The effects of institutionalization - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
The effects of institutionalization A  A  A

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17 JULY 2010


One of the consequences of globalization was a greater institutionalization of money, a trend that commenced in the 70s as mutual funds started to become popular. In the developed markets, individuals are increasingly channeling their investment through funds, rather than investing directly, thus contributing further to the increasing size of institutions. Institutional holding of US equity is now around 75% and individual holding is 25%; it used to be the reverse 5 decades ago. As with anything else, this institutionalization has both positive and negative sides to it.

On the positive side is that the size gives these institutions access to management and thus better information flow to base their investing decisions on. Not that this always helps; over half of the funds in the US underperform the index. When they want to, institutions can influence corporate governance, by virtue of their size of holding in the company. The key phrase is 'when they want to'. Usually funds vote with their feet, preferring to exit the stock rather than take cudgels with management. Activist shareholders who are large enough to have a say, are getting rarer by the day.

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On the negative side is that the pressures institutional investors put on management for improved quarterly earnings translates to an increasingly shorter term horizon for corporate management. The institutional investors themselves are under pressure from individual investors, because most of the money lies in 'open ended' mutual funds with an exit option at NAV. Fund managers get a variable pay package, of which a large part is linked to performance, so the pressure put on them to improve NAV results in a pressure put by them on corporate management to improve quarterly earnings.

Corporate management at some of the publicly trade banks like Citi, for example, succumbed to this pressure on improved quarterly earnings by taking foolish bets on mortgages, which ended in the subprime crisis, the trigger for a financial meltdown. The earlier case of near destruction of Lucent Technologies is also illustrative of this trend. Lucent was, in a prior avatar, the famous Bell Laboratories of AT&T, the place where huge innovation took place. When AT&T was broken up by the Supreme Court, Bell Labs was spun off as a listed entity, called Lucent. Post listing, Lucent did brilliantly for the first few years but then its management succumbed to the pressures of improving quarterly earnings, gave up on promising innovation which would have succeeded in a longer term, and almost bankrupted the company.

In India, the Government is considering an alternative strategy for a few PSUs which are required to divest at least 25% to the public. Instead of an IPO, in which retail investors can also participate, the Government is contemplating selling the issue privately, through auction, to a few institutional investors, to fetch it a better price. This is being done reportedly on two considerations. One, that retail investors pay a lower price than institutional ones do (obviously, since retail investors pay out of their own pocket whereas institutional ones also pay out of the former's pockets). Two that there are certain 'compliance issues' that need not be resolved if the auction route is adopted.

To me, this thought has more holes than Swiss cheese. If, indeed, there are compliance issues, is it not good governance to solve them first? And is not a Government supposed to encourage good governance by setting an example, instead of seeking short cuts to avoid it? Then again, does it not encourage the process of greater institutionalization? And if so, has the Government thought through the consequences of it logically? If I, as an individual shareholder, have no chance of being allotted shares in public sector undertakings (which taxes paid by me have helped set up), would I not think of investing through mutual funds that do? Is the Government playing fair driving individual investors to go the institutional way?

The Government ought to also take a look at history. The equity boom in India actually started when foreign companies were forced to divest 51% of their holding in favour of Indian shareholders. The price was dictated by an archaic formula worked out by a now disbanded authority called the Controller of Capital Issues. This formula basically gave the shares away at a huge discount, and investors found lots of money on the table subscribing to FERA shares. Now, when it comes to PSU shares, what was sauce for the goose is not sauce for the gander!

The way out is to make mutual funds less open ended, to make fund manager's pay less variable based on quarterly performance compared to peers and to make Government less greedy (oops, remove the last suggestion). IDBI had given a solution decades ago when it launched a semi closed ended fund, with a bi annual window of exit to investors at NAV; the exit provided by the IDBI bank. More mutual fund houses should be encouraged to follow this model so that fund managers make longer term bets on companies, encourage longer term perspectives of their management, and are not pressured by their investors on short term NAV improvements. AMFI should work on this.

Greed was also evidenced in the auctioning of 3G spectrum, which raised huge amounts of money for the Government, thus making a dent in the fiscal deficit, to the joy of investors. However, this has a cost, borne by society (namely consumers). Sunil Mittal of Bharti Airtel says that in order to justify the high cost of 3G spectrum, the service would need to be priced at Rs 700-900 per month. It seems to be a repeat of the 2G experience. Then, the spectrum auction raised Rs 10,000 crores, to the delight of Government, but resulted in the cost per minute being Rs 16 (paid by both caller and receiver, hence Rs 32 per minute). The telecom revolution was dead on arrival because of this. It was only when the Rs 10,000 crores was returned and the Government accepted, instead, a revenue share, that the telecom success story really began. Instead of learning from our mistakes, we are apt to repeat them.

Good results for the quarter ended June 30 were announced by Indusind Bank, LIC Housing, Axis Bank, TCS and HDFC. The growing economy has resulted in 8 Indian companies hitting the FORTUNE 500 list, viz IOC, RIL, Tata Steel, Tata Motors, BPCL, HPCL, ONGC and SBI. Had the Government not taken the decision to allow a hike in prices of petrol and diesel, IOC, BPCL and HPCL would have dropped out in a few years; so badly have their balance sheets been mauled by the slowness in taking the decision. The two Tata companies made it on the back of big acquisitions.

The BSE-Sensex ended the week up 122 points, at 17955. It is struggling to cross the 18,000 mark which it did, last week, but not in closing. The NSE-Nifty ended the week at 5393, up 41.

It is foreign investment buying that is holding the market up; all of last week domestic institutions were net sellers. Should anything dampen the enthusiasm of the FIIs, there could be a sharp correction. One does not know what, or when, that would happen but it seems that patience is a virtue now most desired.

J Mulraj is a stock market columnist and observer of long standing. His weekly column on stock markets has run for over 27 years. An MBA from IIM Calcutta, he has been a member of the BSE. He is Conference Head - India, for Euromoney. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stock markets yet being a reader of his columns. His other interests include reading, both fiction and non-fiction, bridge, snooker and chess.

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4 Responses to "The effects of institutionalization"
Punit Jain
Jul 19, 2010
In fact, PSU firms are public property, and should be sold 100% to retail in the IPO/ FPOs. Government should 'get out of industry' sectors, and let the gains go to the people, than to Institutions. PSUs should be asked to adopt the L&T model, of professional managers and independence. Like 
Chandrashekhar Vaidya
Jul 17, 2010
I have always wondered why 'closing price' is so important. Does this mean that a group of large operators allow their minions to trade stocks at little deviation from the 'true value' during the day but while closing, they take personal charge to ensure that the closing happens at 'true value'?

Can someone please explain this to me?
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Gurumani
Jul 17, 2010
Financial processes and decisions in India are driven exclusively by the ruling party's compulsive need to be remain in power. To remain in power, the government has to announce new schemes, give aways and use excessive resources to create elbow room for themselves to take decisions which are often damaging to the economy and the country as a whole. The 3G auction had to be done the way it was because the government has to raise resources to pursue potentially wasteful actions dictated by the NAC. Simple, common sense solutions based on a basic understanding of individual and market behaviour elude us because we are perpetually caught in a compulsive money trap of our own making. Like 
R.Radhakrishnan
Jul 17, 2010
It is kind of shocking to hear about the government's new thinking to sell in bulk PSU shares to comply with the government's requirement of equity dilution. The government directs and the government acts. Reasons for doing so are flimsy and for a government to think in terms of overcoming hurdles/impediments (which are created bythe government itself) by taking short cuts is, to say the least, very regrettable. It is the tax payers' money that has gone into these PSUs which have surivived in spite of political maneuvering and interference. Some lucky people have milked opportunities by associating themselves with these PSUs. Many PSUs did not survive or became sick or wounded in the process. The few that have done well could certainly reward the taxpayers - retail investors.
Government wanting to sell these shares to private investors in bulk to overcome procedural hurdles is like a traffic police defying traffic light.
God save this country.
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