Time and time again the markets have moved in the opposite direction that policymakers intended; the result of so-called quantitative easing by the US Fed and the interest rate hike in China are good examples
Powerful governments feel that they have the ability to manipulate markets in furtherance of a policy agenda. Investors often invest accordingly. In the United States for example, the saying is "don't fight the Fed" (the US central bank). The reality is that the market always wins.
One of the more spectacular recent examples has to do with the US Federal Reserve policy of quantitative easing. The Fed and its chairman Ben Bernanke have told us that the reason for quantitative easing was to avoid deflation, drive down interest rates, and stimulate growth. Although not one of their stated purposes, it was obvious that this policy should have weakened the dollar. It was also supposed to create a "wealth effect" by driving investors from the supposed safety of government bonds to more risky investments.
Despite the howls of protest from economists throughout the world and disagreement on its own board, the Federal Reserve decided to go forth. The market of course had other ideas. Interest rates rather than declining have gone up. The interest rate on the 10-year US treasury bond used to be about 2.48%. Today they are almost 3%. Thanks to the Irish crisis, the dollar has strengthened against the euro. It has also strengthened against the Japanese yen.
The Federal Reserve has been successful in creating inflation. Both food and oil prices have increased around the world, often negatively impacting some of the poorest members of society. Yet, members of the Federal Reserve committee remain unrepentant. This week, in a speech, one of the members of the committee blithely dismissed the rise in nominal interest rates as misleading, rather than entertain the possibility that the policy was simply wrong.
Of course it is not just the Federal Reserve or the divided US government who get policy wrong. China's leaders have often been lauded in the past for their economic management which has lifted millions from poverty and created rapid economic growth. But then again, many used to think that Alan Greenspan, the former Federal Reserve chairman walked on water too.
The reality is that the combination of a partially reformed economy and massive bank loans have created the potential for an inflationary nightmare that may be exceptionally difficult to control without a dramatic economic contraction.
Normally to rein in runaway inflation governments and central banks raised interest rates. Most observers of the Chinese economy expect that this will happen and it will have the desired effect. It won't.
Interest rates are anti-inflationary for three reasons. First it makes it more expensive for consumers to make purchases. Secondly, higher interest rates normally drive down equity and bond prices, which lowers consumption as consumers feel poor. Finally higher interest rates make investment more expensive and lower growth can increase unemployment.
Professor Pettis of Peking University's Guanghua School of Management points out that these assumptions in China are wrong. Raising interest rates in China may not slow inflation. First there is very little consumer financing in China, so raising interest rates may not have much of an impact. Second, since much of the wealth of China is contained in bank accounts, raising interest rates, if allowed to flow through to those deposits, could actually increase demand and inflation. Finally, raising interest rates may not slow investment or employment partially because so few of the loans are actually paid back.
What Professor Pettis does not point out, is that raising interest rates in China might have a more dramatic effect. Interest rates in a market economy have different impacts on different businesses and consumers. So a rate hike might take time to make its way through the system. In a partially reformed command economy like China's, the government calls the shots. The rise of interest rates sends an enormous signal throughout the economy that the government intends to slow things down. So, rather than make different decisions, businesses and consumers all make the same decision at the same time. This could have a rapid and dramatic impact on the economy as it did in 2008 when the economy ground to a halt even before the US meltdown.
Government policy makers often have the wrong tools. The tools they do have are often used for the wrong reasons, often short-sighted and political. The policies are invariably based on incomplete, inaccurate, and even false information, which in different systems can result in different effects. Sometimes it is surprising that they get any policy right.
Investors spend a great deal of time and money analysing the policies of various governments. The assumption is that if an investor can determine the direction of government policy, he can determine the direction of the market. What often occurs is that the markets have other ideas. Investors, who don't fight the Fed, will sometimes find that they have to surrender to the market.
Ambit Research says that over the past four years accounting quality has deteriorated, the most in large-cap companies. Higher fees paid to auditors, rising debtor days and increasing contingent liabilities point to the need for investors to be on their guard
In a recent report to its clients, Ambit Research finds that in most sectors there is a direct correlation between accounting quality, share price changes and forward P/E multiples.
Here are highlights from the report.
Ambit has included 360 companies out of the BSE 500 companies in its analysis, leaving out 62 financial companies and 78 other companies that have not been listed for more than four years. It has put the 360 companies through something it calls 'revenue recognition checks', which includes CFO/EBITDA, audit fees as a percentage of revenues, and debtor days; 'expense manipulation checks', which includes depreciation as a percentage of gross block and contingent liabilities as a percentage of net worth; and 'cash pilferage checks' which involves miscellaneous expenses as a percentage of revenues, other loans and advances as a percentage of net worth, and advances recoverable in cash/kind as a percentage of revenues.
The CFO/EBITDA ratio checks a company's ability to convert EBITDA (which Ambit believes can be relatively easily manipulated) into operating cash flow (which is more difficult to manipulate). The depreciation as a percentage of gross block detects whether the company is changing its depreciation rate to report better profitability.
The reason tourism, textiles and the media score low is weak cash conversion, high miscellaneous expenses and high advances recoverable in cash/kind as a percentage of revenues.
Ambit claims that the top 50 companies by market cap in the BSE 500 had the highest decline in average annual (accounting) score over FY07-10, with the worst decline in FY10 and that, fittingly, in FY10 these companies saw the lowest share price appreciation. However, this is relative-they did perform 127% versus 146% by the next 50 by market cap, 192% by the next 50 and so on. In a bull market, mid- and small-caps do tend to outperform large-caps.
According to the report, promoters are largely behaving themselves. "The most encouraging trend is that all three 'cash pilferage' checks point in the right direction of minority shareholders. In general it appears that promoters are gradually coming to terms with the fact that withdrawing their hand from the cash register is good for their overall wealth."
In terms of the auditors, the report brings out some interesting points. "According to a report published by the Indira Gandhi Institute of Development Research, 80 per cent of Indian companies in FY07 and FY08 gave consultancy mandates to the same firm which conducted its statutory audit." This creates the possibility of a conflict of interest. Ambit finds that "companies which pay their auditors more seem to produce lower accounting scores." But one explanation of this is that smaller listed companies, who by and large tend to have lower accounting scores than larger companies, have to pay broadly a similar audit fee in absolute terms; so expressed as a percentage of their revenues, the smaller firms end up paying more than larger firms.
Housing-related companies have a weak accounting score because of poor cash generation (CFO/EBITDA is low), expense manipulation (the fall in the depreciation rate is high and provision for doubtful debts is low) and cash pilferage (loans and advances as a percentage of revenues is high); for chemicals and petrochemicals, scores are weak due to revenue manipulation (growth in audit fees is higher than growth in revenues) and expense manipulation (the fall in the depreciation rate is high), says the report.
(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author's own and may not necessarily represent those of Moneylife.)
New Delhi: Billionaire industrialist Mukesh Ambani is planning to provide Rs1,000 crore seed capital to kick-start a new venture that would invest in innovative business ideas, including in technology and healthcare segments, reports PTI.
Mr Ambani, who heads the country's most valued corporate entity Reliance Industries (RIL), will probably make an investment of about $250 million in his individual capacity, sources close to the development said. A RIL spokesperson did not offer any comment.
The process has begun for stringing together a team of experts with domain knowledge of various sectors for managing this private equity venture, sources said.
It said some of his close aides at RIL group might also be brought on board.
The top tier of people to be associated with this venture would include those with expertise in biotechnology, healthcare, energy and consultancy businesses, besides private equity and venture capital segments.
The new venture would mostly invest in start-ups working on innovative business ideas in sectors like biotechnology, healthcare, information technology, new and renewable energy as also traditional energy sources, among others.
However, it was unlikely that RIL group itself would get involved in the venture and it was most likely that the investment would be made by Mr Ambani in his individual capacity, sources said.
The sources said the venture would also look at roping in other investors, mostly from overseas.
He would join the likes of NR Narayan Murthy and Azim Premji—founder and chairman of two of the country's biggest IT majors Infosys and Wipro, respectively, who have floated private equity investment ventures at their individual levels.
Besides, a number of large industrial houses, such as Tatas, Aditya Birla group and Anil Ambani group have their own private equity investment arms that invest in various companies as per their respective mandates.
RIL and Mr Ambani himself have often talked about need to invest in areas like business innovation, new technology and research and development.
Earlier in 2007, RIL group firm Reliance Life Sciences had announced a partnership with MPM Capital, a US-based global investment management firm focussed on healthcare business, to invest in Indian life science sector.
Subsequent to the deal, RIL invested nearly Rs80 crore in a MPM BioVentures fund during the last fiscal 2009-10.
The group has also created a Reliance Technology Group (RTG) by consolidating various research and technology functions of its businesses.
It has also set up a Reliance Innovation Council that comprises of eminent scientist RA Mashelkar and Ambani himself, among other global leaders, from fields of science and business.