A funny, scary story for every investor and taxpayer
(Jan 30, 2015)
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In this issue:
» PE firms likely to exit investments worth US$ 30 bn this year
» Roundup on markets
» and more....
A friend recently shared a very witty allegory on the state of economics in current times and the making of a financial crisis. It was both hilarious and scary. We thought it was very important that our readers know about it. So here it is...
John, a bar owner in Europe noticed that almost all his frequent customers were unemployed alcoholics. That means people with no jobs plus a drinking problem. What to do? If they had no jobs, they would soon run out of money and stop visiting the bar. And the business would have to shut down. How could John avert this impending crisis and salvage his liquor business?
After much brainstorming, John had his Eureka moment. He came up with what he thought was a genius marketing idea. The idea was simple: drink now, pay later.
So his customers could have as many drinks as they desired and not worry about having to pay immediately. John, on the other hand, kept track of all the bills and granted customer loans to his loyal drinkers. Both seemed happy. The customers didn't have to bother about paying up upfront. And John was able to revive a declining business. The marketing plan created a buzz and John had his sales grow exponentially. From time to time, he was able to easily hike prices of the drinks. And his customers never complained. John was now the proud owner of one of the busiest bars in Europe. Not to forget the real cash earnings existed in the future, if at all.
Seeing his growing business, the bankers were happy to increase the borrowing limits for John. They saw the debts of unemployed alcoholics as valuable future assets. Some young ambitious geeks at the bank saw a big opportunity here to transform the customer loans into securitized tradable bonds. Then of course, these securities were bundled and traded on the international bond markets. The investors do not know that what was on offer was really a bundle of debt of unemployed alcoholics. They simply joined in the extravaganza of this new hottest-selling bond and the bond prices went flying skywards.
Guess what? Everybody seemed to be making money and getting richer. John had a thriving business. His customers were happy. The bank was doing great business. The brokers were earning great commissions. The rising bond prices also made investors rich.
Sounds like the economics of happiness? Well, this story, as you may have guessed, certainly does not have a happy ending. Finally, a newly joined risk manager at the original bank saw the debt pile and decided it was time that the debt be repaid. He approached John, who in turn demanded payment from his customers. But well, where was the money? Most of them were still unemployed. And this was precisely where the party ended. John was forced into bankruptcy. The bar shut down.
But this is not all. When the news of the non-payment spread, the bond prices came crashing down. Investors saw a massive wipe-out of wealth. The local bank that had lent heavily to John witnessed a critical credit crunch and was unable to issue new loans.
And there were even more parties involved. For instance, John's suppliers had significantly relaxed their credit terms. Some of them had to shut down. Others had to downsize their operations.
But there were some who came out of the crisis untouched, in fact, much richer. Who were these people? Can you make a guess? Well, the answer is bankers and brokers. Their cronies in the government were happy to help them out with a multi-billion euro cash infusion, all in the name of saving the economy from a systemic collapse. But where did all this bailout money come from? As it turns out, the bailout money was raised by levying higher taxes on employed people, most of whom were non-drinkers. Now you see who paid for all those drinks?
If you have been wondering what's going on in the global economy, this allegory does explain quite a bit. Many of the developed economies are in a mess right now because they consumed a lot more than they could pay for. They were consuming their future incomes in the present with this magical concept called debt. But when you have too much of it, you have a crisis eventually. We saw how the global financial crisis that broke out in 2008 rocked the world economy.
And to tell you the truth, we believe that the world economy is even more fragile now than before, thanks to reckless monetary policies by various developed economies' central banks. We will talk more about this a bit later.
For now, there are some crucial points that we would like to highlight to our readers. Some may think it is pointless to worry about the world economy or the monetary policies of the developed economies. How does it concern India and Indian equity investors?
Well, let us tell you that the world economy and the global financial markets are way more interconnected and interdependent than ever before. If developed economies pump in cheap money, a lot of it finds its way to developing and emerging markets. We just saw recently how the Indian markets soared following European Central Bank's (ECB) announcement of Euro 1.1 trillion (about US$ 1.25 trillion) quantitative easing program. The reason you should be worried is that this flood of money is not coming out of real earnings and savings. It is a dangerous monetary experiment that various central banks are toying with. Whenever this money changes direction or reverses back, it could rock the already fragile global financial markets. And India would be no exception.
In conclusion, we would repeat the same old wisdom, however boring it may sound. Invest in value. Don't become a slave of stock price movements. Corporate earnings or the Indian economy didn't get any better because of ECB's QE plan. So don't be shocked when you see stock prices falling when this money changes its course.
Are you banking on the flood of cheap global liquidity to drive stock prices higher? Let us know your comments or share your views in the Equitymaster Club.
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Private equity companies are touted to be amongst the smartest guys in the financial world. But even they seemed to have gotten carried away by the very good times that occurred during the pre-2008 crisis situation. Today's chart of the day displays the value of the private equity transactions that have taken place in India over the past decade. As you can see, 2007 was a busy year for them with deal values coming in at a high figure of US$ 19 bn.
Is the PE mania back?
However, as the Financial Express has stated, this year is likely to see a large chunk of those investments being exited given the stipulated time period of those funds coming to an end. And with this, PE firms are likely to make an exit of US$ 30 bn (current value of those investments) in the full year 2015.
Initial public offerings are amongst the many exits routes available to PE firms. And with the markets clocking highs one day after another, the sentiments could not be riper for making the most of it. As such, it may not be surprising to see a flurry of IPOs hitting the market this year.
However, what will eventually decide the fate of these IPOs and the subsequent performance of stocks on the market will be the quality and performance of those businesses. That goes without saying. However, considering that these businesses would have been backed by PEs, there would be a general lure to buy into those businesses given the transformation, professionalism and expertise that the PE companies would have provided to the managements of these businesses. At the same time, investors should also keep in mind that PE companies work on high internal rate of return targets. And thus, to achieve those, it would not be surprising to see the issues being priced expensive at the time of IPO. As such - something that we have always been saying - what it boils down to is for an investor to take into consideration the risk-reward ratio before applying for such IPOs.
It was not long ago when an IPO of well known clothing brand was oversubscribed by 7.8 times. While the company had decent fundamentals, the stock was seemed quite expensive to us. We thus asked our subscribers to avoid the issue. One of the other key reasons for us to give this view was the fact that it was the promoters (which included a PE firm) who were cashing out, rather than any money going back into the business. As of yesterday, the stock closed lower by about a fourth from its issue price; the stock has been listed for less than two months.
In the meanwhile, the Indian stocks markets were traded week with selling activity intensifying as the day progressed. At the time of writing, the BSE-Sensex was trading lower by about 380 points or 1.3%. Stocks from the banking and consumer durables spaces were amongst the top under performers while power and realty stocks were in demand today. Asian stocks ended the day on a mixed note while the European markets were trading firm at the time of writing.
"For most people, attaining the intellectual clarity and emotional detachment that investing requires is tough." - Guy Spier
|| Today's investing mantra
Editor's note We will not be releasing the weekend edition of the 5-Minute Wrap as the Equitymaster Conference 2015 is scheduled for tomorrow. Looking forward to seeing you there.
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