Financial problems worse than before

Sep 15, 2009

In this issue:
» From 'Too big to fail' to 'Too big may fail'
» Buffett's Chinese investment gives stellar returns
» Protectionism on the rise despite promises to the contrary
» Mid cap IT stocks beat their larger counterparts
» ...and more!!

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Optimists, who believe that the systemic risks in the global banking and financial sector have been ironed out, need to revisit their theories. Particularly when somebody of the caliber and stature of Nobel laureate economist Joseph Stiglitz begs to differ. According to Stiglitz, the days of 'Too Big to Fail' banks are over and it is time for 'Too Big May Fail'.

In a recent interview, the economist has opined that the US has failed to fix the underlying problems of its banking system after the credit crunch and the collapse of Lehman Brothers. In fact, with the banks having become even bigger, the problems are worse today than they were in 2007 before the crisis. Stiglitz has also said that though the Obama-led US government is wary of challenging the financial industry because of political difficulties; it is pertinent that the G-20 leaders cajole the US into tougher action. Else, the world economy will go into an extended period of economic malaise.

 Chart of the day
Warren Buffett calls this probably the best single measure of where valuations stand at any given moment. And we have it in the form of today's chart of the day. The metric is nothing but a country's market cap divided by its GNP. In an article in Fortune, Buffett had once commented that if the ratio falls between 70%-80%, buying stocks is likely to work out well over a long-term period. That long term period we believe should be ideally in the range of 3-5 years. And it is said that markets start looking very expensive if the ratio exceeds 115%.

As far as Indian markets are concerned, over the years, we seemed to have moved to a higher level. While 60%-80% range was the earlier peak for us as was evident during the tech bubble, emergence of the country as an attractive investment destination and India's relatively higher GDP growth has meant that a ratio in the vicinity of 115%-130% constitutes a new peak for us. It should be noted that after falling to 70% at the end of FY09, the ratio stands at 104% currently, indicating that long-term returns may not be as attractive anymore as few months back.

Source: CMIE, Ministry of Finance

At a time when the global economy is trying to revive from the worst crisis since the Great Depression, this is indeed not good news. As per the WSJ, a disturbing trend of countries around the world imposing or increasing tariffs on imported products and services has been on the rise in the past few months. Infact, a report released by the WTO and backed by its 153 members has gone on to mention that governments are applying protectionist measures at the rate of 60 per quarter and more than 90% of goods traded in the world have been affected by some sort of protectionist measures.

Interestingly, this development comes on the back of promises made by G20 nations in London earlier this year that they will refrain from raising new barriers to investment to trade in goods and services and imposing new export restrictions till end of 2010. However, as it turns out, those promises have been quickly forgotten, imperiling a speedy recovery from the financial crisis.

Global banks and how they operate have come under intense scrutiny since the financial crisis unfolded as many of them dabbled in toxic financial instruments, letting their core banking operations suffer as a result. Since then regulations for banks have been the order of the day. Infact, former Federal Reserve Chairman Paul Volcker is of the opinion that banks should not be allowed to own hedge funds or equity funds and their trading activity should be limited.

He further goes on to say that those banks whose majority of the income comes from trading activities should be denied a banking license. He also feels that banks need to come out with a strategy of lowering their employees' pay packets, branding them obscene. And what is more even credit rating agencies have not escaped his harsh words as he believes them to be among the battery of architects of the global financial crisis. Given that the banking business in the past was synonymous with stability and conservatism, we for one believe that banks should focus more on their core business operations rather than venture into new age fancy financial and ultimately questionable instruments.

It appears that the on-going stock market rally has favored the mid-cap stocks particularly in the IT sector. Evidently, while the cumulative market caps of the top four IT firms i.e. TCS, Infosys, Wipro and HCL has risen by a whopping 126% since March 2009, the stocks of IT mid caps like Tech Mahindra, Patni Computers, Mindtree and Mphasis have skyrocketed by rising by 251% during the same period. So does it mean that Mid caps are taking the sheen off the large caps? Probably not. Though the valuations of all the IT companies look overstretched as the sector witnessed huge inflows in the recent months, the mid-caps' stellar performance came largely on back of a low base-effect. These stocks fell abysmally during stock market crash earlier this year.

The recent buzz about the midcap IT stocks is not entirely misplaced but given their not so stellar financial performance, investors will do well not to bet too big on them. The downturn favors the IT biggies as customers tend to consolidate between larger vendors and cut cost. The smaller peers usually loose out and this is clearly reflected in the drop of volumes and margins of mid-size players. Exercising caution is what we suggest about mid-caps and small-caps.

The first anniversary of Lehman Brothers' collapse saw an annoyed US President Obama address Wall Street about their opposition to the government's proposals that seek to reform the US's financial regulation system. These proposals for reforms that are aimed at preventing excessive risk taking by large financial institutions have met with intense lobbying and resistance from well financed special interests that are hell bent on maintaining the current status quo of lax regulation.

Many central elements of the proposal have come under attack by vested interests, thus inducing the risk of the entire plan failing to go through. For example, as per the New York Times, major Wall Street companies have worked to water down the President's proposal on tightening the rules for derivatives like credit default swaps. They have also lobbied heavily to make sure that any attempts to impose tough new restrictions on executive pay do not get passed. It remains to be seen whether they become successful at stalling the proposals from going through, but it would indeed by an ironical thing if that were to happen, as it would put the country at risk all over again.

One of the ironies of being Warren Buffett is that his decisions have now become self-fulfilling. So, if he invests into a company, just the act of his investing makes it perform well. Take the case of BYD Co., the Chinese maker of cars and batteries. Buffett put US$ 232 m into the company and the stock price has jumped seven times, making it the best performing Asian stock since the collapse of Lehman Brothers as per Bloomberg. Of course, the company has posted good financials, with a bottomline growth of 98% in 1HFY10 on the back of new models and government tax cuts. But the fact is, Buffett's seal of approval makes the business more visible and also adds to investor interest. Such are the rewards of building a reputation by years of disciplined work.

Meanwhile, after declining yesterday, the Indian markets opened on a strong footing today and were trading strongly in the positive at the time of writing. Most of Asia closed in the positive whereas majority of the European indices are trading in the red currently.

 Today's investing mantra
"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere." - Warren Buffett

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3 Responses to "Financial problems worse than before"


Sep 20, 2009

a well blown balloon of stock market, some another harshad mehta waiting inside ?



Sep 15, 2009

Interesting and insightful newsletter, with business news and happenings delivered in a crisp and concise format.
Is it wrong if governments try to protect domestic industries by imposing import tariffs? Surely self survival and growth comes first and foremost, so why cry foul?
Btw, if you noticed, the articles posted alternate from wildly optimistic to deeply pessimistic on a daily basis? Is this by design or default?


Mayank Pandya

Sep 15, 2009

Thanks for sharing ur valuable insight, that was worth learning..

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