with NYSE) brings together the strengths of institutions from North America, Europe and Asia. This alliance marks a significant milestone for NSE in developing a place for itself in the emerging global scenario. The global financial investors are amongst the most pedigreed institutions in the world, and will contribute to building value in the NSE," said Ravi Narain, managing director and chief executive officer of NSE, in a statement. The investment of NYSE, which has a market capitalization of more than $15 billion, is strategically important for NSE, he said.

"Indian exchanges are the best in the world when it comes to capital market transactions. However, local exchanges can learn from their foreign counterparts when it comes to derivatives and structured financial products," said Nilesh Shah, who manages assets worth $9.8 billion at Prudential ICICI Asset Management Company, based in Mumbai.

While the alliance with Goldman Sachs, which is a leading advisor to many of the world's major exchanges, will help NSE strategically, the deal with Softbank Asian Infrastructure Fund, which has over 60 portfolio companies in the region, will bring SAIF's extensive network of Indian as well as international relationships in the financial services sector to the advantage of NSE.

"Exchanges like NYSE already attract listings from around the world. Consolidation among exchanges across the globe would lend leading exchanges a stronger cross-border presence. Alliances among exchanges will also help investors better manage assets in foreign countries. As consolidation picks up strength, companies could list their shares in varied markets. But a listing in a different market would make sense only if it adds value to the stock in terms of valuation," said Vineet Suchanti, managing director of Mumbai-based consulting firm Keynote Corporate Services.

BSE, too, is aggressively forging alliances with foreign exchanges. The exchange has about 4,800 companies listed, a fully automated trading platform and nearly a billion dollars a day in turnover. Both NSE and BSE stand smaller in comparison with NYSE where $70 billion to $100 billion in shares trade each day. Though BSE is the oldest bourse in India, it trails behind NSE when it comes to attracting listings. It plans to sell 51 percent of its shares to partners and strategic investors in roughly 5 percent increments to enhance its operations and gain a technical edge.

BSE expects its alliance with Deutsche Boerse to strengthen its competencies, especially for trading in derivatives. The move in turn will help Deutsche Boerse to expand into Asia, and establish its presence in multiple time-zones and regulatory environments. Through the deal with the Singapore Exchange, BSE expects to capitalize on Singapore's position as a regional hub for derivatives and international listings.

"The Singapore Exchange is already listing a lot of GDRs (global depositary receipts) of Indian companies. Once the Indian rupee becomes a convertible currency - which is likely to happen in the near future – foreign exchanges such as SGX would be able to attract more Indian listings and increase trade," Suchanti said.

"Foreign exchanges are investing in India's long-term growth story," said Shah. "For Indian exchanges, tie-ups with their foreign peers would mean visibility, technology, and access to new financial products," he said.

Ownership

The Indian government lifted a ban on foreign ownership of exchanges in December last year. A single foreign investor can now own no more than 5 percent in any of the 22 stock exchanges in India. However, the total foreign ownership cap was raised to 49 percent under rules issued by the Reserve Bank of India. Foreign direct investment is capped at 26 percent, and foreign institutional investment at 23 percent.

Stocks on the Indian exchanges are some of the most richly valued in Asia, after the Sensex index of BSE jumped 45 percent in 2006. They are also volatile. The Asian market correction in the first week of March took some sheen off Indian stocks. Despite the volatility and fears of overheating, many argue that India's long-term economic prospects are too attractive for potential overseas partners to ignore. The efforts by foreign exchanges to form alliances with Indian peers mean that they would want to be a part of the growth the Indian market is likely to witness in the long run.

"Indian equities are most likely to continue to perform over a longer-term perspective, possibly much faster than many other emerging markets," said Shah.

Consolidation across the world

In fact, consolidation is becoming easier for stock exchanges now than ever before—through massive computers, fiber-optic cables, wires and satellite links. Consolidation also makes sense in many other ways. Clearing and settlement will continue to be cumbersome as long as exchanges remain fragmented. A large number of exchanges will also push up transaction costs. Consolidation makes trading easier for exchanges and brings in more liquidity. Bigger exchanges enjoy economies of scale that reduce trading costs, and attract more traders and listing companies. And as trading volume increases, it is easier for buyers and sellers to find one another. Added liquidity helps stock prices respond quickly to changes in supply and demand.

World over, shares are increasingly held by large institutions, who need added liquidity to manage huge trades; only large exchanges can offer this. Institutions are becoming sophisticated and cost conscious. Consolidation also brings a lot of transparency in transactions, which smaller bourses cannot offer.

Regulations

Tighter regulations make it difficult for US exchanges to compete with bourses in other countries, where regulations are not as stringent as in the US in attracting fresh corporate listings. For instance, the Sarbanes-Oxley law enacted in the wake of the Enron scandal makes company officials legally liable for the accuracy of their firms' financial statements. By acquiring foreign peers, US exchanges such as NYSE can serve listing companies that want to avoid harsher regulations in the US.

Like companies, stock exchanges also want to be 'big' to remain competitive in an integrated global economy. Those who don't join the race would just end up laggards. The purchases of stakes in Indian exchanges by their foreign counterparts reinforce this.

(This report was written a few years ago and the backdrop against which it was written has changed)

Of rash exuberance and its aftermath

Of rash exuberance and its aftermath

When irrationality becomes the norm rather than an aberration, the consequences can be perilous. The current crisis reminds why regulators and market players need to adopt a different approach

Jojo Puthuparampil

Sustained virtual growth of seemingly exotic sectors (for instance, home loans), driven by innovatively crafted assumptions (that realty prices will perpetually rise), leads to heightened confidence in the ability of the markets to thrive. Confidence, after a certain threshold, makes market players and subsequently investors irrational, leading to reckless indulgence in amassing hollow financial instruments (say, sub-prime debt) disguised as hallowed assets. After a while, when exuberance turns irrational and then insane, the titanic bubble of greed bursts, crushing the global financial façade under its weightlessness.

This, in a nutshell, is why the US banking and financial sector is badly battered and global financial markets are shivering (no one is guessing when the mess will be cleared). This also proved that even robust economies are under the jurisdiction of poetic justice (simply, this means whatever goes up will come down as long as gravity prevails).

No method in madness

Securitization—wherein cash-flows from a pool of underlying assets (such as mortgages) are turned into bonds, which are then repackaged and sold to investors as smaller slices—has been existing for over 30 years. But over the past five years, it turned into a dubious means to camouflage the huge exposure of exotic financial instruments, such as collaterized debt obligations (CDOs), to delicate underlying mortgages.

Securitization originally aimed to reduce risks—instead of banks holding every loan on their balance-sheets until it matures, risks would be sold and spread among a wider group of investors. But, of late, it has started betraying its grand motives, and became a coveted tool for revered financial re-engineers who mistook it for a magic potion to rake in exaggerated returns.

For one, securitization didn’t disperse risk effectively; when assets turned toxic, risks flowed back to banks’ balance-sheets. Two, it degraded credit quality by weakening lenders’ ability to monitor the status of the loans they write. The estrangement, and the subsequent widening gulf between lenders and borrowers, deepened the crisis.

Weapons of financial destruction

CDOs were just one of the myriad exotic instruments that lured and then trapped an entire generation of institutional and individual investors. Credit default swaps (CDSs)—contracts that insure against the default of financial instruments such as bonds and corporate debt—and structured investment vehicles (SIVs)—funds that borrow money by issuing short-term securities at low interest and then lend that money by buying long-term securities at higher interest, thus making a profit for investors from the difference—were equally glossy but lethal. As these instruments abounded, the distance between imagination and reality grew; nobody asked how many times they were re-repacked, and expecting gravity-defying 25% plus returns year after year ceased to be a sin.

Unprecedented damage

Bigger stars suck as much matter around them when they collapse. The present crisis is a colossal financial back hole, threatening to wipe the entire market cap growth that global markets underwent over the past decade.

It is also unprecedented for many reasons. Economic slumps lead to the death of companies; but this time, investment banks vanished en masse; the death of an exalted business model is even more shocking. Economies rebound when central banks tweak interest rates; this time, landslide cuts in rates announced by banks across the globe—along with massive bailout packages—did not stir even a minuscule ripple. Normally, economists and bankers fathom the depth of crises, though they may not come up with tailored solutions; now, it may take a few years before we approximate the extent of damage.

Be radical, else perish

An unprecedented crisis requires an unparalleled solution. Thirty years ago, everyone exhorted China to emulate capitalism to survive; today many wonder if China’s protectionist, authoritarian capitalism is a better alternative to US-style capitalism that helped lead many western economies to prosperity. Till now, markets were thought to be efficient, capable of fixing fair value and taking care of themselves. Today, banks shudder to lend without prudent regulatory norms.

Radical thinking can spawn unique solutions. For instance, London-based New Economic Foundation, which predicted the current crisis five years ago, proffer ‘deconsolidation’ as a means to reduce the chances of similar crises in future. Consolidation blew up the current crisis—banks are so big that when one slumps, everything collapses. If we slice banks into innumerable smaller entities, in times of distress, we will have many alternatives to resort to.

“Demerge banks to reduce the risks of systemic failure. Instead of further consolidation, the discredited financial institutions that have needed so much public money to prop them up during the credit crisis should be reduced to a size whereby their failure would not jeopardise the system itself,” it says. Any takers?

(This opinion piece was written when the mighty Bear Stearns, Lehman Brothers et al went belly up following arguably the biggest crisis in financial market history)  

It’s time the king of opulence brewed a different concoction

It’s time the king of opulence brewed a different concoction

It is early to write an epitaph for Kingfisher Airlines; but Vijay Mallya may have to pause, heed warnings and tread cautiously

 

Jojo Puthuparampil 

 

Those Bangaloreans who believe Vijay Mallya’s United Breweries (UB) group embodies the ‘spirit’ of the garden city are disheartened by the trouble brewing at Kingfisher Airlines (KFA). But those who are less empathetic feel the turbulent weather the airline has landed in is the result of feckless exuberance, or euphemistically fiscal indiscipline, at a time when the markets have been besieged by a spate of contagions—from sub-prime mortgage crisis to the spectre of defaults by once bellwether countries to shrinking fund flows and growth domestically, triggered by scams, policy paralysis, stratospheric inflation and a weak currency.

 

Importantly, the airline has hit an air pocket at a time when the group is facing tough competition elsewhere. For instance, though United Spirits (USL), the group’s flagship, exports liquor to over 37 countries and is the largest spirits company in the world by volume, selling 114 million cases a year and owning 21 millionaire brands (selling more than a million cases a year), it has already lost the coveted stature as the most profitable liquor maker in the country to Pernod Ricard India (PRI), the privately held local arm of French beverages major Pernod Ricard. Though USL’s beer brands still have nearly 50 percent market share in the domestic market, which is the second biggest in the world and the largest for whisky, with debts worth Rs 6,000 crore on its books, it rivals KFA (debt of around Rs 7,000 crore and accumulated losses of about Rs 6,000 crore) as a drag on UB’s financials. Rubbing salt in the wound, Kishore Rajaram Chabbria-owned ABD Distillers’ Officer’s Choice is expected to unseat USl's flagship product, Bagpiper whisky, as India’s largest selling spirit brand.

 

Decades of efforts to drive volume, overlooking margins and profitability, have taken its toll. A relentless focus on the low-price, high-volume segment where USL is the undisputed leader has also been proven to be wrong—while the premium segment has been growing at 25 percent over the last few years, the low-price segment has grown less than 16 percent.

 

Chinks began to appear in the king of good times’ armour much early. The group’s market cap has been eclipsed by the combined debt of its six listed companies—UB, USL, KFA, UB Holding, UB Engineering and Mangalore Chemicals—most of which has been spent on a spree of acquisitions, including Shaw Wallace in June 2005 for Rs 1,500 crore and Scotch whisky firm Whyte & Mackay (W&M) in May 2007 for Rs 4,800 crore. In addition, operating cash flow has been negative year after year; investment banks have swallowed words many a time after promising to infuse funds; aircraft leasing companies have reclaimed leased jets; oil companies have threatened to stop supplying fuel; tax bills have ballooned; and pilots have deserted KFA en masse. But Mallya, for whom risk-taking is a way of life, seems to brush these aside as minor roadblocks in his group’s ambitious journey to be a global major, by surpassing the likes of Diageo, the world's largest liquor maker, in scale and grandeur. 

 

Living ambitiously is a characteristic that distinguishes Mallya from most new-age Indian business magnates. For the same reason, he continues to fascinate most Indians who see him as the apotheosis of what they aspire to achieve in life. Zealously living up to his image of the flamboyant booze baron, Mallya, who placed the winning bid of £175,000 for the sword of Tipu Sultan at an auction in London and brought it back to India in 2004, has always excelled erstwhile rajas of the subcontinent when it comes to living in affluence—more than 20 residences across continents, including a $60-million villa on the picturesque island of Sainte Marguerite, half a mile off the French town of Cannes and those in Scotland, South Africa, New York City and California; three exotic yachts, one of which (Indian Empress) is among the world's larger (95 metres long) and most expensive (worth $89 million) cruisers; four private jets one of which is bedecked by a priceless Picasso; a 240-strong vintage car collection that includes Porsches, Bentleys, Maseratis and Ferraris; cricket and Formula One teams; and a stud farm at Kunigal in Karnataka whose history dates back, again, to Tipu Sultan.

 

Mallya shouldn’t be deprived of the credit for his larger-than-life accomplishments just for being his father’s son. Youngest child of an army doctor, Vijay’s father Vittal Mallya became the first Indian director of UB at the age of 23 in 1947. Founded by a Scotsman, Thomas Leishman, in 1915, UB was initially supplied liquor to British colonial troops in India. Vijay kept alive his father’s legacy by taking over the group’s reins at the age of 28 in 1983 when Vittal Mallya died of heart attack when he was only 59. While Vittal Mallya set the tone for expansive growth for UB by acquiring a slew of breweries and companies, including McDowell and Kissan, Vijay transformed the group in to a vast conglomerate of over 60 companies, spanning varied industries such as brewing, distilling, real estate, engineering, fertilizers, biotechnology, information technology and aviation.

 

All's well only if what one does ends well. Mallya, whose biggest ambition is to pilot an Airbus A380, burnt his fingers when UB group forayed in to civil aviation in May 2005. KFA, which envisioned to be ‘the biggest and the best’, was meant to be everything other domestic carriers were not—efficient and glamorous. Initially, Mallya personally picked cabin staff and instructed them to treat passengers as if they were guests in his home. And KFA loyalists relished hitherto unheard frills like goodies, valet service at check-in, live in-flight satellite television, and ‘the prettiest air hostesses’ in the sky.

 

But the going got tough very soon. And roughly six years after its flashy launch, KFA is a meek shadow of what it was supposed to be. The latest numbers are hugely disappointing—losses of Rs444.26 crore in the quarter ended December 31, 2011 and Rs1,027 crore in 2010-11.

 

However, KFA is not the lone loser in the domestic airline industry, mauled by rising fuel prices, a depreciating rupee and cut-throat competition. While IndiGo has remained an aberration (a net profit of Rs650 crore in 2011), KFA’s arch rival Jet Airways has been bleeding profusely and state-owned Air India has accumulated a debt of Rs42,570 crore (as of March 2011). The plight of domestic airlines is only a reflection of civil aviation industry’s perilous predicament elsewhere. For instance, in US alone, airlines have shed more than 130,000 jobs and lost close to $33 billion since 2000.

 

But all is not lost. A consortium of banks led by State Bank of India is ready to provide more funds if KFA arranges fresh equity of Rs2,000 crore, to help the airline maneuver near-term headwinds. Mallya has also received recapitalisation offers from two domestic investors for Rs800 crore in return for a 24% stake in KFA which will enable the airline to regain breath after tax authorities froze its accounts. And, considering the inherent strength of some of the group companies, Mallya’s personal wealth (more than $1.4 billion) and his uncanny ability to turn challenges into opportunities, no one is writing an epitaph for KFA yet.

 

But the close to one million who follow Mallya on twitter would expect him to pause, heed warnings and tread cautiously. After all, frugality is not a dirty word in India where a large chunk of the population still considers having a mingy meal of rice and lentil twice a day is opulence.

 

(This piece was written when mounting debt forced Kingfisher Airlines to ground half of its fleet)

Humans are closer to finding an Earth-like inhabitable planet

Humans are closer to finding an Earth-like inhabitable planet

According to a new study, discovery of multi-planet systems is much more likely than ever, hinting that one or more planets in those systems can be like Earth

 

Jojo Puthuparampil 

 

Astronomers have always been intrigued by exoplanets (planets outside the solar system) as they possibly offer a clue to finding an Earth-like planet in the outer space that supports life. According to a new study, published in Astrophysical Journal, humans are one step closer to finding an ‘inhabitable’ planet within the solar system. The study, based on data from NASA’s Kepler spacecraft which envisions to discover Earth-like planets orbiting other stars, says discovery of multi-planet systems is much more likely than ever, hinting that one or more planets in those systems can be like Earth.

 

The spacecraft, named in honour of the 17th-century German astronomer Johannes Kepler, has since its inception in March 2009 identified 1,235 planetary candidates in 997 host star systems. Of these candidates, 759 are confirmed exoplanets, including 54 that may be in the habitable zone, the region around a star where liquid water, and thus life, can exist. For instance, one of the newly discovered worlds, dubbed HD 85512b, lies at the edge of its star's habitable zone. According to the study co-author Elisabeth Adams, an astronomer at the Harvard-Smithsonian Center for Astrophysics (CfA) in Cambridge, Massachusetts, of the 997 planetary systems, 170 have multiple planet candidates, implying the chance of one or a few of them being Earth-like, possibly with life-supporting elements like water.

 

Kepler looks for Earth-size planets around Sun-like stars. It has an inbuilt photometer that continually monitors the brightness of over 145,000 main sequence stars which are known for longevity and stability. With the help of this photometer, it spots potential alien worlds by staring at a patch of sky and watching for dips in starlight caused by objects transiting their stars, as seen from Earth. For instance, if a planet’s orbital period is 10 days, it will pass in front of the parent star every 10 days, resulting in a dip in the light emanating from the star. This data is transmitted to Earth, then analysed to detect periodic dimming caused by extrasolar planets that cross in front of their host stars.

 

But simply seeing a transit isn't enough to prove a planet is involved. Some other phenomenon, such as a smaller star passing in front of its much larger neighbour, could be causing the main star to dim periodically. Therefore, astronomers rely on other methods such as ‘radial velocity’ and ‘transit timing variation’ to confirm that the spotted body is indeed a planet. In the study, Adams and colleagues ran a statistical analysis and found that, if a star system has multiple planet candidates, the confirmation step can be skipped, as most planet candidates in multi-planet systems are likely to be ‘real’ planets.

 

Discovery of multi-planet systems also helps astronomers look at multiple worlds that were born together to get a better understanding of planetary transformations and hence deeper insights into Earth’s formative years after the Big Bang.

 

Scientists are enthused by Kepler’s recent discovery of Kepler-22b, a planet about 2.4 times the radius of Earth, in the habitable zone of its star. They do not yet know if it has a rocky, gaseous or liquid composition, but they feel its discovery is a step closer to finding Earth-like planets. Kepler has also found two other planets with higher atmospheric densities, suggesting they have atmospheres of mostly water, and therefore conducive for life to sprout. Spotting water in any of the Earth-like planets is the biggest leg-up astronomers are expecting in their search of life elsewhere.

 

The findings of Kepler are supplemented by data from High Accuracy Radial Velocity Planet Searcher (HARPS) at the European Southern Observatory's La Silla facility in Chile. HARPS recently found 50 new alien worlds, including 16 ‘super Earths’. Astronomers use Doppler wobble technique which involves searching for wobbles in a star's light that indicate the gravitational pull of an orbiting planet. The method helps them find massive planets that orbit close to their host stars. In 2007, HARPS discovered a super-Earth, called Gliese 581d, that is believed to be lying within the habitable zone of its star.

 

Scientists plan to upgrade HARPS hardware and software and use the instrument to conduct a more refined search of nearby Sun-like stars for rocky Earth-like planets that could support life. They are encouraged by the fact that there has been a significant increase in the number of rocky exoplanets discovered by space missions, including Kepler and HARPS. They expect that in 10 to 20 years, humans should have the first list of potentially habitable planets in the Sun's neighborhood, according to another study by Michel Mayor, an astronomer at the University of Geneva in Switzerland. One of those would-be-discovered planets, they hope, may splash chemical signs of life—such as oxygen—in their atmospheres, helping unicellular organisms to evolve.