Friday, January 12, 2018

How the market fall of 1996 impacted me personally...

Was reading the book 'Bulls, Bears and Other Beasts', written by Santosh Nair. Over 42 chapters spanning about 400 pages, this book crisply explores the evolution of India's stock market from mid of 80s to about 2010, a quarter of a century.

While reading this book, I couldn't but remember how some of these events impacted me.

I was reading about MS Shoes scandal of 1995. Remember that? Pawan Sachdeva, the promoter of the company wanted to raise some money from the market. The route he chose was a convertible debenture - cum - rights issue. To make the issue attractive to the public, over a period of three months, he and his cohorts manipulated the share price of the company from 270 to 505.

This caught the attention of regulators who initiated investigation and arrested Sachdeva along with three officials from SBI Caps and three officials from SEBI. That was the beginning of a long correction in the market that lasted till February 1997, when the then Finance Minister, P Chidambaram, presented the 'Dream Budget'.

In the mid of '95, I had joined IISWBM, Kolkata (then called Calcutta and affectionately called 'Cal') for an MBA specializing in Finance. Daily reading of  'pink papers' like 'ET' and 'Business Standard' was sine qua non for MBA students specializing in Finance. 

The papers used to be full of news about MS Shoes. It it was not a full page ad about the rights issue, it would be an opinion piec on the innovative approach to fund raising by the company.Of course, you could not turn the 'money' page without being bombarded with news about the rising share price of MS Shoes. 

Those were exciting times. FIIs were making a beeline into the country and there was constant demand for MBAs to cater to the new area of equity research.

One would have said that it was the best of the times to be specializing in Finance. 

The market was trending high by the day and the demand for equity researchers were increasing as more and more FIIs set shop in the country.

One of the institutions that focused on equity research was ICFAI (Institute of Chartered Financial Analysts of India), located in Hyderabad. The Institute was into Finance education with its flagship program awarding CFA (Chartered Financial Analyst)Charter. While this charter was different from CFA charter provided by the US based Organization, the curricula and the exams were equally rigorous. CFA program was specifically focused on the Financial Analysis and Investments leaving the financial control activities to the accountants.

CFA had three levels. Level 1 was called DBF (Diploma in Business Finance) and level 2 was called ADF (Advanced Diploma in Finance). Once you complete level 3, you are awarded the CFA Charter. 

ICFAI also had an arm that was doing equity research. Their job was to prepare equity research report of various companies. These reports in turn, were sold to Institutions that were interested in investing in those companies. 

The Institute used to get these reports generated by MBA students who did this under guidance from professionals as a part of their summer internship. Summer Internship (also called Summer Project) with ICFAI was the most sought after assignment in tier 2 MBA campuses, because they were generous paymasters. While other companies used to pay Rs.5000 per month (slightly less than USD 100 at current exchange rates), ICFAI used to pay Rs.15000 per month to an intern. 

While doing MBA, I had also enrolled for the CFA program. By end of '95, I had completed my level 1 (DBF). 

When ICFAI came to the campus for recruiting interns, I was ready. We had to clear a rigorous test cum interview process to be eligible for internship. Three students from the campus, including yours truly, got selected for the internship.

The Internship pay was Rs.15000 per month. I was on cloud nine. (because I was very happy)

Unfortunately, by the end of '95, cloud of trouble and uncertainty enveloped the Indian Markets. First sign of trouble was when Sachdeva and his cronies were arrested and convicted in the MS Shoes scandal. Markets started drifting down. There was pessimism all around.

One of the immediate casualty was a significant drop in demand for research reports. Who needed them when no one was investing?

By mid of '96, as we were getting ready for summer internship, the market was lackadaisical. ICFAI was caught in the bind of contract to give us internships. They send us a revised offer, reducing the internship pay to Rupees 3000 a month !

Of course none of us accepted the offer. In retrospect, that decision was wrong, because the experience would have been hugely beneficial. But our ego was at play. From strutting around the campus with a pay of Rupees 15000 per month to fall to 3000 per month was a disgrace which we were not prepared for, and that is what ICFAI wanted probably.

All ended well as I managed to get an internship with another small company to do research on Power Sector, an area which I was familiar with...

Reading about MS Shoes and the associated market down turn brought forth so many memories....

Thursday, January 11, 2018

Excerpts from the book Bulls, Bears and Other Beasts: MS Shoes Scandal

This is an excerpt from the fascinating book 'Bull, Bears and Other Beasts' written by Santosh Nair.

I remember reading about, and not understanding anything, about MS Shoes Scandal that effectively started the stock market correction of 1995. From the book....

---Meanwhile (in 1994) the party in the the primary market continued. Junk companies and their dubious promoters were having a free run, with the underlying strength in the economy giving investors the confidence that the best was yet to come. Then in February 1995, investors got their first reality check as to the quality of companies and promoters that were raising money from the market. The botched MS Shoes public issue revealed how easy it was for promoters and merchant bankers to hoodwink the regulator. Worse still, the episode also exposed the lax oversight by SEBI in this particular case, and the corruption within its ranks.

The Pawan Sachdeva-promoted company wanted to raise Rs.700 crore to fund a hotel project and a yarn project. It decided to make a composite public issue-cum-rights share offering. The public issue was for fully convertible debentures - bonds that could be converted to equity later on. 

MS Shoes was already listed, and the promoter, in collusion with associate brokers, ramped up the stock price to charge a hefty premium for the issue. Shares of MS Shoes climbed from Rs.268 in July 1994 to a record high of Rs 505 by January 1995, thanks to rampant manipulation by brokers backed by Sachdeva. When the stock price of MS Shoes collapsed, the brokers who were buying on behalf of the company could not meet their pay-in obligation to the stock exchange. The BSE had to be closed for three days as the exchange officials sorted out the mess caused by defaulting brokers. Sachdeva was raided by the taxmen, and soon after arrested by the CBI. FIRs were filed against two officials of SBI Caps, the merchant banker to the issue and three senior SEBI officials.


Tuesday, January 9, 2018

Excerpts from the book Bulls, Bears and Other Beasts: How BSE scored a self goal

In his book 'Bulls, Bears and Other Beasts', author Santosh Nair presents a fascinating story of how BSE (Bombay Stock Exchange) scored a self goal and allowed unfettered growth of NSE (National Stock Exchange).

The history of this country is replete with antediluvian forces with vested interest hindered the progress of the country by opposing technology and innovation in their areas. Ideology did not matter. Be it communists in West Bengal who opposed computerisation and delayed the economic progress of the state or the 'Bombay Club' of leading industrialists who opposed the opening up of the economy or as the case below shows the brokers and jobbers at Bombay Stock Exchange....

Progress did not matter. Only vested interest mattered..

Read on the case of BSE that opposed computerisation, and how it pushed the exchange back a lot, as told by the author...

---(During the early 90s), there was no dearth of stock exchanges across the country, but BSE was by far the biggest and the most important of them all. It had the maximum number of companies listed on it, and was more liquid compared with its peers. CSE (Calcutta Stock Exchange) came within respectable distance of matching it in terms of liquidity, while Delhi Stock Exchange was a distant third. 

While many retail investors in far-flung towns preferred to transact on BSE, they invariably ended up getting poor prices because their orders would be routes through a chain of sub-brokers to the main broker in Mumbai. Each sub-broker in the chain would charge his commission, with result that brokerages charges alone would amount to 3-4 percent or even higher. Finally whether the investor got a good deal or not depended on how efficient and scrupulous the main broker was. More often than not, the purchase price was marked up closed to the highest price of the day and the selling price closer to the lowest level of the day. Brokers could afford 'take-it-or-leave-it' policy with their retail clients.

This is not to say that BSE did not have progressive minded members. Mahendra Kampani, when he was president of the exchange tried hard to computerise the trading process and convert the open outcry system int a screen-based one. The advantages of electronic trading were twofold. One, liquidity would increase as more investors could simultaneously access the system. This would shrink the spreads dramatically. More importantly, there would be greater transparency about the prices at which shares were actually bought and sold.

---this move would have dented the profitable business of many jobbers and brokers who thrived on the wide spreads and opaque prices resulting from low liquidity. 

--Not surprisingly, Kampani faced huge opposition from the broking community, and the proposal was put in cold storage.

What the broker-jobber lobby did not realize was that in blocking computerisation, they had dealt a crippling blow to BSE, a blow from which the institution would never really recover. 

-- a veteran BSE broker (who had once been a President of the exchange) told me how the exchange's electronic trading plan never got the backing that it should have from the government. In fact, it appeared that some influential people in the government wanted to marginalize BSE.

--- my own view is that (sic) somewhere along the way, BSE broker's lobby had become too powerful for its own good and was beginning to be seen as a challenge to the government. In the late 80s, when former UTI chairman Phervani, tried to get a broking card for a UTI subsidiary, he was denied it. UTI did huge business with the brokers and was aware that it was being regularly fleeced on quite a few transactions. To get around the problem, UTI decided to have its own broking card. But the big boys of Dalal Street would have none of it. One, the brokers who made a living off UTI's deals would lose a big share of the business. Two, giving membership to UTI would lead to similar requests from other institutions too. 

---When SEBI tried to get brokers to register with it for a fee, the proposal was stoutly opposed by brokers and jobbers. They refused to carry out transactions, with the result that BSE had to shut down for a week in April 1992.

Finance minister Manmohan Singh, who visited Bombay during that time, came down to BSE to meet the agitating brokers. Brokers behaved badly with the finance minster, shouting slogans and booing him. This would have piqued the government. A leading exchange of the country holding the government to ransom would have served to drive investors away..

Thus it was that NSE, set up with financial institutions as its principle shareholders, and originally meant to be a trading platform for wholesale debt, was given permission to start and exchange for trading in shares too. It commenced operations in November 1994, overnight changing the rules of the game.

From the first day of its operations, NSE started operations with an electronic trading system. NSE's biggest contribution to the stockbroking industry was the vast new breed of brokers it spawned. Anybody could become an NSE member by paying a (refundable) deposit fee and clearing an exam. 

The introduction of electronic trading rapidly shrank the spreads and dramatically improved liquidity. Liquidity, in turn, attracted more players, making the market even more liquid. No longer the brokers could fleece the investors as prices were transparent. 

In barely eleven months of going live, the NSE nosed past the BSE in terms of daily traded turnover, becoming the top exchange in the country.

That must have hurt...


Sunday, January 7, 2018

Excerpts from the book Bulls, Bears and Other Beasts: How BSE used to work in the eighties

In the fascinating book 'Bulls Bears and Other Beasts', author Santosh Nair describes the workings of the Bombay Stock Exchange (BSE) in the 80s and early 90s. The story is told from the perspective of his protagonist Lalchand Gupta

This excerpt explains how BSE used to work.

...A broker could have seven of his dealers in the trading ring, apart from himself. Orders placed by clients over the telephone to the broker's office would be conveyed to the dealers on the trading floor, who would  then execute the trades. Before the days of the hotline, brokerage firms had runners who would rush to the trading floor to relay orders.

....For one month I was assigned to a senior, and had to observe him as he negotiated deals with brokers and jobbers. 

A jobber is a professional speculator, and buys and sells shares for himself. He does not have any clients. His business is to speculate on which way the prices are moving and make a quick profit on it. He does not want to buy shares and keep  them for long term as investors do. But, to do business on the floor of the exchange, he needs to have a broker as a sponsor. He shares a part of his profit with the broker under a pre-decided agreement.

In a way jobber acts as an agent of the broker. If the jobber defaults on a deal, the broker is held responsible by exchange. Hence brokers chose jobbers with care. Jobbers were an important source of liquidity and brokers would always deal through them. 

A jobber helped create liquidity in a stock by offering two-way quotes and also helped in price discovery. He took on the risk, confident that he would be able to sell whatever he bought and buy back whatever he sold. 

In those days there were 'counters' for individual stocks. Jobbers and brokers dealing in Reliance shares would gather at a certain sport, those dealing in TISCO in another spot and so on. 'A' group shares, where a buyer or seller could carry forward trades the next settlement by paying an interest charge known as badla, were called vaida. 'B' group shares, which were not eligible for carry forward were known as rokda (Cash), since they had to be settled at the end of the fortnightly settlement cycle.

There was a public address system on every floor of the stock exchange building, on which would be broadcast the prices of most A group stocks, and some times B group stock if there were big moves on them. For a price, brokers could get an extension of that system so that they could hear the broadcast sitting in their offices. Brokerages wanting to cut costs would usually station one of their employees in the corridor of the exchange so that they could alert their offices about important announcements.

The trading ring was on the first floor. Outside both the first and second floors were huge blackboards on which an employee of the stock exchange would write down the prices of the most actively trades stocks, updating them every thirty minutes.

The trades done on the floor of the exchange had to be entered in the sauda pad. Every sheet of sauda pad had five columns for five details about the deals - the clearing number of the broker one has dealt with, whether shares were bought or sold, the name of the stock, quantity of the shares and the price at which the deal was done. Disputes would arise if one broker erred in recording the quantity of shares or the nature of the transaction in his sauda pad. The stock exchange would then issue an objection memo, known as vaanda kaapli, to the two members and ask them to sort out their disagreement. 

The colour of the sauda pad itself contained information about the traders. Broker-owners had pink pads while their employees and jobbers had blue ones. If the two parties failed to arrive at an agreement, the pink sauda pad would prevail since the broker was accorded a higher weightage in the caste system of the stock exchange. 

Around half past five in the evening, the stock exchange would publish the 'bhav copy', a report listing the high, low and closing prices of the stocks traded that day. It was not done scientifically, but was broadly reliable. Its compilation was done by a stock exchange official collecting the prices by talking to the brokers and jobbers and by checking their sauda pads.

The stock exchange issued only a limited number of bhav copies, so there was a scramble to get them. Some ingenious players found a way to profit from this by taking photocopies of the bhav copy and selling them outside the exchange for a few rupees.

After trading hours there operated an unofficial market for some of the more liquid stocks. this was called the kerb market and, true to its name, the dealings were conducted on the street outside the stock exchange. The prices in the kerb market would be at a premium or discount base don the closing prices on the stock exchange, depending on the sentiments and events. 

Today, it all looks fascinating, the level of primitiveness that existed in the stock markets just about 30 years ago. It is not for nothing that people did not trust stock market and called it gambling. With the lack of transparency and the level of manipulation, it was akin to gambling, retail investors stood no chance.

Saturday, January 6, 2018

Book Review #33: Bulls Bears and Other Beasts: Author: Santosh Nair

The book, Bulls Bears and Other beasts tells the story of the evolution of equity markets in India as seen through the eyes of the protagonist Lalchand Gupta. While the visible hero is Lalchand, the invisible hero is the Indian stock market ecosystem, including the stock exchanges, SEBI (Securities and Exchange Board of India) and the GOI (Government of India) that introduced significant market reforms that catapulted the Sensex from 750 in the 1990 to almost 34000 by the end of 2017.

Both stories run in parallel in this fascinating book. One is the story of Lalchand himself, his ups, downs, fights, wins and loses. You tend to sympathize, empathize and get excited with him. The other is the evolution of India from a closed economy - consisting of close knit group of powerful brokers, market manipulations, only one Institutional Investor (UTI), minimal retail participation in the markets and a slowly growing economy - to open economy - consisting of globalization, SEBI, National Stock Exchange, wider retail participation and of course the mother of them all the arrival of Foreign Institutional Investors (FIIs)

Having worked with Economic Times and then with Moneycontrol.com, Mr.Nair writes from a vantage point of having 'been there, done that'. He is as much an author as a participant in this brilliant book.

This well written, fast paced and easy to read book paints a large canvas, the evolution of equity markets in India starting from the beginning of the tumultuous years from about 1988. Lalchand is a product of the Mumbai (it was called Bombay in those times) underbelly of the 80s. He was born and brought up in the slum areas and got into lot of bad company. However, he quickly corrected himself and while working in a chemical company, got opportunity to know about the workings of the stock market.

In the early eighties only few stock exchanges existed in India, the biggest of them being Bombay Stock Exchange (BSE) followed by Calcutta Stock Exchange (CSE). In the late eighties, where this story begins, there was hardly any retail participation in the stock market. Easy money was made by a lucky few who has subscribed to the IPOs of MNCs. UTI was the only domestic institutional investor. Brokerage rates were 1.5 percent and investment based on the fundamentals of a company was still in its infancy. There was hardly any publicly available information on the companies. A lot of 'research' done those days would constitute as insider trading today.

More than the stock market professionals, company promoters used to speculate heavily in their own shares through their favored brokers, known as 'house brokers', who were known to be proxies for the promoters.

UTIs business was crucial to the prosperity of the brokers, since it was the largest institutional investor. Since UTI traded in large blocks of shares, there was good money to be earned by way of commission. More money was made by front-running UTI trades. If it was a buy order from UTI, the broker would buy shares on his personal account. Then when the block purchase was done, the share prices will go up and the broker will sell his personal stocks and make good fortune. The reverse process happened in case of sell order from UTI.

There were few high rollers like Nimesh Shah, Manu Manek and Ajay Kayan who were revered and feared at the same time for their ability to make or break a company. Sometimes the companies fought back. The personality clashes between stake holders is very exciting to read. For example, the story of Manu Manek's fight with Reliance Industries makes fascinating reading.

Prior to 1995, the stock market processes and reporting were very primitive. Most of the transactions were manual and used crude forms of data entry and reporting tools. Speakers installed in various trading floors were used to communicate and blackboards were used to update the prices of the frequently traded shares. Trading data was entered in colour coded sauda pads, end of the day reporting was through bhav copies and disagreements were sorted through mutual discussion based on a strictly observed 'caste' system of the stock exchange.

When you are discussing India's stock market, you cannot avoid Harshad Mehta, the original big bull. The way he manipulated the banks to fund his stock purchases, how he routinely moved money between money market and stock market, how he ran up the prices of ACC to unheard of 10500 rupees based on a vaguely constructed 'replacement cost' theory, how he spend lavishly and attracted attention to himself and finally how this ponzi scheme that he ran was discovered, he and his cronies were arrested and the markets went through a major tailspin....all are discussed in much detail.

The year 1992 was significant for the Indian markets. Significant financial sector reforms were initiated. SEBI (Securities and Exchanges Board of India, in the lines of SEC in the US) was formed. The office of the CCI (Controller of Capital Issues) was abolished. Companies were given freedom to price their IPOs as they wanted, (prior to that, the shares had to issued only at the face value), FIIs (Foreign Institutional Investors) were allowed in the country from October 92. Initially they were hesitant to come to India. In the first six months, by March 93, only 15 Crores of FII investments came to the country.

India's response to the Mumbai serial blasts of '93, form a pride of a place in India's history. One of the blasts happened in the basement of BSE on a Friday. By working overtime over the weekend, the staff of BSE made it operational for trading on Monday, showing to the world that India will not be cowed down by terrorism. 

The evolution of the Indian markets starting 1993 are fascinating to read. In the FY 93-94 alone, 770 IPOs raised about 13000 crores from the market. Most of them were raised by greedy promoters who raised money at crazy valuations. FIIs pumped in 5000 crores in the year. The highlight of the year was the NFO (New Fund Offer, used to be called IPO back then) of Morgan Stanley Growth Fund. It was a 15 year close ended fund, and raised 1000 crores against a target of 300 crores !!

It listed in the market at a discount to the face value. Many investors, who wanted to make quick buck, lost money. 

The history of India is the story of forces of modernization fighting against forces of status quo. It was no different in Indian markets. While there was a lot of suggestions to computerise and modernize BSE, the strong Broker Lobby opposed it vehemently. They did not allow new brokers into BSE by rapidly hiking the membership charges. They were blind to the regulatory changes taking place all around them. In November '94, National Stock Exchange (NSE) started operations and this led a crippling blow the entrenched interests in BSE.

This was a self goal by BSE

NSE and BSE were different like chalk and cheese. From day 1, NSE started operations with an electronic trading system. While NSE had a weekly settlement system, unlike BSE, positions were not allowed to be carried forward. Unlike BSE which was run by brokers, NSE was run by professionals and did not have a single broker member in its board. In addition, unlike BSE, which was restricted to Mumbai, NSE had a pan-India reach offering services across the country. Unlike BSE, where membership was severely limited and expensive, anyone could become an NSE member by paying a refundable deposit fee and clearing an exam. This democratized the trading ecosystem in the country unlike any other action. 

In just eleven months after going live, NSE overtook BSE in terms of daily traded turnover, becoming the top exchange in the country!!

While electronic trading had its benefits, it created certain pitfalls. Since the very nature of electronic trading was faceless, a group of brokers could get together and trade in a stock among themselves to give an impression of heavy volumes. 

Asian currency crisis hit the market in 1997 and led to a prolonged bear market. For the first time in India, companies started downsizing. Downsizing was unheard of in India till then and many equity analysts that were earning huge packages found themselves without jobs, worst the MNC brokerages that employed them downed shutters. There was bloodbath all around.

The book celebrates Indian market, warts and all. The rampant manipulation of IPOs in the mid 90s, the MS Shoe scandal, the high interest rates (retail investors received interest of about 16% on their bond investments, I still have some like ICICI money multiplier bond and Zero coupon bonds), the depression of the mid 90s, series of market reforms initiated by SEBI, P Chidambaram's 'Dream Budget of 1997 that revived the market sentiments, Asian Currency Crisis  of 1997 that led to a bear market, the retrenchment of equity analysts, rise and fall of Ketan Parekh, the boom and bust of 'New Economy Stocks', Unit-64 fiasco, IPO manipulation of the early millennium through benami Demat accounts, disastrous IPO of Reliance Power, the carnage of 2008 in the aftermath of subprime crisis, the run on ICICI Bank, the return of UPA in 2009 and the ensuing bull market, Satyam Scandal ...

All of these are covered in just enough detail to sate the curiosity of a reader who just want to have an overview or for a researcher who may want to dig deeper...

UPA 1s maiden budget of 2004 which abolished LTCG (Long Term Capital Gains Tax) and introduced Stock Transactions Tax was another major morale booster for the market and single-handedly enabled the arrival of long-term retail investors into the Indian market through expansion of mutual fund industry. 

Seamlessly weaved together with the story of the stock market is the story of Lala. His progressive elevation as a respectable broker, his father's demise, his brother's graduation, the playing out of his dreams...

In Lala, we see a pragmatic and ethical stock market professional, playing dual role of a bystander story teller as well as a successful market participant. There are lessons to be learned for a newbie investor there..

This book is a must read for anyone who is interested in the India's stock market. If you are an investor, this book will give you perspectives about the benefits of long-term investments in equity market, after all Sensex moved up from 750 in 1990 to 34000 today, an annualised return of 15% . If you are historian, this book has details about some of the critical incidents that happened in the markets in the last 30 years. If you are policy wonk, this book will give you some ideas of what works in the market and what does not.

Finally, for my generation, we were lucky and unlucky at the same time, I would say. We came of age around the 90's, when the major changes were initiated. To that extent, one could say that we were lucky to have been living through these exciting times. However, the sad part is, we lived our life by the day, oblivious to these path breaking changes and unable to yield any major benefits from them. In the last thirty years, people have won everything. lost everything and recouped the losses and became millionaires twice over. Many of us missed the exciting journey.

There is still time. India is just starting to grow. Join the fun and run with it....

I give this book a rating of 5/5, the second book in this series of '50 Finance Books' that is getting this rating.

How did you like this review? Please update the comments so that I can improve upon.

Excerpts from the book Bulls, Bears and Other Beasts: The key players

This is an excerpt from Chapter 1 of the book Bulls, Bears and Other Beasts by Santosh Nair. You can read the book review here. (Notes to self: Add link later)

Nemish Shah, Manu Manek and Ajay Kayan were the high rollers, revered by market players for their ability to make or break a stock. Manu Manek was more feared than respected because he could be downright ruthless to further his business interests. He had no qualms about hammering down the price of the very stock he had financed for a bull operator. Manubhai, who was considered something of a mini-stock exchange himself, could quickly figure out a bull operators capacity to support the stock he was operating. If the operator was weak, Manek would short sell the stock. And once the operator mad a distress sale, Manek would buy back the shares cheaper than he had sold them for, making a tidy profit in the process.

.....And he had one more strong point - an excellent rapport with the key officials in the Bombay Stock Exchange (BSE) employees' union. Call it a coincidence, but whenever Manek was in a tight spot over a trade, there would be a flash strike by the union, and the settlement would get extended by a few days, helping him to buy time. 

Manek was fearless enough - or reckless, as subsequent turn of events would show- to take on Dhirubhai Ambani in leading a bear raid on  the shares of Reliance Industries. The bear cartel heavily short-sold Reliance Industries, aiming to break the stock price. 

.... He also made some disparaging remarks about Dhirubhai for good measure.

Bears won the initial round as the stock price flagged under their relentless onslaught. But they had not bargained for an equally fierce counter-attack led by Anand Jain, Dhirubhai's key lieutenant. Jain and his associates took over the positions of the brokers and traders who had bought Reliance Industries shares, and also themselves bought as many shares as they could from the market. On the other side of these trades was the bear cartel,, which had short-sold Reliance shares or sold shares they never owned in the first place. 

As the share prices began to climb because of the demand created by Jain and his associates, the bears tried to get out of their position by buying shares from the market. But shares were in short supply, as most of them had been bought by Jain and company, and the bears' attempts to square up their positions only sent the stock price shooting up further.

The bears thought they could buy time by paying an interest charge to the bulls on settlement day to carry forward their trades to the next settlement. They were still convinced that if they hung on to their positions for a bit longer, the price movement would reverse in their favour. But the 'buyers' of the Reliance shares refused the offer of interest payment, and insisted that the bears deliver the shares, fully aware that they would not be able to. Frantic buying by the bears to square up their positions further drove up the stock price. The crisis led to the stock exchange itself being closed for a few days as the bears could not deliver the shares and the bulls would not settle for anything less.

A truce was worked out eventually, but not before a few bears were bankrupted and the legendary Manu Manek forced to eat humble pie..

Thursday, December 28, 2017

Book Review #32: The little book that builds wealth: Author: Pat Dorsey

The book is written by Pat Dorsey who is a director of equity research at Morningstar Inc. He played an integral part in the development of the Morningstar Rating for stocks as well as Morningstar's economic moat ratings. 
In addition to this book, Mr.Dorsey is also the author of the book 'Five Rules for Successful Stock Investing'.
The book, 'The Little Book that Builds Wealth', aims to provide a conceptual anchor to help you evaluate stocks and build a rational portfolio. It is spread over 14 Chapters.
The approach followed by Morningstar is as follows. Each analyst builds a detailed discounted cash flow model to arrive at a company's fair value. The analyst then assigns a moat rating -Wide, narrow or none. The objective is to identify companies with wide moats available at discount to fair value. Making investment decision based on company's economic moats is a smart long-term approach.
The book details the economic power of moats by studying how specific companies with wide moats have generated above-average profits over many years.
The book aims to provide a solid foundation for making smart investment decisions.
The investment strategy should be to buy wonderful companies at reasonable prices and let those companies compound cash over long periods of time. The steps to implement this strategy are:
1. Identify businesses that can generate above average profits for many years.
2. Wait until the shares of those businesses trade for less than their intrinsic value and then buy
3. Hold those shares until either the business deteriorates, the shares become overvalues, or you find a better investment. This holding period should be measured in years, not months.
4. Repeat as necessary
As per the author, 'Return on Invested Capital is the best benchmark for a company's portfolio. It measures how effectively a company uses all of its assets - Factories, people, investments - to make money for shareholders.
The book is broadly divided into two parts. The first part covers understanding of  'Economic Moats'. These are traits that endow companies with truly sustainable competitive advantage. There are four parameters to valuing a company. These are, risk, earnings growth,  return on invested capital and durable competitive advantage. 
The last factor is also known as economic moat. The wider it is, the better is the company as an investment destination. Four factors can generate economic moat. These are availability of intangible assets like patents and brands, high switching costs for the customer, network effect and cost advantages. Cost advantages could be due to better processes, location near to the customer group, access to unique assets or economies of scale generated due to wider distribution network, cheaper manufacturing and access to niche markets. 
Once a foundation for moats is established in the first part of the book, the second part discusses the erosion of moats, role of Industry Structure in creating moats and how management can create or destroy moats. There is discussion on valuation as well so that the investor can decide if they are paying a fair price for the moat. The final chapter of the book covers four reasons why an investor should sell her stock. 
This is a good book that provides an overview of the value investing. This book is targeted towards beginners and gives a fair grounding on the concepts of value investing and sates the reader's curiosity to explore the wide and beautiful world of value investing.
Read on for the chapter summary...
Chapter 1: Economic moats
This chapter covers the importance of moats. Moats is defined as 'Durable Competitive Advantage that can provide strong and increasing free cash flows for the company over extended periods of time'. Hence these companies are more valuable than the companies without moats. Since moats provide durable competitive advantages, when you buy shares of companies with moats, you are buying a stream of cash flows that are protected from competition for a long period of time. Thinking about moats can protect your investment capital in a number of ways. One, it enforces investment discipline, making it less likely that you will overpay for a hot company with shaky competitive advantage. While the hot companies may have fat margins and profits in a short term, it is the duration of the profits and margins that matter. Moats provide us a framework of separating the fly by night companies from those with durable advantage.
Another reason why moats are important is that they significantly reduce the risk of permanent capital loss. Companies with moats are likely to increase their intrinsic value over time, so if you wind up buying their shares at a value that is somewhat high, the growth in intrinsic value will protect your investment returns.
Companies with moats also have greater resilience and can recover quickly from temporary troubles (remember Bata and Nestle?). This resilience of companies with moats is a huge psychological backstop for an investor who is looking to buy wonderful companies are reasonable prices, because high quality firms become good values only when something goes awry. If you analyze these companies thoroughly, you will know if the troubles of the company are temporary or permanent and take the necessary investment action.
Finally, moats can help you define your 'circle of competence', a set of industries where you  develop expertise.
The idea of this book is to help you identify companies with moats and those without...
Bottom line to Chapter 1:
1. Buying a share means that you own a tiny piece of business.
2. The value of the business is equal to all the cash it will generate in the future
3. A business that can profitably generate cash for a long time is worth more today that a business that may be profitable only for a short time
4. Return on capital is the best way to judge a company's profitability
5. Economic moats can protect companies from competition helping them earn more money for a long time, and therefor making them more valuable to investors
Chapter 2: Mistaken moats:
The four common 'mistaken moats' are:
1. Great Product: This can be copied or competition can design a similar product at much less cost.
2. High market share: This can be quickly eroded. The investor should focus on how the market share was achieved. If the market share is achieved due to a moat, then it is good. Market share is mostly an outcome of the moat rather than a moat in itself.
3. Great Execution: This can be replicated, especially if there is an outside force pushing standardization
4. Great Management: Moats are structural in nature and the cash flow continues over a relatively long term. This has mostly nothing to do with the management.
So what generates moats for a business. There are four characteristics that are mostly create moats.
1. Intangible assets like brand, patents or regulatory licenses.
2. High Switching costs
3. Network economics
4. Cost advantage stemming from process, location, scale or access to unique asset which allows them to offer goods or services at a lower cost than competition.
Bottom line to chapter 2
1. Moats are structural characteristics inherent to a business. Some business are simply better than others.
2. Great products, market share, great execution and great management do not create moat.
3. The four sources of structural competitive advantage (moat) are intangible assets, customer switching costs, network economics and cost advantages. Any company with solid return on capital and any one of these characteristic is worth a decko.
Chapter 3: Moat 1: Intangible assets
There are three intangible assets that can create a moat under certain circumstances. First is the brand. Brand can generate customer loyalty. A brand can become a moat if they can raise prices without fall in market share. (Green Trends is an example. Once they go there, ladies continue to go to that place only. Maggi noodles could be another example).
Patents can create an economic moat if the the firm has a demonstrated track record of innovation shown by large number of patents it has.
Regulatory licenses are most effective as a moat when the company needs approval to enter the industry, but is not subject to price control. Utilities and Pharma are a comparison. While both need regulatory approval to set up business, the price that can be charged by utilities for its products is controlled by government.
A typical example of regulatory licenses acting as a moat is the NIMBY (Not in my back yard) companies like waste management which need licenses but discourages new entrants from coming in due to structural barriers to entry.
Bottom Line to Chapter 3
1. Popular brands are not always profitable brands
2. Legal challenges are a great risk to patent moat
3. The best kind or regulatory moat is one created by a number of small-scale rules, rather than one big rule that could be changed.
Chapter 4: Moat 2: Switching costs
Switching costs are a valuable competitive advantage because a company can extract more money out of its customers if those customers are unlikely to move to a competitor. Customer may not want to switch from company's product to a competitor's product due to two reason. One, the product is at the core of the customer's business, ERP for example. Two, switching over to another product could cause a lot if integration issues since this product could be a part of an integrated ecosystem.
Switching costs as a moat is widespread. This type of moat can be powerful and long lasting but very difficult identify.
Chapter 5: Moat 3: Network effect
A company benefits from Network effect when the value of a company's product or service increases as the number of users increase. The more the number of users the more the benefit and ease of transactions for the new users in the network. The network effect can be broad - there are many users transacting in the company's product or service or it can be deep - there are many different products or services of the company that the users are transacting with.
Some examples are Credit card companies (like Amex) where the larger the number of the attached merchants, the more users can use the credit cards of the company, Auction Sites (like eBay) where more the number of existing users, more products and features can be rolled out for new users, Option Exchanges (like CBOE)  where the buying and selling of the options is restricted to the same exchange (unlike stock exchanges), some money exchange sites (like Western Union), third party logistics service providers who connect buyers and sellers of shipping and logistics services etc.
Since the size of the existing network determine the market power of these companies, it creates a barrier to entry for competitors who has to replicate the network. Hence the companies in the industry tend to form natural oligopolies.
Some of the characteristics of network effect are:
1. Network effect can quickly dissipate due to external activities. For example, if the investor is allowed to buy options in one exchange and sell it in another, the competitive advantage of the option exchanges will quickly dissipate.
2. Network effects are seen in businesses that deal in information or knowledge transfer. The reason is that these companies sell 'Non rival' goods, which can be used by many users in parallel.
3. For a company to benefit from network effect, it has to operate in a closed network. As the network opens up, the effect will wane quickly.
4. The benefit of having a large network is non-linear. It means that the value of a network increases at a faster rate than the absolute size of the network. (Multiplier Effect)
Chapter 6: Moat 4: Cost advantages
Cost advantages matter most in those industries where price is a large portion of customer's purchase criteria. Mostly these are in the commodity sector. Cost advantages stem from four different sources.
1. Cheaper processes
2. Better locations
3. Unique assets
4. Economies of scale
This chapter covers the first three sources above.
Cost advantages arising out of better and cheaper processes can be transient. However, during the time the company owns the process, it can make windfall profits. While processes can be replicated, sometimes structural issues with the competition can provide a long window of opportunity. Process based cost advantages can create a temporary moat if incumbents are unlikely to replicate them immediately. Process based moats are worth watching closely, because the cost advantage often slips away as competitors either copy the low-cost process or invent one of their own.
Chapter 7: Size advantage: Economies of scale
When it comes to economies of scale, the absolute size of a company matters much less than the size relative to the rivals. To understand economies of scale, we have to understand the difference between Fixed Costs and Variable Costs. Fixed costs are the upfront costs that you have to incur even before you make a single unit of sale. Fixed costs normally cover the cost of machinery, vehicles, salaries, rent etc. Variable costs are the costs that increase with the number of units sold. The main example of variable costs could be the raw material costs - the more you sell, the more you have to buy raw material to produce the products that you sell.
The more the level of fixed costs relative to variable costs, the more the scale advantages the company has. There are three categories of scale based advantages:
1. Distribution
2. Manufacturing
3. Niche Markets
Large distribution networks can be a source of tremendous competitive advantages. The portion of fixed costs are very high for these network and any incremental revenue leads directly to the profits of the company. Large distribution networks are extremely hard to replicate and are often sources of very wide economic moats
Same is the case with manufacturing. Once a fixed cost of setting up a factory is incurred, the incremental revenue can directly go into the profits of the company since the ratio of Fixed Costs to Variable costs is high in this case. Even a small company that is strong in a niche market can have a wide moat that is difficult to replicate. Private infrastructure is a good example. In India, GMR owns and operates multiple airports including Bangalore, Hyderabad and New Delhi.
Chapter 8: Eroding Moats
Moats can be quickly eroded due to changes in the business environment. If you can get an early read on a weakening competitive advantage, you can improve the odds of preserving your gains. There are two sides to this threat. For a company that sells technology, threat of a better technology is a given. However, technological disruption is a severe threat when it affects non-tech companies because these companies can look like they have very strong competitive advantages before a technological shift permanently eroded their moat. Examples abound. Eastman Kodak before digital photography was a cash making machine selling photo films. BSE, with its manual transactions was the King before NSE came into prominence with electronic trading. Telephone companies ruled the roost before the age of VOIP and Skype.
Another type of change that can erode a moat is the change in the structure of industries. For example, the advent of big ticket retail chains has eroded the pricing power of their suppliers.
The changes need not be local. The entry of low-cost Chinese labour has eroded the competitive advantages of many US manufacturers.
Yet another change could be the entry of an irrational competitor. For example, when British Government started deciding on the pricing policies for Rolls Royce after the take over, the changes impacted the few competitors in the aircraft engines business.
Companies using excess cash to move into unrelated businesses can severely erode the moat.
Another change that could erode the moat will be the transfer of bargaining power from the seller to the buyer, as Oracle experienced for its support services.
Chapter 9: Finding moats
It is easier to find moats in some industries than others. It is easier to find a moat in an asset management company than an auto components manufacturer. In technology, a software product developer could have a wider moat than a hardware manufacturer. Former gets integrated into the customer business and lead to switching costs, while the later is standardized and easily replaceable with a competitor product.
For Telecom companies, a favourable regulatory environment (like in UAE) creates a moat. While media is more susceptible to competition and moat erosion, control of vast amounts of content can act as a moat for  some media companies.
While Pharma companies are subject to regulatory environment, a wider product portfolio gives them a moat. Also small Pharma companies in specialized niche areas can enjoy moats for a long time.
Companies that provide services to the business can enjoy a wide moat largely because these firm integrate themselves so tightly into their client's business processes that they create very high switching costs giving them pricing power and excellent ROIC.
Companies in consumer sector usually enjoy a wide moat mostly because of the brand loyalty. In this sector, on should look out for small companies in niche areas.
While oil and gas sector is a commodity and hence do not have a moat, some industries that cater to Oil and Gas sector can have a wide moat. One example is the pipes manufacturers.
To measure a company's profitability, we look at how much profit the company is generating relative to the amount of money invested in the business.
There are three ways to measure the return on capital
One is the Return on Assets (ROA). This measures how much income a company generates per dollar of assets. A non-financial company that can consistently generate an ROA of 7 percent or above is likely has some kind of moat.
Return on Equity (ROE) measures the profits per dollar of shareholder's capital. One flaw of this measure is that firms can substantially increase the ROE by taking a lot of debt relative to equity. As a rule of thumb, you should look for ROE of 15 percent and above.
Return on Invested Capital (ROIC) measures the return on the capital invested in the firm including both equity and debt. This helps remove any effect of the firm's financing decision (debt vs equity).
Chapter 10: The big boss: Does management matter?
Managements do not matter much. This goes against popular wisdom. Some industries are more conducive to digging a moat than others. Company's structural characteristics have much more effect on the company's long-term performance than the quality of management. Why then management receives so much of attention? Two reasons. One, the media needs heroes. Two, it is human nature to look for a causal agent to assign success or pin blame. Of course there are companies where the management quality created a moat. Starbucks and Dell being examples.But these are exceptions and not the rule.
In summary, while great managers can add value to the business, management by itself is not a sustainable competitive advantage (aka moat).
Chapter 11: Where rubber meets the road: Examples of competitive analysis
This chapter talks about a three step process to determine if the companies have moats.
Step 1 focus on the historical performance of the company. Has the firm historically generated solid returns of capital? If the answer to the above question is no, then the next question to ask if the firm's future is likely to be different than the past. It the answer is no to this question also, then we can conclude that this company do not have an economic moat.
If the answer to the first question in step 1 is 'Yes', we move to step 2. In this we check if the firm has any one of the competitive advantages that we discussed earlier vis. High switching costs, Network economics, Low-cost production, economies of scale or Intangible assets (like brands or patents). If the answer to this question is No, we can conclude that this company do not possess an economic moat.
If the answer to the question in step 2 is 'Yes', we move to step 3. Here we assess the durability of the moat. The question is 'How strong is the company's competitive advantage? Is it likely to last a long time or a relatively short time? Based on the duration of prevalence of the competitive advantage, we classify them as 'Narrow Moat', or 'Wide Moat'
Chapter 12: What's a moat worth?
All the chapters till now focused on the step 1 of the Investment Strategy discussed in the Introduction. That is 'Identify businesses that can generate above average profits for many years.' This chapter and the next focus on the step 2 of the strategy 'Wait until the shares of those businesses trade for less than their intrinsic value and then buy'. The focus of this chapter is on calculating the Intrinsic Value of the company. Valuation of a company is difficult due to two reasons. One, every company is slightly different, which makes comparison between peers a tough exercise. Parameters like growth rates, ROIC, strength of the moat..all differ from company to company even in the same industry. Two, value of a company is directly tied to its future financial performance which is unknown.
You need not know the precise value of a company before buying its shares. All you need to know is that the current price is lower than the most likely value of the business. One of the ways is to compare the growth rate implied in the price to your estimate of the potential future growth.
What is value? As per the discounted cash flow method, the intrinsic value of a company is the present value of all the free cash it will generate in the future. Free cash is the cash flow net of operating and capital expenditures. While estimating the future cash flows, four things are important. The risk of the cash flows materializing, the growth rate of the cash flows, ROIC and the duration of the excess cash flows (economic moat).
There are three types of tools for valuing companies, price multiples, yields and intrinsic value. This chapter focus on the valuation of the company. Over long stretches of time, there are two things that pushes the stock price up or down: the investment return, driven by earnings growth and dividends and speculative return, driven by changes in the PE multiple. The investment return reflects the financial performance of the company while the speculative return reflects that exuberance or pessimism of the market.
When we focus on companies with economic moat, we are maximizing our investment return, which we can estimate and is under our control,  and minimizing our negative speculative return which we cannot control.
Chapter 13: Tools for valuation: How to find stocks on sale?
The focus of this chapter is on price multiples. These are the most commonly used, and misused, valuation tools.
The first multiple is the Price to Sales (PS) which is current price divided by the sales per share. This is mostly useful for cyclical companies or companies that are having some kind of trouble. Low margin businesses have low PS ratios compared to high-margin business like pharma. This ratio is most useful for companies that have temporarily depressed margins, or that have room for improvement in margins.
One useful way to use price to sales ratio is to find high-margin companies that have hit a speed bump. These companies might be facing temporary problems, but beaten down by investors. If the company can return to former level of profitability, then the stock is probably quite cheap. This is one instance where PS ratio is better than PE ratio. PE on an under-earning company might be high since earnings are low. Lesson: Look for companies where PS is lower than PE
The second multiple is the Price to Book (PB). Book value can be thought of as representing all the physical capital invested in the company - factories, computers, real estate, inventory etc. The rationale for using book value in certain cases is that the future earnings and cash flows are ephemeral, while the stuff that a company physically owns has a more tangible and certain value.
When using book PB ratio, you have to be clear as to what 'B' represents or do not represent. For an asset intensive firm, the Book value represents all the assets of the company. However, the value of intangible assets like patents, brands or human assets are not reflected in the book value.
Also, book value can be inflated through good will which is the value the company paid for acquiring another company over and above the value of its physical assets. Since low PB ratio is better than high PB ratio, the use of goodwill can inflate the book value and lower the PB ratio.
Where is it best to use PB? It is useful for companies in the financial services. Since most of the assets are 'marked to market', the book value of the company is a good reflection of its tangible value. Only caveat here is that an abnormally low PB ratio can indicate that the book value is not realistic and may contain a lot of NPAs
The third multiple is the Price to Earnings (PE) multiple. PE ratio is useful because earnings are a decent proxy for value creating cash flow, and because earnings results and estimates are readily available. These are tricky because earnings are a noisy number and because a PE ratio has to be seen in comparison.
Another challenge with this ratio is that while there may be only one P, there could be different versions of E including Trailing Twelve Months (TTM), calendar year, fiscal year and estimated future PEs. Forecasting earnings are risky because it is observed that they normally pessimistic before a beaten down company rebounds and is optimistic just before a high-flier slows down.
What this means that you have to come out with your own views of earnings to be used in the PE ratio. Once this is done you can use PE to compare it with a competitor, industry average or the same company at different points in time.
The fourth multiple is the Price to Operating Cash Flow (PC) multiple. Cash flow can present a more accurate picture of the company's profit potential because it simply shows how much cash is flowing in and out of a business, whereas earnings are subject to a lot of adjustments. This ratio is also a bit steadier than earnings. For example, it is not affected by non-cash charges that come from a corporate restructuring or an asset write-down. Cash flow also takes capital efficiency since company's need less working capital will show more cash flow than earnings. Since cash flow do not take depreciation into account, asset intensive companies will have higher cash flow than earnings. This could overstate their profitability. 
These are the four multiple based valuation metric. The next set of metrices are yield based metric. Advantage is that yield can be compared with bond yields. 
There are two yield based matrices. One is the earnings yield and the other is the cash return. 
Earnings yield is the inverse of PE ratio. If the PE is 20, then earnings yield is 5%.
Cash Return is an improvement over earnings yield. It tells us how much cash flow a company is generating relative to the cost of buying the whole company, including the debt burden. This measure improves on the earnings yield since it looks at Free Cash Flow and incorporate debt into company's capital structure. Cash return is calculated by the formula:
(Free Cash Flow + Interest Expense) / (Market Capitalization + Long - term debt - Cash)
Now that we have covered four multiples and two yields, the question is to know how to use these measures. The following five tips are useful.
1. Always remember four drivers of valuation: risk, return on capital, competitive advantage and growth. All else being equal, you should pay less for higher risk and more for companies with the remaining three. 
2. Use multiple tools. If multiple tools align, it is a sign of a truly undervalued company
3. Be patient: Not making money is more important than losing money.
4. Be tough: Buy when everyone else is selling
5. Be yourself: Put effort in understanding moat and valuation before you invest. 
Remember, the best business in the world will be a bad investment if purchased at an unattractive price.
Chapter 14: When to sell
There are four reasons to sell a stock. They are:
1. You made a mistake
2. The company has changed for the worse
3. There is a better place for your money
4. The stock has become a large portion of the portfolio
You sell a stock if you have made a mistake in your original investment thesis. You missed some critical information while analyzing the company. At the time of purchasing the stock, write down the reasons why you purchased the stock. Review the assumptions regularly. Every time the facts go against the assumptions, sell the stock.
Another reason to sell the stock is when the company's fundamentals deteriorate completely
Third reason to sell is that you have come across a better investment opportunity. Remember that sometimes it is worthwhile staying in cash. For example if the stock has gone significantly out of value, it is better to sell it and stay in cash. 
The last  reason for selling a stock is that it has become a very large portion of your portfolio. So you sell the overweight ones to re-balance your portfolio.
Note that none of the above four reasons is based on stock price. They are all dependent on what happens or likely to happen to the values of the companies. Also, do not look at the past performance of the company before investing in it. Money is made in future, not in past.