Weapons of mass destruction strike again!

Feb 15, 2010

In this issue:
» Wall Street hand seen in Greece crisis
» SEBI and IRDA at loggerheads
» "Safe Haven" comes under serious doubt
» Warren Buffett's record is a fluke, says Taleb
» ...and more!!

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Weapons of mass destruction strike again! No, we are not referring to the ones of the nuclear type. We are alluding to the ones prevailing in the financial world, namely derivatives. The New York Times reports that the perverse use of derivatives had helped the near bankrupt Greece to hide its debt problems. Infact, had it not been for some clever use of derivatives, Greece's entry into the European Union itself would have come under grave threat. And Greece is not an isolated example. The newspaper further alleges that instruments developed by such Wall Street biggies like JP Morgan and Goldman Sachs have enabled politicians to hide additional borrowings also in Italy and elsewhere. Clearly, it seemed a case of banks wanting to exploit the free spending tendencies of some of the Western Governments.

This episode is sure to leave investors in a tizzy. With something as hallowed as the government finances coming under the firing line, they would not know who to trust now. But we believe there is hope. And it could be found in the wise words of the sage of Omaha, Warren Buffett. He is firmly of the belief that if the people at the helm are full of integrity, then one may not lose sleep over the fact that there is some hidden liability lying on the balance sheets, threatening to blow up the company any moment. Thus, while management evaluation should always form an integral part of stock research, its importance in today's day and age where a lot of financial innovations are happening, cannot be emphasized enough. And this holds even more importance in the case of companies with small market capitalization that are not followed adequately enough as compared to the larger ones.

 Chart of the day
It is said that over long term, growth in GDP determines rise in stock market indices. However, between FY02 and FY08, what happened was dramatically different. While India's GDP grew in the region of 2 times, the Sensex witnessed a mindboggling seven fold jump. A part of the reason is of course higher multiples awarded to the index at the end of the period than at the start. But a great deal of buoyancy could also be attributed to the jump in corporate profits as a percentage of GDP as shown in today's chart of the day. It should be noted that during the period under consideration, shareholders in India companies became eligible for a greater portion of India's nominal GDP than the preceding period. Thus, if you are counting on a higher than 15%-16% returns from the Indian Sensex over the long term, India Inc will have to work hard on increasing its profitability from the current levels. It would indeed be great if margins are restored back to FY08 levels. However, the task may not be that easy.

Source: LiveMint
Net profits of top 500 companies by net sales

Is the recovery in India for real or is the government only hyping it up? As reported in the Mint, three sets of data with respect to agriculture, industrial output and national income have been issued by the government all of which paint a relatively rosy picture. Especially with respect to agriculture, despite the worst monsoon in 33 years, the government data shows that it is not doing as badly as imagined.

However, in this regard the government's projections are most likely to be optimistic at best. To put things into perspective, agricultural growth is expected to partially recover and decline by a marginal 0.2%. However, if foodgrains, fibres, oilseeds and sugar (that have a collective weight of 56% in total agricultural output) decline by 7% and fruits and vegetables (that account for 24%) are growing by 4%, then the balance would have to grow at 10% for overall agriculture to decline by 0.2%, which appears a bit stretched. Maybe, the government is looking for a plausible reason to hype up growth so that they can begin to rollback the stimulus and focus on deficit control. Reason or no reason, reducing deficit will have to be the government's priority sooner than later lest the debt situation gets out of control.

Foreign investors who are offloading investment in Indian stocks under the pretext of transferring wealth to a 'safe haven' may do so at their own risk. For the safety of the 'safe haven' is itself being challenged. That too by none other than Niall Ferguson, the noted author of 'The Ascent of Money', an international bestseller and one that tells the story of how the money game has evolved over the centuries.

In an op-ed to the Financial Times, Ferguson writes "US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941". He calls it 'the fractal geometry of debt, wherein the problem is essentially the same, be it for Greece or the UK or the US, just varying in sizes. Ferguson explains that the possibility of Greece's bailout by the European Union is limited. The onus therefore squarely rests on the German authorities, provided they are willing to extend their generosity to Spain and Portugal as well. With the US government's projections of a ballooning deficit problem, it is only a matter of time before the crisis assumes magnified proportions for the world's largest economy as well.

As European economies go into a tizzy over sovereign defaults, the noise for investing in the safe haven gold is getting louder. Now Marc Faber, the author of the 'Gloom, Boom & Doom' report has suggested that investors should buy gold even if the price continues to dip. And his reasoning is that the precious metal is merely in a correction phase of an upward trend.

Faber believes that even as gold could fall to as low as US$ 950 an ounce from current levels, it will rise again as governments continue to print money to narrow deficits. As he says, "I still believe gold should continue to be part of every investor's wise investment portfolio." We also toe Faber's line, but would suggest that one must not go overboard with the yellow metal. A 5-10% allocation of your portfolio to gold is enough.

As per reports, two of India's top regulatory bodies, the Securities and Exchange Board of India (Sebi) and the Insurance Regulatory and Development Authority (Irda), are engaged in a skirmish of sorts. The bone of contention is the regulation of 'Ulips' or unit linked insurance plans. It all started when Sebi last month sent a show-cause notice to all life insurance companies asking them to explain why they hadn't taken its prior approval before launching Ulips. Irda, for its part, considers Ulips under its purview.

Further, it is in no mood to give in to Sebi's intervention in the matter. We believe that since Ulips have a big component that goes towards investments in various securities, it is not surprising that Sebi sees itself as a governing body for the same. Further, reports suggest that the expenses and commission charged towards management of assets under Ulips are deducted from the premiums paid by policyholders. Agent commissions from an Ulip premium can be as exorbitant as 40%. With the kind of astuteness that Sebi has shown in recent issues concerning the stock market, we feel that any regulation from Sebi in this matter would be a welcome move.

Is it possible to beat the market consistently? Is it just a matter of luck? This is not a new debate. Around the 1960s, academics came up with a theory called efficient market hypothesis. Soon mainstream finance was convinced that no amount of skill can lead to superior investing results. Since then, the performance of prominent investors like Warren Buffett has caused an irreparable hole in the theory. But some experts are still not convinced. Bestselling author and quant trader Nicholas Taleb is one of them. Recently he has reiterated his view that there isn't sufficient evidence that Buffett is not merely lucky. We disagree. The best proof comes from a talk that Buffett himself gave in the early 1980s. There are several successful investors who sprang from the value investing school. Too many for it to be a mere coincidence. Statistically speaking, it is unlikely for all lucky people to be bunched together. For investors in India, this means cast your lot on the value investing school for sensible and superior investing. We certainly do skeptics aside.

Meanwhile, on a day when most Oriental markets were shut on account of holiday, the Indian stock market traded weak today with the Sensex down more than 100 points at the time of writing. Bharti, the telecom bellwether is looking quite weak currently, having lost in the region of 10%. Most of Europe however has opened on a positive note.

 Today's investing mantra
"If you believe you or anyone else has a system that can predict the future of the stock market, the joke is on you." - Ralph Wanger

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11 Responses to "Weapons of mass destruction strike again!"

Mony Nararyanan

Feb 22, 2010

ULIPs are essentially insurance and mutual fund packaged into a single product. In that sense, in my opinion, they need to be regulated by both IRDA (on the insurance part) and SEBI (on the investment part).

As far as investors are concerned, ULIPs provide the worst of both worlds.... a complete rip off. ULIP does not give enough life cover since it is packaged with an investment guaranteeing / projecting some returns / bonus. Return on investment of ULIP is less as compared to a pure investment scheme due to embedded costs of life cover. Investors will be far better off if they can just simply go for a pure life term plan which will give multiple times cover for much less premium. The saving in premium can then be invested in a pure investment product to generate better overall returns.

It is high time, the authorities seriously lookat banning ULIPs in the interest of investors.



Feb 16, 2010

1. Insurance Companies in India are regulated by Insurance Regulatory and Development Authority of India.
---- TRUE

2. Unit Linked Insurance Plans are basically, INSURANCE PRODUCTS, (of course investment component is there) and they are launched by the Insurance companies after prior approval of IRDA.
---- TRUE

3. IRDA - Protects the interests of the Policy holder.
---- TRUE

How come SEBI intervene ? or Why should?



Feb 16, 2010

I am surprized by your endorsing the statement "Warren Buffett. He is firmly of the belief that if the people at the helm are full of integrity, then one may not lose sleep over the fact that there is some hidden liability lying on the balance sheets, threatening to blow up the company any moment" If the people are full of integrity, then why would there be "hidden" liability on the balance sheet. The statement is a contradiction in itself.



Feb 15, 2010

I am going to make a politically incorrect statement. I agree with Taleb. Take the case of Business. why some business succeed some fail. On hindsight you may find some mistakes in failed business. did anybody check whether the successful business also did the same mistakes and still succeed. I do not say it is fate or god given dicstum. The success is random in the sense that so many factors contribute to the success or failure that is is difficult to isolate reasons and study them as you do in a laboratory experiment. Life itself is a series of random events. You meet a girl by chance and marry her for life. Of course your contribution for success of failure is an important aspect among those very many aspects. So continue to do prudent value investing and do not be discouraged by failures because it happens to many.


V. Ramasubiramanian

Feb 15, 2010

Your today Mandra says that no one can predict about the market performance, which acts on so many factors. But, you are asking us to subscribe for your recommendations. It is complete contradiction to your mandra. So, belief is life and this is the correct Mandra.



Feb 15, 2010

This is one time, I liked each one of the articles. (i)Greece should prompt the other nations to desist from window dressing their economies and go in for solid, real progress.
(ii)SEBI is right in regulating the investment angle of ULIPS. IRDA has not done anything to enhance the investor value from the ULIPs. It is still regulating most mundane matters.
(iii)India, with all its problems, is still the safest haven. Its companies are much more reliable than others in other countries - despite Satyam.
(iv) Warren Buffet's Value Investing is evidently for the long term. In the long term, There is no way, value investing can fail. Our success rate in Value Investing can be around 70 %, if not more. It is not mere fluke. it is scientific.
(v) Buying Gold - this is one thing on which I have some misgivings.Except ornaments and a few lab applications - it is not put to any great earthly use. Gold is therefore still for Barter regime.Suppose China wants to sell huge gold after one year, but, there are no takers - then what? Suppose, 3,4 countries want to sell simultaneously - can they? How much?


Kersi Pirojshah Mahudawala

Feb 15, 2010

one must not go overboard with the gold and even 5% allocation of your portfolio to gold is enough.The retuns on equity are always more than the gold in the long run.


Sanjay Srivastava

Feb 15, 2010

honest and realistic comments



Feb 15, 2010

prediction is possible because the fundamentals affecting the market prices - including fundamentals of the company, available liquidity chasing stocks, and economic outlook change in small to medium increments and subsequently it affects the perceptions of the investors, if you track the prevailing sentiment which a lot of people do, where the market is at the moment from where it was and then where the market is going to be can be logically inferred because any index or number does not go anywhere other than where it is predetermined.


Adi Daruwalla

Feb 15, 2010

I agree that intervention from SEBI in ULIPs issued by insurance companies is totally valid. Some companies have been so lax in their dealings that, after taking premium for a year, have not even issued the policy and then later as it was their fault, under the pretext of the applicants bad health rejected the policy. This has happened with the HDFC SLIC group. Their ad vertising "Sar utha ke jiyo" is a hoax and mockery of people who invest with them. Also policies that collect premiums for 3 to 5 years and stop, (some have those clauses) there are huge handling fees that are taken by the companies. SEBi needs to regulate these fees. Also we understand that there is risk, but all ULIPS should give a growth guarantee of the bare minimum like 7% per annum, especially if monies are invested for children and their future prospects. if they give more than 7% they are welcome but cannot give less than 7%pa. Also there should be a capital protection clause, as top executives are careless with public funds. They should be made to work on their portfolios diligently (with empathy). Would he put his money and his families money where he is investing the public money? They should think that first and then manage public funds. Thanks and Regards Adi Daruwalla

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