Predicting interest rates in a volatality

Bond markets:-
Provides an early idea of the direction in which interest rates will move.
Yields on govt. bonds have fallen to a four-and-a half year low---- a clear sign that deposit rates will follow suit.

To a certain extent bond yields are determined by the extent of liquidity in the market.

Inflation:-
It is logical that interest rates in an economy should be higher than the expected rate of inflation.
If rates were lower, it would make more sense for the lender to purchase goods and sell them a year on.
If there is a situation of low interest rates and higher inflation, it is clear that something has got to give.

Yield curve:-
Interest rates go up along with the term.
A two year deposit should get higher rates than a one year and so on. If banks offer higher rates on long-term deposits, it is clear indication that they expect present high rates to be of a temporary nature, and that rate could go down in future.

So what does 2009 hold for interest rates? Clearly, there is slope for a reduction in deposit and lending rates.

However, govt. bonds have already priced in an interest rate cut. The yield on the 10-year govt. bond has fallen to four-and-a half year low of 5.5%.

Investment Guru’s basic fundamentals for tyro investors

According to Guru 1, look for companies who are good at Return on tangible assets.
According to Guru 2, companies which have great,

• Capital profile: what is its Capital investment—capital investment they need every day in order to grow their earnings.
• Working capital profile: Nestle and Lever has partly been able to get this kind of return on capital employed because they are able to squeeze their suppliers and they are able to sell everything on cash.
• Business superiority: In Bharati’s case it is marketing. From title also it is marketing.
  What Indian investor lands up doing is buying MNC stocks who have the worst corporate governance in this country. And Satyam is nothing.

According to Guru 3,

• It’s the cash flow which matters the most to the company and the investor too.
• Other important thing is capital allocation: many companies generate a large amount of free cash flow but they just blow it up. They buy fixed assets, they buy a building for themselves to live in rather than rent it. They invest in bonds and debentures; they find ways to deal with the cash flow rather than paying dividend.

corporate governance in India

This is a big issue in Indian corporate governance because one of the fallout I see is the corporate structure is not been respected and very large managements are also treating it as a proprietary kind of situation and they are not disposing off the earned income in a proper way. The kind of payout that they should have is not happening. They should learn from what’s happening in other parts of the world. We have the lowest payout in this country.

So much of corporate treasuries have been managed and even the laws are in favour of management of corporate treasuries where the treasury income is post tax more or less and the cost of fund within the corporate are pre-tax.

In the IT sector itself, you will find the companies which are well governed, which are transparent, which care for the minority shareholders at a much high PE multiple.

Solution accredited by Mohandas Pai, Head- HR, Infosys, is: “Auditing process should get more rigorous and that all companies should make sure that bank balance confirmation goes directly to auditors”.

Strategies for retail investors in a bad market

• In a bad market, remember that cash is king
• In such markets, do not invest all your cash at one go as one will get numerous chances.
• Also, do not buy and hold until the trend reverses.
• The first phase of buying will always start in large-caps rather than small-caps.

So, what are the different types of ratios that investors can use?
Price to book ratio:
Book value is the accounting value of company’s assets minus all liabilities. If the market price is lower than the book value, the company is estimated to be available at a real bargain. For certain sectors the book value is always high. For example, heavy machinery in textile industry as machineries actually depreciates faster. One should also be careful while using this ratio as accounting practices can artificially lead to a higher book value. Assets are depreciated over time, but the fair market value can be much lower.
Market capitalization to cash ratio:
It is calculated as the market capitalization of shares divided by the free cash flow of the firm, or FCFF.
FCFF= operating cash flow less tax, interest and capital spending for business.
= NOPLAT +Depreciation- Increase/ (decrease) in working cap- CAPEX+ Increase/ (decrease) in deferred Taxes
This is a ‘point-in-time’ ratio and is available only after a delay of at least two quarters. But the real issue is that the business scenarios change dynamically. Also, FCFF is only estimation.
It cannot be calculated correctly by outsiders.

So, what should investors do?
A consolidation phase is a good time to invest systematically. Value strategies may have a longer pay-off period, but in that patience is key. Also, one should remember that no indicator works in isolation.

Other things to keep in mind are:

• Return on tangible assets
• Look for companies which have got strong cash flows.
• Very small debt piles
• High interest coverage ratio
• Their Business model:
• Positive Operating cash flows
• Relative valuations
• Debt-Equity ratio:
• High Interest coverage ratio to service the debt
• Price-to-book value
• Return on capital employed (RoCE) & Return on Net Worth (RoNW), which should be higher than prevailing Interest rates.
• Dividend history
• Company management

Innovation in the financial market leads to current downturn across the world

Innovations like,

• Non-banks made home loans and let them offer creative, more affordable mortgages to prospective homeowners, which was lacking in conventional banks
• Then these loans pooled and packaged into securities that can be sold to investors, reducing risk in the process.
• Then makes call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in.
• And in case, still nervous, created derivatives that allow investors to purchase the insurance against default by issuers of those securities.

Thanks to these innovations, millions of poorer and hitherto excluded families became homeowners, investors made high returns and financial intermediaries pocketed the fees and commissions. It might have worked like a dream.

Then it all came crashing down.
Now, the near $1 trillion bailout of troubled financial institutions that the US Treasury has had to mount makes emerging-market meltdowns.

But where did it all went wrong?
Were the problem unscrupulous mortgage lenders who devised credit terms—such as ‘teaser’ interest rates and prepayment penalties—that led unsuspecting borrowers into the debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.
So maybe the culprit is the housing bubble that developed in late 1990s, and the reluctance of Alan Greenspan’s Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations (CDO) and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume.
So not only these made the downturn of this huge havoc, many financial institutions acted as a catalyst to pursuit huge returns.

But what the credit rating agencies doing? Had they done their work properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did.

So all the above mentioned are the crux of the matter?
Perhaps….

Maybe the true culprits lie halfway around the world.
High-saving Asian households and dollar-hoarding foreign central banks produced real interest rates into ‘glut’, which pushed real interest rates into negative territory, in turn stoking the US housing bubble while sending financiers on ever-riskier ventures with borrowed money.
Policy-makers could have acted in-time to unwind those large and unsustainable current-account imbalances.

But what really got us into the mess is the then US Treasury played its hand poorly as the crisis unfolded. Like the then Treasury secretary Henry Paulson’s refusal to bailout Lehman brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional. If Bear Stearns has been provided the bailout package then Lehman Brothers too can and AIG in the next few days should have saved them with taxpayer money. Wall Street might have survived, and US taxpayers might have been spared even larger bills.

So it is futile to look for the single cause.
And what will the post-mortem on Wall Street show? Was it a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure?

In short: ----
· Due to bad mortgage securities
· Collateralized Debt Obligation (CDO)
· Bursting housing bubble
· Excess leverage in the system
· Build-up of huge trade deficits in the US
· Securitization
· Derivatives
· Mark-to-market
· Short-selling

Is china really immune to the crisis?

Does the Chinese govt. really have the tools needed to keep its economy so resilient? Perhaps, but it is far from obvious.
Twofold:-
1. Export exposure of the Chinese economy.
2. Investment environment operated over the course of last 6 years.

China has misplaced capital in a very dreadful way. So, this builds up bad investments in the capital & capital structure.

If these two problems persists this year, 2009 then this will tend the Chinese economy growth much to zero.
If this happens, then we will see cut in interest rates, their govt. will spend more money & will be depreciating the currency. All there was a thought to devalue the currency.

Slamming china’s export sector:
America’s deepening recession is slamming china’s export sector, just as it has everywhere else in Asia. The immediate problem is a credit crunch not so much in china as in the united states and Europe, where many small and medium-size importers cannot get the trade credits they need to buy inventory from abroad.
Foreign-exchange reserves:
With roughly $2 trillion in foreign-exchange reserves, the Chinese do have deep pockets to fund massive increases in govt. spending, and to help backstop bank loans. Many leading Chinese researchers are convinced that the govt. will do whatever it takes to keep growth above 8%. But there is a catch. Even if successful in the short run, the huge shift toward govt. spending will almost certainly lead to significantly slower growth rates a few years down the road.
Infrastructure projects:
Simply put, it is far from clear that marginal infrastructure projects are worth building, given that china is already investing more than 45% of its income, much of it in infrastructure. But is there any reason to believe that new loans will go to worthy projects rather than to politically connected borrowers?
Balance between govt. and private sector expansion:
In fact, china’s success so far has come from maintaining a balance between govt. and private sector expansion. Sharply raising the govt.’s already outsized profile in the economy will upset this delicate balance leading to slower growth in the future.
Reasons to doubt sustainability:
There are strong reasons to doubt the sustainability of china’s growth paradigm.
The environmental degradation is obvious even to casual observers.
And economists have started to calculate that if china were to continue its prodigious growth rate, it would soon occupy far too large a share of the global economy to maintain its recent export trajectory. So, a shift to greater domestic consumption was inevitable anyway.
Interestingly, the US faces a number of similar challenges. For years, the US achieved fast growth by deferring attention to a variety of issues, ranging from the environment to infrastructure to health care.
Bringing these two countries’ savings into line:
One of the great challenges ahead is to bring the two countries’, the US and the China, savings into line, given the vast trade imbalances that many believe planted the seeds of financial crisis.
Lure Chinese than US for private consumption demand:
It would be preferable for china to find a way to lure Chinese than US for private consumption demand, but the system seems unable to move quickly in this direction. If govt. investment has to be the main vehicle, then it would be far better to build desperately needed schools and hospitals than ‘bridges to nowhere’, as Japan famously did when it went down a similar path in the 1990’s.
One way or the other, the financial crisis is likely to slow medium-term Chinese
growth significantly. But will its leaders succeed in stabilizing the situation
in the near term? Hope so, but one would be more convinced by a plan titled more toward domestic private consumption, health, and education than to one based on
the same growth strategy of the past 30 years.

Resilient INDIA- how, why?

"It is very easy to shout fire in the crowded financial markets (for example, in
a theatre) and cause more deaths by a stampede than by the original fire. The
hype created by many analysts and economists across the world have really
created fear in the minds of investors. "

These analysts do not understand that in the end we are all participants in this economy and not mere observers or communicators and therefore it is incumbent upon us to not exaggerate the reality or draw inverse conclusions from every analysis because being bearish is the latest fashion in the financial markets.

In this environment it is clear that every piece of news can be twisted in whatever way the analyst wants, particularly with a negative view. Like if-

• RBI cut interest rates—oh, it must be because they are panicking ;
• X company announcing buy back—the promoter might be getting margin calls;
• Y Fund manager was positive on the market—she must be facing redemptions;
• India with short-term debt—no NRI will roll his bank deposit;
• Commodity costs down—end demand will be down even more;
• Low oil prices should help reduce import bill—exports could be down even more;
• Management predicting that they still grow at 15%-- they will not get it;
  

Till a year ago, high oil prices was the biggest risk for India and now low oil price reflects demand weakness and therefore a factor for worry.

Last year and a half, India had less than $200 billion of foreign exchange reserves and there were no reports saying that we had inadequate reserves which needed to be built up urgently. Now that FX reserves have fallen from $320 billion to $250 billion, economists are highlighting how we have had a record decline in FX reserves. But it is a separate matter that more than half this fall can be explained by the strength of the US dollar which has reduced the dollar value of our reserves held in other currencies.

Govt. role appreciated, how?
A year ago the govt. of India wrote off $16 billion of loans, made over the past decade or so, to more than 40 million farmers (at the rate of $400 per head) and was criticized by the whole world that economics was being sacrificed for the sake of politics.
Now everyone is asking for similar (and larger) and much more morally indefensible bailouts throughout the world.
Until a few weeks ago, investors were hoping that in the pursuit of its reform policy, the Indian government would accelerate the opening of its banking sector and insurance sector to foreign and private sector; and today all potential foreign partners are themselves seeking equity investments from their governments.

India first to turnaround, why?
Redemption is the buzz word in the equity markets across the world. If a foreign investor is really playing for the end of the ‘world as we know it’ situation, the last place he should redeem from is the Indian market. Indians (i.e, households) are the largest owners of gold in the world with their holdings estimated at more than 15000 metric tones, currently valued at $400 billion plus. All the bearish doom and gloom analysts in the world have their price target for gold at $2,500 or higher. At $2,500/ ounce of gold, Indian households stand to make a paper profit of nearly $1 trillion (which is the same size as India’s GDP). Now compare that with the total market capitalization of the Indian market of $600 billion with Indian retail ownership of $600 billion with Indian retail ownership of the market of around 20% and you can imagine why the average Indian may actually feel relatively much richer by the time the dooms day scenario comes along for the rest of the world.

The Indian markets have been mauled as badly as any other this year but have the following in their favor:

1. No bank has needed to raise any equity to remain in business or needed to be nationalized of its deposits guaranteed.
2. There has so far been no restriction on short selling in the Indian equity market—whether in financial stocks or otherwise. Although SEBI has effectively prohibited shorting via overseas borrowing of stock, foreign and domestic investors can short via the futures market.
3. There was no closure of the markets on any day whatsoever (irrespective of whether the government liked the sharp falls in the market or not, unlike in many other markets).
4. There were no government-associated funds, which were made to buy stocks in the markets to artificially support it.