When greed is no longer good

Nov 21, 2011

In this issue:
» Auto cos turn to exports as domestic sales dip
» Best solution to prevent IPO rigging
» New crisis lurking around the corner: Mobius
» Foreign banks selling India Inc's loan portfolios
» ...and more!
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Gordon Gekko, a character from the famous movie Wall Street, coined the phrase 'Greed is good'. Since then, the phrase had become a mantra for most of the investment professionals not just in US but the world over. Companies with high profit margin and the ability to increase these further were the darlings for any investor. But it is the same greed that drove many companies into doing things that eventually led to their downfall when the global crisis hit. So the question now is - is greed good?

There is no direct answer to this question. Companies that are able to earn high profit margins and expand them quarter on quarter and year on year undoubtedly reflect better business sense. After all they must be doing something right which their competitors are unable to replicate. As per the very definition of value investing, these companies have the moat of safety around them making them an ideal investment. So what are the signs that an investor needs to watch out for in such companies. Signs that would ring the warning bells. The sign is simple.

It is not the growth in profits but how these profits are being used by the company which should be given more importance. A company can use its profits for several things. Those who use these for paying out hefty bonuses to its executives or exorbitant salaries to their top management do not really care much for their own businesses. Such companies would do anything to ensure that the wealth keeps coming so that they can continue to reward themselves. And such companies are the ones which go bottom up when the tide gets tough. Fine examples of this are Enron and Lehman Brothers

On the other side of the equation are those companies who use their profits to grow the business, to innovate or to create more employment opportunities. This is not to say that these companies do not pay out a dividend. They do. But dividends are just the extra funds that the company is unable to utilize in its own business. These are the kind of companies that survive the tide of time and increase shareholders returns over a long period of time.

What in your opinion is the best way for a company to utilize its excess profits? Share your comments with us or post your views on our Facebook page / Google+ page.

 Chart of the day
FY10 and FY11 were very strong years for the Indian auto industry as demand for vehicles surged and bolstered the overall performance for companies from this sector. But come FY12 and the picture has become quite tainted. Indeed, with petrol prices and interest rates rising, demand for vehicles has dampened, thereby leading to slower sales growth in the domestic market at least. But what has been the silver lining for companies is the robust growth in exports. Statistics by Society of Indian Automobile Manufacturers (SIAM) show that in the April-October 2011 period, while car sales grew by just 2% in the domestic market, exports were up 19%. This is a complete reversal in trend because in the years when the sales from the domestic market were healthy, export growth was rather muted. Indian auto companies are venturing into newer geographies which have strengthened revenues from overseas. And while exports have come to the rescue of auto players in the year so far, this is not expected to be a near term phenomenon as companies want exports to be a part of their long term growth strategy as well. The problem is that economic conditions in the developed markets especially Europe have only deteriorated and many Indian players do have quite a significant presence there. Thus, while newer regions will help in offsetting the pressure felt in the US and Europe, in the long term, increasing focus on these geographies is the only way that India can emerge as a serious auto exporter.

Data source: Society of Indian Automobile Manufacturers (SIAM)
* Period from April to October in each financial year

Much of the lure of initial public offerings (IPOs) lies in the prospect of unrestricted listing gains. On the day of listing, no price filters are applied on stocks. This gives investors a chance to make phenomenal gains in just one day. The sincere purpose behind this mechanism is to facilitate price discovery. However, more often than not, this same mechanism falls prey to stock price rigging, especially in the case of sub-Rs 1 bn IPO segment.

What can be the likely solution to put an end to this malpractice? Last week, SEBI (Securities & Exchange Board of India) Chairman U K Sinha said that a 10% intra-day circuit filter was being considered for the listing day. Do you think this is a real solution? We don't think so. Firstly, a price filter will conflict with the idea of price discovery. Secondly, will a price filter on the listing day guarantee that there would be no price manipulation in the post-listing days? So rather than putting a price filter, the regulator should strengthen its surveillance, find the wrongdoers and give them a fitting punishment. Of course, zeroing down the wrongdoers is a big challenge because they often operate through a new set of investors, brokers and finance entities. The other solution is to try and make the merchant bankers more accountable.

If you are amongst those contemplating higher exposure to blue chips, rest assured that you are not alone. No, we are not just referring to retail stock investors here. Indian banks too may soon be making the beeline to buy some good quality Indian corporate loans from their foreign counterparts. In a world where the quality of debt is getting increasingly important, Indian companies with good fundamentals continue to fetch loans at reasonable rates. Most of these entities had approached foreign banks for cheaper loans due to the steep up move in interest rates in domestic markets. True, some of them have taken the hit due to forex volatility. But the quality of loans has remained bankable. The European banks, in a bid to recapitalize themselves have put some corporate loans on sale. Hence as the foreign banks seek to liquidate their Indian loan portfolio, some Indian banks may be eager to buy them out at reasonable rates. That will in fact be better for borrower companies as well as the loans may get denominated in rupee terms. However, with the Reserve Bank of India's warning on over exposure to large corporate at the cost of financial inclusion in the rural areas, we believe Indian banks too will be cautious in their purchase.

The financial weapons of mass destruction aka derivatives are still going strong and unregulated. And it is a new round of threat posed by them that makes another crisis very much possible in the near future. These were the thoughts echoed by guru of emerging markets, Mark Mobius. "There is definitely going to be another financial crisis around the corner because we haven't solved any of the things that caused the previous crisis," Mobius is believed to have said to a leading magazine recently. And if this wasn't shocking enough, Mobius' estimates puts the size of the credit default swaps, a derivative instrument that brought the giant AIG on its knees in the 2008 financial crisis, at a whopping US$ 600 trillion. Thus, if say Greece was to default, it is not only the banks that hold Greek debt that could come under threat but also the ones that have taken a bet on the default swaps related to Greek debt. Thus, the repercussions could reach far and wide and put the entire financial system at risk.

With around two fold increase in its value in the last two years, gold seems to be the only asset holding its head high in the time of inflation. The trend has made Indian Government richer by Rs 1 trillion, 30% of which can be attributed to the gold purchased from IMF (International Monetary Fund) two years back. While the performance has been outstanding so far, what is the case for investing in gold at a time when prices have already doubled? We believe that at a time when global currencies, stock markets and overall economy are losing trust, the prospects of gold seem promising. Besides, it comes as a good diversification option as country's physical gold holding has remained unchanged since last purchase from IMF in 2009.

In the meanwhile, the Indian stock markets were trading deep in the red after opening weak. At the time of writing, the BSE Sensex was down by 200 points (1.2%). All sectoral indices, except for FMCG, were trading in the negative. Declines were seen across entire Asia with Taiwan (down 2.6%), Indonesia (down 1.5%) and Hong Kong (down 1.4%) being the top losers.

 Today's investing mantra
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." - Warren Buffett

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2 Responses to "When greed is no longer good"


Nov 21, 2011

A couple of points;
a) I have written a couple of months ago, the only solutions to stop the manupulation in the IPOs is to put 10% circuit eitherway. AND MORE IMPORTANT FOR THE FIRST MONTH THE STOCK HAS TO BE in T TO T:SEC. It has to be in "trade to trade" very clearly, if you sell you have to give deliveryof the stock and if you buy you have to take compulsory delivery. NO Trading. Only by putting up this strictures than we can find the correct price of the stock. What we have to day is plain and simple looting of the small investors by very smart market manipulators.

Secondly regarding Gold: An ineresting small note is put in today's ET: Govt. holding of gold has gone upto 24L crores. Well than why not sell half of it and reduce the fiscal deficit.??? If you sell 50% of the recent purchase ie: 100T, you can wipe out all the fiscal deficit, you can get huze dollars, which can bring back the Rupee back to reasonable rates of 47 /48 to the Dollar. There will be critics of selling valuable assets, but than the assets has grown almost four times the purchase price. Two you are not selling the entire stock. It would be the most prudent step the UPA govt. would have taken in this term.

The opposition will shout and critise, but than when RBI purchased it had not taken the approval of the opposition, so no need to take their consent now.


Thanks DAMANI.


Suresh Kumar

Nov 21, 2011

The best way to utilize the excess profits is to fund growth organically or inorganically. Campanies like GE want to be among top 2 companies in the line of business they work. If the company does not have a strategy and a plan for expansion to reach such a position or to enter related line of business, there is something wrong with the management. Of course, all companies should try and reduce debt burden during unfavourable interest rate cycles.

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