Why the Rs 6,500 bn of EPFO money poses enough risks... - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Why the Rs 6,500 bn of EPFO money poses enough risks... 

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In this issue:
» Should you start SIPs in bull markets?
» Should India have a formal whistle blower policy?
» Euro sinks as ECB indulges in rate cut
» LIBOR needs a suitable replacement
» ...and more!

The Employee Provident Fund Organization (EPFO) is known for its conservative investment mindset. It has shunned stocks in the past despite getting an approval to invest in the markets from the Finance Ministry. However, its inability to beat inflation solely with bond investments has tempted the organization to invest in equities.

The EPFO has finally opened its mind to invest about 5% of its corpus into equities. This shall translate into a yearly inflow of about Rs 60 bn into the stock markets. Annual inflows to the EPFO kitty have been increasing amidst rise in statutory ceiling for PF contributions. Thus, we believe this was a good move. Certain exposure to equity was definitely needed considering EPFO has a long investment horizon. Bonds alone are insufficient to give inflation adjusted returns over long periods.

An inflow of Rs 60 bn a year will make EPFO the second largest institutional investor into Indian equities after LIC. And this is just at the 5% corpus limit. The overall limit as per Finance Ministry is pegged at 30%. And EPFO has Rs 6500 bn of funds at its disposal. Just imagine the kind of inflow we shall see into stock markets, if the EPFO gradually relaxes its self imposed limit to equities.

If that happens, EPFO may well over take LIC as the largest institutional investor. Of course, Indian markets need more domestic participation and hence EPFO investments are welcome. However, huge inflows also increase liquidity into markets and thus stock valuations. This makes stock picking all the more complex as prices defy fundamental logic during such times. Most investors get lured into the bull story. And end up buying businesses at absurd valuations to later find themselves into huge losses.

This is where we believe the expertise of investors with conservative mindset comes into play. Take the case of ValuePro for instance. Our long time subscribers of ValuePro would recollect a sharp run up in FMCG stocks couple of years back. Excess liquidity drove up prices ignoring all valuation principles then. However, Radhika, our Managing Editor for ValuePro and her team stuck to their fundamental principles and overlooked the euphoria surrounding those stocks. Later their faith was vindicated as evident by the outperformance of the first ValuePro portfolio and correction in FMCG stocks.

The bottomline is that investors should be extremely careful about investing in markets now. With the overall macro environment improving valuations are moving to historical highs. If liquidity from domestic markets (via the EPFO mode) or global markets (via the QE mode) increases, valuations could enter bubble zone. Only investors who are able to buy companies after screening their valuation and fundamental aspects will be able to create wealth over the long term.

Do you believe valuation plays a bigger role in buying stocks as liquidity in stock market increases? Let us know your comments or share your views in the Equitymaster Club.

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It is hardly surprising that the rally in the stock markets has made most investors want to join the bandwagon. Some are investing directly in stocks, others are opting for the mutual fund route. Systematic investment plans (SIP), specifically, have been seeing a lot of investor interest in recent times.

Does that mean that one should opt for SIPs in a bull market? Not necessarily, according to us. The mindset that one requires for SIP investing is different. Investing in SIPs does not mean that you will get greater returns. So what is the rationale for SIPs? It is not easy taking a call on the direction that stock markets will take. However, one would still want to stay invested in the markets and in that sense SIPs bring some discipline in investing. This is because every month, there is fixed amount that goes out. So in a falling market, the cost of acquiring goes down and the units allotted go up and vice versa. However, if you are confident that the rally in the stock markets is here to stay for a while then it actually makes sense to make a lump sum investment. Because the returns in such a scenario could even trump those of SIPs should the markets rise significantly. However, not everyone is equipped to take a call on the markets and in such a scenario investing in SIPs is the best way to go.

What would you do if you came to know there was some wrongdoing happening in your company? Especially, if the people involved were the ones above you in position. Would you dare to play the whistle blower? Would you be willing to put yourself in the line of fire? We are not undermining your integrity. But anyone with a family and a home loan to pay off would find it a bit risky to confront his bosses.

There have been many cases where employees have been aware of the wrong doings of senior managements. But they have been wary of playing the whistle blower for the reasons we discussed above. From October this year, all listed companies will have to ensure that there is a whistle blower mechanism in place that will allow employees to take up issues of workplace malpractice. While this is a good move, the effectiveness will depend on how well it is implemented. People are generally not comfortable reporting to an in-house whistle blowing mechanism. They tend to be more comfortable if the whistle blowing mechanism is handled by an external party.

02:45  Chart of the day
Shareholder activism seems to be finally bearing results. Institutional investors had earlier come down heavily on Maruti Suzuki for the proposed takeover deal of the Gujarat facility by parent company Suzuki Motor Corp. Buckling under pressure, Maruti Suzuki changed the deal for cars to be sold by Suzuki from the facility only at cost. In a move to appease minority shareholders and mutual funds to clinch their approval for the deal, the company has made announcement to pay royalty for new models in rupee instead of yen.

Rising royalty payments by Indian subsidiaries to their foreign parents have always been a cause of heartburn for shareholders. In case of Maruti Suzuki, the royalty payment as a proportion of sales has gone up from 2.8% in FY08 to 5.7% in FY14. However, Maruti Suzuki has blamed appreciation of yen against the rupee for the steep rise in royalty outgo. Therefore to offset the exchange rate fluctuations, royalty payment for new upcoming models has been fixed in rupee terms. Maruti Suzuki has also said that share of royalty proceeds are expected to fall with the company undertaking a higher degree of product development in India. The company is investing Rs 20 bn in an integrated R&D facility and plans to launch its first sports utility vehicle early next year.

Will Maruti's royalty burden decline in near future?

We believe it was Warren Buffett who once opined that interest rates act very much the same way as gravity acts in physical world. He further added that at all times, in all markets and in all parts of the world, the tiniest change in rates changes the value of every financial asset. Indeed, change the rates a few percentage points and the present value of dollar that you will receive in the future from an investment will change dramatically. But what if the rates themselves are not arrived at using the right mechanisms? This is even more catastrophic we believe. For it can lead to huge misallocation of capital. Projects that are originally non-viable can suddenly start looking viable. And then when the real rates finally bubble up to the surface, project non-viability gets exposed and there is a significant loss of wealth.

Now, the US Fed has somewhat similar issues with the famous Libor benchmark interest rate. As per estimates, Libor is used as a reference rate for some US$ 150 trillion in contracts denominated in other currencies and is also common in financial derivatives! But the confidence in Libor has been terribly shaken. This is on account of all the allegations of its manipulation few months back. Consequently, one of the US Fed Governors is of the view that an alternative reference rate should be developed. Frankly speaking, this holier than thou attitude hasn't gone down well with us. According to us, the US Treasury rate, arguably the biggest reference rate of all is also badly manipulated. This is simply to benefit lenders at the expense of savers. And therefore if anything, the US Fed will have to set this anomaly right first.

The economies in the Eurozone are certainly not out of the woods. The US Federal Reserve has given indications of winding up its bond buying program. However, if the ECB's latest rate cut move is anything to go by; economic recovery is not even a remote possibility. The European Central Bank has stunned markets by cutting interest rates and embarking on a trillion-euro asset-buying binge. The need to pump cheap money into the economy seems to be backed by fears of a slowdown. According to ECB, the aim is to expand the bank's balance sheet back to the heights reached in early 2012. This would mean growth of nearly 50% or 1 trillion Euros in new assets. Plus the central bank will be penalizing banks in Eurozone who do not spend it. Thus there is every possibility of more cheap liquidity finding its way into emerging markets. And even if the US does not open its liquidity tap, the Eurozone will do the needful.

After opening in the positive, the Indian stock markets have not managed to hold on to their gains. At the time of writing, the BSE-Sensex was trading down by 115 points (0.1%). The sectoral indices were trading on mixed note, with the losers being led by automobile and banking stocks. Asian stock markets too were trading on a mixed note with China among the gainers and Korea leading the losers. European markets have opened the day on a mixed note.

04:50  Today's investing mantra
"Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value". - Warren Buffett

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5 Responses to "Why the Rs 6,500 bn of EPFO money poses enough risks..."

Krishna Murthy

Sep 6, 2014

The basic knowledge for investing in Indian market is not the product or the market. First priority we should know who is promoting, what are their background, their earlier activities in blade companies, their blood group or linage, their group and caste, where they have been arrested, case booked and whom they have cheated, which politicians are their backbone are the primary cretirion for selecting your equity. Then only you can feel slightely better of than others.



Sep 6, 2014




Andrews W Salim

Sep 5, 2014

EPFO has a moral responsibility to initiate attempts to locate those people, at least once to alert them for a refund with their PF details.

They have enjoyed this free money for all these years, and is morally obliged to send at least one letter or even sometimes a mail atleast to them.


Andrews W Salim

Sep 5, 2014

It will be great to see, if Mr.Narendra Modi asks EPFO, try to locate those People who put their hard earned money and attempt to Refund.
At least one attempt should have been initiated as the fund has enjoyed their money all these years.(all personal details are given in the PF form) Private Companies and Trusts all have their permanent address .
Why nobody is writing anything about an attempt to Refund those unclaimed funds.
this will be unheard of a public sector organisation and Modi certainly will get the mileage for such approach.

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Sep 5, 2014


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