I sometimes wonder how my life would have turned out if I was born in a different family, maybe a less privileged one. When I was small, my family went through severe financial constraints but despite everything my father was adamant that I study in an English Medium school. During middle school I was borderline autistic because despite my attempts I pretty much understood nothing in class. Just before the exams my father and mother used to write down answers (while I sat beside them crying my eyes out) to the problems which I sort of crammed in my head.
Let me now fast forward to 2004. I came out of the IBA admission test exam dejected because I knew I sucked. My father was waiting outside. When I told him that I had a horrible exam the only thing he told me “ kono bepar na, tumi NSU te bhorti hoye jao”. I did however pass that written test only to get kicked out after the Interview.
What if I did not get all this support? What if my family could not afford the tuition for NSU? I am pretty sure I would not have been in the position I am in now. Maybe I would have turned into a Sweden Aslam or a Porimol. The third part of a video called Zeitgeist explains that the way a person is brought up by his family has immense impact on what he becomes. Of course there are outliers and criminals are born in good families as well. But outliers are well, “outliers”.
However, when we consider or judge a person we do not take these factors into account. In fact, I am inclined to believe that the whole societal value system is a complete farce. These days the person with the most expensive car, best looking girlfriend/boyfriend, or richest father is automatically treated with the most respect. People look at them as their role models and want to be like them.
Society fails to acknowledge the unsung heroes which are making huge impact in the lives of people. I started reading a book called “The Black Swan” by Nicholas Nasim Taleb. He wrote about a fictional person who made a legislation that imposed locks on cockpit doors. This helped avoid the 9/11 attacks (since the locks prevented the attacks) at high cost to the airlines. Since his measures squandered public resources the public with the help of airline pilots kicked him out of office. He thus retired depressed with a great sense of failure. Ultimately he died with the impression of doing nothing useful.
This is probably a very extreme story but similar stories are there in real life. I personally know two people (not my parents) who never said “no” when someone needed help. They went so out of their way to help other people that they could never concentrate on their own life. Both are sort of considered unsuccessful by the people they helped numerous times.
There is a wonderful film related to this topic called “It’s a wonderful life” which I recommend everyone to watch. The main character tried to save his town from the clutches of an evil banker but ultimately failed. He became so poor that he could not feed his family and ultimately decided to suicide. At that moment an angel came down and saved him and showed him how much he has impacted the lives of people around him. Even very small things he did had helped save lives.
So, if you are amongst the people, who believe in good deeds and believe in Allah, then have faith and keep doing what you are doing. Regardless of your social status, wealth or appreciation by people, you are definitely in the right path.
Let me conclude by saying that I really do not have a conclusion planned. Maybe after a few days something will come to my mind and I will just edit the last part (thanks to all these options).
Monday, July 18, 2011
Wednesday, March 16, 2011
Can a share buyback program solve our capital market problems?
Disclosure: The article was written on Wednesday, March 16, 2011 at 11:36am. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
This writeup is definitely not one of my better pieces. I wrote it in a hurry because I think that raising awareness on this issue is a must. So please forgive any mistakes and errors.
Background
Instead of going after valid issues like insider trading, price/volume manipulation, monitoring and compliance we seem to go after the wrong issues. I am basically referring to the plan to use “share buyback” as a way to ensure that stock prices do not remain “undervalued”. How does this work? Basically, when a company feels that its stock is trading below fair value it uses its own cash to buy back shares. It is easier to think that share buyback is similar to paying cash dividend because the company pays cash to existing shareholders to buy the shares.
Share buybacks are allowed in many countries of the world and particularly developed countries. However, that does not mean that it has to be adopted in Bangladesh as well. In fact, given the current condition of our economy and market I think that it will be a big mistake to allow share buyback. This is my preliminary response to the idea and I will hopefully write more after I get the final copy of the guideline in hand.
Reasons
I will try to be very specific on the reasons I am going to cite.
1. A new method of stock price manipulation: Once legalized, company management and sponsors will now be free to use the rumors and news of stock buyback to increase stock prices. Now since it is going to be legalized the manipulators would not face any problem whatsoever.
Let me give an example. When the seller knows that there is a ready buyer for the stock, the seller will be able to hike prices. Given the highly speculative nature of our market this is going to be a ticking time bomb where retail investors will once again fall prey to the schemes of the manipulators. This will be the new fad after bonus shares, rights shares and stock splits all of which led to unjustified increase in stock prices.
2. Objective of capital market: A developing country like Bangladesh needs to invest a lot for growth. Capital markets are created primarily because entrepreneurs can raise funds for investment. When we are allowing buy backs we are basically doing the reverse. Companies will be giving back money to the shareholders. This is definitely counter intuitive. When most of the companies are unable to give decent dividend yields how would they be able to buy back shares? One way may be to use leverage which makes things even worse. Already our capital market is heavily leveraged and the banks are going to pay a price for that. We really cannot afford to increase leverage any more.
3. Supply of shares would decline: It is common knowledge that we have lack of supply of quality shares. Now if companies start buying back own stock we are actually decreasing supply rather than increasing it. How that helps is a big question mark.
4. Focus to be diverted away from operations towards financing activity: Allowing buyback will definitely divert attention of management and the directors towards financing activities instead of trying to improve operational capabilities. These days everybody is trying to get rich in the shortest possible time which is why we see manufacturing companies investing in the capital market. This is highly detrimental for the country as resources are not being used for productive purpose but rather for speculative purpose.
5. Who has the necessary cash balance?: The only companies who should go for buybacks are companies with huge ‘net cash’ position which are unable to use that money for productive purpose. Thus there should be a clear guideline on who can go for buy back. Like I already mentioned, leveraged must not be allowed at any cost to buy back shares. Now if we look at the listed companies there are only a handful of companies who has the required balance sheet strength to buy back. I am quite sure that once the buyback rule is passed its going to be the companies with the weaker fundamentals that will use it rather than the ones who should go for buyback.
6. What are the penalties for violating rules?: My last concern is violation of the buyback rules. This is a sensitive thing and involves huge amount of money. Thus violation of buy back rules must be penalized with hefty punishment like imprisonment. I guess the penalty aspect would be clearer once the final copy of the law is out.
Conclusions
Instead of focusing on complex things like buybacks, we should use this time to work on the basics first. The priorities in my opinion are
1. Strong insider trading laws: Insider trading is rampant in our market where everybody seems to know earnings and corporate declarations much before the company announces them. This is the biggest evil right now.
2. Preventing price and volume manipulation: This is the second biggest problem. Syndicates corner shares and then start spreading rumors. In finance terms this is called “pump-and-dump”. We need to stop this.
3. Corporate governance and transparency: No need to elaborate on this. In terms of corporate governance and financial transparency we fall far behind compared to most neighboring countries.
4. Bonus shares/Splits: It is high time that investors realize that bonus shares do not mean anything. They don’t add any value to the company and thus should not increase stock price.
This writeup is definitely not one of my better pieces. I wrote it in a hurry because I think that raising awareness on this issue is a must. So please forgive any mistakes and errors.
Background
Instead of going after valid issues like insider trading, price/volume manipulation, monitoring and compliance we seem to go after the wrong issues. I am basically referring to the plan to use “share buyback” as a way to ensure that stock prices do not remain “undervalued”. How does this work? Basically, when a company feels that its stock is trading below fair value it uses its own cash to buy back shares. It is easier to think that share buyback is similar to paying cash dividend because the company pays cash to existing shareholders to buy the shares.
Share buybacks are allowed in many countries of the world and particularly developed countries. However, that does not mean that it has to be adopted in Bangladesh as well. In fact, given the current condition of our economy and market I think that it will be a big mistake to allow share buyback. This is my preliminary response to the idea and I will hopefully write more after I get the final copy of the guideline in hand.
Reasons
I will try to be very specific on the reasons I am going to cite.
1. A new method of stock price manipulation: Once legalized, company management and sponsors will now be free to use the rumors and news of stock buyback to increase stock prices. Now since it is going to be legalized the manipulators would not face any problem whatsoever.
Let me give an example. When the seller knows that there is a ready buyer for the stock, the seller will be able to hike prices. Given the highly speculative nature of our market this is going to be a ticking time bomb where retail investors will once again fall prey to the schemes of the manipulators. This will be the new fad after bonus shares, rights shares and stock splits all of which led to unjustified increase in stock prices.
2. Objective of capital market: A developing country like Bangladesh needs to invest a lot for growth. Capital markets are created primarily because entrepreneurs can raise funds for investment. When we are allowing buy backs we are basically doing the reverse. Companies will be giving back money to the shareholders. This is definitely counter intuitive. When most of the companies are unable to give decent dividend yields how would they be able to buy back shares? One way may be to use leverage which makes things even worse. Already our capital market is heavily leveraged and the banks are going to pay a price for that. We really cannot afford to increase leverage any more.
3. Supply of shares would decline: It is common knowledge that we have lack of supply of quality shares. Now if companies start buying back own stock we are actually decreasing supply rather than increasing it. How that helps is a big question mark.
4. Focus to be diverted away from operations towards financing activity: Allowing buyback will definitely divert attention of management and the directors towards financing activities instead of trying to improve operational capabilities. These days everybody is trying to get rich in the shortest possible time which is why we see manufacturing companies investing in the capital market. This is highly detrimental for the country as resources are not being used for productive purpose but rather for speculative purpose.
5. Who has the necessary cash balance?: The only companies who should go for buybacks are companies with huge ‘net cash’ position which are unable to use that money for productive purpose. Thus there should be a clear guideline on who can go for buy back. Like I already mentioned, leveraged must not be allowed at any cost to buy back shares. Now if we look at the listed companies there are only a handful of companies who has the required balance sheet strength to buy back. I am quite sure that once the buyback rule is passed its going to be the companies with the weaker fundamentals that will use it rather than the ones who should go for buyback.
6. What are the penalties for violating rules?: My last concern is violation of the buyback rules. This is a sensitive thing and involves huge amount of money. Thus violation of buy back rules must be penalized with hefty punishment like imprisonment. I guess the penalty aspect would be clearer once the final copy of the law is out.
Conclusions
Instead of focusing on complex things like buybacks, we should use this time to work on the basics first. The priorities in my opinion are
1. Strong insider trading laws: Insider trading is rampant in our market where everybody seems to know earnings and corporate declarations much before the company announces them. This is the biggest evil right now.
2. Preventing price and volume manipulation: This is the second biggest problem. Syndicates corner shares and then start spreading rumors. In finance terms this is called “pump-and-dump”. We need to stop this.
3. Corporate governance and transparency: No need to elaborate on this. In terms of corporate governance and financial transparency we fall far behind compared to most neighboring countries.
4. Bonus shares/Splits: It is high time that investors realize that bonus shares do not mean anything. They don’t add any value to the company and thus should not increase stock price.
Saturday, March 5, 2011
Whose money are we spending?
As per statistics the Bangladesh economy has been growing at a rate of 6% (Real) on average per year. Even though statistics are always a debatable issue it seems from indicators of people’s new found affluence and wealth that real incomes have indeed grown by 6% (or even more).
With rising incomes (on an aggregate basis) we are also seeing other factors coming up. One is the rise of “consumerism” and the other is “increasing inequality”. Let us talk about the former first. To prove this I do not need to work very hard. The signs are everywhere. Even though car taxes have been increased significantly I do not see any slowdown in car sales. Apartment prices have increased but sales did not slow down. Expensive tickets of dance shows that feature foreign artists are “sold out” instantly. How are people affording these things despite the high prices attached? The answer is very simple. These consumers represent a small portion of the population having a large portion of the wealth. It does not really matter to them whether prices have doubled or quadrupled. They can afford it.
On the contrary there is this other group (which off course represents the vast majority of the population) who are having a hard time to simply gather food and lodging. As per ILO’s Global Wage Report 2010/2011 the real average monthly minimum wage in Bangladesh has been on the slide, although its annual rate of fall had increased from -7.2 per cent in 2008 to -5.7 per cent in 2009. These people are seeing their purchasing power and living standards fall continuously.
I don’t think it requires any explanation to show that the rich are actually getting richer because of the sacrifices of the vast majority of the country’s people which includes the minimum wage workers, remittance earners and the farmers. Problem is GDP growth through inequality does not help the country but rather helps a particular group of people. Both governance systems as well as religious systems have acknowledged this issue and had tried to find ways to solve inequality. Governments try to do it by taxing the rich and providing safety nets for the poor. Religions (like Islam for e.g.) have a system of ‘Zakat’ and ‘Fitra’ which ensures that inequality is reduced. Unfortunately, most of us neither pay taxes properly nor pay ‘Zakat’ properly. Furthermore, because of corruption the tax that is paid by honest tax payers are also not utilized properly and thus these groups are being deprived even more.
A person like me can go out and spend my money as I wish thinking that it is my earnings. But when I look closely I need to remember that while economy is growing some people are being worse off. This indirectly suggests that there are people whose efforts led to my increased wealth.
The case becomes even stronger when we think of imported goods. When people become rich somehow they start wanting goods of higher quality and status (basically I am talking about imported goods). Let me use the example of a luxury car which people are buying even after paying 600% tax. Apart from the duty the actual import cost is paid in dollars. Thing is the importing consumer did not earn the foreign currency. “It is our migrant workers working and toiling away in far away countries away from their families (and presently risking their lives) who earned it”. You might say that we do earn foreign currency through exports but please remember that we have a trade deficit. Along with export earnings we do have associated import costs of raw materials and capital machinery. So, imported goods are bought using the migrant workers toils. Now tell me whether we give these guys their due respect for working so hard and being one of the major growth factors of our country. We don’t. Instead they are harassed, cheated and deprived.
Its now time to ask ourselves the very basic question “whose money are we spending?”. Relying on our government to reduce inequality is going to be futile. We ourselves have to find out ways to help solve this problem. I do not have a solution right now but I am going to try to find ways. Inequality harms the long term growth prospect of countries. This has been realized by the second largest (and fastest growing) economy in the world. China has already decided that they will lower growth expectations for 2011-2015 to 7% from their current double digit growth rates and instead focus on equality. Instead of focusing on exports they want to go for internal demand lead growth, which is only going to be possible by reducing the rich poor gap. Given the current state of the global economies where we are seeing shocks after shocks, as well as inevitable fiscal austerity programs (Europe started it already while US will go for it from 2013) this is probably the right way Bangladesh should move towards.
Please share article if you have liked it.
With rising incomes (on an aggregate basis) we are also seeing other factors coming up. One is the rise of “consumerism” and the other is “increasing inequality”. Let us talk about the former first. To prove this I do not need to work very hard. The signs are everywhere. Even though car taxes have been increased significantly I do not see any slowdown in car sales. Apartment prices have increased but sales did not slow down. Expensive tickets of dance shows that feature foreign artists are “sold out” instantly. How are people affording these things despite the high prices attached? The answer is very simple. These consumers represent a small portion of the population having a large portion of the wealth. It does not really matter to them whether prices have doubled or quadrupled. They can afford it.
On the contrary there is this other group (which off course represents the vast majority of the population) who are having a hard time to simply gather food and lodging. As per ILO’s Global Wage Report 2010/2011 the real average monthly minimum wage in Bangladesh has been on the slide, although its annual rate of fall had increased from -7.2 per cent in 2008 to -5.7 per cent in 2009. These people are seeing their purchasing power and living standards fall continuously.
I don’t think it requires any explanation to show that the rich are actually getting richer because of the sacrifices of the vast majority of the country’s people which includes the minimum wage workers, remittance earners and the farmers. Problem is GDP growth through inequality does not help the country but rather helps a particular group of people. Both governance systems as well as religious systems have acknowledged this issue and had tried to find ways to solve inequality. Governments try to do it by taxing the rich and providing safety nets for the poor. Religions (like Islam for e.g.) have a system of ‘Zakat’ and ‘Fitra’ which ensures that inequality is reduced. Unfortunately, most of us neither pay taxes properly nor pay ‘Zakat’ properly. Furthermore, because of corruption the tax that is paid by honest tax payers are also not utilized properly and thus these groups are being deprived even more.
A person like me can go out and spend my money as I wish thinking that it is my earnings. But when I look closely I need to remember that while economy is growing some people are being worse off. This indirectly suggests that there are people whose efforts led to my increased wealth.
The case becomes even stronger when we think of imported goods. When people become rich somehow they start wanting goods of higher quality and status (basically I am talking about imported goods). Let me use the example of a luxury car which people are buying even after paying 600% tax. Apart from the duty the actual import cost is paid in dollars. Thing is the importing consumer did not earn the foreign currency. “It is our migrant workers working and toiling away in far away countries away from their families (and presently risking their lives) who earned it”. You might say that we do earn foreign currency through exports but please remember that we have a trade deficit. Along with export earnings we do have associated import costs of raw materials and capital machinery. So, imported goods are bought using the migrant workers toils. Now tell me whether we give these guys their due respect for working so hard and being one of the major growth factors of our country. We don’t. Instead they are harassed, cheated and deprived.
Its now time to ask ourselves the very basic question “whose money are we spending?”. Relying on our government to reduce inequality is going to be futile. We ourselves have to find out ways to help solve this problem. I do not have a solution right now but I am going to try to find ways. Inequality harms the long term growth prospect of countries. This has been realized by the second largest (and fastest growing) economy in the world. China has already decided that they will lower growth expectations for 2011-2015 to 7% from their current double digit growth rates and instead focus on equality. Instead of focusing on exports they want to go for internal demand lead growth, which is only going to be possible by reducing the rich poor gap. Given the current state of the global economies where we are seeing shocks after shocks, as well as inevitable fiscal austerity programs (Europe started it already while US will go for it from 2013) this is probably the right way Bangladesh should move towards.
Please share article if you have liked it.
Wednesday, March 2, 2011
Real heroes of Bangladesh: Part 1
Disclosure: This article is not meant to show how great a person I am. I am a human being full of flaws and mistakes and this is my way to pay back some people who deserve praise. Please ignore the grammatical mistakes since I do not feel like rechecking.
Foreword
This is not going to be a really organized post. I just felt like writing something about deprived people and did not feel like collecting any data to back up the claims I am going to make. Most of the claims will be based on logic.
Before I go into the topic I want to talk a bit about myself. I am a member of the privileged class. I studied in an English Medium school and a private university because my parents could afford it (they did have difficulty and I am grateful for the education I got). But frankly speaking, if I had not received this education and had been born in a poorer family I might have ended up in the streets. It is required that people like me acknowledge that we are lucky and that we have a responsibility towards specific groups of people.
The farmers of Bangladesh
The people I want to talk about first (next parts will hopefully focus on other groups including remittance earners and workers with minimum wages) are the farmers of Bangladesh. Bangladesh is about 90% (this is just a guess) self sufficient in rice production. This is definitely a big achievement considering the land area and the total population of the country. Food is a necessity and the simple fact that we are almost self sufficient in food production has saved the country from huge macroeconomic shocks. One interesting thing about economics is somehow everything is linked. Just because of food self sufficiency I can think (If I had time I could possibly expand this list) of the following factors
1.Lower inflation: This can be proven very easily. Firstly inflation rates in Bangladesh are still single digit whereas in neighboring India and Pakistan it is much higher. Another method would to compare PPP prices of rice amongst these countries.
2.Fx reserves: We are not having to import too much rice and hence we are not losing Fx reserves. That foreign currency is being used to import raw materials, capital machinery and luxury goods.
3.Food security: The world is currently going through a tough phase. A country dependent on others for imports can easily face a situation where no one wants to export food. We have been able to avoid that problem largely.
How they are losing out (the common factors)
The problem with farmers is that when production suffers due to weather problems (or any other factor) they make losses as they cannot recover their investments. However, the same problem is again seen when they have bumper harvests. In such times also product prices fall below their costs. So either way they lose. Together with this consider the margin that is stolen by the middle men. All this is common knowledge and all of us know it. The farmers themselves know it but since they were not born in the privileged society they have to live with these problems.
What did we miss?
There are however some other factors that we did miss. Central banks usually keep target inflation rates of around 4-7%. However, inflation rates frequently cross these targets. In such periods there are people who cannot pass on the increased cost of living by increasing product prices. While I do not have backing data on this, I am quite sure that farmers lose out in inflationary scenarios. The only way they can survive is by consuming less. I read numerous news of farmers in India committing suicide because they could not bear any more losses. The funny this is that because of the monetary system that central banks run, money supply will continuously increase and inflation will continue to happen.
In this same line of thought let me talk a bit about “inflation tax”. Like most countries in the world Bangladesh has been running budget deficits. Some of the deficit was there because the government had to improve the infrastructure, provide security, healthcare and education etc. However deficits are also increased by corruption and inefficiencies. Deficits are increased by state owned institutions that run at losses (due to greedy people). Deficits are increased by government’s bailing out of the stock market and failed institutions. How do the governments finance these deficits? The easy answer (and a widely practiced method) is just simply money printing. The result is higher inflation which has the same impact as a tax because both reduce purchase power. For the greed of a few corrupt people the whole country has to suffer loss in purchasing power. And the worst victims are those whose income does not increase with inflation (real incomes decline) and farmers are amongst this category.
Conclusion
I have never worked as a farmer and thus cannot describe how hard it really is. However one of my colleague had tried working in the fields once. According to him it is three times more difficult than pulling a rickshaw. I probably did not do justice to the farmers of Bangladesh and may have missed out the most important points.
Right now people give more value to things like BMW’s and Mazda’s compared to food, but that is going to change sometime or the other. We have already seen food crisis in 2008 and once again in 2011. In fact the protests that have shaken Middle East are somewhat related to food prices as well. There are no guarantees that international weather conditions would improve anytime soon and we might see a situation where food could easily become the most expensive item in the world. If all that is true maybe we should try to ensure that our farmers live a better life and are not deprived because of our actions and misdeeds.
Please share article if you have liked it.
Foreword
This is not going to be a really organized post. I just felt like writing something about deprived people and did not feel like collecting any data to back up the claims I am going to make. Most of the claims will be based on logic.
Before I go into the topic I want to talk a bit about myself. I am a member of the privileged class. I studied in an English Medium school and a private university because my parents could afford it (they did have difficulty and I am grateful for the education I got). But frankly speaking, if I had not received this education and had been born in a poorer family I might have ended up in the streets. It is required that people like me acknowledge that we are lucky and that we have a responsibility towards specific groups of people.
The farmers of Bangladesh
The people I want to talk about first (next parts will hopefully focus on other groups including remittance earners and workers with minimum wages) are the farmers of Bangladesh. Bangladesh is about 90% (this is just a guess) self sufficient in rice production. This is definitely a big achievement considering the land area and the total population of the country. Food is a necessity and the simple fact that we are almost self sufficient in food production has saved the country from huge macroeconomic shocks. One interesting thing about economics is somehow everything is linked. Just because of food self sufficiency I can think (If I had time I could possibly expand this list) of the following factors
1.Lower inflation: This can be proven very easily. Firstly inflation rates in Bangladesh are still single digit whereas in neighboring India and Pakistan it is much higher. Another method would to compare PPP prices of rice amongst these countries.
2.Fx reserves: We are not having to import too much rice and hence we are not losing Fx reserves. That foreign currency is being used to import raw materials, capital machinery and luxury goods.
3.Food security: The world is currently going through a tough phase. A country dependent on others for imports can easily face a situation where no one wants to export food. We have been able to avoid that problem largely.
How they are losing out (the common factors)
The problem with farmers is that when production suffers due to weather problems (or any other factor) they make losses as they cannot recover their investments. However, the same problem is again seen when they have bumper harvests. In such times also product prices fall below their costs. So either way they lose. Together with this consider the margin that is stolen by the middle men. All this is common knowledge and all of us know it. The farmers themselves know it but since they were not born in the privileged society they have to live with these problems.
What did we miss?
There are however some other factors that we did miss. Central banks usually keep target inflation rates of around 4-7%. However, inflation rates frequently cross these targets. In such periods there are people who cannot pass on the increased cost of living by increasing product prices. While I do not have backing data on this, I am quite sure that farmers lose out in inflationary scenarios. The only way they can survive is by consuming less. I read numerous news of farmers in India committing suicide because they could not bear any more losses. The funny this is that because of the monetary system that central banks run, money supply will continuously increase and inflation will continue to happen.
In this same line of thought let me talk a bit about “inflation tax”. Like most countries in the world Bangladesh has been running budget deficits. Some of the deficit was there because the government had to improve the infrastructure, provide security, healthcare and education etc. However deficits are also increased by corruption and inefficiencies. Deficits are increased by state owned institutions that run at losses (due to greedy people). Deficits are increased by government’s bailing out of the stock market and failed institutions. How do the governments finance these deficits? The easy answer (and a widely practiced method) is just simply money printing. The result is higher inflation which has the same impact as a tax because both reduce purchase power. For the greed of a few corrupt people the whole country has to suffer loss in purchasing power. And the worst victims are those whose income does not increase with inflation (real incomes decline) and farmers are amongst this category.
Conclusion
I have never worked as a farmer and thus cannot describe how hard it really is. However one of my colleague had tried working in the fields once. According to him it is three times more difficult than pulling a rickshaw. I probably did not do justice to the farmers of Bangladesh and may have missed out the most important points.
Right now people give more value to things like BMW’s and Mazda’s compared to food, but that is going to change sometime or the other. We have already seen food crisis in 2008 and once again in 2011. In fact the protests that have shaken Middle East are somewhat related to food prices as well. There are no guarantees that international weather conditions would improve anytime soon and we might see a situation where food could easily become the most expensive item in the world. If all that is true maybe we should try to ensure that our farmers live a better life and are not deprived because of our actions and misdeeds.
Please share article if you have liked it.
Monday, February 21, 2011
Sustainable versus unsustainable growth: An analyst’s view towards the state of the banking sector
Disclosure: The article was written on Sunday, February 20, 2011 at 8:48pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
Background
The first time I studied economics in school I learned that there is an opportunity cost for everything in this world. This extends even to highly desired things like “growth”. The examples of unsustainable growth are probably all around us. The prime example is probably the USA. In an attempt to boost the economy it had (and still is) been on a path of continuous monetary expansion, first by lowering interest rates and then by what they call “quantitative easing”. However, right now, I would like to focus on the banking sector in Bangladesh. Please note that by banking sector I am limiting myself to the private commercial banks.
The banking sector in Bangladesh is considered to be a real success story by many people, particularly stock market investors. The 3 year (2008-10) CAGR profit growth for the private commercial banks as a sector was 88%. This is a ridiculously high number specially because we are talking about a sector and not a specific bank (if this was a distressed bank coming out of recovery this might have been realistic). The real question that remains is whether this growth is sustainable and whether we can expect adverse consequences for such growth in earnings and assets/deposits.
The growth in assets and deposits
A big driver of banking sector profits is loan growth. The real problem is that when a bank tries to grow too fast there is a risk of asset quality deterioration which creates more damage than benefits. As per BB data, YoY loan growth for November 2010 was around 28% while deposit growth was 23%. Just like 88% profit growth is abnormal so is 28% loan growth for the sector.
Was there a real reason for such loan growth?
I can off course argue that Bangladesh is a developing country with huge growth potential and there is a justification for large loan growth. However even If we use a top down approach we can see that nominal GDP growth has been around 13-14% and there is a clear mismatch with loan growth numbers (given that Loan to deposit ratios were not very low in the first place). We can also do some sort of bottom up analysis to identify where the loan growth actually happened by breaking up the loan portfolio into corporate, SME and retail. Since data is not available in this format I need to rely on anecdotal evidence to draw conclusions.
Before proceeding further, let us remind ourselves that in the last 9 years we have probably added around 1,100 MW of electricity. However net addition is lower than that because some old plants went out of operation. If this is the case, then there is no reason to expect huge demand for loans. In reality also, if we look at the early part of 2010, demand for loans were low and the banking sector had a huge amount of excess liquidity. Somehow, suddenly everything changed and by the end of 2010 the huge excess liquidity situation reversed to that of severe liquidity shortage.
Let us now go back to the potential loan growth sources. SME is a relatively new product in Bangladesh and because of that some banks have already seen asset quality problems by trying to grow too fast in this area. I would guess that the gross NPL ratio for SME lending is no less than 12%. So while it might be the case that most of the growth happened in SME there is a risk of asset quality deterioration. On corporate side I have already mentioned that chances of ‘true’ loan demand is low because we still have huge shortage of electricity. This leaves us with only retail loans.
Condition of the reported stock market exposure
Forgetting the diverted loans (which I will discuss later) we can take a look at the declared stock market exposure of the banks. A substantial portion of the banking sectors excess liquidity went to the capital market in the form of both proprietary investments as well as margin lending. In 2010 the capital market showed a tremendous performance with the index growing close to 100% which boosted the banking sector earnings.
Now let me bring your attention to something called financial leverage. I calculated the equity/assets ratio of 22 private commercial banks (using 3Q2010 numbers). The number comes to 8.28%!!!! This means that for every 100 taka of assets the bank has only 8.28 taka as equity while 91.72 taka is in the form of liabilities. Leverage magnifies both positive and negative events and since the equity investments grew significantly profits were magnified.
Now comes the interesting part. As per Bangladesh Bank rule, the maximum stock market exposure that banks can have is limited to 10% of liabilities. If we are to believe media reports then a number of banks exceeded this limit. However, even if I assume that the exposure was 5% of liabilities then we find that stock market exposure is 55% of equity. For a number of banks, the capital market exposure is greater than the equity base. Given that in 2011 the market has fallen by around 30+% it is clear that a significant portion of the equity can get wiped out just because of the proprietary portfolio performance. There is also a circularity issue since there is cross holding of stocks within the financial sector’s portfolio investments. If the first quarter earnings are unsatisfactory (which is the base case scenario at the moment) to investors then we would see a further wave of price fall in the stock market.
That is not the end of the story because the margin loans are also under risk as “trigger sales” have virtually been banned by the regulators.
Story of diverted loans
This is not a new story as the newspapers have highlighted this issue already. Just for the unaware readers, let me recap a bit. A good amount of loans disbursed in the form of corporate, SME and retail actually found its way into the capital market. There is no number on the extent of this but as per my discussion with bankers I am inclined to believe that this is quite a substantial amount.
What is even more fascinating is how people used credit cards to invest in the stock market. As no interest has to be paid on credit card loans for 40 days (probably varies a bit), credit card holders used cheques issued against cards to invest in the stock market. In 2010 there has been a massive increase in the number of credit card issuances. As per a banker I talked with, around 80% of the credit cards issued in 2010 were for this purpose and very soon we are going to see credit card defaults going up.
Asset quality and provisioning
Given that my hypothesis is true, we are likely to see a dramatic decline in the banking sector asset quality. Since the majority of the stock market crash happened in 2011 the non-performing loans (NPL) numbers reported for 2010 will probably not reflect the true situation. As a result the provisioning that was required would also fall short of the required amount. I also have my reasons to believe that banks have a tendency to under report NPL numbers.
It might be a good idea to check interest earnings on accounting basis and cash flow basis to see whether there are any significant deviations. That can be done once annual numbers are out.
Capital Adequacy and BASEL II
I have already mentioned that the leverage is huge and provisioning has been inadequate so far. The final thing to check is whether banks have enough cushions to withstand a shock. The decision to implement the BASEL II guidelines was taken quite some time ago and the initial deadline was 2009. This deadline was off course broken. As a result the Bangladesh Bank gave additional time to the banks to adapt to the BASEL II requirements. One of the major requirements was to have a Capital adequacy ratio of 10% (calculated as Capital/Risk Weighted Assets).
As per Bangladesh Bank data (as quoted by newspapers) the CAR for the private commercial banks at the end of June 2010 stood at 8.69% which not only falls much below international standards but also below BASEL II requirement. Now given that assets have continued to grow and that equity investments have not done very well it is much more likely that current CAR figures are even lower.
I believe that Bangladesh Bank has done some stress tests on the banking sector. Therefore they are well aware of what the outcome will be in the case of different scenarios. It would be interesting to know what the results of those tests were.
Conclusion
In conclusion we can list down the 4 major reasons which caused the profit figures to grow so much
1.High loan growth, a significant portion of which got diverted
2.Large exposure to the stock market through proprietary investments
3.Huge leverage that magnified the return from the stock market
4.Under reporting of non-performing loans and hence lower provisioning so far
It is quite clear that this situation is not sustainable in any way. In fact, the wind is now blowing in the opposite direction. Given the tight monetary situation, stock market crash and high leverage the outlook indeed looks gloomy. Whatever “accounting earnings” the banks earned in the last year are probably going to vanish due to the asset quality problems. Asset quality is something that can be kept hidden on a temporary basis but sooner or later it comes out of the box. Usually that is time when the economy can least afford a banking sector problem.
Unfortunately, I cannot quantify the magnitude of the problem due to inadequate data. Even if the problems evolve in the manner I am expecting this is a problem that could be contained by prudent guidance by the central bank and proper decision by the commercial banks as well. I have seen banks come of out much worse situations (e.g. Kazakhstan where banks used wholesale funding from other countries to increase loans and loan-to-deposit ratios went up to 200%).
Given the present situation I can recommend a number of things that the banks ought to do
1.The most important thing is to understand the magnitude of the problem. An external analyst like me does not have access to enough data to make specific conclusions. However bank managements can pinpoint their problem and identify a plan to get out of it.
2.Secondly, they need to stop thinking about growth for the next 12-18 months. Loan disbursements must be very strict. If necessary banks can even think about lowering their balance sheet sizes which has happened many countries of the world.
3.Instead of growth, the focus must be put towards asset quality. The immediate priority should be the recovery of the diverted loans because they are the riskiest. The next target should be lowering the size of the proprietary portfolios. Interest rates on margin loans should be allowed to increase because it is actually a risky product contrary to what people think.
4.Capital adequacy must be improved. A CAR of 8% is really not acceptable when most banks around the world have CAR ranging from 15%-18%.
5.Often times when stock markets crash investors have a tendency of ‘averaging’. This must be avoided by banks at any cost because they really cannot afford to increase their capital market exposure.
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Background
The first time I studied economics in school I learned that there is an opportunity cost for everything in this world. This extends even to highly desired things like “growth”. The examples of unsustainable growth are probably all around us. The prime example is probably the USA. In an attempt to boost the economy it had (and still is) been on a path of continuous monetary expansion, first by lowering interest rates and then by what they call “quantitative easing”. However, right now, I would like to focus on the banking sector in Bangladesh. Please note that by banking sector I am limiting myself to the private commercial banks.
The banking sector in Bangladesh is considered to be a real success story by many people, particularly stock market investors. The 3 year (2008-10) CAGR profit growth for the private commercial banks as a sector was 88%. This is a ridiculously high number specially because we are talking about a sector and not a specific bank (if this was a distressed bank coming out of recovery this might have been realistic). The real question that remains is whether this growth is sustainable and whether we can expect adverse consequences for such growth in earnings and assets/deposits.
The growth in assets and deposits
A big driver of banking sector profits is loan growth. The real problem is that when a bank tries to grow too fast there is a risk of asset quality deterioration which creates more damage than benefits. As per BB data, YoY loan growth for November 2010 was around 28% while deposit growth was 23%. Just like 88% profit growth is abnormal so is 28% loan growth for the sector.
Was there a real reason for such loan growth?
I can off course argue that Bangladesh is a developing country with huge growth potential and there is a justification for large loan growth. However even If we use a top down approach we can see that nominal GDP growth has been around 13-14% and there is a clear mismatch with loan growth numbers (given that Loan to deposit ratios were not very low in the first place). We can also do some sort of bottom up analysis to identify where the loan growth actually happened by breaking up the loan portfolio into corporate, SME and retail. Since data is not available in this format I need to rely on anecdotal evidence to draw conclusions.
Before proceeding further, let us remind ourselves that in the last 9 years we have probably added around 1,100 MW of electricity. However net addition is lower than that because some old plants went out of operation. If this is the case, then there is no reason to expect huge demand for loans. In reality also, if we look at the early part of 2010, demand for loans were low and the banking sector had a huge amount of excess liquidity. Somehow, suddenly everything changed and by the end of 2010 the huge excess liquidity situation reversed to that of severe liquidity shortage.
Let us now go back to the potential loan growth sources. SME is a relatively new product in Bangladesh and because of that some banks have already seen asset quality problems by trying to grow too fast in this area. I would guess that the gross NPL ratio for SME lending is no less than 12%. So while it might be the case that most of the growth happened in SME there is a risk of asset quality deterioration. On corporate side I have already mentioned that chances of ‘true’ loan demand is low because we still have huge shortage of electricity. This leaves us with only retail loans.
Condition of the reported stock market exposure
Forgetting the diverted loans (which I will discuss later) we can take a look at the declared stock market exposure of the banks. A substantial portion of the banking sectors excess liquidity went to the capital market in the form of both proprietary investments as well as margin lending. In 2010 the capital market showed a tremendous performance with the index growing close to 100% which boosted the banking sector earnings.
Now let me bring your attention to something called financial leverage. I calculated the equity/assets ratio of 22 private commercial banks (using 3Q2010 numbers). The number comes to 8.28%!!!! This means that for every 100 taka of assets the bank has only 8.28 taka as equity while 91.72 taka is in the form of liabilities. Leverage magnifies both positive and negative events and since the equity investments grew significantly profits were magnified.
Now comes the interesting part. As per Bangladesh Bank rule, the maximum stock market exposure that banks can have is limited to 10% of liabilities. If we are to believe media reports then a number of banks exceeded this limit. However, even if I assume that the exposure was 5% of liabilities then we find that stock market exposure is 55% of equity. For a number of banks, the capital market exposure is greater than the equity base. Given that in 2011 the market has fallen by around 30+% it is clear that a significant portion of the equity can get wiped out just because of the proprietary portfolio performance. There is also a circularity issue since there is cross holding of stocks within the financial sector’s portfolio investments. If the first quarter earnings are unsatisfactory (which is the base case scenario at the moment) to investors then we would see a further wave of price fall in the stock market.
That is not the end of the story because the margin loans are also under risk as “trigger sales” have virtually been banned by the regulators.
Story of diverted loans
This is not a new story as the newspapers have highlighted this issue already. Just for the unaware readers, let me recap a bit. A good amount of loans disbursed in the form of corporate, SME and retail actually found its way into the capital market. There is no number on the extent of this but as per my discussion with bankers I am inclined to believe that this is quite a substantial amount.
What is even more fascinating is how people used credit cards to invest in the stock market. As no interest has to be paid on credit card loans for 40 days (probably varies a bit), credit card holders used cheques issued against cards to invest in the stock market. In 2010 there has been a massive increase in the number of credit card issuances. As per a banker I talked with, around 80% of the credit cards issued in 2010 were for this purpose and very soon we are going to see credit card defaults going up.
Asset quality and provisioning
Given that my hypothesis is true, we are likely to see a dramatic decline in the banking sector asset quality. Since the majority of the stock market crash happened in 2011 the non-performing loans (NPL) numbers reported for 2010 will probably not reflect the true situation. As a result the provisioning that was required would also fall short of the required amount. I also have my reasons to believe that banks have a tendency to under report NPL numbers.
It might be a good idea to check interest earnings on accounting basis and cash flow basis to see whether there are any significant deviations. That can be done once annual numbers are out.
Capital Adequacy and BASEL II
I have already mentioned that the leverage is huge and provisioning has been inadequate so far. The final thing to check is whether banks have enough cushions to withstand a shock. The decision to implement the BASEL II guidelines was taken quite some time ago and the initial deadline was 2009. This deadline was off course broken. As a result the Bangladesh Bank gave additional time to the banks to adapt to the BASEL II requirements. One of the major requirements was to have a Capital adequacy ratio of 10% (calculated as Capital/Risk Weighted Assets).
As per Bangladesh Bank data (as quoted by newspapers) the CAR for the private commercial banks at the end of June 2010 stood at 8.69% which not only falls much below international standards but also below BASEL II requirement. Now given that assets have continued to grow and that equity investments have not done very well it is much more likely that current CAR figures are even lower.
I believe that Bangladesh Bank has done some stress tests on the banking sector. Therefore they are well aware of what the outcome will be in the case of different scenarios. It would be interesting to know what the results of those tests were.
Conclusion
In conclusion we can list down the 4 major reasons which caused the profit figures to grow so much
1.High loan growth, a significant portion of which got diverted
2.Large exposure to the stock market through proprietary investments
3.Huge leverage that magnified the return from the stock market
4.Under reporting of non-performing loans and hence lower provisioning so far
It is quite clear that this situation is not sustainable in any way. In fact, the wind is now blowing in the opposite direction. Given the tight monetary situation, stock market crash and high leverage the outlook indeed looks gloomy. Whatever “accounting earnings” the banks earned in the last year are probably going to vanish due to the asset quality problems. Asset quality is something that can be kept hidden on a temporary basis but sooner or later it comes out of the box. Usually that is time when the economy can least afford a banking sector problem.
Unfortunately, I cannot quantify the magnitude of the problem due to inadequate data. Even if the problems evolve in the manner I am expecting this is a problem that could be contained by prudent guidance by the central bank and proper decision by the commercial banks as well. I have seen banks come of out much worse situations (e.g. Kazakhstan where banks used wholesale funding from other countries to increase loans and loan-to-deposit ratios went up to 200%).
Given the present situation I can recommend a number of things that the banks ought to do
1.The most important thing is to understand the magnitude of the problem. An external analyst like me does not have access to enough data to make specific conclusions. However bank managements can pinpoint their problem and identify a plan to get out of it.
2.Secondly, they need to stop thinking about growth for the next 12-18 months. Loan disbursements must be very strict. If necessary banks can even think about lowering their balance sheet sizes which has happened many countries of the world.
3.Instead of growth, the focus must be put towards asset quality. The immediate priority should be the recovery of the diverted loans because they are the riskiest. The next target should be lowering the size of the proprietary portfolios. Interest rates on margin loans should be allowed to increase because it is actually a risky product contrary to what people think.
4.Capital adequacy must be improved. A CAR of 8% is really not acceptable when most banks around the world have CAR ranging from 15%-18%.
5.Often times when stock markets crash investors have a tendency of ‘averaging’. This must be avoided by banks at any cost because they really cannot afford to increase their capital market exposure.
Please share article if you have liked it.
IPO Valuation: A deeper look at relative valuation
Disclosure: The article was written on Sunday, February 13, 2011 at 9:18pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
Background
In some countries of the world, issue managers are not allowed to make financial forecasts because by doing so they risk the chance of getting sued (if the real numbers do not match with the forecasts). One of the country that practices this is USA (here are links to two relevant studies on this matter 1. http://findarticles.com/p/articles/mi_m4130/is_3_36/ai_n24222147/ 2. http://ideas.repec.org/a/kap/rqfnac/v26y2006i3p275-299.html ). If I am not mistaken, recently the SEC in Bangladesh has also removed the provision to use forecasts in any prospectus/IM. This means that no type of DCF or Income based approaches can be used for valuation purpose. The only other valuation method possible is thus “relative valuation”.
Trying to use relative valuation methods in frontier markets like Bangladesh lead to some unique challenges. I would like to discuss some of these challenges and maybe try to give some solutions to these that the SEC can take into consideration. The reason I am mentioning SEC is because in our market investor knowledge is limited and other than very few practitioners of valuation most people will be unable to understand what is going on. Currently for the people in the Investment Banking industry there is greater incentive to distort valuation methods (and hence get more deals) to show higher prices for IPO’s.
Challenges and problem
1. Lack of proper comparables: The first step in relative valuation is choosing proper comparable companies. The idea is that similar company should have similar margins and growth prospects and should thus trade at similar multiples. This is a big problem in Bangladesh because the number of stocks in the capital market is small and many companies do not have any comparables at all. Especially for companies with unique project based business model like shipbuilding (Two shipyards are it does not make any sense to compare multiples with companies that have smoother earnings.
2. Presence on non-recurring items in the income statement: This is not really a challenge but rather something that issue managers are doing on purpose to intentionally jack up values. I have observed companies even forecasting capital gains from stock market (present in the historical also) where the company is actually engaged in hotel and entertainment services. Non-recurring items in the income statement would distort earnings multiples. The problem is going to be greater if the comparable companies do not have non-recurring items (leading to higher multiples) while the issuing company has such items (leading to higher issue prices).
3. Book value enhanced by revaluation surpluses: When we observe that new companies have more than 30-40% of their equity in the form of revaluation surpluses the company automatically becomes a suspect. This would be less of a problem if all the companies (included the comparables) revalued assets in the same time frame. However this is not the case and we see that most multinational companies revalue assets after considerable time periods. So naturally these companies will trade at higher P/B’s (and have really high ROE numbers) and using these high P/B ratios will lead to inflation IPO prices for the company that has revaluation surpluses.
4. Earnings cycle and stock market cycle not taken into consideration: This is a major problem of relative valuation in general. A company at the peak of its earnings cycle/business cycle tends to trade at not only its peak earnings multiple but also has its higher earnings. Similarly at the peak of stock market cycle because of the beta effect all stocks tend to trade at high multiples (thus many of these companies are overvalued). So automatically the company is priced very highly and in many instances much above the fair value when the market is doing good and vice versa. This causes a substantial deviation from fair value.
5. Multiples not linked with operating metrics: At the end of the day we buy companies by comparing stock prices with core operating performances. If price multiples like P/E, P/B, EV/EBITDA are being used, they need to be compared alongside operating metrics like sustainable earnings growth (for P/E), core ROE (for P/B) etc. Naturally if Bank A can achieve higher ROE compared to Bank B then we should be ready to pay more for it. Unfortunately, I do not see multiples being justified by profitability and growth prospects.
6. IPO price and opening day stock price seeing considerable deviations: This point is not exactly relevant to relative valuation but I wanted to discuss it because of its importance. As a practitioner of valuation our aim should be to find asset values that are fair to both buyers and sellers. Historically under fixed price methods IPO’s have been significantly underpriced. In recent times with the introduction of direct listing and book building methods we saw the extreme opposite happening. Examples of such direct listings include Jamuna Oil which caused substantial losses to investors. Similar things can be said about KPCL which came through the process of book building. I think a number of things were primary responsible for such gross distortion. Firstly, years of IPO underpricing made investors believe that all IPO’s are profitable. Secondly, investors have a habit of comparing Face Value with issue price which is an absolutely ridiculous idea. Most importantly, there is substantial evidence to conclude that price and volume manipulations are rampantly practiced in Bangladesh. The easiest way to do that is giving out private placements to influential investors who in return keep prices high until the time it takes for retail investors to be convinced that the stock prices will remain high. Unfortunately for the retailers the prices never remains at that level.
Solutions
Now let us look at potential solutions.
1 & 5. I am linking these two together because the solution is similar. Firstly, if we cannot find proper comparables in the domestic market we need to find comparables in other frontier markets (preferable in the same region as Bangladesh). However, it does not end there because despite being in the same industry companies can have different profitability and growth potential due to macroeconomic differences. So, the issue manager can ask for higher than regional multiples if he can justify higher growth and profitability for the company to be listed. Another thing I want to emphasize is the choice of proper multiples. For project based companies like real estate and ship building earnings multiple does not make much sense. Rather a NAV based valuation would be better. For financial companies P/B is the correct choice. For other manufacturing companies P/E, EV/EBITDA, and industry specific (EV/reserves for E&Ps and EV/tonne for cement for example) multiples are appropriate.
2. This is very simple. For all companies, non-recurring items from the income statement has to be removed and multiples should be calculated only on core earnings.
3. Revaluation surplus could be removed from all companies while calculating multiples. The other option is to compare P/B with ROE (Calculated using averaged equity). This way companies with higher revaluation surpluses will automatically be showing lower ROE. In case companies show surpluses they need to provide precise information on how much land bank they have and what is the average price per acre (or any other metric) they have assumed. This will allow investors to see whether the numbers make sense.
4. This is a problem that is very hard to solve. At the peak of the stock market cycle IPO's will always be expensive and at the bottom they will be cheap. The only solution I can suggest is that Issue managers give 3-5 year average P/E, P/B etc of comparables that can be expected to cover a significant part of the business cycle.
6. I think that private placement should actually be banned in a country like Bangladesh where are issues are oversubscribed. In case it is not banned, the lock-in periods have to be increased. Furthermore, the regulators must monitor the trade patterns of private placement holders (the large ones) to identify price and volume manipulation.
Please share article if you have liked it.
Background
In some countries of the world, issue managers are not allowed to make financial forecasts because by doing so they risk the chance of getting sued (if the real numbers do not match with the forecasts). One of the country that practices this is USA (here are links to two relevant studies on this matter 1. http://findarticles.com/p/articles/mi_m4130/is_3_36/ai_n24222147/ 2. http://ideas.repec.org/a/kap/rqfnac/v26y2006i3p275-299.html ). If I am not mistaken, recently the SEC in Bangladesh has also removed the provision to use forecasts in any prospectus/IM. This means that no type of DCF or Income based approaches can be used for valuation purpose. The only other valuation method possible is thus “relative valuation”.
Trying to use relative valuation methods in frontier markets like Bangladesh lead to some unique challenges. I would like to discuss some of these challenges and maybe try to give some solutions to these that the SEC can take into consideration. The reason I am mentioning SEC is because in our market investor knowledge is limited and other than very few practitioners of valuation most people will be unable to understand what is going on. Currently for the people in the Investment Banking industry there is greater incentive to distort valuation methods (and hence get more deals) to show higher prices for IPO’s.
Challenges and problem
1. Lack of proper comparables: The first step in relative valuation is choosing proper comparable companies. The idea is that similar company should have similar margins and growth prospects and should thus trade at similar multiples. This is a big problem in Bangladesh because the number of stocks in the capital market is small and many companies do not have any comparables at all. Especially for companies with unique project based business model like shipbuilding (Two shipyards are it does not make any sense to compare multiples with companies that have smoother earnings.
2. Presence on non-recurring items in the income statement: This is not really a challenge but rather something that issue managers are doing on purpose to intentionally jack up values. I have observed companies even forecasting capital gains from stock market (present in the historical also) where the company is actually engaged in hotel and entertainment services. Non-recurring items in the income statement would distort earnings multiples. The problem is going to be greater if the comparable companies do not have non-recurring items (leading to higher multiples) while the issuing company has such items (leading to higher issue prices).
3. Book value enhanced by revaluation surpluses: When we observe that new companies have more than 30-40% of their equity in the form of revaluation surpluses the company automatically becomes a suspect. This would be less of a problem if all the companies (included the comparables) revalued assets in the same time frame. However this is not the case and we see that most multinational companies revalue assets after considerable time periods. So naturally these companies will trade at higher P/B’s (and have really high ROE numbers) and using these high P/B ratios will lead to inflation IPO prices for the company that has revaluation surpluses.
4. Earnings cycle and stock market cycle not taken into consideration: This is a major problem of relative valuation in general. A company at the peak of its earnings cycle/business cycle tends to trade at not only its peak earnings multiple but also has its higher earnings. Similarly at the peak of stock market cycle because of the beta effect all stocks tend to trade at high multiples (thus many of these companies are overvalued). So automatically the company is priced very highly and in many instances much above the fair value when the market is doing good and vice versa. This causes a substantial deviation from fair value.
5. Multiples not linked with operating metrics: At the end of the day we buy companies by comparing stock prices with core operating performances. If price multiples like P/E, P/B, EV/EBITDA are being used, they need to be compared alongside operating metrics like sustainable earnings growth (for P/E), core ROE (for P/B) etc. Naturally if Bank A can achieve higher ROE compared to Bank B then we should be ready to pay more for it. Unfortunately, I do not see multiples being justified by profitability and growth prospects.
6. IPO price and opening day stock price seeing considerable deviations: This point is not exactly relevant to relative valuation but I wanted to discuss it because of its importance. As a practitioner of valuation our aim should be to find asset values that are fair to both buyers and sellers. Historically under fixed price methods IPO’s have been significantly underpriced. In recent times with the introduction of direct listing and book building methods we saw the extreme opposite happening. Examples of such direct listings include Jamuna Oil which caused substantial losses to investors. Similar things can be said about KPCL which came through the process of book building. I think a number of things were primary responsible for such gross distortion. Firstly, years of IPO underpricing made investors believe that all IPO’s are profitable. Secondly, investors have a habit of comparing Face Value with issue price which is an absolutely ridiculous idea. Most importantly, there is substantial evidence to conclude that price and volume manipulations are rampantly practiced in Bangladesh. The easiest way to do that is giving out private placements to influential investors who in return keep prices high until the time it takes for retail investors to be convinced that the stock prices will remain high. Unfortunately for the retailers the prices never remains at that level.
Solutions
Now let us look at potential solutions.
1 & 5. I am linking these two together because the solution is similar. Firstly, if we cannot find proper comparables in the domestic market we need to find comparables in other frontier markets (preferable in the same region as Bangladesh). However, it does not end there because despite being in the same industry companies can have different profitability and growth potential due to macroeconomic differences. So, the issue manager can ask for higher than regional multiples if he can justify higher growth and profitability for the company to be listed. Another thing I want to emphasize is the choice of proper multiples. For project based companies like real estate and ship building earnings multiple does not make much sense. Rather a NAV based valuation would be better. For financial companies P/B is the correct choice. For other manufacturing companies P/E, EV/EBITDA, and industry specific (EV/reserves for E&Ps and EV/tonne for cement for example) multiples are appropriate.
2. This is very simple. For all companies, non-recurring items from the income statement has to be removed and multiples should be calculated only on core earnings.
3. Revaluation surplus could be removed from all companies while calculating multiples. The other option is to compare P/B with ROE (Calculated using averaged equity). This way companies with higher revaluation surpluses will automatically be showing lower ROE. In case companies show surpluses they need to provide precise information on how much land bank they have and what is the average price per acre (or any other metric) they have assumed. This will allow investors to see whether the numbers make sense.
4. This is a problem that is very hard to solve. At the peak of the stock market cycle IPO's will always be expensive and at the bottom they will be cheap. The only solution I can suggest is that Issue managers give 3-5 year average P/E, P/B etc of comparables that can be expected to cover a significant part of the business cycle.
6. I think that private placement should actually be banned in a country like Bangladesh where are issues are oversubscribed. In case it is not banned, the lock-in periods have to be increased. Furthermore, the regulators must monitor the trade patterns of private placement holders (the large ones) to identify price and volume manipulation.
Please share article if you have liked it.
Where did all the money go?
Disclosure: The article was written on Thursday, January 13, 2011 at 10:47pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
Recently the drastic fall in the stock index made headlines and became a much talked about issue. A large amount of blame was put on the stock market regulator and the government. However, the biggest blame was on the Bangladesh Bank which decided to increase the Cash Reserve Ratio from 5.5% to 6%. According to financial market “experts”, the increase in CRR caused a liquidity crisis in the money market which ultimately led to the stock market sale pressure (which off course led to panic sale).
Without going into all these arguments about who is to blame I would rather focus on the money market situation. As per newspaper reports, because of the hike in CRR the central bank took out BDT 2,000 crore from the system. A similar amount was brought out through issue of government securities. However, the Bangladesh Bank claimed that they had injected more than 20,000 crore to the system through repo financing. So in simple math (20,000-2,000-2,000=16,000).
If 16,000 crore (net) has been added to the system then definitely the fund crisis that banks and other financial institutions were in should have been resolved. The funny thing is that the crisis is not over. Even though the call money rates have come down, most financial institutions are still in a fund crisis. This is EXACTLY why stock brokerages and merchant banks are unable to give margin loans to their clients. If banks dont have money, then brokers and merchant banks also do not have money. If the brokers and merchant banks actually had money they would have definitely given out loans because that is how they make profit. Unfortunately neither the media understands this nor does the retail investors. While one segment is busy breaking offices the other is adding fuel to the fire by making illogical media reports. At the same time the SEC increased the margin loan ratio from 1:1.5 to 1:2 in a period when most brokers can’t even provide 1:0.6. What I don’t further understand is, in such a volatile (and off course highly overvalued market) why the hell would someone need additional margin loan? I guess the general investors know more about stocks than me, so I will leave it to that.
Now there has to be a reason why the liquidity crunch has not been resolved in spite of BB injecting more funds, banks increasing deposit rates (to attract more deposits), financial institutions liquidating part of their portfolio etc. At first I thought that maybe the CRR hike led to a reverse multiplier effect on the money supply. The mistake in this logic was that it would actually take some time for the reverse to occur and off course the magnitude would not be as big as I thought (pointed out by my colleague Ali bhai).
Now what happened in reality (this is still a hypothesis) was that we were seeing rapid increase in imports (in a period when remittance growth was negative). For quite some time, the banks were using deferred LC’s to finance these imports. This meant that they were only buying the dollars when they had to pay the money (not at the time of opening these LC’s). As expected Bangladesh Bank intervened and stopped them from creating deferred LC’s. Now, while opening LC’s the banks had to buy dollars using BDT. So supply of BDT was automatically decreasing from the financial system. Now let us again look at some numbers for the period between July-Nov 2010.
Exports Receipts (BDT 57,925 crores), Import Payments (BDT 66,871 crores), Remittances (BDT 32,067 crores), Fresh Lc opening (BDT 87,472 crores)
The key number here is the fresh LC opening which is much greater than all the other figures. Moreover, when banks suddenly have to make payments for the deferred Lc’s a substantial amount of BDT has to go out of the system to buy dollars. Further proof of this hypothesis is evident since dollar is getting stronger against the BDT.
I agree with the view of the BB governor who believes that 160 mn people cannot suffer because of the greed of few stock market investors. With inflation inching up, the prudent step (debatable according to some people) by the central bank was probably tightening of the monetary policy. Then again, if that is the case then BB should probably stop saying that there is adequate liquidity. The truth is that the liquidity shortage still exists. Because of this if real sector investors are deprived of financing then the ultimate loser will be the country.
Please share article if you have liked it.
Recently the drastic fall in the stock index made headlines and became a much talked about issue. A large amount of blame was put on the stock market regulator and the government. However, the biggest blame was on the Bangladesh Bank which decided to increase the Cash Reserve Ratio from 5.5% to 6%. According to financial market “experts”, the increase in CRR caused a liquidity crisis in the money market which ultimately led to the stock market sale pressure (which off course led to panic sale).
Without going into all these arguments about who is to blame I would rather focus on the money market situation. As per newspaper reports, because of the hike in CRR the central bank took out BDT 2,000 crore from the system. A similar amount was brought out through issue of government securities. However, the Bangladesh Bank claimed that they had injected more than 20,000 crore to the system through repo financing. So in simple math (20,000-2,000-2,000=16,000).
If 16,000 crore (net) has been added to the system then definitely the fund crisis that banks and other financial institutions were in should have been resolved. The funny thing is that the crisis is not over. Even though the call money rates have come down, most financial institutions are still in a fund crisis. This is EXACTLY why stock brokerages and merchant banks are unable to give margin loans to their clients. If banks dont have money, then brokers and merchant banks also do not have money. If the brokers and merchant banks actually had money they would have definitely given out loans because that is how they make profit. Unfortunately neither the media understands this nor does the retail investors. While one segment is busy breaking offices the other is adding fuel to the fire by making illogical media reports. At the same time the SEC increased the margin loan ratio from 1:1.5 to 1:2 in a period when most brokers can’t even provide 1:0.6. What I don’t further understand is, in such a volatile (and off course highly overvalued market) why the hell would someone need additional margin loan? I guess the general investors know more about stocks than me, so I will leave it to that.
Now there has to be a reason why the liquidity crunch has not been resolved in spite of BB injecting more funds, banks increasing deposit rates (to attract more deposits), financial institutions liquidating part of their portfolio etc. At first I thought that maybe the CRR hike led to a reverse multiplier effect on the money supply. The mistake in this logic was that it would actually take some time for the reverse to occur and off course the magnitude would not be as big as I thought (pointed out by my colleague Ali bhai).
Now what happened in reality (this is still a hypothesis) was that we were seeing rapid increase in imports (in a period when remittance growth was negative). For quite some time, the banks were using deferred LC’s to finance these imports. This meant that they were only buying the dollars when they had to pay the money (not at the time of opening these LC’s). As expected Bangladesh Bank intervened and stopped them from creating deferred LC’s. Now, while opening LC’s the banks had to buy dollars using BDT. So supply of BDT was automatically decreasing from the financial system. Now let us again look at some numbers for the period between July-Nov 2010.
Exports Receipts (BDT 57,925 crores), Import Payments (BDT 66,871 crores), Remittances (BDT 32,067 crores), Fresh Lc opening (BDT 87,472 crores)
The key number here is the fresh LC opening which is much greater than all the other figures. Moreover, when banks suddenly have to make payments for the deferred Lc’s a substantial amount of BDT has to go out of the system to buy dollars. Further proof of this hypothesis is evident since dollar is getting stronger against the BDT.
I agree with the view of the BB governor who believes that 160 mn people cannot suffer because of the greed of few stock market investors. With inflation inching up, the prudent step (debatable according to some people) by the central bank was probably tightening of the monetary policy. Then again, if that is the case then BB should probably stop saying that there is adequate liquidity. The truth is that the liquidity shortage still exists. Because of this if real sector investors are deprived of financing then the ultimate loser will be the country.
Please share article if you have liked it.
Since I made a 100% return this year I must be the next Warren Buffet? Sorry wrong number
Disclosure: The article was first written on Sunday, November 21, 2010 at 11:45pm. It reflects the writer's personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
Why do we need stock indices?
Have you ever wondered why we need a stock index? It took me quite a while to understand what a stock index is and why we need it. Everyday a number of stocks go up and a number of stocks go down. The index is a mathematical calculation used to understand whether the market as a whole went up or went down. The popular indices that we have in Bangladesh (DGEN DSI) are “market capitalization” weighted indices which means that they put more importance to the price movement of larger companies rather than smaller ones. This is exactly why you see the index move by a greater amount when large caps like Grameenphone or the “banking sector” moves.
The index gives us a benchmark to compare our returns with the market returns. For example if I say that I made a 100% returns in 2010, it might sound super impressive. But given the fact that all stocks on average increased by close to 100% in 2010 it sounds quite normal because I barely beat the market. Furthermore, the additional information that corporate earnings would probably increase by a maximum of 25% makes the situation even riskier.
The conclusion from the above discussion is that I can only be considered a good fund manager/investor if I can consistently get a return above the market indices. Now comes the bad part. The indices that are available to us (DGEN, DSI etc) are absolutely incorrectly calculated. So, there is no way we can compare performances. Until and unless the calculation is corrected, we cannot compare our performances.
Stock market cycles and long term average returns
Whatever I write I tend to come back to macroeconomics somehow. The economy usually moves in cycles. So sometimes you have a situation when the economy is growing strongly, unemployment is low, inflation starts picking up etc (so Interest rates also start rising). Then we also have the other extreme when the economy is in a recession, unemployment is high, prices start falling (deflation) and interest rates are low. In between there are transition periods.
Similar to economic cycles, stock markets also move on cycles. Usually we see stock market cycles move in a similar pattern to the economic cycles but it is not necessary that this will happen every time. During periods of bull runs the investors are highly optimistic and are willing to pay a high price for shares and hence the market P/E ratios are high. The strong faith in the market brings stock prices to such a high level that is far beyond their stocks “intrinsic value” (true value). So naturally the next phase is the bearish one when stock prices steadily fall and the panic button starts ringing causing investors to sell shares even at high losses. So suddenly, despite the blind faith in the market the investors lose a lot of money causing their confidence in the market to fall down to tatters. This is the period when market volume falls to extremely low levels and most stocks trade at bargain prices. It usually takes quite some time for the confidence in the market to come back.
The reason I took so much time to explain these cycles is to explain that ultimately capital market performances are driven by macroeconomic performance. When the macro economy performs well, the corporate earnings improve and thus stock prices increase. However, there should be some sort of uniformity between these variables. Many a time stock prices move far ahead of earnings (like in 2010 stock prices in Bangladesh increased by around 90% while earnings growth would be around 20-25%) which is why we see some sort of correction (I am referring to fall in stock prices).
The interesting thing that we notice is that stock markets tend to overreact on both positive and negative news. When earnings were growing 20-25% stock prices grew 90% and when the correction should have been 10-15% they might fall by 20-25% or even more.
The part which most people overlook is that, if you take a 5-10 year period the average return you get should more or less be similar to the growth of earnings. I have used some dummy numbers to show the stock market returns for 5 years over two different scenarios.
Scenario 1 (Prices moving ahead of fundamentals and then subsequent correction):
65%, 100%, -30%, 0%, 10%.
Scenario 2 (Steady and stable increase in price and earnings):
20%, 20%, 20%, 20%, 20%.
You might be surprised (Some of you may not though) that the returns under both these situations are identical at the end of the fifth year. However, under scenario 1, there are many other adverse impacts. I can think of a couple of them at the moment
1.People might lose faith in the stock market for a prolonged period of time. We saw that after the 1996 stock market crash in Bangladesh.
2.Equity financing will become less attractive because they will get lower price for their shares (far below true value).
All of this suggests that a steady and sustainable growth in stock prices backed by “core” earnings growth is much better compared to a boom and bust. But reality is that the world is not a textbook full of theories but a place where people’s emotions have more (probably way more) importance than rationality and logic. So, we will continue to experience such ups and downs in the stock market. And in such a market to judge our performance we should not look at absolute returns but compare our returns with the broad market index.
Please share article if you have liked it.
Why do we need stock indices?
Have you ever wondered why we need a stock index? It took me quite a while to understand what a stock index is and why we need it. Everyday a number of stocks go up and a number of stocks go down. The index is a mathematical calculation used to understand whether the market as a whole went up or went down. The popular indices that we have in Bangladesh (DGEN DSI) are “market capitalization” weighted indices which means that they put more importance to the price movement of larger companies rather than smaller ones. This is exactly why you see the index move by a greater amount when large caps like Grameenphone or the “banking sector” moves.
The index gives us a benchmark to compare our returns with the market returns. For example if I say that I made a 100% returns in 2010, it might sound super impressive. But given the fact that all stocks on average increased by close to 100% in 2010 it sounds quite normal because I barely beat the market. Furthermore, the additional information that corporate earnings would probably increase by a maximum of 25% makes the situation even riskier.
The conclusion from the above discussion is that I can only be considered a good fund manager/investor if I can consistently get a return above the market indices. Now comes the bad part. The indices that are available to us (DGEN, DSI etc) are absolutely incorrectly calculated. So, there is no way we can compare performances. Until and unless the calculation is corrected, we cannot compare our performances.
Stock market cycles and long term average returns
Whatever I write I tend to come back to macroeconomics somehow. The economy usually moves in cycles. So sometimes you have a situation when the economy is growing strongly, unemployment is low, inflation starts picking up etc (so Interest rates also start rising). Then we also have the other extreme when the economy is in a recession, unemployment is high, prices start falling (deflation) and interest rates are low. In between there are transition periods.
Similar to economic cycles, stock markets also move on cycles. Usually we see stock market cycles move in a similar pattern to the economic cycles but it is not necessary that this will happen every time. During periods of bull runs the investors are highly optimistic and are willing to pay a high price for shares and hence the market P/E ratios are high. The strong faith in the market brings stock prices to such a high level that is far beyond their stocks “intrinsic value” (true value). So naturally the next phase is the bearish one when stock prices steadily fall and the panic button starts ringing causing investors to sell shares even at high losses. So suddenly, despite the blind faith in the market the investors lose a lot of money causing their confidence in the market to fall down to tatters. This is the period when market volume falls to extremely low levels and most stocks trade at bargain prices. It usually takes quite some time for the confidence in the market to come back.
The reason I took so much time to explain these cycles is to explain that ultimately capital market performances are driven by macroeconomic performance. When the macro economy performs well, the corporate earnings improve and thus stock prices increase. However, there should be some sort of uniformity between these variables. Many a time stock prices move far ahead of earnings (like in 2010 stock prices in Bangladesh increased by around 90% while earnings growth would be around 20-25%) which is why we see some sort of correction (I am referring to fall in stock prices).
The interesting thing that we notice is that stock markets tend to overreact on both positive and negative news. When earnings were growing 20-25% stock prices grew 90% and when the correction should have been 10-15% they might fall by 20-25% or even more.
The part which most people overlook is that, if you take a 5-10 year period the average return you get should more or less be similar to the growth of earnings. I have used some dummy numbers to show the stock market returns for 5 years over two different scenarios.
Scenario 1 (Prices moving ahead of fundamentals and then subsequent correction):
65%, 100%, -30%, 0%, 10%.
Scenario 2 (Steady and stable increase in price and earnings):
20%, 20%, 20%, 20%, 20%.
You might be surprised (Some of you may not though) that the returns under both these situations are identical at the end of the fifth year. However, under scenario 1, there are many other adverse impacts. I can think of a couple of them at the moment
1.People might lose faith in the stock market for a prolonged period of time. We saw that after the 1996 stock market crash in Bangladesh.
2.Equity financing will become less attractive because they will get lower price for their shares (far below true value).
All of this suggests that a steady and sustainable growth in stock prices backed by “core” earnings growth is much better compared to a boom and bust. But reality is that the world is not a textbook full of theories but a place where people’s emotions have more (probably way more) importance than rationality and logic. So, we will continue to experience such ups and downs in the stock market. And in such a market to judge our performance we should not look at absolute returns but compare our returns with the broad market index.
Please share article if you have liked it.
Consequences for different companies during a market crash/correction
Disclosure: The article was first written on Saturday, November 13, 2010 at 12:53am. It reflects the writers personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
The two kinds of adverse impacts on stock prices
During a market correction/crash there are two kinds of adverse effect on listed stocks.
One is what we call the “beta affect”. Most stocks are positively correlated with the market and since the market falls they fall as well. This would mean that when there is a significant correction there would not be a single stock that will be safe. However, the extent of the decline in stock prices would vary from company to company.
The other effect is the “earnings” effect. The companies that depend on the capital market for earnings will fall in this category. These would include banks, non banking financial institutions, insurance companies, brokerage houses and merchant banks. These should be the worst affected because not only are they seeing the beta affect but also they see earnings fall.
Breaking down the stock price
One very common ratio we use in the stock market is the Price/Earnings ratio. Basically, it shows how much price we are willing to pay for 1 taka of earnings for any specific company. Companies with higher p/e are ones that are expected to have higher earnings growth figures. Another way of looking at the ratio is to say that high P/E stocks are more expensive. Now,
“ stock price”=” earnings per share” x “the P/E people are willing to pay”
Now we can relate the stock price with the earnings effect and the beta effect. Because of the correlation with the overall stock market people will be willing to pay less (a lower P/E) for the same amount of earnings.
Any other effects
For companies with earnings effect we can also think of something similar to a Keynesian multiplier. If we go back to introduction to macroeconomics and relate to the financial sector of Bangladesh we can see a surprising similarity. This one would apply to companies who earn profits from trading in stocks. Let me explain through an example.
Suppose there are 5 banks in the stock market. Each of them start buying the stocks of the other ones. Due to higher demand stock prices will rise. Then, they will sell some of these shares for a profit and now because they are having higher profits their stock prices will rise even further. This way the cycle goes on and on. This was probably a very simplified and crude example. But the point I am trying to make is that if you can see stock prices going up due to multiplier effects so can they go down due to multiplier.If the first banks price declines, then the profit of all the other banks will fall and so will the stock prices. Then the profit of the first bank will fall because it holds the shares of the other 4 banks.
The only silver lining is that the financial institutions in Bangladesh record stock prices at cost in the balance sheet. So as long as market prices of their stock investments remain above cost their book values/shareholder's equity would not decline. However earnings would definitely take a hit. (I know these two lines are slightly complicated to understand for non accounting/finance based students but I had to put them here).
Conclusions
1.If you have a broad market correction no single stock will be a safe investment. However, the extent of the price reduction will differ across companies.
2.Companies with earnings exposure to the capital market will be the most risky ones.
3.The companies to hold should be those that are undervalued and are likely to report good profits in 2011 and 2012(How to determine whether a stock is undervalued or not is beyond the scope of this small note). These stocks will not only fall less compared to other stocks but will also bounce back faster because of better earnings figures.
Please share article if you have liked it.
The two kinds of adverse impacts on stock prices
During a market correction/crash there are two kinds of adverse effect on listed stocks.
One is what we call the “beta affect”. Most stocks are positively correlated with the market and since the market falls they fall as well. This would mean that when there is a significant correction there would not be a single stock that will be safe. However, the extent of the decline in stock prices would vary from company to company.
The other effect is the “earnings” effect. The companies that depend on the capital market for earnings will fall in this category. These would include banks, non banking financial institutions, insurance companies, brokerage houses and merchant banks. These should be the worst affected because not only are they seeing the beta affect but also they see earnings fall.
Breaking down the stock price
One very common ratio we use in the stock market is the Price/Earnings ratio. Basically, it shows how much price we are willing to pay for 1 taka of earnings for any specific company. Companies with higher p/e are ones that are expected to have higher earnings growth figures. Another way of looking at the ratio is to say that high P/E stocks are more expensive. Now,
“ stock price”=” earnings per share” x “the P/E people are willing to pay”
Now we can relate the stock price with the earnings effect and the beta effect. Because of the correlation with the overall stock market people will be willing to pay less (a lower P/E) for the same amount of earnings.
Any other effects
For companies with earnings effect we can also think of something similar to a Keynesian multiplier. If we go back to introduction to macroeconomics and relate to the financial sector of Bangladesh we can see a surprising similarity. This one would apply to companies who earn profits from trading in stocks. Let me explain through an example.
Suppose there are 5 banks in the stock market. Each of them start buying the stocks of the other ones. Due to higher demand stock prices will rise. Then, they will sell some of these shares for a profit and now because they are having higher profits their stock prices will rise even further. This way the cycle goes on and on. This was probably a very simplified and crude example. But the point I am trying to make is that if you can see stock prices going up due to multiplier effects so can they go down due to multiplier.If the first banks price declines, then the profit of all the other banks will fall and so will the stock prices. Then the profit of the first bank will fall because it holds the shares of the other 4 banks.
The only silver lining is that the financial institutions in Bangladesh record stock prices at cost in the balance sheet. So as long as market prices of their stock investments remain above cost their book values/shareholder's equity would not decline. However earnings would definitely take a hit. (I know these two lines are slightly complicated to understand for non accounting/finance based students but I had to put them here).
Conclusions
1.If you have a broad market correction no single stock will be a safe investment. However, the extent of the price reduction will differ across companies.
2.Companies with earnings exposure to the capital market will be the most risky ones.
3.The companies to hold should be those that are undervalued and are likely to report good profits in 2011 and 2012(How to determine whether a stock is undervalued or not is beyond the scope of this small note). These stocks will not only fall less compared to other stocks but will also bounce back faster because of better earnings figures.
Please share article if you have liked it.
Why I believe a stock market crash is imminent
Authors Note: This article was written on Tuesday, November 9, 2010 at 11:57pm. The article reflects my own personal views and any decisions taken based on this article is not my responsibility.
Background to the issue at stake
Starting from mid 2009, the Bangladesh Stock Market has been experiencing a prolonged bull run. The market returns has been amongst the world's highest over the period. Even in 2010, only Sri Lanka (+110%) and Mongolia, has probably beaten our market where prices grew roughly by about 90%. Now while this sounds great, people frequently forget the risks of investment in such times of "irrational exuberance".
Coming back to the point. I have been thinking for quite a while that the market will undergo a correction. However, for better or for worse the market stuck to its upward trajectory. But I believe that this has made the situation even riskier. Lets first look at what made the market go up in the first place.
What caused the market to act this way?
The first half of 2009 was a bad time for the capital market. Firstly, investor confidence in the economy was low following the 2 year stint of the caretaker government. But most importantly, the world was experiencing the phenomenon called the "global financial crisis". Even though Bangladesh is relatively less correlated with the global economy, most economists were projecting a bleak macro outlook. Consequently, stock prices suffered.
From mid 2009 the situation started improving thanks to heavy investment in the capital market by state owned banks and financial institutions. This brought back the confidence in the capital market and since the stocks were at extremely cheap prices (I remember AB Bank trading at a trailing P/E of around 6) all stocks looked like a bargain. After that we saw positive surprises in our GDP growth rate (5.7% growth achieved despite global slowdown) and also corporate earnings. But the biggest factor that led to the current state of the capital market was what we call "excess liquidity". To explain that let me use bullet points.
1. Because of power and infrastructure shortages most entrepreneurs could not invest in the real sector (meaning industries).
2. Bangladesh was having current account surpluses (thanks to huge remittance flows). So more money was coming in than going out.
3. Interest rates went down. So, it was not a good idea to get around 8.5% interest per year (before tax) when inflation was around 5-7%.
So suddenly, people had a lot of idle money which they were unable to invest anywhere. Anywhere except the stock market that is. Thus the joyride of equities (stocks) began and that situation is still continuing. Because of this excess flow of funds by both general investors as well as institutions (Banks, NBFI's and Insurance companies), multiple attempts by the regulator failed to cool down the market. I can't blame anyone because no alternative investments were available. Plus, when you can earn 30% return in 7 days why would someone invest elsewhere?
Why I think that a reversal is imminent?
The simplest of reason is that nothing goes up forever. But since I am supposed to be an analyst in profession I need to do my job.
1. Market P/E (trailing) is around 30 at the moment. This is probably amongst the highest in the world right now. High P/E's can only be justified when you expect superior earnings growth. But that is not the case here. The best companies in BD over the last 10 years have experienced earnings growth of about 20%. For 20% earnings growth on average, the market P/E should be around 20 and not 30 (which it is at the moment).
2. The P/E is calculated using the earnings reported by the companies. However, not all of these earnings figures are recurring earnings. Specially for banks and nbfi's a large portion of income is coming from one-off equity gains that might not be repeated in the future years.
3. Investor confidence is coming back in the real sector as seen by the indicators like loan disbursement, opening of LC's for capital machinery etc. If this trend continues then at least some money would come out of the capital market to the real economy and in the process share prices would fall.
4. Interest rates are going up. Just a few days ago 1 year fixed deposit rates were about 8.5%. Now it ranges from 10%-10.5%. Since inflation is going up, we can be quite sure of further increases in interest rates. When that happens some funds will move from the capital market to the banking sector and other fixed income investments.
I can probably list other reasons as well but since these are the major ones, we can ignore the less important ones.
But I thought the macroeconomic outlook was improving?
Let me be VERY VERY clear on one issue. There is a big "top down" (or in other words growth) story in Bangladesh. It is a small country with a large young population. By all probabilities (Inshallah) the economy will continue doing well and if there are advances made to solve the power and infrastructural bottlenecks then we are definitely going to grow at a higher trajectory (7-8%).I believe myself to be amongst the most optimistic people regarding the long term prospects of the country.
Now from common logic
Strong Macroeconomy=Good corporate earnings=Higher share prices.
While this is true there is always a price for everything. Compared to a Dhaka College shirt I am surely going to pay more for a designer shirt made in Italy but if the price tag is unreasonable then it is not justified. We do not have to look very far. Even in Vietnam (a frontier market very similar to Bangladesh) a few years ago the stock market had tremendous performance. The whole idea was economic growth. But the market fell because the prices being paid for growth were not justified by fundamentals. Please go to the link below and choose the 5Y graph to see the Vietnam market performance.
http://www.bloomberg.com/apps/quote?ticker=VNINDEX%3AIND
When will the crash occur?
It is virtually impossible to predict a crash. The higher stock prices go up, the more confident investors become and the more risk they take. Right now we are at the peak of investor confidence due to which regulators cannot do anything to the market. So, the crash can happen in the next 1-2 month or it might even take 1-1.5 years. But we probably need a catalyst to dampen the investor confidence. Such possible catalysts could be
1. Big investors and big institutions like banks and NBFI's getting out of the overvalued market.
2. Any natural disaster (Happened in Pakistan recently. The flood there had a major impact on the share market. Pakistan market P/E is about 7 right now whereas Bangladesh is about 30).
3. Any sort of political unrest
4. Lower than expected earning figures.
Can we expect a slow correction instead of a crash?
While it is possible, I would assign a very low probability to a slow correction. Why? Because, if that was the case then investors would have started to move out of the market. Everybody understands that the market is overheated. However, everyone also thinks that they can earn another 15-20% and have the perfect exit. Unfortunately perfect exits are quite impossible. So, once a big downward movement starts everyone will just jump on the bandwagon.
Our present situation has surprising similarities to the housing bubble that happened in the west. When housing prices skyrocketed (beyond logical limits) Wall Street knew very well that houses are overvalued. However, because everybody assumed that house prices would just continue going up they should not lose out on the marginal profit. Now here we are doing the same thing. Almost all investors will tell you that stock prices are too high (compared to earnings off course) but only a handful are acting on the conclusion that they are making themselves due to "expectations" of greater returns.
What should my strategy be?
1. Risk averse investors can sell all their shares and wait for the market to come down.
2. Those with more appetite for risk can partially offload their shares and keep the rest of the money in defensive shares with solid fundamentals. Staying away from any company whose earnings depend on the capital market would be strongly advisable.
Please share article if you have liked it.
Background to the issue at stake
Starting from mid 2009, the Bangladesh Stock Market has been experiencing a prolonged bull run. The market returns has been amongst the world's highest over the period. Even in 2010, only Sri Lanka (+110%) and Mongolia, has probably beaten our market where prices grew roughly by about 90%. Now while this sounds great, people frequently forget the risks of investment in such times of "irrational exuberance".
Coming back to the point. I have been thinking for quite a while that the market will undergo a correction. However, for better or for worse the market stuck to its upward trajectory. But I believe that this has made the situation even riskier. Lets first look at what made the market go up in the first place.
What caused the market to act this way?
The first half of 2009 was a bad time for the capital market. Firstly, investor confidence in the economy was low following the 2 year stint of the caretaker government. But most importantly, the world was experiencing the phenomenon called the "global financial crisis". Even though Bangladesh is relatively less correlated with the global economy, most economists were projecting a bleak macro outlook. Consequently, stock prices suffered.
From mid 2009 the situation started improving thanks to heavy investment in the capital market by state owned banks and financial institutions. This brought back the confidence in the capital market and since the stocks were at extremely cheap prices (I remember AB Bank trading at a trailing P/E of around 6) all stocks looked like a bargain. After that we saw positive surprises in our GDP growth rate (5.7% growth achieved despite global slowdown) and also corporate earnings. But the biggest factor that led to the current state of the capital market was what we call "excess liquidity". To explain that let me use bullet points.
1. Because of power and infrastructure shortages most entrepreneurs could not invest in the real sector (meaning industries).
2. Bangladesh was having current account surpluses (thanks to huge remittance flows). So more money was coming in than going out.
3. Interest rates went down. So, it was not a good idea to get around 8.5% interest per year (before tax) when inflation was around 5-7%.
So suddenly, people had a lot of idle money which they were unable to invest anywhere. Anywhere except the stock market that is. Thus the joyride of equities (stocks) began and that situation is still continuing. Because of this excess flow of funds by both general investors as well as institutions (Banks, NBFI's and Insurance companies), multiple attempts by the regulator failed to cool down the market. I can't blame anyone because no alternative investments were available. Plus, when you can earn 30% return in 7 days why would someone invest elsewhere?
Why I think that a reversal is imminent?
The simplest of reason is that nothing goes up forever. But since I am supposed to be an analyst in profession I need to do my job.
1. Market P/E (trailing) is around 30 at the moment. This is probably amongst the highest in the world right now. High P/E's can only be justified when you expect superior earnings growth. But that is not the case here. The best companies in BD over the last 10 years have experienced earnings growth of about 20%. For 20% earnings growth on average, the market P/E should be around 20 and not 30 (which it is at the moment).
2. The P/E is calculated using the earnings reported by the companies. However, not all of these earnings figures are recurring earnings. Specially for banks and nbfi's a large portion of income is coming from one-off equity gains that might not be repeated in the future years.
3. Investor confidence is coming back in the real sector as seen by the indicators like loan disbursement, opening of LC's for capital machinery etc. If this trend continues then at least some money would come out of the capital market to the real economy and in the process share prices would fall.
4. Interest rates are going up. Just a few days ago 1 year fixed deposit rates were about 8.5%. Now it ranges from 10%-10.5%. Since inflation is going up, we can be quite sure of further increases in interest rates. When that happens some funds will move from the capital market to the banking sector and other fixed income investments.
I can probably list other reasons as well but since these are the major ones, we can ignore the less important ones.
But I thought the macroeconomic outlook was improving?
Let me be VERY VERY clear on one issue. There is a big "top down" (or in other words growth) story in Bangladesh. It is a small country with a large young population. By all probabilities (Inshallah) the economy will continue doing well and if there are advances made to solve the power and infrastructural bottlenecks then we are definitely going to grow at a higher trajectory (7-8%).I believe myself to be amongst the most optimistic people regarding the long term prospects of the country.
Now from common logic
Strong Macroeconomy=Good corporate earnings=Higher share prices.
While this is true there is always a price for everything. Compared to a Dhaka College shirt I am surely going to pay more for a designer shirt made in Italy but if the price tag is unreasonable then it is not justified. We do not have to look very far. Even in Vietnam (a frontier market very similar to Bangladesh) a few years ago the stock market had tremendous performance. The whole idea was economic growth. But the market fell because the prices being paid for growth were not justified by fundamentals. Please go to the link below and choose the 5Y graph to see the Vietnam market performance.
http://www.bloomberg.com/apps/quote?ticker=VNINDEX%3AIND
When will the crash occur?
It is virtually impossible to predict a crash. The higher stock prices go up, the more confident investors become and the more risk they take. Right now we are at the peak of investor confidence due to which regulators cannot do anything to the market. So, the crash can happen in the next 1-2 month or it might even take 1-1.5 years. But we probably need a catalyst to dampen the investor confidence. Such possible catalysts could be
1. Big investors and big institutions like banks and NBFI's getting out of the overvalued market.
2. Any natural disaster (Happened in Pakistan recently. The flood there had a major impact on the share market. Pakistan market P/E is about 7 right now whereas Bangladesh is about 30).
3. Any sort of political unrest
4. Lower than expected earning figures.
Can we expect a slow correction instead of a crash?
While it is possible, I would assign a very low probability to a slow correction. Why? Because, if that was the case then investors would have started to move out of the market. Everybody understands that the market is overheated. However, everyone also thinks that they can earn another 15-20% and have the perfect exit. Unfortunately perfect exits are quite impossible. So, once a big downward movement starts everyone will just jump on the bandwagon.
Our present situation has surprising similarities to the housing bubble that happened in the west. When housing prices skyrocketed (beyond logical limits) Wall Street knew very well that houses are overvalued. However, because everybody assumed that house prices would just continue going up they should not lose out on the marginal profit. Now here we are doing the same thing. Almost all investors will tell you that stock prices are too high (compared to earnings off course) but only a handful are acting on the conclusion that they are making themselves due to "expectations" of greater returns.
What should my strategy be?
1. Risk averse investors can sell all their shares and wait for the market to come down.
2. Those with more appetite for risk can partially offload their shares and keep the rest of the money in defensive shares with solid fundamentals. Staying away from any company whose earnings depend on the capital market would be strongly advisable.
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