Corporate Governance anyone??

Last few days have been a lesson in corporate governance. And it is surprising that it came from a company which had recently won an award in corporate governance. Satyam, on Tuesday, in a shocking decision decided to acquire stake in group companies Matyas Infrastructure and Maytas Properties, citing the long term growth story of infrastructure in India as the reason behind the acquisition. What was the biggest problem with this decision was that it was taken without consulting any shareholders (while the promoters themselves hold less than 10% stake in Satyam). While that may be legally acceptable in the court of law, it is definitely not an ethical practice to keep shareholders out of the loop for such an important decision. There were a few other issues as well with the deal
· Satyam decided to buy the promoters’ stake in these companies – the promoters were family and friends of the promoters of Satyam
· The money thus was going to the promoters, and not in the company. Essentially, the money which belonged to Satyam, and hence its shareholders, was being doled out magnanimously to the promoters of 2 unrelated businesses.
· Even if Satyam wanted to do an acquisition, there are far too many companies available in the IT space, and a much larger number outside the sector, if the group wanted to diversify. They could have bought out Unitech with that kind of money!
· No clarification was given either on the choice of the target company or on the process of valuation
· While Satyam cited tough business environment in the IT Sector as one of the reasons behind this acquisition, the company which they were planning to buy was not in a sector which had any better business environment than the IT sector. In fact it was much tougher
· The management refused to give exact details about who valued the firm
· The management refused to give exact details about how much debt Maytas Infrastructure has.

These and many more concerns clouded the deal, which was eventually sensibly called off. The very fact that the management even thought about pulling off something like this was shocking. What made it even more ludicrous was that they were actually defending something like this – saying that they are surprised that the investors do not see the value which they see. Quite obvious, since the investors were the ones who were losing the money at the expense of the promoters!

Sadly, things will never be the same again for Satyam, even though the promoters decided against the deal, and now are in the process of a buyback. It took ages for Satyam to build the reputations that bigger firms like Infosys and TCS enjoy, and the promoters frittered it all away in a ridiculous move. The stock quite aptly got pasted, and whatever the management does now, it will never enjoy the patronage that Infosys and TCS enjoy.

Bailouts work in the short run, economics in the long run

The US Congress finally passed the bill for the USD 700 billion bailout of the US financial system. Elsewhere, there have been many more high profile bailouts, in Europe - The major ones being the USD 50 billion bailout of Hypo Real Estate, Germany second largest mortgage lender; The Irish government's USD 572 billion blanket cover for liabilities in the banking system; and the USD 16 billion bailout of Fortis by Belgian, Dutch and Luxembourg governments. Call it bailout, or call it nationalizing, there is little disagreement that something needs to be done to clean up the mess that has been created globally. The era of easy credit, that drove business cycles and unprecedented profits is under grave threat.

The New economy was driven by globalization of markets, which led to a strong surge in job creation and profit maximization globally. However, the issue with any such opening up of economy is that it is always two-sided. So while benefits spread across the globe over the last 4-5 years, problems also broke national barriers. It was just to naive of all of us to think that globalization is only going to have a positive impact, wasn't it? But that was just all of us thought. When the news of the sub-prime mess first broke out, in the beginning of 2007, most global markets were yet to see the biggest boom of the decade. We saw the entire boom, always asserting the decoupling theory, thereby saying that while the benefits of globalizations will flow to Emerging economies, the problems will be for the developed world. What will happen to China when the US and Euro-zone slow down, was never on our minds. Alas, if we had gone back to basic economics and questioned this, maybe we would have been better off. But then, we are all human beings right, and we all have a short term memory.

I am a fan of classical economics, and believe in the demand supply equation. In the long run, that is the only truth that stays. So while prices can move anywhere during periods of boom and bust, it will finally be governed by demand and supply. This is particularly important when we think about the US bailout. The US government is supposed to be buying assets which are frozen up in the markets, or in simpler terms, no-one is buying these assets in the markets. Some of the assets are selling at 20% of the actual price. The question is - is the actual price correct? Is the risk pricing of the asset correct. When the asset was sold for say USD 100 million, was the risk underlying priced correctly. My guess is that this is unlikely, as evident from the current crash in asset prices. Today the same asset is trading in the markets at USD 20 million. Is this a correct price? Again my guess is as good as yours. The US government believes it is not. And hence they are willing to pay prices even slightly higher than these in order to save the holders of these assets. The success of this bailout depends on the actual defaults on the loans underlying these assets. If for some reason the defaults are higher than what the assets are pricing now, markets will be in serious trouble.

There is also an inherent belief regarding the astuteness of central banks when it comes to dealing with such crisis. This is even more pronounced in the case of the US, where it is virtually believed that the US Fed and the government will solve all problems and crisis. History is full of examples when central bank actions have not really helped in improving the economic scenario - in fact, some of these actions have aggravated the crisis. The equity markets till last week believed that the bailout plan will work. But these week, as the bill was being discussed in the US Senate, the markets first dipped, then jumped and finally when the bill was passed, ended lower. Maybe the markets are now uncertain about the bailout plan succeeding. Equity markets in the US are most likely headed down, and if the bailout does not work - substantially lower.

Whether this will work or not is anybody's guess. What is definitely going to happen is that markets will arrive at a mechanism of pricing these assets, as underlying economics prevails. Economics is also a mean reversion theory. Demand Supply dynamics work in this fashion. First we have periods of high demand and high profits and soaring inflation. This is preceded by higher supply coming up, falling prices, lower profits and hence lower demand, till the time supply starts to fall again, due to unviability of the business. There are price distortions in the short term, but economics ensures that larger the price distortions, longer the correction that follows. This may very well be the case this time. Sometimes, these corrections are very fast, and furious - difficult for even central banks to manage. The markets tend to realize this over a period of time, and hence the recovery of markets could be a painful and long-drawn process. In fact, after the 1929 crash in the US markets, the markets recovered a long way in the next year. It was only after that that they realized the magnitude of the mess, and ended nearly 80% lower from the top. Similar was the case with Japan, in 1990, where the initial crash was followed by a bounce. However, what followed has been a ruthless example of an asset price bubble bursting, and its aftermath (See chart below). This is not to say that we are in a similar situation, but just to assert, that not every dip is a buying opportunity. The underlying economics needs to be carefully monitored, and investment decisions need to be based on the same.

Source: www.chartsrus.com (This is a good website that collates lots of historical charts, and is great for anyone who wants to draw inferences from history)

What is happening to the markets - and what can we expect?

Well, interestingly, the equity markets just refuse to go up. Just about an year back, there could be nothing wrong with the markets. Now, there seems to be just nothing right. So what is the deal here? And what has changed on the macro front, that has caused this kind of a correction?

The answer to this question lies in the history of world markets as we have seen them, if we choose to look at them again. Time and again, there have been great stories about markets, such as this is the place to be in and this is the time to invest, only to realize that such euphoria lasts only about 2-4 years, and then we witness history all over again. Be it the scams of 1992, the dotcom bubble in 2000 and the credit boom now, we keep seeing these cycles, only to say that this time it is different than the last one. Alas, it isn't so...

The key issues right now are two - one the credit crisis slowing the US economy appreciably and hence affecting the world economy, and the second is a definite slowdown in India as borrowing costs surge and demand slows down. Both are impacting India's growth story, and hence the valuations of the markets. Is the story over - by no means. We are still one of the few countries in the world growing at more than 7%, and structurally we are in a phase of the economy growth that will last more than just a few years. The momentum of this growth is not going to slow appreciably, and the story is definitely going to last through 2015. But that does not mean there will be no hinderances in the way - or that the growth cannot slow down for a couple of years before resuming. This could happen due to various factors, some domestic such as elections and populists measure, and some international such as the credit crisis in the US. Also remember that long term returns from equity markets are typically in the region of 12-20%, depending on various stages the economy is in. The last 4 years witnessed an unprecedented bull run in India, and the returns were much higher than these long term averages. Markets are just mean reverting, and what is happening now is that the returns are moving towards the mean. If we stay around 15000 levels on the Sensex for a couple of years, we would have largely reverted to the mean return of 15-20% per annum. And most likely, it is going to happen.

So in the near term, expect more downside, and volatility. Most markets bottom when the underlying story regarding the markets starts getting questioned. From the look of things, i still do not think many people question the underlying story of India. The next 2 quarters will reveal that corporate growth is slowing down, and earnings are under stress. That is when the India story will get questioned - and that is when markets will bottom in my opinion. Such savage corrections where stocks are hammered 80% from their peak prices are not succeeded by V shaped recoveries, but by slow sideway movements of markets which are long enough to make investors question their beliefs. Otherwise - it was becoming all too easy a game, which I am afraid, it is not.

And to cap the story - an interesting observation. Most analysts around us say that to make money in the market, we need to stay invested for the longer term (please note that none of them define the term 'longer term', and the definition varies from 1 year to 10 years depending on what is the case the analyst is presenting ). While on average if you are diversified, this would hold in economies like India (stress on 'India', since developed economies could faceother pressures, which may impact these returns), there is an important pre-requisite for the above statement to hold for individual stocks and even sectors. You should not have invested at the peak. An example is Unitech. The following charts show its move from 2005 to 2008 beginning, and then from 2008 January till date. And yes, you are right - it moved from Rs 2 to make a high of Rs 550 in 2008, and is now at Rs 110!! If someone bought it in January 2008, he can be rest assured that he needs to be invested for the long term to get positive returns on this. And this 'long term' my friends - will be really long. The real estate story is now being questioned in India, and probably these stocks will bottom out valuewise in the next 3-6 months. The same needs to happen with the markets. Does that sound bearish - it surely does, but this is good for the markets. The earlier it happens, the better it is. These next few months will throw up immense opprtunities for the 5 year investor in India, but he needs to sit through the near term pain that the markets may witness.