The case against monetary easing

The monetary policy for the second half of 2013 (Calendar year) is coming up. There are widespread rumors that this will be an expansionary monetary policy with a potential policy rate cut. Some even go to the extent of saying that reserve requirements will be reduced. As an analyst I strongly believe that an expansionary monetary policy would be the wrong move and maintaining status quo would be the more prudent policy decision.


Before I delve into my arguments let me try to understand what can prompt central bank to go for monetary easing. The only factor that comes to my mind is the sharp decline in private sector credit growth which stood at 11.43% at the end of May 2013. Despite the decline in loan demand, lending and deposit rates remained quite sticky and have not been coming down as much as central bank would have liked. So, maybe central bank believes that further easing would cause interest rates to decline and thus spur on credit growth and investment in the economy.

I have two major points against this theory.

First, I believe that the slowdown in credit growth was less due to high interest rates and more due to the global economy, political violence etc. We have also seen from the past that credit growth comes down during the election year and thus 2013 was no exception. No businessmen in his right mind would go for heavy investment in such an uncertain situation. If that is the case, then going for further monetary easing would not really spur on growth at all. Credit demand would normalize once the election is over by itself without a monetary stimulus.

Secondly, we do know that there is enough liquidity in the banking system. As per a Financial Express report, loanable excess liquidity rose to BDT 695 bn in April 2013 from BDT 456 bn in June 2012. M2 growth is around 18% as of March 2013 driven largely by unsterilized dollar buying by the central bank. This is quite high by any global standards and going for further monetary easing is quite risky from an inflationary standpoint. The situation reminds me of 2009-10 periods when central bank went for unsterilized dollar buying to prevent the BDT from appreciating. The result was a stock market bubble and double digit inflation. The real estate market also was in a bubble like situation and has been correcting ever since. We surely do not want a repeat of that situation.

I think that the policymakers should put more attention to supply side bottlenecks such as energy and infrastructural constraints. Trying to boost GDP growth during times when ‘real’ demand is low, will only haunt the economy in the future.

How herding behaviour deters capital market price efficiency in Bangladesh

Co-authored by Asif Khan, CFA and Sajib Hossain, Lecturer of finance at Dhaka University. Original article appeared at Dhaka Tribune Website.

Identical investments in the Bangladesh capital market, without any significant shifts in economic fundamentals, can be explained partially by the herding behavior of investors. This is where investors discard their fundamental analysis of stocks and follow the crowd. A high level of herding may be evident from the fact that when the stock market falls, all participants go down the same path. Similarly, when the index experiences some upward trend, market participants follow. Surely, such herding behaviour can also be attributed to a poorly regulated environment, lack of quality and timely disclosures, and the type and sophistication of both retail and institutional investors.

Many investors, believing some particular stocks to be very risky or overvalued, or vice versa, still buy or sell the same stocks discarding their personal opinions, which is a market phenomenon here. Sometimes such behaviour turns into a pattern that deters market efficiency. Investors do not seem to have taken any lesson from the recent bubble and burst in the market, as they keep on repeating the same behaviour.

Rational investors, especially institutional ones, are expected to make an investment decision taking into account full financial and operation aspects, and the growth prospects of stocks being considered.
They are also expected to be independent of market noise and bias. Now, if such investors were really rational, they would get analytical information in advance, and use that while investing. Other participants would then follow the informed investors, resulting in efficient pricing of market instruments.

However, reality reflects something different. Perhaps, rational investor behavior is ignored by other participants, resulting in irrational behavior in the overall market. Or perhaps, the size and participation of rational investors is not large enough to have an effect on irrational investors.

Investment sophistication and financial skill and knowledge among market participants are rapidly growing in our market. However, free flow of information, more research based periodic reviews and quality corporate disclosures are not increasing at the same pace.

Herding in emerging markets, like Bangladesh, may also be attributed to incomplete regulatory frameworks, especially in the area of market transparency. Insider traders have been consistently taking undue advantage, and are able to persuade the crowd to follow them, ignoring fundamental information. The Bangladesh Securities and Exchange Commission either fails to detect and prevent such insider trading, or the market regulator fails to take punitive action because of undue influence or lack of sufficient means. Moreover, deficiencies in corporate disclosures and information quality create uncertainty in the market, throw doubt on the reliability of public information and impede fundamental analysis. A recent study (unpublished) by Accounting for the Capital Market Development, a research project sponsored by WB and UGC, found that audited financial statements of a good number of listed companies contained unqualified audit opinion by reputed firms and were not prepared according to international standards.

So, it is reasonable to assume that investors will lose belief in analysis-driven investment strategy, and thus, prefer to base trading on their peers' actions. Alongside intentional herding, unintentional herding also occurs in the market here due to simultaneous reaction to a common signal.

However, herding does not always result in an inefficient outcome that impedes proper functioning of the market. Herding can have an efficient outcome, provided it comes from the simultaneous reaction on fundamental values. In this case, it speeds up price adjustments, making the market more efficient.
But herding not based on fundamental values may drive prices away from the latter, which can result in subsequent return reversals. In this case, asset prices will fail to reflect fundamental information.
Herding behaviour, especially of retail investors who are dominant in daily trading, can destabilize markets, with the potential to create, or at least contribute to, bubbles and crashes in the capital market.

Therefore, properly scrutinizing and assessing the types, causes and extent of herding and ensuring that such behavior is driven by fundamentals are essential for efficient functioning of the capital market in Bangladesh.

In search of excellence

"Human beings are imperfect".

Sounds pessimistic, but in reality is just the opposite. This is a sentence about endless opportunities. It means that we have infinite potential to improve and improvise. The potential to be better at almost everything because we can never reach perfection as mortals.

The idea of writing something on this topic came to me after reading a book called "Made in America" by Sam Walton. Sam Walton is the founder of WalMart. This book tells the story of how WalMart grew from scratch to the corporate giant that we know today. What did I learn from the book? A great deal indeed.

As one reviewer wrote, he learned more in this book about management than he did in college. Just like him, I learned that hard work really pays off. I learned that the customer always comes first. I learned that we should learn from everybody and even from our competitors. I learned how important it is to get good people to run our companies. If we find the right talent we should chase that person for months and even years if required.

However, the most important thing that I learned was that we must continuously strive for improvement. The willingness to improve the current practices and procedures must be there all the time. At times we will make mistakes in our attempt to try out new things. But as the writer/philosopher Nassim Taleb said "Mistakes that are reversible aren't really mistakes". Mistakes make our systems and processes much more robust.

The strive for excellence is not only limited to our personal self but the whole culture can be incorporated in communities, societies and organizations. Actually, that is exactly how the great companies of the world came to become "great". They stuck to their core values, but everything else was dynamic. This dynamic nature is what enabled them to adapt and survive while other big companies perished.

Personally, I am trying to identify my weaknesses and make a conscious effort to improve upon that. I know that if I try enough and God willing, I can become a better employee, a better husband, a better son and a better almost everything.

Knowledge based Bangladesh

I am planning on a new project to bring students and professionals into closer contact to improve knowledge level of the students. It will also help them gain more practical knowledge. Here is a video that explains the strategy.




Knowledge based Bangladesh (Introduction) by freerudite

Moral hazard and our RMG industry

This article was published in the Dhaka Tribune on May 7, 2013 in the opinion segment. Here is the link.

Risk and reward should ideally go hand in hand. If we take excess risks, and it leads to success, then the reward is usually high. However, when excessive risk results in something bad, we must be ready to bear the costs of that decision.

In economics, “moral hazard” refers to a situation where one party takes excessive risk because that party knows that it would not have to bear the costs of that risk. Such an environment promotes excessive risk taking which is usually detrimental to the whole society and the economy.

The best recent example of moral hazard is the US government’s bailout of the financial sector that fell into problems after the sub-prime bubble burst. The financial sector had earlier taken huge risks in real estate and also reaped the benefits through huge profits and personal bonuses. However, when things went south, they got bailed out by the general people of the country.

What does RMG have to do with moral hazard? A lot, actually. The typical RMG factory owner knows that if there is a problem in their factory caused by their negligence (Tazreen Fashions and Rana Plaza are both cases in point), their associations will come to their rescue. So by giving less attention to worker safety they are able to lower some costs and take higher risks because they know they will be bailed out.

The other interesting information that I came across was that banks have decided to raise around Tk1bn for the Savar victims.The newspaper article mentioned that they did it on the request of the central bank. A few might have taken initiatives at their own discretion but I would contend, for most, the central bank request had a lot to do with it.

Why should banks pay for a mistake made by garment factory owners or building owners? Even though some people believe that banks should be more responsible before lending to organisations, I think that banks should stick to their core operation. The responsibility of checking whether a building meets construction standards is not the core operation of a bank and thus should be left to relevant authorities like Rajuk. Banks are already in a fragile situation due to loan scams, political problems, real estate slowdown, etc, and asking them to pay for others’ mistakes is a recipe for disaster.Tomorrow if banks get into trouble, who will bail them out? Of course it will be the average citizen of the country who did nothing wrong.

Being an optimist I honestly believe that most of the factory owners do care about the safety of their employees. It is a few rotten ones that are causing the image crisis we presently face. But we can still blame BGMEA on the grounds that they are not penalizing the rotten ones for their failures.

So, it is the responsibility of the factory owners, the foreign buyers and the BGMEA to pay for the rehabilitation of the victims and not the responsibility of banks. Of course people are free to donate of their own free will but making an innocent group pay for the mistakes of other people will only exacerbate the problem.

Knowledge from unconventional sources

This is a video I made to promote unconventional methods to attain knowledge which can be complimentary to classroom education. I think these are great ways to learn and I used them extensively in my life.

Knowledge from unconventional sources by freerudite

The perils of the retail investors in Bangladesh

Co-authored by Asif Khan, CFA and Sajib Hossain, Lecturer of finance at Dhaka University. Original article appeared at Dhaka Tribune Website.

The Bangladesh stock market is still in an infant stage when we consider the maturity of investors, the quality of corporate disclosures and the strength of the regulators. Therefore, it is no wonder that the market in Bangladesh is highly driven by momentum where investors have short holding periods.

In the short run, the market tends to act like a zero sum game. If someone wins, someone else has to lose. This is the perfect situation for the slaughter of small retailers.
Let us go through the problems one by one:

Quality of earnings and financial disclosures:

The first major problem is related to the “quality of earnings” and the level of financial disclosures. Quality of earnings refers to the sustainability and trustworthiness of earnings numbers. At present, other than a handful of listed companies, it is very difficult for knowledgeable investors to trust the financial statements. The blame, to some extent, goes towards the auditing firms. However, the first step in preparing clean and transparent financial statements has to be taken by the companies themselves.

Secondly, the accessibility to financial statements is a big problem in itself. Many of the companies do not have websites, and even if they do, the statements are not uploaded in due time. The solution to this problem is to upload statements in the stock exchange websites.

Without access to trustworthy and timely financial statement it is not possible to do fundamental analysis.

Insider Trading: 

Insider trading refers to the trading of shares by people who have access to material news flow, like earnings and dividends, before they are disclosed to general investors. Examples of such investors would be company management, audit firms, company directors etc. This harms the retail investors who get the news flow only after it has already been priced into the share.

The problem lies in the lack of a strong legal framework, along with the enforcement of such laws. For example, if a person earns Tk10m from insider trading and is fined Tk100 thousand, he will happily pay the fine. Therefore, in order to discourage insider trading, the scale of the punishment has to be increased by a large magnitude. We do realize that the regulators might not have adequate manpower to catch all cases of insider trading. However, even if they could set some examples by penalizing few high profile cases, that should work as an example to others.

Pump and dump strategies:

Next, we have pump and dump strategies. By cornering shares (reducing liquidity) and spreading rumors, some manipulators jack up the stock prices in order to dump their holdings on to the unsuspecting retail investors.

As the stock market is a sensitive issue, regulators and governments are sometimes afraid to take steps against market manipulators for fear of the market coming down. In the short run, that is a possibility. However, in the long run, these steps would be much more beneficial to all the stakeholders.

Lack of knowledge of investors:

The lack of knowledge of retailers, and even some institutional investors, is also a problem. Even today, stock bonus is considered to be something great and causes stock prices to go up significantly. When the target victims are not smart enough and need to rely on rumors to make money, they are likely to lose money in the stock market.

The players who will continue to make money will be the “insider trader” and the “large retailer” because of information and capital advantage. If these guys continue to make money, then someone else will lose it.

Lack of transparency in asset management industry:

The stock market is not for everyone. Not everybody has the time to study or learn it. Therein lays the importance of professional fund management. However, the present state of the managed fund business would deter most of the investors who would like to give funds for professional management.

Before giving funds to a management company, an investor needs to look at its track record, investment strategy, background of fund managers and top holdings. None of this information is available in Bangladesh. However, by not promoting transparency, not only are many investors forced to take a shot at investing by themselves based on rumors, the asset management industry is also not growing as much.

Conclusion

In such a situation, the chances for retail investors to make money will be limited. In the short run, the momentum chasing strategies could work out, but eventually the investor is likely to make losses.

We should not let the stock market turn into another tool for redistributing wealth from the poor to the rich. In a country where saving instruments are limited, the role of the stock market is crucial. Before everything else, we need to focus on corporate governance, minority shareholder rights and quality of auditing.

Studies said that …………….

Everyday newspapers report astounding discoveries by scientists and researchers. Some of this research is done upon absolutely new topics. There are also tests done on existing topics where the new study either agrees or disagrees with existing studies done on the subject matter. The ones that get highlighted are usually (notice the word “usually”) done by much acclaimed people with a lot of credentials. So for laymen like us it is easier to agree with them rather than disagree. After all, who are we to agree or disagree with these experts? 

 Now this raises a couple of very interesting questions. At least they did for me. Firstly, how sound are these studies? Are they unbiased and done through rigorous research? Secondly, how do we react when we see these studies? 

  I got the answer of the first question when I listened to numerous Econtalk podcasts. For the unaware, Econtalk is a talk show hosted by Professor Russ Roberts of George Mason University. What I realized is that these research findings which frequently find the way to the newspaper headlines are not as sound or rigorous as we may have assumed them to be. The distinguished researchers, many from top notch universities of the world can be quite biased. They frequently manipulate the data (data fitting) to ensure that the outcome matches with what they want to show rather than what the truth is. 

 The newspapers only mention the summary of the findings. However, we rarely have access to the data set used to come to the conclusion. Even if we had access to all the data, how many of us would have to look at it to check for mistakes. If another unbiased scientist using the same methodology came to a similar conclusion then only we can call the study quite robust. 

 However, just because some people decided to be less truthful does not mean that there are no good researchers. There are people following rigorous methods to come to conclusions. There are also people who cite the weaknesses in their methodology while submitting the results. Thanks to these people human beings have advanced quite a bit.

 Now we come to the other interesting part. How do people react when they learn about the outcome of a new research finding? This is where things get even more interesting. I have seen the same person saying that there a new research on healthcare saying that XYZ food has harmful side effects and the same person (another layman like me) on a different occasion trashing a separate research on a different food item . What has happened here? “Confirmation bias” has happened. 

 How do we actually decide which study to believe and which not to? Like I said, it is all about confirmation bias. We just believe the one that we want to believe and ignore all others. Other times, we also do a one person study by ourselves where the only data set is us. Let me take an example of a study which concluded that exercising makes us healthier. Normally I would just quickly relate to myself and try to remember whether that applied to me. Maybe, I did exercise in the past, but I never lost any body fat. I would then quickly say that the research is rubbish because it never applied to me. 

 What did I wrong here? Practically everything. Firstly, there are many variables that can influence ones health. My one person study did not control for all the other variables. Secondly, statistics gives a viewpoint about a large sample. I could very easily be an outlier. But that would not necessarily mean that the original research was wrong. Thirdly, I may not have even done the exercises correctly and cheated on form. There could be many more.

 Biases are and will remain an integral part of human life. However, it would do all of us good to try to minimize these biases. The first step is to be aware of them. Only then can we try to minimize them while thinking or analyzing. 

 Easier said than done (saying from personal experience).

The need for heretics in the society

Disclosure: I have realized that my blog pieces rarely have a coherent flow and I tend to jump around from one topic to another.  I wrote this piece after a long time. I guess the topic was something that was moving in my head for a long time.

Do not be shocked by the title. The word heretic has two different definitions according to Merriam-Webster.

1: a dissenter from established religious dogma; especially : a baptized member of the Roman Catholic Church who disavows a revealed truth

2: one who dissents from an accepted belief or doctrine 
 

I am actually referring to the latter definition. The modern heretic is a non-conformist who challenges assumptions. This makes the heretic an outlier. 

The amount of knowledge in this world is endless. In 2013, even with thousands of years of civilization the knowledge human beings have attained is probably about a drop in an ocean (in my opinion). There is just so much we don't know. There are also things we think we know but in reality what we know is incorrect. In spite of all this, we really love to believe that we know a lot and this problem is more so in our so called experts and politicians. 

I tend to believe that the people who have reached the highest levels on knowledge in their specific disciplines actually realize how little they know. However, according to Ariel Rubinstein of Tel Aviv University many of these so called experts (and politicians) have a natural incentive to give the impression that they already know everything. But we do have a few people like Friedrich Von Hayek whom many considers as the Renaissance man of twentieth century economics. Von Hayek in his final works mentioned that the economy is just too complex for politicians to avert recessions and unemployment without unintended consequences that may well be worse. He advised politicians and economists to be a bit more humble.

Human being in general loves to follow the herd. We try to follow the recent fad and buy the shares that most people are recommending. I guess it gives us a sort of mental peace that even if what we are doing is wrong we are still with the crowd. And boy, do we love shooting down those who come up with radical thoughts.

But we NEED the outliers, the people who would dare to go against the crowd.The people who would challenge the theories which we have taken for granted. History has shown us that time after time that such people have emerged and their discoveries have changed the course of the entire world. But, easier said than done. It takes guts to go against the mass.

Personally I am guilty of acting like a so called EXPERT. So this is what I am advising to myself (and anyone else who is reading this post). 

1. Always look at both sides of the table before coming to my conclusion. Only after neutrally looking at alternate sides can I come at a solution. In certain issues, like economics for instance their might not be a solution at all. 

2. Encourage other people to be outliers. Do not shoot down people who hold the absolute opposite views than me. Be ready to change my view if enough evidence is shown.

3. Be more humble.

How to utilize the last 30 days before CFA exam

Preparation for any exam is somewhat of an art and people use different techniques. Still, we know that hard work is the key to success. Also, there are some methods which work better than others. I just wanted to mention some of the techniques which I followed during the last 30 days or so in all the 3 levels of the exam. Hopefully these will help everyone.

General Tips for last 1 month
Mock Exams
• I usually used the final month to give 3-4 mock exams in the first 15-20 days or so. After every exam, I put in my scores in an excel sheet to see topic wise scores.
• While giving the exam I usually marked the questions which I found difficult and the questions which I just answered on guess work.
• Next, I identified my mistakes by looking at the correct answers for not only the mistakes but those I got correct through guesswork. When I was unable to understand the answer, I went back to the text book.
• When I scored poorly on a topic I revised that topic and then went for the next mock exam. I repeated the same thing for the next exams but also observed whether my scores are improving or not overall and my weaker segments. Usually I put a lot of emphasis on my ethics score.

Revision
• In the last 10-15 days I usually went for a revision of the whole syllabus. Usually I went LOS by LOS. The objective was to see whether I could understand the concept crystal clearly for all the LOS. Once a LOS was mastered I crossed it out.
• I constantly revised the formulas. I usually made my own formula sheet and used to carry it wherever I went.

Things not to be missed 
• Make sure you have done ALL the end of chapter (EOC) questions from the original book. I would suggest that people do not waste time on questions from Schweser as real exam is very different from Schweser questions. If you have completed everything else and still have time then do Schweser exams.
• Some of the EOCs are quite complicated. I usually marked them to review them over and over again until I mastered them.
• Go through all the blue box examples from original book.

Planning for the 30 days
• I used to make a 30 day plan specifying what I will revise or read in the last 30 days. Sometimes I fell behind my plan due to family obligations or work pressure but by studying more on other days I used to cover it up.
• Normally I suggest that people try to beat their own plan and stay ahead.

Notes
• Some people make their own notes. I usually only made notes for the most critical chapters. However, notes are supposed to be made 3-4 months before exam. Trying to make notes at the last moment is not advisable as it will eat away time.
• If however you already have own notes then instead of reading the book you can just read your notes (depends on the depth of the notes).

Day before the exam
• This day is very important. Confidence level is as important as the preparation itself. To cool the nerves remember that you have studied hard and given your best shot. After this it does not matter whether you pass or fail.
• Try to go to sleep early. I had insomnia problems on this day on almost all three levels and as a result on the exam day I felt weak. If you see any such problems take a sleeping pill on the night before the exam.
 • Check your admit card, pencils, eraser, pen, passport, calculator. Check your calculator settings and go through the important functions in your calculator. If you can borrow an extra calculator then borrow one for emergency purpose. Also carry batteries and screwdriver.
• Go through the formula sheet quickly. See if you correctly remember the notations and symbols used in the formula.

Exam day  
• Wake up early in the morning and take a shower. Go to the venue as early as possible. Do not try to study just before the exam. You can off course take a look at the formulas.
• When the exam starts, go to your favorite topic and start answering. THERE IS ONE GOLDEN RULE I FOLLOWED. IF I COULD NOT ANSWER A QUESTION ON THE FIRST ATTEMPT I SKIPPED IT. I GOT BACK TO THEM LATER ON. Please do not waste time on any questions. All questions carry the same marks. However some of them can make you lose a lot of valuable time. TIME MANAGEMENT IS ESSENTIAL IN ALL 3 levels.
• Read all the questions carefully and understand what is being asked. The worst thing that can happen is failing due to silly mistakes.
• If the AM session feels exceedingly hard do not lose hope. In that case PM will be easier. I remember coming out of the Level 2 AM session with the feeling that I will surely fail. However the PM was much easier and I actually scored >70% in 9 segments and between 50-70 in 1 segment.
• While filling out answer boxes please make sure you are answering the correct question. A mistake in answering sequence could change your grade absolutely.
• Even if you have finished the exam with 1 hour extra please recheck all the answers.
• Fill out answers for each and every question as there is no negative marking.

Level 1
• In level 1 you just need to go through the entire syllabus. The actual exam is usually quite easy and has more focus on theoretical questions. The quantitative questions are also quite simple.
• Normally, you would not even have to think for many of the questions. Also, some of the quantitative questions can be answered without even calculating anything.
• Focus on the ethics segment which is very crucial.
• Overall you can expect to finish both AM and PM within 2.5 hrs. But like I mentioned earlier, please use the whole time and recheck.

Level 2
• Level 2 has the largest syllabus, highest number of formulas and much tougher study material compared to level 1.
• Even though the focus is on asset valuation and FSA, I found derivatives to be quite complicated. In fact, I probably had to read the derivatives chapter 3-4 times to get the basic essence of it. In spite of that, I found the actual derivative questions to be exceedingly difficult.
• Unlike level 1, the portion of quantitative questions is larger. Also the questions are not that straight forward. CFAI throws some curveballs from time to time. After reading a particular vignette the questions might look absolutely alien to you. Use your common sense in answering in those times.
• Put strong emphasis on formulas. Also notice whether questions states annual, quarterly or monthly compounding etc. These can be tricky while doing Swaps, Forward Rate Arrangements etc.

Level 3
• Level 3 syllabus is slightly smaller than level 2. It is not as difficult as level 2 to understand but the trick is to apply the knowledge in the actual exam.
• To pass level 3 the candidate must know the concepts like the back of his/her hand. Even the simplest topic can be made very difficult by structuring the question in an obscure manner.
• The key to succeeding in level 3 largely depends on managing time for the AM (written) section. I would recommend that candidates practice as many AM sessions as possible. CFAI website has a lot of such practice exams.
• Just because AM was difficult do not expect PM to be much easier. Some questions had a lot of curveballs which many candidates did not even realize existed. However it is easier to score more in the PM compared to the AM section.

Final Words
Give your best shot and study as hard as possible. However, success or failure also has a bit of luck in it. However know that you can pretty much pass if you get 70% on average. So even if you get 50% of the questions right, eliminate one wrong answer on 25% of the questions and blindly guess the rest 25% you can score about 70.75% statistically. Also the pass marks for level 3 is definitely set at a lower level.

A message for the people of my generation

Do you have a university degree or are in the process of getting one? Did you start your career? If any of these criteria apply to you then this write up is meant for you. Regardless of your social and financial status, you still fall in the privileged class of the society. You might have worked very hard for reaching this stage but you CANNOT deny the contribution of luck and the millions of people working at minimum wages. Directly or indirectly, society did have an impact on your good fortunes. If you agree with me so far then you MUST show your gratefulness by giving back to the society. There are many ways of doing that but for now I want to talk about Zakat and Taxes.

Why should I give Zakat? I should give Zakat because it is not fair that some people are wasting their wealth while others are deprived of basic needs. I can give hundreds of more reasons but that is not necessary. Only additional comment I want to make about Zakat (I am not an Islamic Scholar so I am saying things from common sense) is that the intention is more important that the outcome. There is no hard and fast rule that one only gives 2.5% of liquid assets as Zakat. Why would you not give more if you can afford to give more? We frequently make up strange logic (cognitive dissonance) in our head and using that logic we try to justify that Zakat does not apply to us. These self made theories are utter bullshit. Today we might be the one in a position to give Zakat. Tomorrow, we can easily be the ones who would need the assistance.

Now, let me come to the issue of “Income Tax”. Less than 2% of the population pays taxes in Bangladesh. Income tax to GDP is probably one of the lowest in the world. This is pathetic. Why are we not paying our taxes? Firstly, we are not paying taxes because we are greedy. Secondly, we say that the government is corrupt and whatever money we are pay as taxes will go to their pockets. When I thought about the latter argument I found that this has no logical basis. If we can give vote to the two major parties we cannot say that they are corrupt and hence evade/avoid taxes. Also, we are using all the facilities that the state is providing using the money given by actual tax payers. We are using the roads, the street light, the public parks, enjoying the subsidies that government provides and what not.

Let us stop feeding ourselves all these lies just because we have become materialistic and greedy. Let us give the Zakat properly and if possible more than 2.5%. Let us pay our taxes properly and then fight for our right to information and transparency. We are accountable for our responsibilities as citizens and government is accountable for their parts. Allah would not make us responsible for the corruption done by the government but would definitely make us responsible if we are enjoying the benefits of taxation but not paying our taxes. In the worst case scenario, if you are adamant that you would not pay taxes then at least calculate your taxes and give that to people directly as charity. Once we are fulfilling our responsibilities let us go to our family and relative and ask them whether they are giving Zakat and paying taxes properly.

The article with no title (Part 1)

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).

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.

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.

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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.

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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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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.

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