GCC needs monetary policy independence

This Article was Published in Gulf News,  Arab Times, Akhbar Al Khaleej and Alqabas

Typically, the topics in the business section of a newspaper in the GCC will almost always focus on issues such as the budget, deficits, subsidies, investment, etc. Meanwhile, a publication in the United States will dedicate more time towards speculating on the Fed’s imminent actions. Global financial markets gyrate to every move made by the Fed and hence are constantly trying to guess what its next one is likely to be. The GCC spends most of its time on fiscal issues since it has effectively outsourced its monetary policy responsibilities to the US Federal Reserve and therefore they are compelled to mirror the Fed’s policies regardless of its domestic economic underpinning. Fortunately, for most part of the arrangement, this worked reasonably well with business and economic cycles of the US and GCC being roughly synchronized. Additionally, strong oil prices throughout much of this period enabled GCC governments to build reasonable reserves; which also thwarted any occasional challenges which would pressurize the pegged currencies.

However, the recent drastic fall in oil prices and oil revenues (on which the budgets are heavily dependent) and the near unanimous consensus of the new low oil price reality going forward has changed that scenario. Given the high and growing break-even oil price (the oil price required to balance the budgets), GCC governments will now either have to draw down on their reserves at a faster rate or resort to borrowings to fill the gap. Being modeled as welfare economies, the restructuring process to rationalize subsidies and stop providing pseudo-employment in the public sector can be painfully slow. Hence, GCC governments will focus on reducing their role as the main investor in their respective markets and dedicate resources towards diversification strategies. The private sector will be encouraged to play a larger role in this diversification effort, especially in sectors such as healthcare, education and transportation where the government is currently forced to commit significant funds and capital. Also, research and innovation will rightfully be granted a higher priority as it can quicken the transition from public to private sector-based economies.  As the shift happens, maintaining a positive business environment will take precedence over government expenditure. Improvements in ease of doing business ranking will have to be achieved in swift time as the economy faces liquidity shortfalls, increase in cost of capital and higher risk premium.

In such a scenario, where government spending and employment will reduce and private sector led diversification process takes center stage, an outsourced monetary policy model may be counterproductive and costly. The ability to set short-term interest rates in order to manage domestic cost of capital and inflation will become important in order to orchestrate the transition. Monetary policy independence would be a necessary requirement for this to be possible. Otherwise, a pegged currency dictated by US monetary policy, where the interest rate curve may be sloping upward going forward, can create serious frictions in  the GCC’s low economic growth environment.

GCC monetary policy independence is also warranted in an environment where the Fed is running out of ammunition. According to The Economist, in the 3 most recent US recessions the Fed slashed rates by 675 bps, 550 bps and 512 bps respectively. However, what is interesting to note is the time taken for rates to return back to normal levels. The Fed took 2.5 years and 3 years to return to normalcy in the first two recessions respectively. However in the most recent recession of 2008, it is 8 years and counting. Should another recession occurs, the Fed will not have the necessary tools at its disposal. It is generally opined that long-term problems which are enveloping in the global system like low economic growth, deflationary concerns and lack of business confidence cannot be solved using the Fed’s short-term monetary tools. For a variety of factors, sooner or later, the Fed will lose its role as the financial market’s sole saviour. Such factors include the fact that its short-term interest rates have already hit rock bottom, an inability to move back to normal rates for a long stretch of time and the long-term nature of many problems that the Fed do not have resources to provide solutions with.

It is therefore time for the GCC to have an independent monetary policy framework like its fiscal policy framework. Such monetary independence will provide the GCC with the ability to set short-term rates and help guide the capital allocation process more cost effectively. It will also enable better control of inflation and will reduce friction in a challenging low growth economic environment. 

GCC M&A: It’s Shopping Time!

This Article was Published in The National

GCC Investment Bankers (IB) should be the most stressed lot! Too much work and too little rewards. The fee based investment banking business has four key components going for it i.e., syndicated loans, equity capital markets, debt capital markets and Mergers and Acquisitions (M&A). While in other markets we can witness activity across the four components, in GCC the IB advisors solely depend on syndicated loans for their survival. (On average 50% of total IB fees) Equity capital market is dull thanks to poor performing capital markets and related dull IPO environment. Debt capital market looks promising given the slew of activity expected from sovereigns and corporates. However, the sticky point seems to be M&A, which can be erratic and suffer from some idiosyncrasies.

The fallout of Global Financial Crisis and the recent oil price crash has dented the stamina of corporates leading to weaker balance sheets for many companies. The operating environment has turned difficult with stagnating earnings and increased cost of capital. After hitting peak of $70 billion in 2014, our research expects corporate earnings to touch $62 billion for 2016. This should be a dream environment for M&A advisors as difficult environment forces corporates to restructure, improve efficiency and productivity, hive off non-core assets and concentrate on strategic business. In other words, corporates need the help of M&A advisors to do all this.

However, the value of announced M&A transactions reached $18.7 billion during the first half of 2016, a decline of 29 percent compared to the first half of 2015 and the slowest first six months for deal making in the region since 2014 according to Reuters. What can explain this conundrum?

GCC market is dominated more by private companies than public companies. Scouting opportunities in the private market is onerously difficult due to lack of transparency and family control. This prevents deal flow even though there may be genuine need for M&A. Even assuming healthy deal flows (cases where companies express interest to hive off non-strategic units), the actual consummation of transaction can be low (poor deal closures) as poor information can prevent meaningful negotiations and conclusion of transaction. Take the case of Emaar Properties buying a stake in Americana (Kuwait Food), a deal that was in the making for years with multiple parties. There are several such examples like Etisalat ending talks with Zain, Kuwait or EFG-Hermes agreement to create the largest Arab investment bank with Qatar’s QInvest collapsing in 2013 after the deal didn’t get Egypt’s regulatory approval.

GCC M&A environment is also characterised by dominance of “mega deals”. Take the recent acquisition of Emaar Properties chairman Mohamed Alabbar’s buying of 9.9% stake in Aramex or his recent acquisition of a USD 2.36bn stake in Kuwait Food Company (Americana) along with a group of investors or the recent merger of National Bank of Abu Dhabi (NBAD) and First Gulf Bank (FGB) which  is expected to create a mega bank with total assets of around USD 171 billion (only bettered by Qatar National Bank whose assets stand at USD 190bn) or the celebrated Emirates Bank and National Bank of Dubai merger to form Emirates NBD in 2007. Domination of such mega deals can “crowd out” other transactions and can also create league tables (rankings of Investment bankers) that can look very different and distorted from one period to another (making it difficult for comparison).

How will things be going forward?

Given the low oil price environment, corporate stress levels are bound to increase going forward. Need to restructure, enhance productivity and efficiency and hiving off unnecessary non-strategic assets will be pursued vigorously by private and public players. This should certainly be good news for IB’s. Also, companies are unusually sitting on very high levels of cash as measured by data available for publicly listed companies. At the end of 2015, total cash levels reached nearly $250 billion with financials (read banking) accounting for $155 billion. Hence, banking related M&A transactions will continue to see action followed by energy and telecom. “Mega deals” may continue to dominate the scene but given the oil price impact across the board, representation from mid-level segments and SME’s can also increase. This will help to improve the ratio of “pipeline to closure” which should be good news for IB’s. Political climate will also play a role in Mena ex GCC countries. Volatile political situation, large scale currency fluctuations and lack of lending and underwriting experience in those regions could increase the risk that could outweigh any potential gains and hence this may shift the focus back to GCC. 

Nifty Top 10, How will it look like in 2025?

This Article was Published in Market Express

Though the Nifty index comprises 50 stocks, the top 10 enjoys a lion’s share. In 2005, the top 10 constituted nearly 60% of the index (in terms of market capitalization) while in 2015 it comprised 48%. Obviously the performance of Nifty itself will be impacted by who is on this coveted top 10 list and funds flow from institutions (both domestic and foreign) that track this index will also be skewed towards these top 10 companies. Hence, the curiosity to study this in greater detail and try and figure out how this top 10 list will look like say in 2025! Also, a look from 1996 to 2015 for Nifty 50 shows that more than 115 companies have been part of Nifty 50 with average age of 8 years. In other words, if a company has been in the Nifty 50 index for more than 8 years , its probability to continue in the Nifty 50 reduces. In this context, the race to top 10 gets even more interesting.

How the sands have been shifting?

Back in 2005, ONGC was the top company in Nifty followed by Reliance and TCS. Fast forward to 2015, the coveted top slot has been taken up by TCS with ONGC pushed to 7^th spot though Reliance managed to keep the same 2^nd spot. However, the attrition rate of top 10 between 2005 and 2015 has been 50% in that only 5 of the top 10 in 2005 made it to 2015. Wipro, Bharti Airtel, ICICI Bank, Satyam computers and State Bank of India dropped out in the 2015 Top 10 list. HDFC Bank, Coal India, HDFC, Sun Pharma and Hindustan Unilever replaced them in 2015. 

The rise of TCS from the 3^rd position in 2005 to 1^st position in 2015 is impressive as its market cap compounded at an astonishing rate of nearly 20% between 2005 and 2015. While it had a market cap of just $18 billion in 2005, it jumped to $72 billion by 2015 making it as the most valuable company in Nifty 50. The saga of HDFC Bank was even more impressive. Back in 2005, it was at 18^th position with a market cap of just $5 billion. It then moved 15 places up to become the 3^rd most valuable company in 2015 where its market cap compounded at an astonishing rate of 22.5%. The rise of Sun pharma is also credible whose market cap grew nearly 10 fold between 2005 and 2015 moving it from 31^st position in 2005 to 9^th position in 2015.

Getting to 2025

While it is useful to know changes that happened in the top 10 coveted list during the last 10 years, it can be challenging to figure out how this list will look like say 10 years from now. On a perusal of growth rate performance of Nifty 50 companies during the last 5 years, I see a normal distribution ranging from a positive +30.7% (Lupin) to a negative -22.7% (Vedanta). However, positive performers (companies with positive rates of growth in market cap) outnumbered negative performers 35:15. In other words, 35 companies enjoyed positive growth during the last 5 years while 15 suffered negative growth rate. The top 25 stocks organized in terms of CAGR shows that companies have grown at a hectic pace during the last five years. The CAGR among top 25 ranged from 30%(Lupin, HCL Tech, Indusind)  to 10% (Mahindra and Mahindra). Going forward, I believe maintaining such high growth rates may be difficult given the headwinds blowing across the world. There is a recent Mckinsey study that says that long-term equity returns for the next 20 years will be nearly half of the last 30 years average for US and European equities. While US and European equities clocked 8% annualized growth in the last 30 years, they are expected to clock a growth of 4-6.5% in the next 20 years. Also, in the next 20 years, Mckinsey expects inflation to rise, interest rates to remain the same, and weaker GDP growth. More importantly, it observes that emerging market companies and new tech competition could cut margins. The story is the same on the bonds side where the last 30 years produced a bond return of 5% in US, the next 20 years will produce a return ranging from 0-2%. Welcome to a world of diminishing returns!

Hence, it may be prudent to assume that going forward the CAGR for Nifty 50 companies could be just half of what it enjoyed during the last five years (excluding negative growth companies). While this may sound conservative, in my view it is more realistic since compounding at a very high rate for a period of 10 years can produce extraordinary numbers. Given this approach, here is the list of Top 10 Nifty 50 companies by 2025.

Who makes it?

6 out of the 2015 Top 10 makes it to 2025 with TCS continuing to remain the most valuable Nifty 50 stock. TCS would have improved its market cap from  $72 billion to $158 billion implying a CAGR of 8%. Sun Pharma would have moved from 9^th position to 2^nd position while HDFC Bank will retain its 3^rd slot even in 2025. Notable new entrants to the Top 10 list would be HCL Tech that was positioned at 22 in 2005, 19 in 2015 and would be 6^th by 2025. Impressive indeed! Maruti Suzuki also has a similar ascent (21: 2005; 13: 2015; 7^th:2025). Kotak Mahindra Bank moves from 16^th position in 2015 to 8^th position in 2025 while Lupin moves from 23^rd (2015) to 10^th (2025) with its market cap improving to $52 billion.

Who loses it?

Notable exclusions in 2025 from the Top 10 include Reliance, Infosys, Coal India, and ONGC. Reliance will move to 11^th position from 2^nd, while Infosys will move to 12^th from 5^th. Coal India will move to 15^th from 6^th while ONGC will move to 16^th from 7^th.

Sector Shifts

While Oil and Gas dominated the scene in 2005, it is nowhere to be seen by 2025. Telecom has already lost it by 2015 while tobacco holds on thanks to ITC. Financials will see continuous growth in the Top 10 while automobiles will be a surprise entrant by 2025 (thanks to Maruti). However, the most important ascent is noticed in pharma whose market cap will explode from $30 billion to $160 billion courtesy Sun Pharma and Lupin. IT will still be a big part with TCS and HCL Tech leading the way.

Investment Implications

The jostling for space in the Top 10 can be important to make investment decisions. Firstly, it will have huge impact on the index per se. If you are investing in ETF’s, you will mostly track the index which is heavily skewed in favour of top 10. Index investors will also navigate this process of churning given the shifts in weights. Index realignment happens over time and hence investors in ETF’s will underperform active managers especially in emerging markets like India where ability to add alpha is very high.

If you are in stock picking, this study shows sectors to avoid (oil and gas, Telecom) and sectors to embrace (pharma, IT). You may even want to deep dive attractive sectors (by dwelling into mid-caps) to bet on future winners. Automobiles and auto ancillary are good examples.

The market cap of Nifty 50 will increase to say $1.6 trillion in 2025 from $824 billion at the end of 2015. That is a modest 7% annualized growth between 2016 to 2025. However, if you focus on the top 10 list likely to be in 2025, your investment performance should definitely be better than 7% at the least. However, what is crucial is to keep an eye on this transformation as even stable companies can spring surprise on the negative side.

PS: The author thanks Rajesh Dheenadayalan for data assistance

FINANCIAL CHALLENGES FOR GCC

This Article was originally written for CFA Institute and published in several newspapers including Gulf News and Arab Times

The GCC is witnessing a period of rapid transformation as oil prices, which were once at a cushy $100 per barrel, has fallen below $50 over the past 18 months. The stable oil prices between 2012 and 2014 enabled GCC to earn more than $3 trillion in export revenues. Thanks to that, GCC governments are now sitting on strong cash reserves.

However, that is only a short-term comfort. Given the extremely high dependence on oil revenues of GCC governments and their lack of economic diversification, the depletion rate of those precious reserves has been highlighted as a major cause for concern. GCC countries now require the oil price to be much higher than $50 in order to balance their budgets. Since prices are still significantly lower than that rate, the region’s governments will face successive years of fiscal and current account deficits; which they will have to plug through additional reserve depletion or through borrowings. Given this context, I would like to specifically look at the financial challenges this period of low oil prices will pose to four specific stakeholders: Government, Banks, Corporates and Individuals.

Government

The biggest pressure is on governments, who face a bloated bureaucratic structure and increasing levels of expenditure largely comprising of salaries and subsidies. Therefore, there is little flexibility for them due to the current social welfare model and the strong social contract with nationals. While rationalising subsidies and reducing wasteful expenditure can be prioritised, this may not reduce deficits within the urgent time frame that is required. Hence, the biggest financial challenge for GCC governments will be funding growing deficits. The IMF estimates GCC countries to pose a fiscal deficit of about 12% of GDP or $150 billion in 2016. I expect this to be met through a judicious combination of reserves, local debt and foreign debt. Research estimates by Marmore point to the cumulative debt increasing from $250 billion to $390 billion by 2020, a significant jump from $72 billion raised cumulatively between 2008-2014. Such a massive growth in debt raising is bound to have an impact on the overall economy in multiple ways. Saudi Arabia, for the first time in eight, had to secure a loan of approximately $26 billion from domestic banks in 2015. It is also in talks to raise $10 billion from a consortium of international banks in an effort to address their growing budget deficit. Most notably the credit rating will be lowered as a consequence of the increasing Debt to GDP ratio. Sovereign ratings of Bahrain, Oman and Saudi Arabia have already been downgraded recently with further downgrades expected in the future. Another point of impact will be the Credit Default Swap (CDS) spreads. In the last six months, CDS spreads of Abu Dhabi, Qatar and Bahrain have doubled while Saudi Arabia’s has tripled. The current macroeconomic conditions will also increase the cost of capital for governments.

Banks

The financial challenge for banks will come in the form of lower levels of liquidity. Banks, to a great extent, largely depend on government deposits for their liquidity; which have experienced significant decreases. With stagnating growth in deposits, banks will have lesser amounts to lend at a lower spread; which will have a negative impact on their profitability. On the other hand, the sovereign bond issuances will see high levels of subscription by banks because of the attractive yields and their risk free nature; this will crowd out lending to the private sector. The pressure this will introduce to the margins of banks will result in lower profitability. Additionally, the financial challenges for corporates will mean deteriorating asset quality and a rise in Non-Performing Assets. As a result, the credit rating for banks will remain on the downward trajectory.

Corporates

Banks being crowded out will directly impact the private sector, since fund raising will be increasingly difficult and expensive. Many companies have solely depended on government spending for projects. In this climate, project delays are inevitable and may affect working capital. Advance payments for projects have been slashed from 20% to 5% of contract value. Since corporates access banks for most of their short-to-medium funding requirements, access to funding may become difficult and expensive given the pressures banks face resulting from lower liquidity and tighter margins. Debt markets may be an attractive source of funding for governments but not for the corporate sector due to wider spreads demanded by lenders. We have already noticed a weak corporate issuance of debt due to the drying up of liquidity. Where funding is absolutely necessary, it will come at higher cost of capital which adds additional pressurise on margins and profits. Introduction of VAT may also impact corporate profitability. These developments will have a substantial impact on Small and Medium Enterprises (SME’s); who will be crowded out the most.

Individuals

Financial challenges for individuals will come in different forms. Firstly, the generous government policies in the form of subsidies will see cuts; especially for the three most highly subsidised amenities which are petrol, water and electricity. As subsidies are reduced, the cost of services will increase and lead to higher inflation. Individuals will also have less access to financing options from Banks as lending procedures are tightened. Simultaneously, borrowing costs will also increase. Such market conditions may lead to increased debt defaults. Also, governments employ a majority of citizens in the public sector more as a social contract rather than genuine need. The absorption rate will come down as a consequence of growing federal deficits.

Opportunities

As many experts say, challenges can also be viewed as opportunities. Increasing government debt will induce financial discipline, better management of fiscal expenditure and more importantly, the much needed development of debt markets and improvement of the yield curve. Efforts to reduce wasteful expenditure will improve productivity levels across sectors and banks will look for overseas expansion opportunities to improve profitability. The current economic conditions will also encourage the adoption of advanced technological products and services to reduce the cost of service offerings. Corporates will focus heavily on efficiency and productivity gains and align corporate planning with thoroughly researched market needs. Mergers and Acquisitions will be on the rise along with alternative financing avenues such as private equity, crowd funding and sukuks. It will be a period of financial reform to navigate through this challenging period for both the government and private sector!

Don't miss the trees for the woods

This is the editorial written by the author for Marmore Bulletin-a quarterly thought leadership publication focused on Mena region.

Let us accept it. The topic of oil price discussion has come to a tiring point now. Every other debate or discussion is around oil price predictions, outlook for oil price and predicting the future of GCC oil economies. Three questions predominate the narrative:

       1.       Is the current fall in oil price cyclical or structural?

       2.       When can we see a strong rebound? (2016 or 2017 or beyond) &

       3.       Can GCC survive a long spell of low oil price?

In fact, the second question is related to the first question. If the current fall in oil price is structural, then we cannot expect any strong rebound. So, may be implicitly we should pray that this is just a cyclical phenomenon. From a mean reversion perspective, a period of low oil price should be succeeded by period of improving strong oil price and hence it may not be out of place to expect a rebound since we have been suffering from low oil price for some time now. Also, with trillions of reserves earned during good times, GCC may be well entrenched to whither the oil storm for longer than we think. So why worry about oil price?

The answer lies in demography and welfare state model of GCC. Both of them will make sure that government expenditure is on the rise which implies requiring higher oil price to balance the budgets. As population grows at a healthy rate (emphasis youth population), the pressure on infrastructure investments, job creation and essential services (education and healthcare) increases manifold. Surround this with challenging geopolitical situation, you can guess the answer. The answer to the challenges enumerated above does not lie in high oil price as we have figured out by now. The answer lies in creating meritocratic institutions that focuses on nurturing innovation and creativity. The answer lies in fostering reforms across the board so that doing business even by local family businesses gets lot easier and cheaper. GCC should restructure their economic business model in such a manner that it no longer depends on just one commodity for its survival. We should use the oil industry to champion the change. We should focus on reduction of wasteful expenditure rather than augmenting non-oil income (through subsidy rationalization and taxes). While subsidy rationalization is essential (given the extremely low pricing of services), it should succeed efforts to augment efficiency in the existing model which can reign in extraordinary savings.

GCC must embark on a path that will make those 3 questions redundant in the next 10 years.

Conflict of interest

In our day-to-day work we come across several situations where we face severe conflict of interest. If we are in a situation faced with a conflict of interest, ethics demand that we disclose and move away from the situation that creates the conflict. However  if you are faced with a situation where there is a potential  conflict of interest that you note but cannot do anything about it that would probably not be as simple to deal with because the ability to remove the conflict of interest is not within your hands. Here is a simple list of certain conflict of interests that I have observed mostly within finance/commerce space over time and it would be interesting to see how they play out in terms of business decisions.

Credit Rating

This is the mother of all conflict of interest that I have ever observed. The credit rater is paid by the credit rated. In simple words, you take money from a company to provide a rating to the company. This conflict probably was at the heart of global financial crisis. However the model continues to operate the same way. Even now the credit rating companies are paid by credit rated companies and not by any independent agency. Well, to an extent credit rating agency can appear to  be unaffected by this conflict of interest, but I am sure down the line there would be an impact of this direct conflict of interest between the rating agency and the rated company. The best way to resolve this is to create an independent credit rating agency fully funded by government. The government can impose some sort of tax on corporate on overall basis and try to do this as an independent exercise completely devoid of any conflict of interest. A credit rating borne out of such a process can definitely be more unbiased and objective. 

Sell-side research

The brokerage industry thrives on brokerage commissions. Brokerage commissions are derived by the extent of trading by clients (investment companies or asset management companies). In order to elicit the interest to trade, brokerage companies come out with a series of research notes on companies in what is now popularly known as sell-side research. The idea is to trigger either buying interest or selling interest about the client firms so that that the commission earned can be increased.  Obviously this sort of research is not going to be independent or objective because the purpose of this research is basically to trigger trade actions and not to enable unbiased objective investment decision.  There is still no way out of this sell- side research dilemma.  Investment communities still continue to depend hugely on sell-side research even though they see this conflict of interest very clearly. Of course, certain regulators mandate publishing details like investment banking business done in the past one year, number of sell call/buy calls and history of calls along with actual performance. More often than not, these disclosures come in small print! 

Media

Media is probably one of the best examples of a conflict of interest. The most popular newspapers and magazines literally thrive on advertising revenues almost completely. Nearly 90% of their total income accrues from advertising revenues rather than subscription revenues. So obviously this poses a limit on how far you can go to be independent about client companies lest your main source of revenue will be hit. This is true for print media, television channels and digital media too. We all know that views that are being aired about these companies that are their clients can never be independent or objective since their existence depend on continuation of their advertising contracts. And curiously enough, the client list can also include political parties! 

Audit and Consulting

Auditors normally are mandated to be extremely independent and they have to provide independent view on the financial status of the company. Like credit rating agencies, auditors are being compensated by the company that is being audited which itself is a potential conflict of interest, but by virtue of their access to almost all records and status of company, they are also in a position to see what type of consulting mandates can be obtained and executed by the audit firms. Technically they may not do it under the same name but there are ways to get around this. 

Board of Directors

Board of directors can either be independent businessman in which case they would try to push their business opportunities or they could be simply also be a client or vendor for the company. It may not be done directly but there is always conflict of interest between being on the board and trying to influence the company to use the services of the businesses that they are directly or indirectly connected with. 

Financial audit

There may be cases where senior partners of an audit firm can hold some sort of a stake (direct or indirect) in the client company for which they conduct financial audit. This will be definitely be at the back of their mind when they conduct the financial audit because their financial fortunes are tied to the audit opinion and they may not be having the courage to give true opinion about the firm since they hold a stake in the firm. 

Hospitals

Major hospitals and to an extent even clinics of a decent size have their own testing laboratories. These laboratories house expensive, often imported, medical equipment whose capital costs need to be recovered at the earliest. Hence, doctors have implicit incentive to refer patients to sometimes necessary but most of the times unnecessary tests in order to recover the capital investments. I believe in many hospitals doctors have targets when it comes to recommending tests! 

In summary, conflict of interest abounds and surrounds us in everyday lives. It may be a source of intense frustration when it impacts our personal lives (like hospital example given above). In corporate situations, it may affect our performance as investment or portfolio manager where we rely on credit ratings or equity research to make investment decisions. In most of the cases, the cost of conflict of interest is not straightforward or apparent though we know it exists. It may pay well to be conscious of this while making decisions though in many cases it cannot be avoided. By no means, this list is exhaustive. Feel free to suggest other apparent conflict of interest that you have observed.

Saudi Arabia and its US dollar peg dilemma

This Article was Published in The National

The fall in oil prices has strained Arabian Gulf countries’ cur­rency policy, and increased the cost of carrying a US dollar peg.

Most GCC countries are pegged to the US dollar to avoid currency fluctuation and eliminate uncertainties in international transactions (Kuwait is pegged to a basket of currencies dominated by the US dollar).

This comes at the expense of monetary policy flexibility. Stable domestic currency and a fixed exchange rate imply that traders do not have to face currency risks, and therefore will be more willing to invest and facilitate trade. Since oil is the chief commodity in the GCC, and the oil price is fixed in dollars, any exchange rate fluctuation could drastically reduce revenue if the currencies were unpegged.

With the US economy expanding, the Federal Reserve has begun hiking interest rates gradually, and plans to achieve a target of 3 per cent by the end of 2018.

While the US is expected to ride a growth wave over the next few years, the GCC economies, especially the oil exporters, are facing contraction because of low oil prices. Declining oil revenue, subdued global growth, liquidity crunch and geo­political issues are some of the challenges facing the region.

These differences are starker in countries such as Saudi Arabia, the world’s largest oil producer and exporter, where more than 73 per cent of government revenues come from the hydrocarbon sector, according to the Institute of International Finance industry group.

In such a scenario, Saudi Arabia can either follow the monetary policy direction set by the US or deviate from it.

If it opts for the former, the kingdom maintains the peg but sacrifices its growth, as it will tighten monetary conditions during a period of low growth. According to the kingdom’s central bank, the Saudi Arabian Monetary Agency (Sama), a 100 basis point increase in the Saudi Interbank Offered Rate (Sibor) leads to a decline of 90 basis points in GDP in the subsequent quarter and 95 basis points in the quarter after that.

If it opts for the latter, then there will be a gap in interest rates between the US and Saudi Arabia, leading to arbitrage opportunities. To counter this, Sama will have to buy Saudi ­riyals in the open market by selling US dollars from its reserves. And as the Fed increases the interest rate, Sama has to keep depleting its forex reserves until it runs out of dollars. Hence there is a cost involved with ­either choice.

The oil price fall since mid-2014, has reduced the kingdom’s revenue, incurring a deficit of $98bn in 2015, and it is estimating a further $87bn deficit in 2016. The Saudi government had funded this deficit by drawing down its central bank deposits, reducing its forex reserves to $602bn; a drop of $132bn, in the year to this January.

During the last Fed hike, Saudi Arabia, along with ­other GCC countries, raised its interest rates tracking the US monetary policy. According to Moody’s, the kingdom has large foreign currency reserves that provide ample room to maintain the pegged exchange rate regime for several years, even in an adverse oil price scenario. At present, Sama holds about 80 per cent of its investments in US Treasury bills.

While this should have been a clear indication of Sama’s dir­ection, early this year the forwards market for the Saudi riyal sprang to life with speculation that the kingdom could be forced to abandon its three- decade peg to the US dollar. The market expected a 12-month forward exchange rate of 3.85 riyals to the dollar, a 2.7 per cent devaluation from the 3.75 level that has, in essence, held since 1986.

Sama doused the speculation by reiterating that it will continue to stick with its currency peg, and ordered banks in the kingdom to stop offering options contracts on riyal forwards to their clients.

Other GCC countries with sufficient SWF assets and central bank reserves, such as Kuwait, Qatar and the UAE, could also maintain the peg with little difficulty.

However, Oman and Bahrain do not enjoy this luxury, and could potentially run out of reserves in less than three years. Both these countries have resorted to issuing debt to extend the longevity of their reserves.

For Saudi Arabia, speculation about the possibility of depegging its currency from the US dollar may have been premature, but it has provided an opportunity to analyse the costs incurred by the kingdom in maintaining the peg, and whether an alternative exists to the current scenario. While the low oil price does not seem to have affected the peg much, thanks to the presence of ample forex reserves, it could have severe repercussions in the future, if the low prices persist.

Looking ahead, cost benefit analysis, stress and scenario testing are a must to gauge the extent to which the status quo is preferable. While the advantages of maintaining the peg are manifold, so are the costs. Ergo, Saudi must also chart out a road map and prepare for a time where depegging from the US dollar is a preferable option to continuing with an expensive peg.

Mistakes I Made As An Investor

Human psychology is a powerful force and spoiler, especially in investing. We tend to glorify our successes and ignore mistakes or best give it a passing reference in coffee tables. Stock market investing is treacherous and requires strategy and monitoring. Even if your strategy is subpar, a good monitoring system can save the day. On the other hand, a great strategy with subpar monitoring can be disastrous.

So long as we earn money, we are savers and investors. Hence, it may be worthwhile to recount some of the mistakes I have done while handling my savings, especially in stock markets. Let us see what those mistakes are.

1.   Not having Endurance

Markets are by nature volatile and hence make your emotions swing. It is normal to get upbeat in a bull market (and laud your expertise) and disheartened in a bear market (and curse bad time and luck). However, what is critical is your endurance during the down market where your emotions are tested to the hilt. I remember buying some of what is called today as blue chips way back in 1990’s when I stepped into a career. If only I had the endurance to have held them today, I could have retired a while ago! Instead, I gave into the market psychology of selling when everyone was selling. Sometimes, your investments go nowhere though they are not producing any losses. They can test your patience since you will have the urge to compare them with broader market or with other stocks. Stock price appreciation can never be a straight line. Many stocks have a long time period of flat performance and then a takeoff (what I call as inflection point). But the point is we cannot predict when that take off will happen. Since we cannot predict this, we sometimes lose interest and exit the investment. That can prove costly as well. Here is an example of Eicher Motors. Notice the long stretch of flat stock prices (2001 to 2009) hovering between Rs.24 and Rs.400, and then a sudden burst of performance taking the stock price all the way up to Rs.21,000 within a short span of time. If you were holding this stock since 2001, it would have really tested your patience!

2.   Going by the Herd Mentality

Identifying investment opportunities is a time consuming and lonely work. It requires validation from several fronts including financial analysis, qualitative analysis and connecting all the dots that are strewn all over the place. Even then, one cannot be sure about the future prospects as on the date of investing. However, there is an easy way of doing all this. Just go by what your friends/colleagues/relatives are doing or what your brokers recommend. If they are buying ITC, so buy it. If markets are going up, keep buying when the trend is positive regardless of whether valuations are reasonable. This is a sure recipe for underperformance. I used to compile the top holdings of all the leading fund managers to see where they are investing in order to mimic their investments only to realize that such a strategy is very similar to herd mentality which the fund managers themselves are suffering from!

3.   Mistaking name/brand for profits

The key indices (like Sensex and Nifty) are always dominated by large caps. By definition, most of them would be market leaders in their respective industry (Bajaj Auto, Infosys, Reliance, HDFC, ITC to name a few). Market leaders are big brand owners. But being big and owning sexy brands do not equate to good performance all the time. Sometimes, it is the small seemingly boring businesses without any recognizable brand power that can create enormous shareholder wealth, which is what we are concerned. Also, once a company becomes large cap and brand leader, it may unnecessarily spend loads of money to keep that status which can be a big negative for shareholders. No wonder, many of the large caps in the index have poor performance track record during the last 5/10 years in terms of creating shareholder wealth.

4.   Not acting when I should Have

It is said that the easiest thing in the stock market is to buy and the toughest is to sell. You will be forced to take a sell decision under three scenarios i.e., when you made good money and wondering if you want to take some profits, when you have lost significantly and wondering if you should cut further losses or when you have a liquidity need where you are forced to sell regardless of the situation. The first is a good problem to have and the third is a bad problem to have. However, the trickiest part is the second. This is where psychology comes and acts as a spoiler. When your investment is down, your psyche refuses to accept it as you feel you have grossly erred in your judgment. And also, there is this innate feeling that this is temporary and the value will come back. This feeling need not be backed by any logic. It can just be a feeling. Also, you have a reference point i.e., your purchase price and your psychology is swayed by this reference point. Unfortunately, the market does not know or does not care what your reference point is. Hence, once the investment goes down in value, it need not come back (as you innately feel). Rather it can go down even further. I remember being caught in one such investment cycle where I invested in a gulf stock called Gulf Finance House (GFH). Relative to my investment value, my realized loss on that investment was 98%!. A classic example of not acting when I should have.

5.   Averaging on the Downside

This probably counts as a very common reaction when your investment value is down. When the stock price tumbles, instead of fearing further downside our instincts let us think that “if it was attractive at the earlier level when I bought, it should be even more attractive now, so let me buy more”. Again the spoiler in this situation is the reference point, which is your initial purchase price. Your reference point has no reference value for the market and hence averaging down on the downside can only result in “throwing good money after bad”. Since markets are volatile, bounce backs are common and can make you feel that you let a great opportunity to average your purchase price when the bounce back happens. However, if price bounces back it will also make your investment look good and hence should be of less worry. But if your averaging down does not pay off, the net loss on that investment will be manifold. Hence, the need to wait for the right price to buy stocks so that we are not caught in this dilemma of “double down”! I am appending a table to illustrate this effect. During the last one year, Nifty has been doing poorly so much so that out of 50 stocks in Nifty 43 of them are in negative territory. All these 43 companies are ripe for “averaging down” concept. The worst performer in Nifty during the last one year was BHEL with a 61% fall in share price. The stock price plummeted from Rs.270 to about Rs.100 now. Any averaging along this path could have produced endless pain. The same can be observed with other indices of NSE as well.

      

   6.   Not being affected by loss on profits

Not all losses are same. A loss of capital can produce more pain relative to say loss in profits. Hence, complacency to deal with losses in the second case. We panic the moment we have a loss of capital. But we do not show the same panic when our profits  are reduced though in theory a loss is a loss. At least, that is how I dealt with my losses worrying the most in cases where the capital is negative and not worrying about those where it is a loss in profit situation. The best way to deal with this problem is to equate your year-end market value to 100 and look at the appreciation/depreciation from that perspective. Appended is a table with some hypothetical numbers to explain the concept. If your investment starts at 100 and in a 5-year horizon touches a peak of 150 and reverts back to 100, your compounded annual growth rate (CAGR) will be 0 with no negative performance highlighted in the interim 5 years. Since you don’t see any negative performance, you may turn complacent to loss in profits. However, if you equated the year end value to 100 every year, years 3,4,and 5 would have highlighted negative performance. Such a performance highlight could either have enabled you to take the profits or do something else other than stare the stagnant performance.

7.   Not Insuring the portfolio

Insurance need not be restricted to just life, cars and bikes. Even your stock portfolio requires insurance lest you run the risk of swinging along with the market. Like life insurance or other insurance products, portfolio insurance also will cost you money. But that cost is bearable given the downside protection it offers during sharp market downturns. Simple portfolio insurance example is to buy put options. Fortunately Indian markets now offer such portfolio insurance products. Even where you have investments only in mutual funds or ETF’s (for some reason many think they are safe investments!), you still need to insure your investment as your fund manager will not do it for you.

8.   Mistaking performance for stability

When a stock performs well on the back of good company performance, we can mistake it for stability and hence may fail to check the story at regular intervals. Turning points, even in a good scenario, can be sudden and can wipe out gains in no time. A recent example is Motherson Sumi, an auto ancillary company. Like Eicher, the company had a long streak of ordinary performance and then had a nice takeoff. From Rs.88 in Sept 2013, the stock went up to Rs.348 in August 2015. Not many paid attention to its over dependence on Volkswagen (40%) and when bad news came in the form of scandal involving VW, the stock price of Motherson Sumi plummeted 42% in just two months!

9.   Mistaking Performance for Skill

The biggest mistake you can make as an investor is to attribute success to your skill and failure to luck! (or bad luck!).  The performance of a company and therefore its stock price is dependent on scores of quantitative and qualitative factors. While through skill you may be able to crack the quantitative part, it is a time-consuming and innate exercise to look through a company qualitatively. Qualitative factors include a deep understanding of the Board and executive management, their track record in terms of corporate governance, ethical conduct of the company and its owners, employee remuneration, tweaking books to show a certain performance number, political connections, front running the stock, insider trading, etc. Either you devote a considerable time unlocking these essential elements to develop the needed conviction or go with a gut feel on the subject. Given our inability to find time, we normally resort to the second tactics. When your decision turns positive, you feel you are in control of this process. Always double check the story during a good performance period just to be sure you can keep the profits.

Honestly I have been through all these mistakes in one form or other. This list of mistakes may not be exhaustive and I may unravel many more as I reflect.