Swinging ....or Hanging? - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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25 FEBRUARY 2008

Children love to swing on ropes tied on trees.
They jump at the white rope and toss their head back in glee as the rope sways from side to side.
There is sheer joy in the face of a child as they throw caution to the wind and look up at fluffy white clouds drifting in blue skies.

Most parents try to be like their children: they want to swing and re-live their childhood.
And why not? The happiest moments of our lives were when we were children.
But, unlike their carefree children, the parents are a worried lot these days.

The parents jumped onto the stock market bandwagon, enjoying the feeling of holding onto the rope and counting the profits they were making as they threw caution to the wind.
They were happy.
Like Tarzan, with a pretty Jane tucked under his arms.

And the markets love to swing for no apparent reason from tree-top to tree-bottom to tree-top.

From 13,650 before the budget in February 2007 the Index plunged by -9% to 12,415 on March 5th. But by July 24th it had gained +27% and reached a then high of 15,795. The Index then lost -11% and ended at 13,989 by August 21st. Ready to aim for the next tree-top, the Index surged to 20,873 by January 8th of this year. That is a +49% return in less than 5 months.

But could the swinging rope have now turned into a hangman's noose?
The Index is now at 17,349 down -17% in less than 2 months.

But many investors may not be exposed to the Index; they have taken the plunge into the easy money to be made on IPO's.

Reliance Power seemed like a great rope to swing on. It was issued at Rs 450 per share and seemed like a sure shot winner. The stock was trading on the grey market at Rs 900 per share. It reached a high of Rs 450 on the NSE, went to a low of Rs 350 on February 13, and on February 22 was clawing back at Rs 417.
Quite a swing.
But no one feels like Tarzan on this one.

And then there are the finance companies: Edelweiss did an IPO at Rs 825, the share price peaked at Rs 1,756 on January 2nd and is now at Rs 881; Motilal Oswal did its IPO at Rs 825, the share price peaked at Rs 2,150 on January 4th and is now at Rs 975; and more recently Future Capital did an IPO at Rs 765, the share price peaked at Rs 1,025 on February 4th and is now at Rs 798.
Wild swings indeed. But, what next?

We can make some assumptions and some estimates on many of these companies - and many others like them. Before we swing, we like to figure out whether these businesses are run by smart managements? And what is the sustainable earnings power for these businesses? And what should the valuation metrics be for these businesses?

Jumping on a rope sounds like a good idea when you are seven years old and have supple bones.
But, at 48 years of age, the bones are more susceptible to damage. Any fall can have dire consequences.
We like to study these ropes that get thrown at us.

Are we swinging on the rope here like joyful children - or are we waiting for the hangman's noose to tighten round our necks?

And we recall Oscar Wilde:
It is sweet to dance to violins
When Love and Life are fair:
To dance to flutes, to dance to lutes
Is delicate and rare:
But it is not sweet with nimble feet
To dance upon the air!

The markets remain a death-trap for those looking for a free ride.

Contrary to perception, having a regulator does not guarantee the ability of investors to make profits.
The job of a regulator is not to guarantee profits for an investor, but to ensure that rules are laid down and rules are followed.
A SEBI approved prospectus is not a guarantee to make money - it was never intended to be.
Investment bankers will work the system to maximise the issue price of shares at an IPO. The fees of investment bankers are a function of how much money they can raise for their clients - the company that does the IPO.
The brokers want you to trade. Each trade earns them a commission. It does not matter to them whether you earn money or lose money in any trade.

And yet, despite the risk of the noose, a carefully thought out investment approach offers an opportunity to make sensible returns.
Returns that can outpace the continuous increase in the cost of living.
And take you to a higher level of wealth.

Part II: Off the beaten track.

I enjoy meeting people, including journalists, and sharing the investment philosophy that we have adopted in the Quantum Long Term Equity Fund. An approach which is based on:

  1. low cost,
  2. high integrity,
  3. a research and investment process that focuses on the long term, and
  4. that a team approach is more resilient than the brilliance of any one individual.

After my discourse on our investment principles, the reaction of everyone tends to be the same: how interesting!

The judgements, though, vary from a dampening "stupid" to an inspiring "wow".

Recently, a leading business daily - after a ninety minute interview with me - wrote an article to mark our second anniversary with a very telling headline "Quantum struggles after going off the beaten track".

The lead paragraph in the article: "Quantum Asset Management Company, which completes two years in March, has gone off the beaten track in an industry which depends mainly on a distributor-led selling model. Quantum decided to change the rules of the game by being the only (underline and italics are mine) fund house which has opted for 100 per cent direct selling. But has it worked? The numbers show it hasn't. Quantum AMC's assets under management (AUMs) is a paltry Rs 56.81 crore."

While the article began with a positive reaction (and thankfully recognised the "off the beaten track" we have chosen to take), the last two lines was their judgement: "it", declared the journalist, is not working.
We are clearly deemed to be in the "stupid" category.

The Honest Truth, though, is a little different and the "paltry" assets we have show that we are, well, "successful".

Consider the data in the table.

Table 1: Why our "paltry" assets show that "it" is working!
Fund Assets, in Rs crore as of March 31st 2006 Change in NAV, in % What assets should be, based on NAV Reported Assets, in Rs crore, as of January 31st, 2008 Can you explain this difference in Assets? Do they pay distributors to sell their Fund?
Large Fund 5,820 46.00% 8,497 3,134 A loss of Rs 5,363 crore Yes
Quantum Long Term Equity Fund 11.3 49.70% 16.9 43.5 A gain of Rs 26.6 crore No
Source; AMFI web site, published NAV data, excludes dividend returns which are likely to have a marginal impact.

In March 2006 - the Inception month of the Quantum Long Term Equity Fund - one of the largest mutual funds in the country had an equity corpus of Rs. 5,820 crore. This large fund had a return of 46.0% since then. So, assuming that all the money which was there in March 2006 remained in this large fund, then the equity corpus of this fund should be the initial Rs 5,820 crore plus the 46.0% return that the fund had = Rs. 8,497 crore. This assumes that there were no new investors in the fund, and that those investors who initially invested in the fund stayed there for this 2 year period. Shockingly, the equity corpus of this large fund is "only" Rs 3,134 crore. This is 37% of what it should have been, if all the initial investors did nothing.

Rs. 5,363 crore is "missing". These "missing" assets are based on the Rs 8,497 crore assets that the large fund should have had (given their impressive +46% return) less the Rs, 3,134 crore assets that they actually have.

Now turn to Quantum Long Term Equity Fund.
With no distributors to "push" our fund, we gathered Rs 10.7 crore at the launch and were Rs 11.3 crore by March 2006. The Quantum fund has had a return of 49.7% over the same time period. Assuming that there were no new investors in the fund, and that those investors who initially invested in the Quantum fund stayed with us for this 2 year period, Quantum Long Term Equity Fund should have an equity corpus of Rs. 16.9 crore (the initial Rs 11.3 crore x the 49.7% return). Surprisingly, the Quantum Long Term Equity Fund has an equity corpus of Rs 43.5 crore. This is 257% of what we should have had, if no new investors came into our fund and we none of the original investors left out fund.

While these return numbers may not include any dividends declared to unit holders by the large fund and the return on any such re-invested dividends, the trends in asset flows are striking and will not be affected by these minor adjustments.

Why did the large fund have "missing" assets of Rs. 5,363 crore?
Why did Quantum Long Term Equity Fund gain an "extra" Rs. 26.6 crore?

The answer, dear Reader, is simple.
The large fund - and all the other funds in the country - uses a well-entrenched distributor system to push funds to investors.

The distributors get rewarded as they push their investors from one fund to the other. There have been enough articles in the media to suggest that many distributors may be giving advice to their clients based on what is good for the distributors and not necessarily what is good for the investors.
We have long argued that paying distributors a fee for what seems like short-term and mis-directed advice is not a practice we are willing to encourage.

The data for the large fund house suggests that there was a huge payment made to the distributor to gather the assets (which they did) but then the distributors may have found another new fund to shovel their clients into - and get a higher fee.
Maybe.
Maybe not.

We will leave that discussion to the distributors, their clients, and the fund houses which pay these distributors disproportionate fees.

But, dear Reader, I am sure you can figure out what happened to the "missing" assets in this "successful" large fund: these assets were rented, they were not sticky.
They were like that wandering lady, moving from party to party leaving a hint of her fragrance at every doorway.

For all our "paltry" assets, we are a success.

Quantum does not pay any distributor to sell our funds.
We are the only group in the country to follow this practice.

We prefer educating people on what we are doing - and why we are doing it.
We want our investors to decide whether our fund - and the business principles we have adopted - is what suits them or not.

Thankfully, some people like what we are doing: that is why the actual assets we have are far higher than the assets we should have based on our returns (see Table 1 above).
We are getting in new clients.
But, yes, it is a slow process.
And, yes, I wish it was faster. (And you can help make it a faster process by starting to invest your money in our funds and tell your friends about us!) (Click here for investing in Quantum Long Term Equity Fund)

But we are challenging the system.
We are clearly off the beaten track.
By choice.
It is a struggle, but we are not struggling.
Struggle is what we are willing to do to fight for a cause: your cause.
Struggling is when one is not succeeding.

We are re-writing practices in the mutual fund industry that have gone unchallenged and unnoticed for ten years.
Change will not happen overnight.
Until then we will be "paltry" in assets, but we stand tall.


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