Time to conquer fear - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
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4 OCTOBER 2008

Investing is primarily all about conquering two primal emotions, greed and fear. The time to conquer the former was in January, when the BSE sensex hit its all time high of 21,206. The time, at least for the moment, to conquer fear, may well be now, when it is at 12,526. With the US Congress having approved the $700 b. bailout package and it having been signed into law by the President, global stockmarket should be expected to rally next week. How long the money lasts in a financial system that is more riddled with holes than Swiss cheese, is anybody's guess but it should last awhile. If the expected rally fizzles away swiftly, it would be a sign that investors think much worse is ahead (it is) much sooner than later. Then my next column would take longer to write; it is difficult to type with a foot in the mouth!

It seems insensitive to term the package as a bailout package, a term usually associated with passengers parachuting off a crashing aircraft. Sadly, the golden parachutes are the preserve of top management that led the institutions into failure and not of those who suffer the consequences. What investors need to figure out is whether the package would be enough or whether there is worse news to come. For that one needs to understand the root of the malaise in the US financial system and if the things that created the problems at the root would change.

Whilst several factors went into creating the mess, at the root one finds two causes. One is the unsupervised free market spirit of shareholder capitalism. The other is the propensity of the citizens of the US, the world's largest economy, to spend more than they earn.

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Shareholder capitalism is based on the proposition that if the interests of providers of capital (shareholders and lenders) are looked after, the interests of other stakeholders (customers, suppliers, employees) would automatically be looked after, too. The driving force of shareholder capitalism is greed, made famous by Gordon Gekko in the line in the 1987 movie, Wall Steet, as being good.

These financial institutions thus so subjected themselves to stockholder pressure for ever increasing business and profits. This made financial institutions (and, of course, companies) to concoct bizarrely complex derivative products. One such, for example, the credit derivative market, which caused the collapse of AIG, Lehman Brothers and others, has grown to over $50 trillion, or more than three times the size of the US economy.

Top management of the financial institutions came on the same side as stockholders by giving themselves stock options (and golden parachutes if their gambits failed). This made them lax in their scrutiny of risk involved for the institution whilst drumming up the business demanded by shareholders. The assessment of risks was outsourced to rating agencies, which failed in their job, for they, too, were under the same kind of stockholder pressure for increased profits. They even rated slices of securitised subprime mortgages AAA.

Will all this change?
There would be stricter supervision for sure, which ought to have been there to prevent a proliferation of exotic derivative products whose risk nobody understood.

The role of credit rating agencies would surely come into question (they could alsobe sued, perhaps) and more competition would be encouraged in the sector, as it should. Currently it is the issuer who pays the rating agency, not the user, thus creating a conflict for a rating agency that, in its effort to increase business, gives a better rating to get the business.

So there would be some changes in the first root cause, viz. the unsupervised shareholder capitalism generating unbridled greed, but the basics would remain. If the crisis leads to better independent supervision and to more shareholder pressure for longer term (not quarterly) performance, something good would emerge. It would, however, take a long time to change.

The second root cause is the propensity of US households to spend more than they earn. This would, hopefully, change faster. When it wants to, the US has a remarkable capacity to change. It also has a great capacity to innovate. An example of the former is the change in driving habits. With petrol at over $4/gallon, US consumers have cut back on consumption of petrol. (this is in sharp contrast to India, which has increased consumption partly because it is subsidised for consumers at the cost of IOC/HPCL/BPCL who are being bankrupted in the process) Car sales in the US are down 27% this year, which is quite a statement from a nation that believes in the freedom provided by a car.

To pay for the bailout the US would need to start having a positive savings rate and would also need to innovate and come out with products/services that can command a premium to enable them to maintain the lifestyle.

In short, the bailout package would be a holding measure till the US works its way through changes needed to reduce the risk of its recurrence. People like Kenichi Ohmae the global strategist, opine that it would need $5 trillion! India is not insulated; it would feel the pain. For example, Genpact, which had a 7 year contract with Wachovia for $1b. in outsourcing, would be affected.

For the moment, though, the bailout package would lead to a rally. People like Bill Gross, of Pimco, feel that, if the assets are bought at a good price, the US Government can even make a profit on the $700 b deal.

In domestic news of interest, the Tatas pulled out their project to make Nano, the world's cheapest car, out of Singur in West Bengal, a state where they were welcome with motherly love but driven out by Mamta. It would set back reindustrialisation of the state several years. Ratan Tata did, however, say that they would consider West Bengal for other projects of the group but was compelled to move this prestigious project out.

HCL Technologies managed to pip Infosys at the post and acquire Axon for 440 million pounds, 8.3% over the latter's bid of 407. It would, however, have to borrow part of the money unlike Infosys, which has surplus cash.

Mukesh Ambani has converted to shares 120 m. warrants of Reliance Industries, paying a whopping Rs 15,142 crores or $3.2b, bringing his holding to 49%.

The sensex, which declined to 12,526 on Friday, is at the level it hit in July. With the bailout package, and the 123 Agreement having been cleared by the US, one can expect the markets to open up on Monday. Once the bailout money is used to purchase distressed assets, credit flow ought to normalise. The problem is far from over, but for now, Hank Paulson is providing the drinks on the house!

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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