Limitations to beating the market

One of my professors (yes I am back to school again, minor detail) is the reason I read a lot of research about the investing process and strategy. Since I have learnt that most academicians who are practitioners too are averse to public profiles, I will stay away from names and stick to the issue.


One of the limitations to generating abnormal returns is the size of portfolio. As your portfolio size increases, your ability to make more profitable bets reduces. One of the reasons is that your individual bets become large enough to affect the price of the asset in consideration due to liquidity demanded and time in which a trade needs to be executed. We recently discussed the tradeoffs between these (the execution costs) and opportunity cost.

Guess who has been feeling the pinch - Warren Buffett (the other explanation is that he is one of those upfront in setting the right expectation). The book value (BV) of Berkshire Hathaway (which considers the right performance measure) rose 13% as compared to 15.1% return on S&P 500. In the letter to shareholders of Berkshire Hathaway he says, "The bountiful years, we want to emphasize, will never return. The huge sums of capital we currently manage eliminate any chance of exceptional performance."

It nice to have immediate validation / application of things you learn in class. Read more at WSJ (needs subscription) and Dealbook at New York Times.

Warren Buffett's philanthropic pledge

Was reading Warren Buffett's philanthropic pledge in the latest Fortune and the following passage stood out.

My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I've worked in an economy that rewards someone who saves the life of others on the battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into billions. In short, fate's distribution of long straws is wildly capricious.

Yes, I know it is great that Buffett and The Gates (Bill and Miranda) are asking wealthy Americans to pledge 50% of their wealth to charity. But for me, it is grave unfairness of the haunting truth of the above statement that needs attention. This, if anything, is what I hope to leave with you today.

Why Do I Volunteer?

The most important of life's lessons do not come to you while you are managing P&L's and fretting over project schedules. They often land in your lap when you take the time (or are forced to) to sit back and reflect.

Nice Guy is this American teenager I met during one of our outreach sessions. The weather was biting cold and we were distributing hats, gloves and sweaters. He told me he didn't need any. We started talking to the other kids. He stood in a corner and then came around to ask me if he could take a cap and a pair of gloves for a homeless friend who wasn't around. I have often met kids/ young adults do not trust adults immediately. One of the first lessons homeless kids learn on the street is that admitting you are homeless makes you an easy target for predators. I thought Nice Guy wanted this stuff for himself and he was either shy of asking or lying to us. Nevertheless, I gave him whatever he needed. He told me that he lived with his aunt in Brooklyn for personal reasons. He didn't give me the details and I didn't push. I thought his eyes were misty when he asked me, "Why do you do this?" I didn't know what to say. I had started getting involved with non-profits in the US initially to find something to do with my long empty days. But you don't want to say that. You want to give a grand answer about how you want to change the world. I blabbered something inconsequential.

Suddenly Nice Guy spotted someone. He called over and handed over everything I had given him. I tried to find out more about Nice Guy. He worked at a Pizza outlet. I asked him if he made enough money. I wanted to make sure he wasn't going to go hungry that night. He told me, "I work 12 hours a day and overtime pays very well. I can even buy stuff for my friends sometimes." He had applied to college and had received an admission offer. He was going to do a bachelors degree and major in finance to get a job that, "will lead to great career." (To put things in context he was most likely planning to work through college to pay for his tuition and living expenses). Nice guy didn't want anything from the world except opportunity and he had no complaints. We shook hands and I wished him well before leaving.

When someone asks me next time, "Why do I do this?" I think I know better. I volunteer because it gives me opportunities to meet people like Nice Guy. It motivates me and makes me feel grateful for what I have. For the sake of Nice Guy I also wish and hope that Finance does lead to a great career, in spite of everything that is going on.

Book Update: SuperFreakonomics (Levitt and Dubner) – The book is an easy breezy read with interesting stories. However some parts are oversimplified such as those about climate change solutions. Often correlation is taken causation. It looks like the interest of the authors was in telling memorable stories from uncommon point of view than real research.

Why those who are too big to fail should be charged ? !

There has been ample debate about need for greater regulation of financial firms. Am sure with so many people employed with financial firms and so many other blaming their unemployment on the same firms, there are opinions on both sides. There are two points on which I have a definite thinking. The consumer protection laws and need for such a agency and the second, the subject of this post, that firms who are too big to fail should be asked to comtribute to 150 billion dollar fund.

The second point is a part of the bill being debated in the house to overhaul the regulation of financial sector. I think it makes perfect sense for such a fund and asking firms to contribute to it in relation to their size. The simple logic is this. So far it has been illustrated that too big is actually an insurance against failing. Because by now everyone knows if you are too big and 'interconnected', you will (have to) be bailed out by the government. To big is then actually an insurance in itself, leading to the moral hazard and temptation of, often, indulging in risky business practices. So like any other insurance, it makes sense that a premium be charged for it.

Update [ Jan 6, 2009] - On, a slightly different note, I think its important that I put down the name of the bill. The bill is called, "Wall Street Reform and Consumer Protection Act." No campaign speech that, a really name for a law. Yes, there is a lot in a name. My apologies to Shakespeare. But then he hadn't met the politicians of today

Credit Bubble in a Slum ?

Far away from the credit boom of USA from 2004 - 2007, both in distance and in time.

A front page article in the Wall Street Journal states that the micro-finance push maybe creating a credit bubble in India. What started as a social initiative, caught the eyes of investors due to higher returns. Micro-finance loans have interest loans to the tune of 24% - 39% and are generally given to women (more than 90%) who are supposed to be better repayers. Apparently the RBI (Reserve Bank of India) does not regulate interest rates in this market except for advising organizations not to charge too high rates.

Today the number of lenders offering micro-finance has jumped almost 400% from 50 in 2004 to more than 200 in 2008. NBFC (Non Banking Financial Companies) have entered the fray. The loaned amount has grown from less than 0.5 million to 2.4 million. As a result, atleast in some towns and villages there are too many lenders are chasing few good borrowers and - funds loaned for starting business are being used to buy TVs or spent on marriages. Apparently in some over-crowded markets - lending practices are lax; it is often difficult for lenders to cross-check with each other or to verify the utlisation of funds. I just hope the stories of Ramanagram are not being repreated across the country.

This is not to the say that the credit needs to Rural India are being met. Rural Indian economy has very few sources of funds and an even lesser understanding of financial products. I know this by virtue spending an year scaling my organization's distribution beyond metros. It will be really unfortunate if poor lending practices deprive the region and the people their chance for development.

The article published on August 13, 2009 written by Ketaki Gokhale is titled - A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum. You can read it at the WSJ website, but a subscription is needed

Lessons from Jim Rogers' life - a gift to us & US

Take a guess as to which country is being mentioned in the following paragraph.

The country X enjoyed a huge bubble in the _____. When it burst in _____, prices collapsed, sending the economy tumbling. Regrettably, the government and the 'central bank of the country X' kept trying to halt the natural, cleansing effects of this recession by propping up many of the companies in trouble. Just as a forest fire serves to clear out deadwood and underbrush so that the forest can renew itself, recessions help to ensure healthy future growth. In 'the country X' , the business that should have been liquidated became "zombie companies" surviving, albeit barely, on government's artificial support. Everything was Band-Aided with quick fixes. While this delayed a decline, it also postponed the country's recovery. A country can actually spend more money trying to stave of a recession than the recession might cost.

You probably think that I am talking about USA. However this is a passage describing 'the lost decade' of Japan by Jim Rogers. Though Jim mentions in passing that America followed the same route in 1970's, he might as well be presaging what may be coming ahead, considering the way the American debt & fiscal deficit has ballooned. To use a cliche, "History repeats itself." As Jim mentions, a country can spend more money trying to avoid a recession than the recession might itself cost. Sounds even more familiar. After all, only last week the Fed chairman Ben Bernanke pointed out that US needs to control is spending & deficits. Of course he did not talk about the fact the balance sheet of the fed itself has been increasing in size as it has been buying just about anything - mortgage backed securities, corporate debt and the T-Bills issued every few days by the US government.

But, lets come back to Jim Rogers, the guy who made enough money to retire at the age of 37. The book in question, " A Gift to My Children - A Father's Lesson for Life and Investing," is packed with knowledge and wisdom. In his own words,
the book is different from his earlier books in the sense that its about the larger lessons distilled from his experiences. Lessons about thinking for yourself, using common sense, learning history, philosophy and languages and making the world a part of your perspective. Lessons, which we all could use. In less than 100 pages Jim packs lessons that can use at all stages of your life and earlier you learn these lessons, the more you can get from them.

As a aside note, according to Jim, 21st century belongs to China. He does not like India and Russia as investment options. So much so that he has moved to Hongkong & is making sure that his two daughters know Mandarin.

Banks find accounting tougher than non-profits?

An important take-away, from  last hearing of the congress committee where the nine top bank CEOs presented their case regarding the update on new loans and how the bailout funds were spent, was the banks stand that the money that has been injected into their balance sheets can not be tracked separately.

   

Have been catching up a little bit on the non-profit space these days. Interestingly this article here article explains that, what banks claim as impossible, non-profits do on an everyday basis. 

Apparently it a basic requirement in non-profit accounting to track the money received for any particular project is spent on that project only. The link here.

The article calls it, soup-kitchen accounting. Interesting right? But hold on before you blame the banks, maybe the never received the money at all. This may sound quirky but another article points that the government has been actually injecting capital into bank holding companies and not banks. With banks barely managing to stand upright, shareholders have non incentive to inject the money into those subsidiaries. Link

Maybe we all have been whipping the wrong poster boy.

Money for free

Today the 'Bernanke helicopter' seems to have landed into uncharted territories. The chairman of Federal Bank who was expected to lower rates by 50 basis points actually reset it to 'ZERO'. Yes this is bizarre headline.  The fed chairman set the fed target rate from  zero to twenty-five basis points, effectively saying that banks will be able to borrow from fed at no price.  If this is not enough to make banks lend, he announced something more, that it will buy mortgage back securities from banks.  

The only other example in history of such low, or rather no interest rates is Japan. The example has not been successful. Money in USA now comes free. But think of this way, what if this does not work. Even if the cost of money is zero, no body wants it. There are two basic problems here

a) Even with money at no price, the banks don't want to lend it furthur. The balance sheets are so messed up that they need a clear head & some time to clean things up. Even in the case of America the previous cuts by the fed have not translated into lower interest rates for the end buyers. 

b) Then there is the gradual unwillingness to spend, the shaken confidence in the system with a lower number every week. Job cuts & threats of job cuts have taken the fun of holiday season and consumption other-wise.

On top of that all this actually reeks of the policy that actually built the bubble from 2002-2007. Isn't  this how the system built so much leverage in the first place. Years of administration policy providing people with easy money.America accounts for 60% of world's consumption and when the American consumer sneezes, no wonder the world catches a cold.  

But to put this in a perspective of time. Monetary policy moves generally take about two quarters (12 to 15 months is the accepted time frame) generally or more to play out. So the affect of these policy moves will be felt at the earliest only, in third quarter of 2009. But the stock markets have already given a thump up sign. The DJIA & S&P 500 & NASDAQ were all up more than 4%.

Another point here is where will fed get the money. Will it keep printing dollars, till it runs out of green ink, as one analyst said. What happens to the exchange rates then ? As of today the European Central bank & central bank of England have both stayed short of both what the Federal Bank has does done. No wonder the dollar fell against both currrencies.

Movie Update : 

'Gran Torino', (Clint Eastwood packs a so much straight forwardness , american-ness and intensity into this movie that even non-americans like me loved it). Read the new york times review here

Slumdog Millionaire  (A great movie, with amazing potraits of everyday life from India packed into a dramatic story) 

What could $ 700 bn do!

 $700 bn is only 14% of the $14 trillion of the Mortgage Debt out in the US market

A huge chunk of the problem is thus out in the open. With about $250 out to capitalise banks, there is not much of money left there. Money goes a long way & you can't really over emphasise the how far can $700,000,000,000 take the world. 

In America you could buy Universal Health Coverage & pay health insurance premiums for all US citizens for six years.

In Africa fight hunger and poverty for 10 years. They only need $72 bn every year in UN funding.

Pay salaries of 22 million american workers for an year.

Finance Germany's annual budget (@$ 420 bn) for more than an year or buy Denmark (GDP less than $350 bn), twice.

This and so many other things that can be done with $ 700 bn are here. But we will end up spending it to pay the price of the asset bubble that has gone burst.

Life is not fair afterall.

End of Capitalism as we know it ?

Ben Bernake addressing the 'The Economic Club' in New York. His statements indicate a shift of long term US policy as we have known it  

a.  Monetary policy has its limits in addresses crises like these and innovative solutions are needed

b.  We need to create systematic authorities to address large non-bank firms that pose systematic risk

c.   We did not have a mechanism;  no body, no authority, no markets for all those securities

d.   There is a problem that these assets do not trade, there is no liquidity and no independent  price discovery. 

If all this retrospection were to be translated into policy talk, he means that policies which let financial firms have there own models to evaluate assets values & risks need to be re-evaluated. The assets should be traded in exchanges & have market determined values. This part of it, to have  a clearing house and an exchange for these assets, is a much agreed view by now.

 

Statement a evaluates a current situation and, statement c clearly indicates part of the helplessness of the US policy as it was, to prevent this situation and provide a way forward. Probably indication of new separate regulatory bodies for non-banks (unlike a situation earlier where Investment Banking firms had no regulatory authorization)

Now add up c , d & the latest actions of US treasury

1. To take a stake in banks

2. To put conditions like 

           a.  No more golden parachutes .,

            b.  Limits on executive compensation (top 5)

            c.  Limits on risk 

            d.  And, government to have voting rights on matters that affect the investment.  

All this together symbolises a distinct shift in from the free for all market to a more centralised one. The reluctance of the US government, adequately pointed out time & again in various statements underscores the point even more. Total communism as was practised by the erstwhile Soviet Union died long time ago and now is the time of reckoning for complete capitalism and free markets. 

This is the system that they have moved to back home in India,  there are markets and there are regulatory bodies - some government owned and quite a few self regulatory ones like AMFI. We decided to move away from the socialist view of Nehrus after about four decades of being independent, leading to about a decade and half of higher growth but we have still maintained a hold on things. The risk taken are far lower. The banks have a minimum capital ratio of 9% stipulated by RBI unlike the US banks where the minimum is only 4% and a bank is supposed to be well capitalised at above 6%. And none of this applied to Investment Banks, a institution category that no longer exists in the US financial system.  This is also the thought shared by some of those European & Asian economies for who moved from extremes on either side to the centralised point of view. 

Are any assets classes worth anything anymore

Am trying to make sense of the events of the last few weeks. First the housing bubble burst - real estate was not worth too much anymore (specially if had bought anything in the last few years); then the real estate based securities - the CDO (Collateralised Debt Obligations) lost value ;  then the Stock market - not just companies that had anything to do with housing or related securities even all those which had nothing to do with them. Stocks as an asset class are not worth too much, nor are mutual funds. And then everything together, commodities , crude & Gold. Nothing seems to be worth anything anymore. Yes we all know cash is King,  the big problem, we are not too sure of the bank where we keep this cash anymore. 

If you are an ordinary citizen of the world, who is a little aware of financial planning & diversification of wealth into asset classes, the question is where do you keep networth, (whatever is left of it) to preserve it ? Not to mention the inflation rate back home in India has been in the 11- 12% for a while, meaning wealth has been eroding for those who have been cash heavy at a rate more than -10% every year.

The big question is knowing all this what am I going to do.  The answer precious nothing. I am planning to ride it out & wait for a financial scene, when the behaviour of people and hence assets is saner, something I can comprehend.

Global Financial Crisis : Coach Buffet, politicians & accounting

By the looks of it Warren Buffet is playing the role of saviour, an angel investor in quite a few big companies today. 

The Washington Post article compared Buffet to the man who saved the Wall Street in 1893 & 1907 & also loaned Gold to the US government, J P Morgan.  The world's richest man (Buffet) provided $ 3 billion as new capital to GE (now it strikes me GE was actually founded by JP Morgan) on ofcourse very sweet terms. He earlier showed his faith in Goldman Sachs. Interestingly the article also mentions the Buffet as the coach, guiding the US treasury secretary Henry 'Hank' Paulson. Buffet also backed the  $700 bn mentioning that it was such a great deal, he wants one percent of it, provided the troubled securities are bought at market price.

Think he puts 'the words' to assuage the concern and the take care the interest of ordinary tax payer. If you could convince (& ensure the corresponding action) that the troubled assets would be bought at right price, this proposed 'Bailout'-please-call-it-by-other-name actually becomes the great investment of 'American tax payer money'. All consequences of the 'bailouts-please-call-it-by-other-name then actually look good. Financial institutions are ready do business with each other and the with the consumers. Companies, banks & individuals are able to borrow money at reasonable rates for short periods (not at current levels which probably are the highest in decades). Government & taxpayer make money while we have liquity in this system. Lets face it we are used to faith & trust and the use of a currency. To think of going back to the barter system is just not possible.

This brings to me another of the much debated 'MTM'  rule.  Quite a few of politicians want me to believe that the 'mark to market rule' is the cause of all failure. That all problems of the world will go away if we pretended that they weren't there. Just ask financial institutions to showcase their assets through some tinted lens that makes them look healthier. If only we could make all of them sit in a Finance & Economy class. Ok its difficult to mark assets to market when there is no market but the fact of matter is an accounting 'fix' will furthur deepen the crisis of trust. It will send the institutions deeper into our current credit contraction because the balance sheets will be even farther from the truth than they are today.

As a matter of fact, financial institutions hold a lot of their assets for investment and hence do not mark them to market. The percentage varies for example in the case of failed Washington Mutual ,  75% of the assets were not marked to market. A WSJ article this morning analyses this well but the online content is only accessible through a subscription. Hence not posting here.

The Washington Post articles are here & here

Back home, there was a run on ICICI Bank's stock & the chairman KV Kamath, RBI , Indian finance minister quickly moved to control the damage after the stock fell 22% in one week to reach the price at which it issued equity almost three years ago. The interview by KV Kamath in Mint is here. ICICI BANK - Kamath sees agenda, says bank is safe

Books Update : 1984 by George Orwell 

The rescue all plan : Print more dollars or what ?

Have been following the US or rather now the global financial crisis closely. To lubricate the financial machinery US central bank and later others seem to have decided to provided the much needed oil, money. Am just wondering how much they think they can pump in and the medium long time effects. USA has the GDP of about a $14 trillion.

A US government decided to put its 'billions of dollars' as per the estimate of its Treasury Secretary on stake to take the risky illiquid assets off the balance sheets of Financial institutions.
The total cost of all the measures in last few weeks is expected to be dollar one trillion.

With a GDP of about $ 14 trillion with deficit of $500 bn which because of these and other measures would increase $650 billion in 2009. The bloomberg article with all the numbers.

I just hope they have a better plan to manage this than buying better and faster printing machines to print more dollars.

Here is funny stuff from the web

Businessweek article on how things would look on the first anniversary of the event with a real innovative idea on what to do about the unsold home inventory, pay people to destroy it for the next shooting Armageddon sequel :)

This shoe site for example has a page on US economy because 'someone has to educate the people in this corporate takeover of media' :)

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PS : Over with the book. Hannibal Lector is a real gentleman

The Grind - Getting into the corporate groove

Finished B-School and joined corporate life. Just realized that 'the grind' I was waiting for is right here. Its hectic, its tense and there is a lot of pressure. Pressure to meet targets & perform. Its amazing because there is so much excitement in the air. I love the place where I work and the people with whom I do my job, I don't recall anyone telling me anything other than taking things as a learning opportunity. But the place is so charged and people are running so fast that there is a natural instinct to run, to beat, to achieve. Everybody talks in terms of over achievement of targets.

Now I know what all those talks meant. A growing sector, liberalization affect, changing perspectives and all those things. I discover something new and different everyday. But is comforting to talk with my fellow management trainees. It just helps to know that there are people going through the same 'teething problems' as I call it.

As compared to this business school was a cake walk. As a friend of mine in Bombay said, " A sales job or sales stint develops a new respect for people in your eyes."

And for another friend of mine.. THE GRIND is right here and.., I am loving it

For others I work in the financial services sector & and apart from my primary job do Investment consultation/Tax Planning for free. Do contact me.

Till I am this free again, adios... and wish me luck
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Book that I am reading these days - 'The Tipping Point'