Investors often overestimate the probability of a favourable outcome coming to pass in a given situation. We also put great faith in mathematical models despite major flaws and create models based on past data, which is validated only against that same past data. This can have some strange results
Investors certainly have a lot of enemies these days. Governments are certainly near the top of the list. Capricious governments are happy to indulge in dubious macroeconomic experiments while failing in their basic regulatory function to prevent fraud and establish a stable investment climate. The failure of government has taken its toll on the one important area where government can make a difference, accurate, complete and timely information. But the investors' real enemy is still themselves.
Our real problem as investors is that not only do we not get good information, we have a tendency to ignore the information we get. For example, many commentators assume that the United States (US) will raise its debt ceiling and that the Eurozone will solve the Greek issue without a default, despite a great deal of accurate information to contrary. This is called the positive outcome bias, which is the tendency of people to overestimate the probability of a favorable outcome coming to pass in a given situation. We put great faith in mathematical models despite a major flaw. We create models based on past data which are validated only against that same past data. This is called the forward bias. These and others can have some very strange results for investors, none so much as the idea of a hot stock. In the US we have a very obvious example, Netflix.
Netflix was a company with a very good idea. Rather than go to a store to rent DVD movies, you could get them by mail. Not only was the delivery a good idea, unlike Blockbuster, the brick and mortar franchise, Netflix did not charge irksome late fees, which often cost more than the rental fee itself. When Netflix started in 1999, Blockbuster had few competitors and so dismissed the threat from Netflix. Blockbuster went bankrupt in 2010.
Meanwhile, Netflix went from strength to strength. It achieved 10 million subscribers in 2009. The stock also did quite well. For much of its history the stock traded barely above 20, but with the demise of what was considered its only competitor, it started doing much better. At the beginning of 2007 it was trading at 22. By March 2009, when all the other stocks had crashed, it had increased 75% to 35. In another year, in 2010, it had doubled to 70, and increase of 40% in five weeks and it was trading at 27 times earnings.
By that time, another cognitive bias had come into play: an availability cascade, a self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse. The Netflix 'story' had taken hold, but it took off with internet streaming. The service was actually available as early as 2008, but really got going in the fall of 2010 with the 'Watch Instantly', service, initially free with a regular subscription. The stock doubled again to 120.
The main part of the collective belief was that Netflix did not have any competition. This is far from true. Its original competition Blockbuster went bankrupt, but not out of business. There are other companies like Amazon and Hulu that stream movies and television shows. Hulu is small, but it is owned by NBC Universal, Walt Disney and News Corp. Other competitors include such heavyweights as Google and Apple. Besides the entertainment and tech giants, Netflix competes against the large cable companies that all allow movie rentals.
Netflix managed to increase its subscribers to 25 million, 70% of this last year, thanks in part to the strength of its brand. Then, Netflix decided to change its fees. The internet streaming which had been free, would be subject to an additional charge. The new charges increased the monthly fees by 60%. The reaction was immediate. Over 12,000 customers posted complaints on Facebook and a survey suggested that 26% of Netflix customers would cancel. But it did not slow the stock. The momentum of the bandwagon effect was firmly in control.
The stock actually reached new highs, based on Netflix's plans to expand into Latin America. Investors thought only about the millions of new customers. Since they were subject to confirmation bias, investors never considered that in emerging markets the bandwidth necessary for streaming movies is not widely available. The stock hit a new high of 300.
But all good things must pass. Netflix, now trading at 80 times earnings, recently fell 16% on disappointing revenues. Did the analysts admit a mistake? No, Anchoring bias. Analysts said the bad news was temporary, only temporary. Netflix would recoup its $300 price target and would hit $1,000 in five to seven years. A perfect example of an 'overconfidence effect', which is an excessive confidence in one's own answers to questions.
In the words of an American cartoonist, Walt Kelly, "We have met the enemy and he is us."
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected].)
The senior management of these institutions that claim to be serving the poor, receive unusually high payments which is not determined through an explicit process
Compensation is indeed a very sensitive and critical aspect of governance in MFIs and it has serious implications for the detailed regulatory guidelines being prepared by the Reserve Bank of India (RBI) and the microfinance bill being drafted by the Union Ministry of Finance (MoF).
That said, let us now look at some real data with regard to compensation in large NBFC MFIs. Data from a very interesting article in Live Minti has been compiled in a table, given below. The table lists the yearly compensationii (for FY2010) of chairman/managing director/chief executive officer (as applicable) at five large NBFC MFIs, with headquarters in Andhra Pradesh, the hotbed of the 2010 microfinance crisis.
As readers would recall, these top five MFIs headquartered in AP, grew at a phenomenal rate between April 2006 and March 2010 (and especially, between the years April 2008 and March 2010) in the backdrop of the earlier Krishna (2005/6) microfinance crisis. As per Mix Market dataiv they are said to have added as much as over $2 billion and about 9.59 million clients, in the two-year period (April 2008-March 2010), which is indeed phenomenal by any standards. And a brief glance at the table (data on governance of compensation) suggests that the compensation drawn by some of the CEOsv (at these NBFC MFIs) is rather unique, given that many of these NBFCs pride themselves on working with the 'poorest/poor' and/or 'excluded' to facilitate and enable their inclusion in the larger financial system.
For example, as a very interesting article in The Economic Timesvi (1 February 2011) commented: The "promoter of microfinance company…Microfin, draws a salary unmatched by any executive among listed banks. In 2009-10, he earned Rs7.4 crore as managing director of his own microfinance company. This is more than double what the highest-paid executive in all listed banks made that year-Aditya Puri, managing director of HDFC Bank, earned Rs3.4 crore. This is more than the limit set by the Companies' Act, which regulates the operations of firms in India. …Microfin is India's third largest microfinance company."
While I am not against anyone getting high compensation for the work they do (provided it is legal and justifiable), I do think it is important for all of us (the Ministry of Finance and the RBI included) to understand what work (done by the MFI bosses) justifies such exceptionally large salaries to them. This is especially critical given that these salaries are sometimes much higher than that offered even by listed (private) banks as noted in The Economic Times article mentioned. We absolutely need to understand this phenomenon fair and square!
If compensation is an aspect worthy of closer understanding, so is the issue by which equity (sweat or whatever) is allotted to the promoters. Recall Professor MS Sriram's article in the Economic and Political Weekly (12 June 2010) which talked about a huge loan of Rs1.636 crore given by an NBFC MFI to its promoter and then managing director, to enable him to buy shares in the same company at face value of Rs10.
Now, as the data (from the draft red herring prospectus filed with SEBI in March 2010 by the same NBFC MFI) reproduced in the table below shows, as of 31 March 2007, 1,636,138 company shares of face value Rs10 were bought by the promoter managing director and the source of funds was the interest-free loan provided by the NBFC MFI to its own promoter managing director to enable him to buy its own shares. This is also evident from the financial statements of the NBFC MFI given in a previous Moneylife articleviii .
Now, as is evident from the data in the table, the promoter managing director bought 1,636,138 shares (at face value of Rs10) for a total outlay of Rs1.636 crore and sold the same in September 2008 for Rs103.91 per share. The total profit booked in this transaction was approximately Rs15.36 crore and profit per share was Rs93.91. Again, please do remember that the same NBFC had lent its promoter and then managing director a sum of Rs1.636 crore to buy the same 16.36 lakh shares at a face value of Rs10.
Roughly 18 months later, all of these 16.36 lakh shares were sold for a huge profit as per the numbers above. There are several other issues here: It seems that from the public responses (received via email from Sa-Dhan) provided by the NBFC MFI, to issues raised in Professor Sriram's article, that the promoter managing director was indeed allotted shares when the concerned meetings apparently approved the ESOPs to him. Further, the papers filed with the registrar of companies (RoC) on the relevant dates also reflect the fact that the then managing director was allotted ESOPs.
Therefore, with all due respect, it is indeed important for the RBI and the Union Ministry of Finance (as part of their work on the microfinance regulatory architecture) to study and understand the rationale, terms and processes by which shares are allotted to promoters, CEOs and others in NBFC MFIs, so that any existing/potential loopholes are plugged and the scope for irregularities removed. Again, I am not against any promoter getting equity that they legally deserve but without question, the rationale, terms and processes must be necessarily appropriate and surely above board.
The above are just two instances, and as we move through the current crisis in Indian microfinance, there are several important lessons here with regard to the governance of compensation in Indian MFIs that the RBI and MoF need to understand. I will try and articulate these here for their benefit, in the hope that they will factor these in the regulatory framework that is being developed for microfinance in India.
Lesson #1: Lack of arm's-length decisions and negotiations
The governance of remuneration and incentive systems seems to have (apparently) failed in some Indian MFIs because decisions and negotiations (carried out) have not been at arm's length. Conflicts of interest at various levels have aided such improper decision-making and negotiation and much of this is applicable to remuneration and incentive systems for a range of senior management personnel and not just the CEO or managing director or chairman of the board. While there are several examples from the Indian microfinance context, the article cited from The Economic Times offers good factual insights.
Lesson #2: Inordinate level of influence of senior management in establishing remuneration schemes
In several cases that I have personally seen, senior management generally appears to have far too much influence over the level and conditions (including measures) set for performance based remuneration. On the other hand, boards are often unable to or, sometimes, even incapable of exercising objective, independent judgement. Here again, there are serious conflicts of interest, which certainly exacerbate this whole issue-in fact, this has been one of the most important reasons for inaction by the board against inappropriate remuneration proposals of senior management in MFIs.
Lesson #3: Medium and long-term risks are not taken into account
In some cases that I have closely observed, the relationship between performance and remuneration is rather tenuous and, sometimes, even difficult to establish, especially given the nature of microfinance operations. A very critical aspect here is that medium- as well as long-term risks and the possibility of adversarial political action are rarely factored into the whole process-something that should have been done, given the nature of microfinance and given what has happened in Andhra Pradesh recently.
Lesson #4: Complicated and opaque remuneration schemes
Some of the MFI remuneration schemes are fairly complicated and also opaque in terms of shrouding actual conditions in the operation of the scheme and the consequences. What I am saying is that these (operational conditions and terms) are perhaps not clear and obvious to the naked eye of an unassuming observer. These conditions also tend to encourage excessive and mindless (growth and) risk-taking and especially with a short-term orientation.
Lesson #5: Mere disclosure is not transparency
While transparency (in some cases) may exist in terms of disclosure, several MFIs couch the main characteristics of their performance related remuneration programmes in verbose technical language and thereby make it very difficult for comprehension to the normal reader. Very rarely do we get information on
(a) The total cost of the remuneration programme to the MFI.
(b) The specific performance criteria and measures along with their conceptual and operational definitions.
(c) The manner in which remuneration has been adjusted for relevant risks-especially, medium- and long-term risks as well as risk of political action (which is so relevant today). Without question, MFIs will surely need to have remuneration and incentive systems that focus and encourage at least the medium-term, if not long-term performance. This, in turn, means that MFIs must choose to reward their senior management after some actual performance has been realised and that has not usually been the case-there are several examples of high front-loaded one-time bonuses paid to senior management executives of large NBFC MFIs and the results are there for everyone to see. In fact, focus on the short-term incentives and compensation is excessive at Indian MFIs and it needs to be changed to reflect the medium- and/or long-term performance and operations.
Overall, remuneration does not seem to have been established through an explicit governance process where the roles and responsibilities of all stakeholders involved, including committee members, consultants, risk managers and others, are clearly defined and separated (without conflict of interest). The roles given to non-executive independent board members in the process-although they may seem somewhat appropriate-again appear to be laden with serious conflicts of interest. And finally, while remuneration policies are sometimes submitted to the annual meeting and subjected to shareholder approval, much of this seems to be a routine matter, with minimal (informed) discussion because of aspects mentioned earlier. Read the first instance given in the articleix on Moneylife on 29 July 2011.
Thus, in my humble opinion, an aspect that stands out very much is the irrational and unusually high compensation to senior management, directors, founders and promoters. Much of this seems to be similar to the practices observed in financial services companies during the sub-prime and global financial crisis. This apart, adhoc bonuses, pay raises (followed by sudden termination), the grant of shares when options have been sanctioned, the non-transparent pricing of options, provision of (huge) loans to enable founders and board members to buy the shares of their own company, are some of the other key remuneration issues in the Indian microfinance business that need to be studied and analysed by the RBI and the MoF.
In fact, while I have observed many of these practices during the last two-three years, the seeds were undoubtedly sown much earlier. Further, given the above situation, we, as stakeholders, need to continually ask a key question, "whether the compensation approaches being pursued are indeed consistent with the institutions' (MFIs) ethical values of creating value for clients and its objectives, strategy and control environment as well as that of the overall industry?" And we certainly need to keep looking for objective answers as well.
Therefore, as has been often mentioned, "Compensation is one factor among many that contributed to the financial crisis that began in 2007. Official action to address unsound compensation systems must therefore be embedded in the broader financial regulatory reform programme, built around a substantially stronger and more resilient capital and liquidity framework. Action must be speedy, determined and coherent. Urgency is particularly important to prevent a return to the compensation practices that contributed to the crisis.x
I hope that the RBI and the MoF focus on this aspect as part of their microfinance regulatory exercise and ensure that the same compensation practices and incentives that (adversely) affected the global sub-prime do not impact Indian micro-finance.
iSource: "Tiny Loans, Not so Tiny Salaries', Khushboo Narayan and Unnikrishnan, Live Mint.
ii Data taken from the Live Mint article, "Tiny Loans, Not so Tiny Salaries", Khushboo Narayan and Unnikrishnan.
iii Name of MFI is withheld.
v They could be chairman, managing director or CEO as applicable.
vi Source: Quoted from "Share Microfin MD takes home Rs7.4 crore, more than double HDFC Bank MD's salary" by John Samuel Raja D & M Rajshekhar, The Economic Times, 1 February 2011.
viiCommercialization of Microfinance in India: A Discussion of the Emperor's Apparel" by Professor MS Sriram, (Economic and Political Weekly, 12 June 2010, Vol. XLV, No. 24).
viii Governance of MFIs: "Time to implement 'connected lending' provisions of RBI circular of 2007" by Ramesh S Arunachalam (28 July 2011).
xi"Who is an independent director? Who should be treated as an independent director in NBFC MFIs?" by Ramesh S Arunachalam (29 July 2011).
x Quoted from BIS paper on Compensation and Corporate Governance, 2010.
(Also read: Four ways to improve the regulation of compensation at MFIs)
(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments.)
"Though customer enquiries have increased, due to the increase in fuel price and interest rates, conversion rate has slowed down," HMIL director (marketing and sales) Arvind Saxena said
New Delhi: The country's second-largest car-maker Hyundai Motor India (HMIL) today reported a 1.48% decline in total sales to 49,667 units in July 2011 against 50,411 units in the corresponding year-ago period, HMIL said in a statement.
In the domestic market, the company's sales decreased 11% to 25,642 units from 28,811 units in same month last year, reports PTI.
Exports of the company increased by 11.23% during the month under review to 24,025 units from 21,600 units in the year-ago period, the statement said.
"The July 2011 sales for both the industry and as well as HMIL had been negative. Though customer enquiries have increased, due to the increase in fuel price and interest rates, conversion rate has slowed down," HMIL director (marketing and sales) Arvind Saxena said.
In the A2 segment (Santro, i10 and i20), the company sold 41,533 units, while in the A3 segment (Accent and Verna), sales stood at 7,980 units.
The A5 segment (Sonata Transform) of HMIL witnessed sales of 13 units, while its new SUV Santa Fe attracted 141 buyers during the month.