Have the Equity Markets Bottomed Out?

Their is Panic after the Euphoria. And equity markets are close to making a panic bottom in the next few days. In January 2008 nobody in the world would have told the Investors to book profits, similarly nobody is now telling the investors to buy into equity. The final panic signs are evident in the markets. With the rejection of US bailout package, world markets are in a state of panic, because of the liquidity crunch. These are clear signs of the markets bottoming out after a free fall.

Fortune favours the brave. Only those who will venture out in these turbulent times with their shopping bags will reap rich rewards in the future. It has happenned in the past, this time around there won't be an exception. At around 12000 BSE, the risk reward ratio is positive, as the markets trade at 12- 12.5% FY09 PE multiple. Anything lower than that is your bonus. The brave have to make a choice in favour long term investment. It is the right time to increase exposure to equity in your portfolio, because equity has always been a good long term bet.

The American Business Culture

The rot in American business culture is a matter of public outcry now. Many CEO's have had such an obsession with the stock prices of their companies that they have often neglected their core businesses. These CEO's have many times taken decisions which only had temporary effect on their share prices, but jeopardised their long term business prospects. Perhaps the system of fat pay packets/ incentives is directly linked to the profits generated by the company. This leads to the root cause of the problem ie. 'Overleveraging'.

The very survival of a nation devoted to 'free enterprise' has been questioned by honest tax payers - Why should they be liable to bail out the unscruplous executives who have inflicted this financial pain, forcing the unprecedented Govt. bail out package. Consider this: Mr. Stanley O'Neil pocketed $161 mn. package before quitting Merril Lynch last year, Mr. Richard Fuld was able to pull out over $490 mn., while Lehman brothers was tottering. This smells of total lack of accountability, the role of Govt. regulators is highly questionable.

These and many other questions about the well being of the Financial system/ Business culture will continue to disturb investors and tax payers alike. We must bear in mind that markets are not a perfect reflection of the underlying worth of the companies you have invested in. But then is a State regulated system better than a Free market system? Given a choice the free market system is always better beacuse it helps in the price discovery process and also increases the efficiency. Markets at times may behave in a chaotic manner, but it is the duty of the regulators to restore normalcy in the long run. The investors, on the other hand, must not expect miracles from the markets in terms of returns, because the markets may not neccesarily always move up. Reasonable expectations from the markets are always fulfilled in the long run.

End of the 'Investment Banking' era on Wall Street

The memories of the 'Great Depression' of 1930's have returned to haunt Wall Street in 2008. It's an end to the 'Era of Investment Banking', with the last two surving Investment Banks viz. Goldman Sachs and Morgan Stanley opting for transformation into ordinary banks. The total bailout package announced by US authorities this year amounts to US$ 1.8 trillion, which is equivalent to 13% of US GDP. For academic interest this figure stacks up to 180% of India's GDP. Why was there a need for such a massive bailout? Are there any lessons to be learnt?

The 'Great Depression' of 1930's resulted in passing of the "Glass Steagall Act" in the US to promote stability of the Commercial Banks. It separated the business of traditional Commercial Banks from the more risk taking, glamorous banks known as 'Investment Banks'. The act provided for close regulation of the Commercial banks, but allowed more freedom and more leverage to the Investment banks. The Investment banks came under the purview of Securities Exchange Commisions (SEC's). The SEC's were deregulated in 1970's and in 1990's Glass Steagall restrictions on separating commercial banking from investment banking were relaxed. In this scenario Investment banks were forced to enter new businesses such as distribution of complex derivative securities to protect their profitability. The 2001 recession in US saw Federal Reserve cut interest rates drastically, leading to a negative savings rate and gave rise to a illusionary credit boom.

The US regulators failed to tighten the Capital inflows and Lending mechanism at that time leading to a runaway boom in US spending. The regulators failed to gauge the quantum of disproportionate risk taken by these investment banks. Investment banks like Bear Sterns and Lehman Brothers were leveraging their equity to the extent of 30 to 40 times. In this case even a 5% drop in valuation of assets would neccessarily lead to the company going 'bankrupt'. And that is exactly what has happened to these investment banks as a fallout of the sub prime crises. The credit rating agencies, unfortunately all the major credit rating agencies are US firms, failed to gauge the risk and continued to rate these investment banks higher than what they desreved. Whatever has happenned in US is more in nature of a 'Regulatory failure' rather than a 'Systemic failure'.

The US continues to be the most powerful economy despite the crises. Threfore, the tremors of this crises will continue to rock the financial markets world over. India may not be impacted directly by the crises, but the failed institutions have substantial investments in our markets. It will take some time before the crises blows over. Long term investors in the equity markets are advised to grab the opportunity to build a long term portfolio on steep market declines, preferably by investing in blue chip stocks or equity oriented mutual funds.

Wall Street Meltdown: A Blessing in Disguise for Indian Consumers

The recent crises on Wall Street, capitulation of Lehman Brothers, crises for Merril Lynch has had a catastrophic effect on commodity markets world over. The 'commodity bubble' has burst. This augers well for India which is dependent on imported energy. The commodity markets were subject of rampant speculation and the traditional rules of trading ie., the matching of demand and supply were thrown to the winds. With the commodity price correction, sanity has been restored in these markets.

The punters in global commodity markets are exiting in a hurry, because of the liquidity crises. The reduction in crude oil prices to around 90$/ barrel augers well for India's import bill. Oil will stabilse around the $100/ barrel mark in the short term, and the chances of a spike remain subdued, bacause of the slowing of demand. The demand for agricultural commodities for bio-fuel has also come down substantially after the crude oil crash. This will put less pressure on agricultural product prices. All this augers well for India in controlling the runaway inflation. The inflation has almost peaked out with the sanity returning to commodity markets. Indian Government's decision to sell wheat in the open market has cooled down the prices of cereals, and the record soyabean crop to be harvested soon will have a sobering effect on edible oil prices.

The prices of base metals on London Metal Exchange (LME) have moved southwards. Even steel producers are feeling the pinch. This may have a temporary negative effect on metal stocks, it augers well for the consumers of metals. This will ultimately lead to the peaking of interest rate cycle. The rate sensitive sectors like Banking and Automoblies are hoping for good times, with input cost reduction leading to a pick up in demand.

The myth that global commodity prices can only rise has been broken.

FMP Vs FD: Where to invest?

With the stock markets on a decline FMPs have emerged as a popular investment option for retail investors. FMP's are essentially closed ended debt funds with fixed maturity offering indicative yield. Due to their tax efficient status they are being marketed as an alternative to Bank Fixed deposits (FD's). Several FMP schemes launched by various Fund houses have mopped up over Rs. 44,000 crores in the year 2008. The tenure of FMP starts from 3 months and the minimum investment amount is Rs. 5000.

How do FMP's compare with FD's?

• The investment depends upon the risk profile of the investor. While FMPs may appeal to investors willing to take a little risk for that extra return; FDs will find favour with investors who are satisfied with a lower but assured return. This is because FMP's do not offer an assured return (the return mentioned is only indicative).
• For investors in highest tax bracket FMP's are more tax efficient. In FDs, the interest income is added to the investor's income and is taxable at the applicable tax slab (or the marginal rate of tax).
  As far as FMPs are concerned, the tax implication depends upon the investment option -- dividend or growth. In the dividend option, investors have to bear the Dividend Distribution Tax. Whereas in the growth option, returns earned are treated as capital gains (short-term or long-term depending on the investment tenure). In the case of short-term capital gains (i.e. if investments are held for less than 365 days), the interest income is added to the investor's income and is taxed at the marginal rate of tax.
  As for long-term capital gains (if investments are held for more than 365 days), the tax liability is computed using two methods i.e. with indexation (charged at 20 per cent plus surcharge) and without indexation (charged at 10 per cent plus surcharge); the tax liability will be the lower of the two.
• The liquidity aspect tilts the balance in favour of FD's. Bank FD's can be instantly encashed any time by paying a 0.5% foreclosure charge. Easy loans are also available against FD's. Banks these days offer attractive two-in-one accounts where Fd's can be switches to liquid deposits (Savings/ Current accounts) and vice versa. Premature payment on FMp's may still take a few days to realise. FD's thus come in handy in case of emergencies.

The investors can make their choice after considering the above mentioned facts. Ofcourse, please read the offer document carefully before investing!

India N-abled: What lies ahead?

India has been able to obtain the Nuclear Suppliers Group (NSG) waiver, post Pokhran - 34 year nuclear trade embargo has ended. What are the ramifications of this historic achievement for the markets?

The way forward for India has been articulated by Dr. Manmohan Singh, the architect of this waiver: "We look forward to establishing a mutually beneficial partnership with freindly countries in an area which is important for both global energy security as well as to meet the challenge of climate change." It opens up business opportunities for technology flows for generating nuclear power in the country as well as export of technology from India. India has already established global leadership in research involving Pressurised Heavy Water Reactors (PHWR) and Fast Breader Reactors. India is exploring the possibility of exporting upto 220 MW reactors to developing nations interested in nuclear power generation. Private sector entry into nuclear power generation is possible only after Parliament ammends the Atomic Energy Act. However, private sector companies can supply equipment for nuclear energy as per existing arrangement. It is expected that in the long run i.e. by 2020, this deal will help India generate over 40000 MW of nuclear power.

The deal is positive for sectors such as Power, Defence, Engineering, IT, and Pharma research. How will the markets react?

• Short Run: The markets are expected to greet the deal with a gap up opening on monday of anywhere between 3-5%. The benefits accruing to certain companies will be visible only in the very long term (5-10 Years). If the rise is too swift, marked by excessive speculation, these counters should be used for profit booking in the immediate short term.
• Medium Term: The market looks good for a reasonable rise in the next few days, given the favourable economic data on inflation and commodity prices. The index has a potential to rise upto 15800 (NIFTY 4750) with ease. It can take the markets higher towards 16800 (NIFTY 5050), if liquidity improves and FIIs oblige. These levels certainly call for profit booking.
• Long Term: The deal is good for long term prospects of PSU power generation companies, and defence suppliers like BEL. Engineering companies like L&T may also benefit substantially, but their high PE multiples put a question mark on their already stretched valuations.

It is time to celebrate and we can expect some fireworks on our bourses. But don't be carried away in the euphoria!

REIT as a vehicle for Real Estate investment

In my last post I had discussed the prospects of real estate as an investment option. Real Estate Mutual Funds also known as Real Estate Investment trusts (REITs), offer an alternate investment option in Realty market. According to global consultancy firm KPMG 'Indian real estate sector is currently facing strong headwind due to the credit turmoil and rising inflation. REITs should help ease the situation and compensate to some degree the relative absence of public equity and challenging debt markets'.

What is a REIT?

• An entity which pools in money and invests in real estate
• Provide a similar structure for investment in real estate
  as mutual funds provide for investment in stocks
• Can be publicly or privately held
• Generally listed on exchange
• Assets of the trust are managed by a Fund Manager
• Provide taxation benefit to investors
• Pass through available in some countries like USA if
  specified conditions are met.
  

REMFs are ideally suited for investors who are keen on investing in real estate but lack the technical knowledge or resources for such investment. Moreover, real estate market in India lacks proper regulation and is guided my rampant speculation. SEBI has come up with a draft proposal for launch of REITs in India. When approved, it will be known as SEBI REIT regulations 2008. This will have two main objectives:

• Help meet the capital needs of the Real Estate sector,
• Allow small investors to participate in the Real Estate growth.

The salient features of the SEBI draft guidelines are:

• The trust and management company must have a net worth of minmum Rs. 5 crores
• All schemes offered bt REITs will be closed ended and will be compulsorily listed.
• The net asset value (NAV) of the schemes will be disclosed yearly based on the valuation report prepared by the principal valuer.
• The scheme will invest only in viable real estate, the contract value of uncompleted projects should not be more than 20% of NAV.
• Investment in vacant land is not permitted.
• A trust shall not have an exposure of more than 15% of any single real estate project, and not more than 25% in all real estate projects developed, marketed, owned by a group of companies.

The launch of such trusts/funds is taking time because of the shortage of professionals especially in the valuation of real estate. Effective valuation of each underlying property has to be extremely clear, before the decks are cleared for launch of REITs in India. Whever such an opportunity arises REITs will form an attractive option for retail investors to invest in Real Estate.

Real Estate Prices: Heading for a Crash!

Real Estate has been considered as one of the Investment options. How does it compare with other investment options? Real estate carries more risk than most other investments due to lower liquidity and a very high degree of speculative interest. According to projections by ASSOCHAM, retail and real estate sectors in India are expected to grow at over 30% qnd 40% respectively in the next 2-3 years. The market size of the real estate sector is currently estimated at US$ 15 billion.

In India the real estate boom took off in 2003 on the back of very low interest rates and low prices. However, the situation has changed now with realty prices going up 3-4 times, while interest rates are 60-70% higher. Incomes have certainly not grown four-fold in the past four years. The prices currently being quoted are simply atrocious. The question that bothers a lot of prospective home buyers is whether they will miss the bus if they wait any further. However, the right question should be: Can I afford to buy a house today? Unfortunately there is no index for the real estate market which allows us to measure the returns accurately.

The stock markets have historically moved ahead of the realty market. Stock markets have already entered a bear phase and realty sector is showing signs of weakness. Are we heading towards a crash in the real estate market? The ground reality is certainly pointing towards such a situation. Rising interest rates have lead to a slowdown in demand. Speculators are exiting the markets. The tightening policy initiatives of RBI have left little money for real estate development. The developers have finnced their projects through expensive private equity and are now feeling the heat. According to industry estimates over Rs. 8000 crores of real estate projects covering over 40 mn. sq. feet are facing delays, leading to cost overruns. And there are no genuine buyers at these rates.

Just like the Price-Earning multiple (PE) decides the worth of a stock, Price to Rent multiple is relevant for deciding the worth of a real estate investment. If you invest in a 2/3 BHK flat in Suburban Mumbai/Delhi NCR for 1.00 cr. ( priced at Rs. 30 lacs 3-4 years back), the expected rental would be around Rs. 25000 per month, which gives an annualised return of 3%, which is not even sufficient to cover your interest cost, assuming that most of the realty transactions are financed through banks. And you still think that you will find a buyer for this property if you wish to sell. Isn't it a bubble in the making?

Delhi Development Authority (DDA) has recently come out with a scheme to sell around 5000 flats through a draw of lots, and is expected to collect over 5,00,000 applications. Most of the applicants are speculators applying with the sole purpose of reaping allotment gains after 3 months. This reminds me of the Reliance Power IPO which was oversubcribed 72 times, and what happened to it on listing is history now.

Like in the stock market, it pays to be patient in the real estate market too. For realty market to sustain itself, there should be a steady inflow of end-users. Speculators and investors can only take it to a certain level. End-users can only come when prices are affordable and for that at least 30-40% correction is a must. If you are planning to buy a property now think twice before making a final decision. It may be a bubble waiting to burst!