Reversion To The Mean

The Theory Around Beta

Beta Maps:
This time we will discuss an important principle of trading called Beta (migration). The theory around Beta Maps goes like this. 'The Market forgets, and the Market gets obsessed....'. In any Index, there is always one part that is 'under-performing', i.e. it is being 'forgotten'. And there is another stock at the other end, which amplifies the underlying theme (i.e. bullish/ bearish) in the Market. 

The key skill in tracking Betas, is the manner in which you define it, and the construction of the average/ Index around which the Beta is measured. The Index is supposed to aggregate a correlation of assets or asset classes, some of which are logically obvious and even available off-the-shelf (like the Nifty). The Nifty, very sensibly, aggregates the leading stocks in the market, which account for the major part of the Market Cap (58-60% currently), Free Float (>70%) and trading volume (45% currently). This makes the Index a good surrogate for the entire market; over time, if enough people think so, it becomes so.

And since the Nifty is known to all, it would be a good idea to explain the Beta with reference to the Nifty. However, the real benefit of this kind of ‘beta tracking’ will accrue if you structure your own ‘indices’ from the ground upwards. For example, how about a composite Index that includes a particular weightage of Nifty, Gold, Silver and Dollar. You will get a certain ‘beta pattern’, which will bring home to you a mean-reverting pattern, which is unique to your understanding of the market. Trading the outliers, playing ‘contrarian’ to a pattern which shows one instrument going out of whack, will mean that you are betting on mean-reverting movements in your ‘Index’. This is not by itself a complete investment/ trading strategy, but it is a very good confirming indicator for the rest of your stock picking.

I use it even to generate leads on which stocks to focus on, based on the underlying belief that all the other (fundamental) factors remaining the same, a particular stock will follow the ‘moods of the market’, i.e. there will be liquidity and sentimental factors that push and pull on the stock. In a big company, things don’t change so much overnight, although they do (change) dramatically over the longer-term. A short-term (trading) strategy that bets on a ‘return to the mean’, will produce profits more often than not. However, prepare to be surprised by large movements as market expectations drive fundamentals (for example, RCom has been deserted by the market, and this alone will drive its fundamentals in a manner not clearly understood by us). Still, if used carefully, it can be a successful trading strategy over the short-term.

For example, the period July- Sep, 2011 saw huge (shocking) bearishness, which was amplified in Tata Steel (Beta 8, i.e. for a 5% drop in the market, Tata Steel dropped 40%). That is because the European crisis was the key theme during this period, and Tata Steel exemplified this theme. Tata Steel did not drop because the market dropped, BUT the Market dropped because of Tata Steel.

There are many different ways of calculating a Beta, and this word is not to be confused with the Beta (relative daily volatility) that you normally hear in the media. I use this word because it comes closest to a concept that is widely understood. As we go deeper into this, it is very important to remember this. For example, how we choose dates will decide what Beta figures we get, and what 'migration pattern' we see. If we choose the wrong dates to denote the various 'themes' of the market, we will get junk information that will positively mislead.

The first period, 12th Nov, 2010- 12th July, 2011 saw a 'classical bear market' developing. During this period, Bharti and DLF were the underperformers. Bharti was downright profitable, because the Beta finally 'migrated' (upwards) as the market fell. During this period, the market fell 18% from 6336 to 5196. After 12th Jan, 2012, you can see the Betas 'diverging' again. Tata Steel has accelerated and so has DLF. Reliance and Bharti look like 'migrating' downward, i.e. they will underperform a bullish market.

When there is a correction, the low Beta stocks will drop more, while the high Beta stocks will be volatile, but will outperform the market. At the next correction, the Beta 'divergence' will emerge and we will see the Beta lines diverge. The 'train is not leaving us', but the next train is coming in. The last train carried Tata Steel with it.


A stock that takes off, also creates a large potential downside, because it gets populated with 'weak hands', who panic easily. Conversely, the absence of 'weak hands' creates a limited downside on the stock. You do very well when you have limited downside. There is no Bull or Bear Market; you just have to keep your downside limited to 20% and you will do well. An early bull market reduces the downside; but a late bull market (like 14th Nov, 2011) creates a lot of downside risk. Since  profits are a function of volatility (which is almost constant), your only cost is the Value at Risk (VaR) coming from the downside.

In the coming 2 years building up to the bull market, you will have to choose many low Beta punts and trade aggressively. The end of the Bull market does not necessarily mean the end of profits; you can short high Beta and buy low Beta, something I would not recommend just now. Defining the end of the bull market is going to be key; like in case of Aug, 2011, if you are shocked by a reversal, you will be in trouble. Meanwhile, we should map every Beta 'migration' or 'divergence' and trade down aggressively. An early Bull market has limited downside as 'all boats rise with the tide', so we should pick up the first 'divergence' and trade. However, we should not be surprised when the 'divergence' accelerates and the stock tanks to bear market lows in the middle of a bull market (like in Bharti, which went down below 2008 lows during the 2010 bull market). This happens when 'weak hands leave a non-moving train and get onto the fast-moving train', thus weakening the rally and increasing the Risk in the high Beta stocks.

All through this, the Beta Map is a safe, steady measure to reduce Risk through Bull and Bear markets. In the short run, it does not make the most money, but in the long run, it definitely takes the least Risk.  
Please find enclosed below the Beta Map.

P.S. To understand this well, you should superimpose the Nifty chart on the above dates, to understand the significance of the choice of dates, in which to classify the ‘moods of the market’.

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Second Factor Derivatives

Going Where the Mind Cannot Have you ever wondered why childhood mathematics was limited to addition, subtraction, multiplication and division. You can be called ‘educated’ if you have mastered these skills, in almost every country in the world. But why isn’t Square Root, or r2 (a.k.a. Correlation), square variance, relative movement (a.k.a. beta), regression or logarithmic relationships not used so much in everyday parlance. Are these mathematical relationships less relevant to the real world? Pythagoras, Fibonacci and a few other geometricians showed us the existence of a few variables that appear regularly in our ‘random’ world. If at all there is a proof that there is (a) God, this is it….how can something so perfect, so symmetrical and so regular suddenly happen in such a chaotic, ‘big bang’ universe? So, e=mc2, a Nobel Prize is given (or not), and everyone goes home…. The Efficient Markets Theory says that all knowledge about a stock is instantaneously factored into its price, assuming perfectly competitive markets. This has since been mostly proved to be bunkum; almost every word of the sentence above has been proven wrong. The Random Walk Theory went a step further and claimed that stock prices followed a ‘random walk’. In its details, however, the book made 2 important points: one, that any ‘trading rule’ that outperformed the markets would be copied by everybody till it no longer works. This, of course, assumes perfect and uniformly transferred knowledge, which I know as a Professor is impossible…but never mind. However, even Burton Malkiel acknowledges one ‘trading rule’ that has been known to outperform the market over a hundred years, although he does still maintain that individuals cannot outperform the market. And that is, that Beta migrates and a portfolio of low Beta stocks will outperform the market over any long period, i.e. what the market forgets, the market later remembers, and this is a consistent cycle. Hence, what the market forgets, it cannot be invested in (by definition), so a good strategy to beat the market would be to invest in a portfolio of low Beta stocks. I have lots of disagreements with this rather simplistic theory. First, the role of human intervention and ‘special intelligence’. There are many ways to beat the market, which itself, is no benchmark. Over the long run, I would think that market returns should track GDP, liquidity, inflation and the profitability of businesses. But they don’t, giving us the feeling that Mr. Market would not make a very good portfolio manager. Just staying out of the market from Jan- Oct, 2008 would have made you 4 times richer than someone who did; what does it say about Mr. Market? The most devastating attack on these theories comes from the likes of Warren Buffet, Peter Lynch, George Soros, etc…..by their very existence!!! Classicists have no comment to offer, saying something like, “….but they too must die”. So here is my theory. The human mind is incapable of second factor (derivative) thinking. It takes an exceptional mind to look at a ticker, full of moving random numbers, and be able to calculate the ‘dispersion’ round the average, even as you calculate the moving average. Jesse Livermore could do it, in his famous ‘bucket shop trading’. It is somewhat similar to being able to calculate the moving odds in a game of Black Jack, which an American professor learnt to do, in order to beat the casino (and make $3.5 mn in a night). If you can do the above, you will get a sense of ‘beta migration’, i.e. in a bullish market, which are the stocks being ignored by the market? If you then see a perverse steadiness during the subsequent correction, you can tell that this stock is being ‘supported’ with an investment hypothesis, which has still to work out. But ‘smart money’ is in the stock, and the first indication of the ‘investment hypothesis’ showing results will result in a huge uptick, which will be confusingly understood as ‘beta migration’ by Mr. Malkiel. For example, Bharti Airtel is going through that phase just now. Why so? Because Mr. Malkiel deals only with market-level phenomena, not with individual stories. That is why he cannot understand the people who beat markets. Rather like sitting on the moon and observing that Mumbai is ‘going nowhere’. Oh, but Mukesh Dhirubhai Ambani is…….if you just look deeper!!! Since Mr. Malkiel does not understand Bharti, he will just take a ‘portfolio’ of low Beta stocks, which will comprise of HPCL, Balrampur Chini and Unitech/ DLF just now. They are different stocks with different investment hypotheses, displaying the same behaviour for different reasons. In case of HPCL, at some price point not very far from here (say, 270), ‘smart money’ will pile in and quietly sit there, waiting for oil prices to fall, or the Govt to tire with its OMC- raping. Or the Govt to wake up to the need to pay for new infrastructure in oil refining, or to pay attention to its off Balance Sheet Fiscal Deficit….whatever! They just buy HPCL at a discount of 50% to Book Value and go to sleep. In India, bad things happen for long, and then India surprises you.....just when you give up, something good will happen, when and where you least expect it. The upside is 150%, the downside is 20%.....an equation acceptable to ‘smart money’. But what is Unitech doing here, the crane among the storks? Its Beta has already migrated, and the stock has been an outperformer recently, giving 15% returns in a flat to reducing market. Its Beta was running at a whopping 6.39 in the run-up from 2004-2008; what is much more relevant is that during the downturn of 2008, its Beta ran consistently above market, i.e. it fell at TWICE the rate of the market. Remember, when something rises, the sky is the limit, but when something falls, the floor is the limit. To outperform the market during the upswing is no big deal, but to outperform the market during the downswing says something special. Three snapshots: market fell 22.09% from 8th Jan, ’08 to 22nd Jan, ’08, Unitech fell 33.22% over the same period for a Beta of 1.5; market fell a further 48.68% from 22nd Jan’08 to 27th Oct, ’08 in a once-in-a-century dive and Unitech outperformed it by falling 87.84% with a Beta of 1.8. Now hold your breath: market ROSE 2.34% over the period 27th Oct, ’08 to 9th Mar’09, but Unitech showed a NEGATIVE Beta by falling a further 41.85% for a negative Beta of 17.85. So a Beta Tracking strategy would have come to serious grief if it had chosen Unitech to practice its skills. Which brings me to the point about there being much more to it than a simple ‘single factor’ relationship to this complex question. What goes up must come down…. maybe…. but what goes down must come up is not necessarily true. The human element is obvious: a computer program that apes Mr. Malkiel’s view-from-the-moon strategy may ‘outperform’ the market over a hundred years, but Mr. Warren Buffet is sure to leave out Unitech from his portfolio intuitively. That would surely improve his track record over the long term. For example, I use 14 such filters to make sure that I don’t ever get caught in an over-priced stock. Yet, I don’t call myself a mathematician; the critical skill to me is that of a Behavioural Economist, who builds an ‘anticipator’ of ‘smart behaviour’ (like I have done for HPCL above) and then tracks it to check for reality.

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An Agenda For Inflation

A Prescription For Increasing Productivity Inflation happens when too much money is chasing too few goods and services. That is why Milton Friedman once said that “Inflation is everywhere and always a monetary phenomenon”. At this point, when the monetary authority (the RBI) has just passed on the (inflation fighting) baton to someone else (the Govt), it would be appropriate to evaluate this statement again. In India, we have to contend with red hot demand for everything, particularly food and energy, besides incremental money supply. We are perhaps the only part of the world that has regular bouts of demand-side inflation; Mr. Friedman was probably referring to the much saner developed world, when he talked about Money Supply as the only driver of (supply-side) Inflation. I cannot fault the RBI for anything they have done in Monetary Management. Given the recent standards by which we should judge them by (Greenspan/ Bernanke/ ECB), our Governors at the RBI have uniformly shown much more character. The fault, it would seem, lies in what the rest of Govt has done to produce the things that are in short supply. Starting with energy. We went down the thermal (coal) route, rather than renewables, in particular Solar. A high capital cost for energy can be managed with a high Savings Rate, which we have. Big fiscal incentives for driving savings into Solar, will reduce the Cost of Capital. Now more than ever, with the cost of Solar dropping to a more affordable Rs.7.5 per unit, we should drive huge investments into Solar. This will cover both the energy deficit and reduce the blended cost of energy. The floodgates of FDI should be thrown open. There is enough money waiting to come in, given the massive investments ($ 500 bn) already going into renewables globally. Given the context of the Durban agenda, it is now clear that China and India will also be launching aggressive emissions reduction programmes, instead of fighting for their “right to pollute”. This will clarify the way forward for industry; Solar is going to be the way to go… The cheap money available in the US, should act as a spur to investments in India. The money coming in, should not be debt, but Equity. Investors can leverage themselves in the US, but should be invested in Equity here in India. This will insulate the country from currency risk (an especially topical issue at this time). There should be no dearth of investments, if the right enabling climate is created. Big companies like Reliance should be encouraged to launch super-ambitious investment plans; they have the debt capacity needed to even fund it off their Balance Sheet. The gestation period for these projects can be brought down to 1 year, if some specific SEZ- type initiatives are taken, to ensure plug-and-play projects for smaller players. These can even be consolidated by the big Infrastructure cos (GMR has something like this in Chennai). The short point is that if there could be one single reason for an Indian resurgence, it would have to be the dropping cost of energy. Worldwide, other trends are kicking in. US production of shale gas has gone up 700% this last decade, and is set to increase further. All this will affect the cost of coal, the dirtiest of the fuels. Oil, too, will eventually come under pressure, but only provided China and India perform disproportionately on the static energy front. The very fact that US and Europe are trying to shut off oil revenues for Iran (leading to higher oil prices for everyone) shows that they now care less about the price of oil than they did earlier. This will also have geopolitical implications. The next is food, which is both dependent on the cost of energy and is far more complex. First, the cost of intermediation (the non-food cost of food) should be brought down. The value chain in food has a very large storage and logistics cost, which are soaked by traders and intermediaries. If these are handled by fragmented markets, costs will be high. Integrated (or organised) supply chains will do a far better job of reducing cost. I don’t know whether a protected Indian retailing industry is better, or foreigners will really bring in technology and good practices (our experience with Banking would suggest that it doesn’t make much difference eventually, but the entry of foreigners would act as a catalyst). But food and agriculture needs some serious structural reform. Look at how the inflation problem is going to get intractable. If this (food inflation) continues, it will push up inflationary expectations at the lowest level, fuelling wage inflation. This will set off a spiral. The old and the weak will be the worst affected. Since food inflation shifts pricing power to big farmers and traders, both of whom are almost entirely outside the tax net (the former officially and the latter unofficially), it will ensure that, over time, the tax :: GDP ratio will drop, increasing the Govt’s Fiscal Deficit. There will be a cost push on a variety of industries, which will set off another inflationary spiral. All in all, not a pretty long-term picture. Productivity can only improve if we bring in serious (corporate) investments into agriculture. I know this sounds completely (politically) impractical, but we need to liberate (land) leasing laws, to allow long-term leases, which allow corporates to get into Corporate Farming. This is in everyone’s interest; the tiller, the absentee landlord and the customer (read: the population of India). It would allow serious investments into wasteland development, water management and soil rejuvenation. New technologies, especially those that use low-cost energy (Solar again?) for water and logistics management, will drive up agricultural productivity. Just ask Brazil how they transformed agriculture within a decade. These two components make up core inflation. If you look at any manufacturing Cost Sheet in India, you will find that the cost of energy and wages make up at least 30% of total Value Added. Managing these 2 costs will decide the company’s Internal Inflation Rate, i.e. the actual Inflation in the co’s input costs, which might be sharply different from the average reported across the entire economy. For example, right now, a textile exporter would be seeing very low inflation in input costs (with cotton prices sluggish because of reduced offtake from the spinners), even as he sees increase in Dollar realisations from Sales. On the other hand, power producers would be seeing sharp increases in the cost of fuel (especially coal), even as price realisations stay sluggish. This would be a good way to evaluate the prospects of companies. Each company has to focus on its Internal Inflation Rate, and focus on the components of its Inflation. This should be set off against ‘beneficial inflation’, i.e. the price increases it gets from the markets it faces. Setting this equation would give it some sense of its future profitability, and its future strategy (to manage its profitability). India’s savings are currently invested in a lop-sided manner. It is the (energy)- consuming industries that are investing incrementally, not the energy- producing ones. The same goes for food. We have the savings flow to fund our deficits domestically; those that interest foreigners should be left open to them, while we drive our domestic savings into investments in Corporate Farming cos, for example. It is not very difficult; we have the tea companies as a shining example, and internationally, there is the Brazilian model in sugar, to learn from. The old argument that markets are self-correcting mechanisms does not hold just now. There is a clear price signal coming from the raging food inflation, yet the market is unable to respond. We don’t even know whether the current food inflation is because of falling productivity, that comes from a lack of adequate investments and a complete stagnation in technology. We do know that some of this is because most Indian agriculture continues at the subsistence level, with no scale, absolutely no technology investments in mechanisation, energy usage and input management. All of this would need organised effort, as much into knowledge and management, as into physical assets. At the moment, that is well beyond the capability of the India agriculturist; but politics will ensure that reform here will be left pending till the crisis is well over our heads.

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The Dawn After

How Things Could Change For The Better There used to be much talk about ‘green shoots’ in 2009, although nobody uses that phrase any more. At a time when sovereigns accounting for about 3% of world GDP look all set to default, it is difficult to imagine just how things will ever come back to normal. Yet, to misuse NourielRuobini’s book title, ‘this time too, is NOT different’. The darkest hour (we might be approaching it now), will still be followed by a dawn. To get past these times, you need to have some picture of what the dawn will look like, which is why, contrarian as usual, I have decided to time this column just now. Remember: you read it here first!!! The cost of Solar (power) has just come level with the grid cost of thermal power, at least in California. Solar capacity used to cost Rs.42 cr per MW a decade back, and in a variant of Moore’s Law, is dropping 60% every 5 years. From Rs.16 cr per MW in 2008, it is now Rs.11 cr per MW in India. The latest American panels should now be launching at Rs.7 cr per MW, not very far from the ‘parity bar’ at Rs.5.4 cr per MW. For India, if you factor in the rising costs and availability issues for coking coal, together with the possibilities for Solar panels over the Thar Desert, ‘grid parity’ will be life-changing. The potential impact will rank along the lines of the IT revolution, followed by the Communications (Mobile Voice & Data) revolutions. First the cost of computing went to zero, then the cost of communications followed suit and now (maybe) the cost of energy will follow. While this will be a worldwide revolution, and I am sure India will lag behind in converting to Solar, I can see spinoff benefits for a variety of economic activity, which will boost poverty reduction. Principally, it will make water management cheap and easily accessible to the rural poor, allowing politicians to dole out their favourite gift: free power for farmers. At a different level, power reforms should see a fitful start, now that bankruptcy is staring both producers and distributors in the face. Amazingly, Tamil Nadu is looking at tariff hikes of 20-30%; reducing free power will create a further impetus for production. But if the real cost of power drops for technological reasons, there will be no dearth of demand, anywhere in the world. We have seen the same thing happen in the Communications Revolution. The development of Solar and other renewables technologies will still be incremental, and will not impact markets, except indirectly. There might be no Big Bang in Solar, and we might not see a Microsoft of Computing (or Apple of Mobile technology). (Solar) Power is an enabler, not a consumer good in itself, hence a producer will remain a Utility. Govts will interfere, preventing the kind of profits that, say, an Apple makes out of its leadership. Not so in Biotech. There are already more than 500 products awaiting FDA approvals, and they will impact big diseases like cancers, renal and liver disease, heart, diabetes and lifestyle disease. Over the next 3 years, they will be coming onto the market, impacting the pharmaceuticals industry in a way that cannot be imagined. The $40 bn of patents expiring, will not be noticed in the excitement that follows. For the equity markets, this (more than Solar) will create the next bubble. In currency and bond markets (the source of all the trouble just now), change will be equally dramatic, although it will be less noticeable, since it will be driven by attitudinal/ behavioural change. Govts will find it more difficult to be fiscally irresponsible, and the consequences of the current spate of bond market defaults will be remembered for a long time to come, at least in the developed world. Remember, Germany’s phobias about inflating away the debts of Greece come from the memory of their own hyperinflation of the 1920’s. Whichever way this current European imbroglio ends, you can rest assured: it will leave lasting memories of the consequences of fiscal imprudence, high Current Account Deficits and ‘hot money flows’. Anybody in Europe who is allowed to live life again, will keep these lessons in mind. That ensures a sharp jump in Govt discipline in the whole of Europe and its neighbours. Whether such learning will impact behaviour as far away as India (and I don’t mean geographically, but attitudinally), is something I cannot yet say, but Jayalalitha’s power sector reforms and Mamatadi’s “Ms. Populist” reaction to oil pricing, would suggest that the impact of Europe’s misfortunes will be far-reaching. Think of the impact of this. Govt deficits will be (relatively) under control, bringing back credibility to fiat currencies. This will take some of the shine off Gold and other precious metals. Commodities in general will get cheaper, not just through technological advances, but because of the absence of front-running flows that ‘anticipate’ Govt profligacy. The ‘dash from cash’ will slow down, and people will start trusting bond markets to preserve their wealth. Who knows, they might even start stuffing cash into their mattresses; it certainly feels softer than gold. Countries (especially in Asia) that were following Europe down the ‘welfare state’ route will tarry for a while. Not India, though, which continues to promise various ‘rights’ (to food, education and all the other things that it has no hope of ever providing). But overall, most countries will have better finances; this will be achieved, indirectly by vacating the towering heights of the economy (infrastructure, utilities and core manufacturing), all of which will be very good for jobs and income growth. So try and imagine a world where the cost of energy is zero, following up on zero- cost computing and communications. Incremental life expectancy comes very cheaply now, with major advances in disease control and rejuvenation. Govts don’t take their (fiscal) credibility for granted, and prefer to stay out of running businesses. Parts of the Indian economy in particular, where supply side inflation is both endemic and structural, will see an improvement in productivity. Even assuming that Indian agriculture stays the way it is, technology will still impact food production through biotech, energy management followed by superior water and logistics management. A doubling of food productivity is all that is needed now, not a very tall order on a very small base. What WILL NOT happen is also clear. There will be no structural reforms in agriculture, no corporatisation of agriculture at one end of the spectrum, nor any land reforms at the other end of the spectrum. Politicians need to keep agriculture free of any taxation, to hide their ill-gotten gains from the business of politics. This will push up the cost of real estate, but at the same time, ensure that leverage levels in India stay low. The world is going to get better. Event risks will remain, like nuclear terror and biological weapons. But they will be mitigated by a change in geopolitics through a tectonic change in, say, drone technology. The new drones being developed are microscopic, with nanotech-sized gnats sidling up to you and shooting you down, wherever you are. The power balance will shift back to America, which is where I would like the world’s geopolitical power to lie. I would have been much more worried if I saw power shift to China, Afghanistan or Iran, which seemed to be the alternatives this last decade. Lastly, private Americans have been paying down debt, even if their Govt hasn’t. Another 4-7 years more of this and they will be down to 1950 levels of indebtedness, which is where the last Baby Boomer generation started. And remember, this new generation of teenagers would have seen enough bad times to hold onto their character during good times, come 2020…

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The Way We Are

Summing Up The Last Decade The MFI will be ten next year. Unlike children, it still has time before it reaches puberty. Yet, it has seen more as a toddler than most people would have seen in an entire lifetime. For starters, it was born when the world had already changed, i.e. after 9/11. The IT Boom had just gone bust, the Sensex had dropped to 2800, and Mr. Greenspan was just embarking on the biggest (mis) policy of the century, something that would leave its stamp on a generation to come. A lot has changed during this period and yet, some things have not. The tone of my own columns has traced this change; I started with observations about human beings, trying to ‘be different’ by pointing out some home-grown observations about human irrationality (e.g. “How To Park Your Car”). This, I thought then, would be original stuff and I had limitless content, taking the broad principles and applying them to the many dimensions of economic life. The facts followed me in my journey. As India got integrated into the world economy, so did the Indian markets. The result was a classic ‘globalisation of irrationality’ that saw itself play out in mini-form in India. Most of the stuff that happened in India traces its roots to some global event or trend, until today we pass off anything that cannot be immediately explained, as ‘global cues’. Others will tell you how the facts evolved during this period. As usual, I will stick to the philosophy and the principles to be derived from it. Markets are supposed to forecast the future and ‘discount’ prospects. In the short run, they are reactive ‘voting’ machines while in the long run, they are discounting/ forecasting machines. They are also culling machines, routinely decimating the wealth of those who ‘react’, while at the same time creating impossible wealth for those who ‘forecast’ AND survive the mayhem wrought by the stampedes of those who react. This paragraph is particularly topical at this time of writing. For the Indian reader of MFI, and maybe for MFI itself, the journey (with the benefit of hindsight) should have been fairly simple and straightforward. Most of the bad news has emanated from the ‘global cues’, to which India has been exposed as an afterthought (and an aftershock). The irrationality that has to be survived is that of the global economy, which includes FII flows. The Indian economy has charted a fairly secular course through this last decade, cruising along in second gear. Yes, there are those who complain that it can do better, but it certainly is not part of the (global) problem. Nor has it contributed much to the debt woes of the world (thanks to some intelligent policing at the RBI). In this context, I must thank our stars that an Indian Mr. Greenspan never got close to the RBI Governor’s seat…we are rather satisfied with the Reddy-Rao axis!!! So you, my reader (and the MFI) would have done well (in hindsight) if you just stuck to your “I love India” bumper sticker. You just had to step back and survive the herds of exiting investors that periodically react to something happening somewhere else. If they heard a different drummer, it was not a beat meant for you. You just had to survive the stampeding herds and (you) would do well. I remember that from the scorched marketsof 2002-03, I picked up a purely domestic Indian play (on sugar), a well-known company (Balrampur Chini) that gave me 42 times my money over 3 years, on an investment of 3 years’ salary. My (financial) life was never the same after that. I mention this to bring home to you how, in exactly the kind of times that we are facing just now, it is possible to pick up a very good stock, believe in it, hold on to it with tenacity, and with (just a little bit of luck), reap life-changing rewards. This is not available to everyone, but to readers of this magazine, you have a chance. Would you believe that before the steel cycle turned up (with China) in the last decade, SAIL used to quote at Rs.5. It went up to 230 in a fairly predictable fashion. There are many such stories across India, which are available to you and me. That (apart from the fact that we have real jobs and maid- servants) is what makes us much more fortunate than those who live in the West. What has changed during this period is recounted every day in the papers, so I will spend little time on it. But mainly, it is the integration of markets, the way currency markets impact equities, commodity and bond markets affect everyone else in an interwoven mesh that really plays out Complexity Theory (remember the quote about the fluttering of the wings of a butterfly in Louisiana causing famine in China). These days, I find myself reading Der Speigel, a German newspaper, to figure out the intentions of the Freedom Party, which is a coalition partner to Angela Merkel. If they vote against the support to the EFSF, the Eurozone will collapse and that will affect my holdings in Tata Steel. How’s that for complexity?Most of you innocent buyers in Tata Steel would not even know of the EFSF, let alone who Angela Merkel is… It is no longer enough being a ‘fundamentalist’, because you might be waiting forever for the market to discover your stock. Especially when little known companies have to build ‘market reputation’ (which includes a reputation for Corporate Governance, a much-vaunted and rare attribute these days), you might find yourself going wrong with the punt of a lifetime. Technical analysis is a little better than astrology; if you read these chartists carefully, you will find they have a margin of error of 50%. If you want to play the price discovery process, it is far better to try and be ‘last man standing’. Read the “Art of War” by Sun Tzu, lots of statistical modelling (which is NOT the same as technical analysis) and Nassim Taleb to complete your education. The road to success hasn’t changed, although it looks very different these days. If you get your investing model right, there is a big market for your skills, which wasn’t so earlier. Just make sure that you don’t just study ‘what to buy’, but the price discovery process itself. When you do the latter, you will find yourself looking at complexity coming from Fx, bond and derivative markets, besides commodities and ‘flows’, a new variable these days. In Equity markets, at least, the old formula hasn’t changed. To take the example above, it doesn’t really matter whether Merkel stays in power or not. If I buy Tata Steel at a 35% discount to Book Value, I will be rewarded one day. The daily shenanigans of FIIs and markets will scare me, but longer-term trends will play out. Good managements will do better than bad managements, good business models will survive. The basics remain the same. The formula for the next decade is known: buy India, buy companies growing in the domestic space, with good business models, corporate governance, technology and a healthy Balance Sheet. And stop reading the (pink) papers thereafter; I promise you, that is NOT good for your financial (or mental) health.

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Je Ne Comprends Pas

Looking The Gift Horse In The Mouth Regular readers know that I mostly write philosophically, trying to derive principles that drive action, rather than recommending specific actions for our readers. Rarely, I speak about a specific company/ event/ trend, except to deal with a macro-trend. Today, here are some disconnected thoughts that slip through my mind as news/ events/ trends roll along in fast forward… • So S & P downgraded the US, and everyone panicked. It wasn’t really news, even from S & P; but I suppose once people start running, nobody knows why they are running. The same day, S & P UPGRADED Tata Steel, which then proceeded to drop like a brick, till it reached a whopping 20% discount to Book Value. The debt has come down to 2 timesconsolidated EBIDTA, well under control. Corus has mostly turned around and cost synergies (estimated at $400 mn) have started to flow. The closure of illegal mining in Bellary will indirectly benefit Tata Steel to maintain its 20% topline growth, both in India and globally. At Rs.130 EPS (including one-time Capital Gains), you are buying the co at 3.7 times earnings and 4 times EBIDTA. This is even better than Bharti, my last recommendation… • The company has a Return on Net Worth of 13%, but the stock is available at a 10% discount to its CURRENT Net Worth of Rs.490 per share; since you would mostly be investing with a horizon of 1 year, that would be a 25% discount to its expected Net Worth (of Rs.550 per share) 1 year hence. In short, you get a 21% post-tax (and 31% pre-tax) return if you hold the stock forever. This is the kind of once-in-a-lifetime investment that Charlie Munger and Warren Buffet talk about. If you have bought the stock at the right price, and it is compounding steadily, the right time to sell it is …..never. • Let us take a look at how this has come about, and what are the canards floating about in the market/ media/ analyst community that have beaten down the stock to such deep value. In these chaotic times, the media is full of misleading stories, sometimes orchestrated by the analyst community, who will change their tune the moment the stock has reached the right hands. I think this is a bigger, and more systematic scam that 2G, CWG and Bellary combined. It is just unfortunate that Anna and his Team don’t have the eyes to see it. • Don’t believe me?!For those of you who remember my columns while the Bharti story was unfolding, take a look at the sequence of events while the orchestrated beating down of the stock was taking place: o The first phase was when the tariff wars started and the stock was marked down on ahuge selloff by Mutual Funds from 457 to 320 (circa 1st – 14th Oct, 2009; look up the technical charts to follow my story). As a natural contrarian, this attracted my attention. o Tired bulls capitulated end-Nov, 2009 (near the expiry) and there was a short-covering rally by mid-Dec to 342. This ended Phase I of my story. o Now starts the co-ordinated‘story-spreading’. In Jan-Feb, 2010, the Zain story broke and an ‘analysts’ consensus’ was worked out, saying the acquisition was ‘value dilutive’ for Bharti, because it was a premium (about 20% per subscriber) to Bharti’s own beaten-down valuations. Look around now, and tell me where those concerns are. Bharti is up 60% from those days, even though the market is down 20%. Anyway, in the week 10-16th Feb, 2010, the stock was marked down from 315 to 271. Thereafter, it trundledalong over March and April, recovering as more information about Zain trickled in. In Feb, 2010, I wrote the first of my columns on Bharti, angry at the disinformation being spread about Bharti. o At just this time, I called up an analyst in a leading foreign brokerage who was covering Bharti. I challenged her downbeat view on the sector, finding that she agrees with all my counter-arguments about Bharti being a sector outperformer, and a relative value argument, etc. She agreed with everything, but maintained the ‘party line’. i.e. the stock is down from 271 with a target of 210. Recently, she has revised the price target to 504. I can’t believe that she did not know what she was doing; her ‘party line’ was to talk down the stock, put out ‘public research reports’ which are duly headlined by the leading pink papers (more money is made by this process than Mr. Kalmadi could ever imagine; in respectable Indian society, this is even called a ‘business’ and gets you Market Cap in Dollars). o But back to my story. After the Zain fracas died down, the 2G scam broke out, circalate April, 2010. It had a limited effect on the already beaten-down Bharti stock, except when a whopper of a story was headlined, obviously (surprise!!!) in the pink papers: the TRAI recommendations about the sector, especially one recommending a whopping Rs.14,000 crlicence renewal fee. These ‘recommendations’ were duly headlined as fact and repeated ad nauseam. I wrote an angry column ‘TRAI-ing to Fail’, which should be read now in the archives, to see how right I was: http://www.valueresearchonline.com/story/h2_storyView.asp?str=14788. The stock dropped below 260 and stayed there for 2 months, during which almost everyone I knew dropped out of Bharti. The stock they sold was picked up by some of the smartest investors in the country (including the promoters). o The point I am making: while the media (and analysts) were in a downgrade frenzy, why were smart, knowledgeable people, not reading those Research Reports (or pink newspapers). Or were they writing them? In trading parlance, we call this, ‘maalnikalvana’, and is in no way different from the manner in which you put a white bedsheet over yourself to make your sister shit in her pants…;). I survived all this, and exited Bharti at 360, happy at the predictable ‘behavioural map’ that I had figured out. After 360, the analysts returned to telling the truth; actually (oh sorry! But Bharti was really a good company, a sector outperformer and would consolidate both India and Africa. So what if the profits are down, the stock is still up, despite a beaten-down market!!!) o Something similar happened recently in DLF, which will give you a sense of déjà vu if you track the story with the technical charts. Thrice, there were prominent headlines in the pink papers on various issues with the company (bad accounting, hidden losses, high debt). Every time, it led to a selloff, the stock bottomed at 209 with huge volumes and backed up 10-15%...it was party time in a bear market. The big story now is the ‘penalty’ on DLF by the Competition Commission of a whopping Rs.630 cr (see the TRAI ‘recommendation’ above). Suitably headlined in the pink papers, it led to a selloff on a day when the broad market bottomed and some very smart investors bought 140 lac shares from some very relieved idiots. Watch this issue one year hence….!!! DLF is since not breaking new lows, despite being from a pariah(real estate) sector…! • But this story is about Tata Steel and I must return to it, first by making my main point: that there are serious, quiet and invisible ‘cosy’ relationships between analysts (especially from foreign brokerages, who put out ‘research’ when the market is delicately poised) and the pink papers, who give it a loud, terrifying voice that will blow you away if you don’t know your facts thoroughly. Recently, the market bottom for this cycle was made on a day when the leading pink paper chose to ‘poll’ some unnamed ‘Fund Managers’, and told you that the market was dropping 13%......not 17%, not 9%, not 12.36%. Just 13%.....the stock sold by its foolish readers was dully lapped up. Now watch this space 6 months hence!!! • The lesson for you, my dear readers…..you will die rich, if you just read these papers one week after they are delivered to your house, and then you watch what your foolish neighbours did when they listened to such false ‘advice’. In my case, I read these (pink papers) to find out what the fools are doing. And I don’t watch TV, which is seriously good for my financial health. • The canards floating around just now: o Tata Steel is a global company, and with Europe facing a double dip, its European operations will be badly affected. Europe accounts for 56% of Tata Steel’s turnover, and about 30% of its EBIDTA. It has high Operating Leverage, i.e. unit drop in selling prices will lead to high negative impact on its EBIDTA. But at 5 times EBIDTA, this belief will at best hold for the short term (even if it is true). At these valuations, just the 20% EBIDTA growth from the Indian operations, which are unaffected, will give you a decent return. o Steel prices are bearish, and Tata Steel will be affected. They have been bearish for some time now (CMIE has projected a 7% increase in domestic prices around Oct, 2011), and recent results showed that Indian turnover growth made up for the decline in prices. EBIDTA was flat, despite lower prices. Going forward, India will still see 10% growth in steel demand, and maybe some price improvement if the ban on iron ore mining and the problems of JSW prove to be good for its competitors. But this is to tell you that even in the short-term, Tata Steel’s EBIDTA will be more or less flat. But its stock price is down 20% below is CURRENT Book Value. At these levels, its current profits give you a 21% post-tax return; all you have to believe is that EBIDTA will not fall significantly. o In a high interest rate environment, this is an interest rate sensitive stock with high debt. It should be badly affected by a recessionary scenario. Wrong! The Corus debt has been reduced steadily, and consolidated debt is at 2 times EBIDTA now, a very stable ratio. Its spare debt capacity gives it the ability to make another aggressive acquisition; watch out. Even if it doesn’t invest, it is paying down Rs.10,000cr debt this year, or its expansion at Jamshedpur will come up with lower leverage than at SAIL or JSW. The company is the most under-geared in its sector, something it has in common with Bharti. o Other Positives. Its ‘global’ operations are genuinely global, with commercial operations in 53 countries. A shortfall in Sales in Europe, will be made up by faster diversion to other growing economies, especially in Africa. Corus is not the operation it used to be in 2008, when it brought down Tata Steel to 40% of its Book Value. Memories of that downfall have triggered the current selloff, and that is why it is an opportunity for you. Today’s Tata Steel is a different company: huge cost synergies have already been extracted, half the Corus debt is paid off and most importantly, Corus technology is now helping Tata Steel with its product development in India and other emerging markets; that will help it outperform its competition locally. And the local markets are both robust and growing. The fears about a European slowdown, even if they are true, don’t justify a 65% discount to its average historic valuations (of 2.3 times Book Value).At a 20% discount to today’s Book Value, you are getting a strong, deleveraged Balance Sheet and a robust P & L with little downside risk. If there are risks, they are in the price. The positives have not been factored in, and some of them are already on the Balance Sheet. Like Benjamin Graham was fond of doing, he wanted to pay only for current reality, not for future potential. You are getting just such an opportunity in Tata Steel right now. Disclaimer:the author has put his money where his mouth is. He has put his shirt (and his reputation) behind Tata Steel.

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