Download - Fortifying Against Riskbeyondmarket.nirmalbang.com/issue67/download/magazine.pdf · 2012-06-25 · Fortifying Against Risk ... IDFC’s strategy of accelerating growth and generating

FortifyingAgainstRisk

The Basel III norms

are aimed at

strengthening the

banking system to

withstand di�erent

kinds of risks and

�nancial shocks

For Pr ivate Circulat ion Volume 1 Issue 67 01st Jun ’12

It’s simplified...Beyond Market 01st Jun ’12 3

DB Corner – Page 5

Falling Rupee: A Matter Of ConcernWhile a weak rupee may be good for certain sectors, it certainly is bad for the Indian economy on the whole forcing the RBI to arrest its decline – Page 6

Lose – Lose SituationIf TRAI’s recommendations are brought into force, they will not only hurt telecom companies but also the end users who will have to bear the brunt of high tariffs passed on to them by the operators – Page 9

Fortifying Against RiskThe Basel III norms are aimed at strengthening the banking system to withstand different kinds of risks and financial shocks – Page 12

Reaching Out To The UnderservedSetting up of white labelled ATMs will not only help tap the rural populace but also aid financial inclusion in the country – Page 18

Taking Reins In Their Own HandsPrivate equity firms have started developing their own real estate projects so as to have complete control over their investments – Page 20

IDFC: An Integrated PlayerIDFC’s strategy of accelerating growth and generating business momentum depending on the macro environment augurs well for the infrastructure finance company – Page 24

Giving A Run For Its Money Beijing’s push to move Yuan towards internationalization will eventually make it a force to reckon with in the coming times – Page 28

A TrailblazerBeing credited with many firsts, Jimmy Patel, CEO at Quantum Asset Manage-ment Company Ltd believes that an honest attempt to give the best possible returns to investors will bear fruit irrespective of the size of the firm – 2

Technical Outlook For The Fortnight – Page 36

The Goodness Of VolatilityArbitrage funds generate income through arbitrage opportunities in cash and derivatives markets in volatile conditions - Page 38

Easier Said Than DoneA day trader’s life is full of ups and downs much like the markets he is involved in – Page 41

A True Measure Of ProfitabilityWarren Buffett calls owner earnings as the true measure of a company’s earnings and therefore it must be employed by investors to get a clear picture of a company’s operations – Page 45

Volume 1 Issue: 67, 01st Jun ’12

Editor-in-Chief & Publisher: Rakesh BhandariEditor: Tushita NigamSenior Sub-Editor: Kiran V Uchil

Art Director: Sachin KambleJunior Designer: Sagar Padwal

Marketing & Operations:Divya Bhurat, Afsana Tamboli

We, at Beyond Market welcome your views, comments and feedback. Do help us to grow better as per your liking. This is our attempt to reach you better while crossing horizons...

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Research Team: Sunil Jain, Silky Jain, Vikash Bairoliya, Dipesh Mehta, Anand Shendge, Manav Chopra, Vikas Salunkhe

PreventingHistory FromRepeating Itself

It’s simplified...Beyond Market 01st Jun ’124

The beginning of May saw the Reserve Bank of India (RBI) issuing the final guidelines for the implementation of Basel III interna-tional accounting standards in India.

The Basel norms refer to the banking supervision Accords (recommendations on banking regulations) that are issued by the Basel Committee on Banking Supervision (BCBS). The regulations drawn up by the association of central banks across the world focus on issues like capital requirements to be maintained by banks as well as the quality, consistency and transparency of the bank’s capital base, among others. The need to confer improved Basel norms came up when the previously followed Basel II norms failed to help the banking system across the globe to withstand the financial crisis of 2008.

In our cover story we have covered the Basel III norms - what they imply and how they will impact the Indian economy as well as the banks. With the aim of safeguarding the banking system in India from any kind of crisis in the future, the accord will be brought into force from January ’13, but in a phased manner.

Among other topics, there are articles on the impact of the falling rupee on the Indian economy and other sectors, remaining a major cause of concern; the likely impact of the recommendations by the Telecom Regulatory Authority of India (TRAI) that may hurt not only the telecom operators but also the end users, the setting up of white labelled ATMs across the country and how private equity players are now turning into realty developers so as to have more control over their investments.

The Beyond Currencies section in this issue covers a very debatable and interesting topic, which is how Beijing’s attempts to move Yuan, the Chinese currency to internationalization could eventu-ally make it a force to reckon with in the coming times.

In the Beyond Work section, we have featured a very interesting interview of Jimmy Patel, the CEO at Quantum Asset Management Company Ltd. Having scored a number of ‘firsts’ in his lifetime so far, Mr Patel always aspires to deliver not only for the company, but also for individuals investing in the funds.

On a lighter note, there is an article in the Beyond Learning section, which describes a day in the life of a trader and how an individual should go about becoming one if he intends tO.

Tushita NigamEditor

History FromRepeating Itself

he beginning of May saw the Reserve Bank of India (RBI) issuing the final guidelines for the implementation of Basel III interna

Repeating Itself


Disclaimer It is safe to assume that my clients and I may have an investment interest in the stocks/sectors discussed. Investors are required to take an independent decision before investing. Investment in equity is subject to market risk. Our research should not be considered as an advertisement or advice, professional or otherwise. The investor is requested to take into consideration all the risk factors including their financial condition, suitability to risk return profile and the like and take professional advice before investing.

Sensex: 16,416.84Nifty: 4,985.65

(As on 28th May’12)

he previous fortnight saw a flurry of activity in foreign as well as domestic markets.

The crisis in Europe continued without showing any signs of recovery amid fears that Greece may break away from the Euro zone, adding to the worries of the market during this period. Also, bond yields in Spain were seen moving higher.

On the domestic front, the quarterly earnings results of India Inc were in line with the expectations, but the performance in the next quarter is expected to be lower.

Also, the value of the Indian rupee fell further owing to a host of internal factors as well as dollar appreciation. Thus, the depreciating rupee continues to be a major cause of concern for the Indian economy.

Moreover, inflation has been rising continuously and Index of Industrial Production (IIP) numbers has been negative and lower than expected.

T The recent hike in petrol prices has created hope for further policy action by the government in order to improve the economic condition.

Both domestic and international issues are likely to keep the markets volatile, but are likely to remain in a broad range.

The Nifty has upper side resistance at the 5,220 level. And market participants can look at buying on declines with an investment perspective around the 4,750 level.

Stocks like Infrastructure Development Finance Corporation Ltd (LTP: `126.50), Indiabulls Financial Services Ltd (LTP: `225.80), Mangalore Chemicals & Fertilizers Ltd (LTP: `40), ICRA Ltd

(LTP: `1,178.40), MRF Ltd (LTP: `10,900) and Apollo Tyres Ltd (LTP: `88.80) can be looked at with an investment perspectivE.

Both domestic andinternational issuesare likely to keep

the markets volatile

While a weak rupee may be good for certain sectors, it certainly is bad for the Indian economy on the whole, forcing the RBI to arrest its decline

Falling Rupee:A Matter OfConcern



rupee in the forex market. But, this will only provide temporary relief.

Some other factors that will affect the rupee movement are described below. One should always remember that like stock price, the rupee value is a function of all these factors at an aggregate level.

Fiscal And Current Account Deficit

Fiscal deficit of a country is an important factor that drives the currency of that nation. Higher deficit means the government will have to pay more and also print more rupee notes. This would result in excess supply of rupee in the market, leading to inflation and reduction in its value.

Similarly, current account deficit (CAD), which represents the net of import and export, results in more obligations for the country to make its payments in foreign currency.

CAD for the current financial year is likely to be in the range of 3-3.5%. Though this number looks small, it is actually relatively high compared to previous years and uncertain foreign investment environment.

Capital Outflows

This is another critical factor that affects rupee in the short-term. The capital inflow and outflow, in turn, depends on many other factors.

Whatever might be the underlying factors, foreign capital outflow has a direct impact on the rupee movement. The impact is immediately visible in the forex market.

The reasons for pulling out foreign money can be many. Bad business outlook, poor government policy, weak equity markets are just some of the examples that are currently acting against the Indian rupee.

Uncertainty Over General Anti-Avoidance Rule (GAAR)

GAAR proposed by the government has been termed as negative for FIIs investing in India, through companies in Mauritius.

The rule, if implemented, is likely to burden FIIs with more tax, thereby reducing the net profit. Foreign companies may reduce their investments in India. Obviously, this would lower the demand for the Indian rupee and weaken it further.

Global Factors

The current crisis in the Euro zone may make investors more risk-averse. As a result, they may reduce their asset exposure from emerging economies like India, thereby selling more rupees.

The present environment is dominated by euro zone concerns, triggered by political uncertainty in Greece. All major global currencies have weakened against the US dollar.

The recent election results in France and Germany are pointing towards negative sentiments for austerity measures taken by the government. Overall, there may be more bad news coming from the Euro zone. Hence, the dollar is getting stronger against other currencies, including the rupee.

Dollar Demand-Supply

Rising oil prices mean more dollars are required by Indian oil companies to import crude oil since oil price is quoted in the US dollar in the international market.

Apart from the usual high requirements of oil companies, dollar demand was seen coming from companies redeeming their external commercial borrowings.

n the past one year, the Indian rupee has been losing momentum continuously. The rupee-dollar exchange rate

crossed the sensitive 50 mark sometime last year, raising fears among many foreign investors and importers alike. It continued to hover above the `50/dollar mark for the past so many months.

Earlier this month, the rupee created more nervousness by hitting an all-time low of 53.83. The currency has depreciated 2% since the start of this month and 5.8% since 1st April this year.

I

USD/INR

While a weak rupee is good for some sectors, it may be bad for the Indian economy on the whole. Unfortunately, there is no visible sign of the rupee coming back to the 40-45 range in the next one year.

In fact, many market pundits believe that the rupee will hit the 56-57 range in the near-term before reversing back to the 50-52 level.

FACTORS AFFECTING THE RUPEE MOVEMENT

The movement of rupee depends on several factors. The important ones being the interest rate regime, fiscal deficit, export and foreign investment in India. The foreign exchange market is very big to be controlled by any central bank.

The Reserve Bank of India (RBI) tries to arrest the rupee movement by asking state-owned banks to buy

Source: RBI

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All these events lead to high dollar demand whereas bad equity market and policy paralysis are attracting little foreign investment, whether in financial or real asset. And there is no sign of any change in this equation in the near future. Hence, this imbalance of higher dollar demand would continue for some more time.

SECTORAL IMPACT

The movement of the rupee is directly correlated to companies’ earnings in several sectors. While the extent of the impact of the rupee on each company needs to be analyzed separately, the following paragraphs will give a broad idea about different sectors and businesses that one should look at for this purpose.

Export-oriented Companies

Companies which export goods and services to the US are the main beneficiaries of depreciation of the Indian rupee. They receive their revenue in US dollars whereas their major expense is in the Indian rupee.

With rupee depreciation, their rupee-denominated revenue will continue to grow even though there is no change in expense. Information Technology (IT) is one such sector, which receives more than half of its revenue from the US.

However, most IT companies carry out hedging activity to protect their rupee revenue from exchange rate volatility. Hence, even if there is a

sharp depreciation in the rupee, the gain would depend on the extent of hedging done by the company.

Textile is another sector which will benefit from a weak rupee. The US is the top destination for India’s handloom products. The annual revenue from exports is pegged at little more than US$ 300 billion. With less dollar denominated expenses, this sector is likely to benefit from a weak rupee.

Import-oriented Companies

With rupee weakening further, companies which import their goods and services from the US will be badly hit. Oil companies import huge amounts of crude oil, which is denominated in the US dollar. With the weakening of the rupee, they have to shell out more cash, thereby hitting their operating margins.

The extent of the loss would depend on the amount of backward integration of oil companies. More the backward integration, the better it is. However, most state-owned oil companies in India lack their own crude oil resources and have to bear the brunt of the same.

Like oil, metal commodities too are denominated in the US dollar. Hence, companies which are heavily dependent on outside sources for their raw material requirements are expected to take a hit on their bottom line. There is no specific sector which belongs to this category.

Companies from across sectors import different raw materials in varied quantities. Investors have to analyze individual companies to dig more on this.

Financial Services Sector

With the rupee weakening and policy paralysis, foreign institutional investors (FIIs) are reducing their exposure to the Indian equity markets. With FIIs pulling out of India, broking firms are seeing a significant decline in volumes. This would have a negative impact on the company’s profitability. Those broking firms which have more number of foreign institutional clients are likely to be hit more.

Sectors Using Heavy Machinery

The sectors that use heavy machineries usually import them from outside India. These items are very expensive and require a huge amount of initial cash outflow. Typically, companies borrow in foreign currency, also known as ECB (external commercial borrowing) to finance their investments.

The interest and principal repayment is spread over several years. When the rupee depreciates, these companies have to shell out more rupees to meet their payment obligations. Those which are planning to set-up a new machinery at this point of time would be the worst hit. Companies in telecom, power and infrastructure are the likely target of this categorY.

regular investments keep worries away

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he recommendations made by the Telecom Regulatory Authority of India (TRAI) recently

have created a major spin in the telecom sector. While the TRAI is of the opinion that these recommendations are good for the telecom sector in the long run, industry players think otherwise.

If accepted by the government, the industry players say, it will lead to increased burden on telecom companies and mobile users, as well. This may, in turn, dent the growth of the sector, once considered to be the rising star among Indian industries. The telecom industry is already grappling with bad news like corruption in 2G spectrum allocation

TIf TRAI’s

recommendations are

brought into force,

they will not only hurt

telecom companies but

also the end users who

will have to bear the

brunt of high tari�s

passed on to them by

the operators

and involvement of certain industry players in the scam. Add to this, such headwinds will further deteriorate the fundamentals of the telecom sector.

Leaders cutting across companies from the telecom sector have reacted sharply to TRAI’s recommendations. They have even made presentations to different government officials including finance, home and telecommunication ministers.

The Chairman of BhartiAirtel, Sunil Mittal said “The recent regulatory developments in India will have significant implications on the future of telephony and broadband, as well as India’s global competitiveness. The entire industry looks to the government for a fair, transparent and sustainable telecom regime.”



2. The reserve price set for spectrum to be allocated at different bands. The TRAI has proposed the reserve price for the auction of spectrum to be about `3,622 crore per MHz in the 1,800-MHz band (for GSM services).

The reserve price for auction of spectrum is nearly 10 times higher than what operators had paid in 2008 for acquiring licenses at approximately `1,658 crore, which came bundled with 4.4-MHz 2G spectrum. The base price for 3G spectrum was fixed at approximately `3,500 crore for five MHz in 2010, which would make the recommended price five times higher than the 3G base price.

3. The telecom authority has recommended that all spectrums assigned through the auction process in future be liberalized. In other words, the spectrum in any band can be used for deploying any service in any kind of technology.

These recommendations come against the backdrop of the Supreme Court order cancelling 122 new licenses issued in 2008 and the auction of vacated spectrum in four months. These auctions need to be completed before 31st Aug ’12.

The development may come as a blow to the telecom companies whose licenses were impacted by the SC order and are looking at the auction to win them back. Newer players such as Uninor and Videocon are offering services through spectrum in the 1,800-MHz band.

An assessment of the value of the available spectrum in different bands on the basis of the reserve price works out to be about approximately `7 lakh crore. This will raise a significant amount of money for the government, which is already facing the problem of high fiscal deficit.

IMPACT ANALYSIS

Industry players, analysts and news editors are assessing the impact of the new recommendation from TRAI. Though there are differences in the opinion between these stakeholders, some important points need to be looked at.

The higher cost of spectrum will have a cascading effect on the profitability of the companies and service cost to the end mobile user. If the companies pass on this cost to the end consumer, then tariffs will go up significantly, thereby hitting the mobile user hard. This, in turn, may slow down the growth in volumes and, hence, less business for companies.

Due to re-farming, more cell-site bases need to be set-up. This would result in increased energy and investment. Further, the quality and coverage of the mobile network is likely to degrade.

The customer may experience poor voice and data quality, especially those living in rural and remote areas.

Some are also of the opinion that if TRAI’s recommendations are implemented, then it will ensure that a lone survivor will dominate the sector, annihilating all significant competitors – Bharti, Vodafone, Idea, Tata, and newcomers like Telenor and Sistema – with they having to pay exorbitant fees just to keep their current business going, even without carrying out any expansion plans.

As per the Supreme Court order, the licenses of those companies which were allocated spectrums in 2008 during former telecom minister A Raja’s tenure, will be cancelled. They need to participate in new auction to get new spectrum allocation. This means that they have to shell out more cash to maintain their existing

Similarly, Kumar Mangalam Birla, Chairman of Idea Cellular said that the regulator’s proposals would kill the industry and it made no sense for anyone to participate in spectrum auction at the proposed price levels.

Even industry associations like Federation of Indian Chamber of Commerce and Industry (FICCI) and Confederation of Indian Industry (CII) have rallied behind telecom companies and have shown their opposition to the proposed recommendations by TRAI.

So much so that a key foreign telecom company, the Norwegian-based Telenor, has threatened to withdraw its investment from India if TRAI’s recommendations are accepted.

“If these recommendations by TRAI become policy, then the government of India will be forcing the Telenor Group to exit. It will be almost impossible for us to participate in the upcoming auctions,” Telenor Group Executive Vice-President Sigve Brekke said.

Considering the importance of this recommendation, it is imperative for readers to know a little more about TRAI’s proposals.

TRAI’S RECOMMENDATIONS

Though TRAI has made several recommendations, only the important ones that need to be looked at have been outlined below.

1. TRAI recommends that re-farming of spectrum in different bands like 800 MHz and 900 MHz bands be carried out progressively. The spectrum available with service providers in the 900 MHz band should be replaced by spectrum in the 1800 MHz band, which should be charged at the price prevalent at the time of re-farming.


network as well as their existing consumer base.

If they do not participate, then they will lose huge number of customers as well as business.

The cancellation will impact 40 million customers of Uninor, 16 million of Sistema, six million of Idea Cellular and 5.5 million of Videocon, among others.

The Cellular Operator Association of India (COAI) has estimated that an incremental capex of `1,250 billion will be required by GSM incumbents in case re-farming takes place.

This would increase the burden of the telecom sector which is already grappling with high infrastructure costs and huge initial cash outflows required for such a development.

Not only the industry but also the common man will have to bear the brunt of this new policy.

TRAI’s recent recommendations on spectrum auction will lead to an increase in outgoing tariffs by 30p/minute, which is almost 8 times more than what TRAI has calculated. An additional 30p/outgoing minute outlay would reflect an increase of nearly 40% in the current tariff.

IN A NUTSHELL

While telecom companies are optimistic that the government will consider their concerns before taking any final decision on TRAI’s recommendations, there is no confirmation from the government until now.

Even if the government reviews TRAI’s recommendation, it may not entirely write-off the points raised by the regulator, considering the sensitivity of the 2G spectrum corruption cases. In any way, telecom companies will have to go through a rough patch, going forwarD.

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FortifyingAgainstRiskThe Basel III norms

are aimed at

strengthening the

banking system to

withstand di�erent

kinds of risks and

�nancial shocks

he Reserve Bank of India’s (RBI) wish to align the Indian banking system with global standards will

soon fructify. On 2nd May, the apex bank released the final guidelines for the implementation of Basel III capital norms for Indian banks.

After hearing from all quarters, the RBI has slightly tweaked the draft guidelines which were out and open for public comments since December last year. Implementation of the final guidelines will begin from 1st Jan ’13 and the process will be completed by 31st Mar ’18 in a phased-wise manner as against 31st Mar ’17 mentioned in the draft.

T In a nutshell, the Basel III guidelines aims for a resilient banking system by putting a higher thrust on loss-absorbing capital during periods of stress, improved liquidity standards and building capital buffers, among others. However, before we get into the details let us understand banks and the risks associated with them.

BANKS AND RISKS

Banks are important for an economy and its growth. Banks in their simplest form engage in borrowing cheap and lending at a higher interest rate. The difference in interest rates or spread as it is called is the money that



The after shocks of the sub-prime crisis are still fresh in our minds!

The question here is whether owners of the bank have their ‘skin’ in the game. Do they have the ability to absorb losses without depositors losing their faith in the bank and without the risk spreading like a wild fire to other sectors and real economy.

This is where Basel capital norms, which mainly focuses on capital adequacy ratio (CAR) come in the picture. The Basel norms safeguard the interest of depositors while performing other roles.

This also brings us to two important concepts of bank capital and capital adequacy requirements.

BANK CAPITAL AND CAPITAL ADEQUACY RATIO (CAR)

Theoretically, capital is the difference between assets and liabilities. A bank’s capital can be thought of as the margin to which creditors are covered if a bank liquidates its assets. In order to support their business, a bank has to hold capital in reserve as per the norms. A bank’s capital comes in different forms, equity as well as debt. For classification in terms of quality, a bank’s capital is divided into different ‘tiers’, Tier 1, Tier 2, etc.

Again, Tier 1 bank capital can be further classified into equity or core Tier 1 capital and additional Tier 1 capital. Instruments that are eligible in Tier 1 capital are common equity, reserve, retained earnings and some forms of preferred stock. Besides instruments with characteristics of both equity and debt. Tier 2 mainly consists of undisclosed reserves, revaluation reserves, general provisions, subordinate debt, and hybrid instruments.

Though a bit technical, in its simplest

form, it means that Tier 1 is a more reliable form followed by Tier 2 in case banks liquidate and distribute it to the depositors.

Now, since banking is a highly leveraged business and the banks lend many times the value of their assets, it becomes important for them to not indulge in risky lending.

To contain this, a bank has to maintain CAR as per norms prescribed by the Basel committee and local regulators, beyond which the bank cannot lend or engage in risky businesses.

So even if banks get in trouble, they have enough money to payback their liabilities like account holders, office employees, etc.

The amount of capital needed as back up depends on the risk of individual assets that the bank acquires. The riskier the asset, the larger is amount of capital required for back up. The central bank assigns risk weightage for different kinds of assets.

Though not technically correct, the following example explains the concept to some extent. If a bank has `100 of loans outstanding, funded by `91 of deposits and `9 of common stock invested by the bank’s owners, then the capital of `9 is available to protect depositors against losses. If ̀ 8 worth of loans are not repaid, there could still be more than enough money to pay back the depositors.

Again, out of this `9, tier 1, which is liquid, is `7 and the tier 2 capital is `2. Now if the bank book grows to `200, the bank has to accordingly increase its reserve in the form of capital. In short, if a bank creates assets (through loans or through investments) it is required to be backed up by bank capital. So, if a bank’s book grows, its capital should also grow in proportion.

the bank makes. The bank relies on people’s deposit and borrowings from the market for lending purposes as well as investments, there by creating assets. The bank needs to payback depositors and also has an obligation towards the markets.

In this regard, a bank has to keep some reserve, both voluntary and regulatory (Cash Reserve Ratio and Statutory Liquidity Ratio with the RBI), to meet withdrawal expectations of depositors and also for other short-term liabilities. Hence, a bank keeps a note on maturity periods of both assets and liabilities through a proper asset-liability management (ALM). Banks see to it that at no time the liabilities are greater than the assets, thus fulfilling the obligation towards the depositor. Also for the bank to not suffer in terms of profitability, it tries to keep only a small amount idle, keeping in mind that the depositors could anytime line up for funds deposited. The revenue generated from assets are used to pay back depositors and to meet other expenses like electricity bills, employee expenses, etc.

This entire process works as a well-oiled machine until the party to which the money is lent defaults. Very few cases of defaults can be easily absorbed by banks.

However, if the number of defaulters increases, as is the case during bad times in an economy, it could lead to depositors losing their money. It is this depositor’s money that the central banks across the globe want to secure.

Central banks know the devastating potential a failing bank has on the economy. Even a single failed bank has the potential to upset the entire financial system and the risk would slowly move onto the real economy.


WHAT ARE BASEL NORMS?Basel is a city in Switzerland. It is the headquarters of Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Every two months BIS hosts a meeting of the governor and senior officials of central banks of member countries. Currently there are 27 member nations in the committee. Basel guidelines refer to broad supervisory standards formulated by this group of central banks - called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system. In fact, on a few parameters the RBI has prescribed stringent norms as compared to the norms prescribed by BCBS.

Basel 1In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

Basel IIIn June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters, which the committee calls it as pillars.- Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets- Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks- Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Basel IIIIn 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity. These are explained below in more detail.

BASEL III GUIDELINES FOR INDIA

Basel III guidelines as put out by the RBI on 2nd May focus on four key parameters on banking, namely capital, leverage, funding and liquidity. Let us consider each of them one by one:

CAPITAL

The Reserve Bank of India has prescribed higher capital for banks

under the Basel III norms and the banks have to abide by it in a phased-wise manner. Banks need to maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs). This will be further divided as 7% for Tier 1 and 2% for Tier 2. The MTC stood at the same levels as prescribed by Basel II norms and as practiced in India. (Globally it is 8%).

The Tier 1 capital is further divided into the following components:

Common equity Tier 1 (CET1) at 5.5% of RWA (common equity is a measure of equity which only takes into account the common stockholders, and disregards the preferred stockholders).

Additional Tier 1 at 1.5 of RWA: In addition to Common Equity Tier 1 capital of 5.5% of RWAs, the banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital.


The main purpose of the proposed capital buffer is that it can be dipped into in times of stress to meet the minimum regulatory requirement regarding core capital and once accessed, certain triggers would get activated conserving the internally generated capital.

Hence, the focus clearly has been more on the common equity tier 1 capital, which has loss-absorbing capacities. And with a capital conservation buffer, the minimum tier 1 capital goes to 8% (5.5 + 2.5) of the RWA and the total capital goes to 11.5% (9 + 2.5) of the RWA.

Further, the RBI has introduced a concept of countercyclical buffer. The RBI is currently working on operational aspects of implementation of the Countercyclical Capital Buffer and the guidance to banks on this will be issued in due course. A countercyclical capital buffer within a range of 0–2.5% of RWAs in the form of common equity or other fully loss absorbing capital will be applicable. According to the RBI, the primary objective of having a countercyclical buffer is to protect the banking sector from system-risks arising out of

excessive credit growth. This could be achieved by building a buffer in good times. Typically, excessive credit growth would lead to the requirement for building up higher countercyclical buffer. However, the requirement could be reduced during periods of stress, thereby releasing capital for the absorption of losses or for protection of banks against the impact of potential problems.

Hence, the overall capital for the bank will vary from 11.5% to 13% considering both the buffer ratios that is the capital conservation and counter cyclical capital buffer.

Impact As capital requirements of banks increase under Basel III, it is likely that banks would slower their

lending activities so that they do not need to keep additional buffer in the form of capital. As lending is linked to the risk profiles of assets, banks would shy away from riskier assets like infrastructure and real estate, taking a toll on the economy and growth. As per RBI’s estimates, there would be a minor sacrifice in GDP growth during the period from 2013 to 2018.

The Indian banking industry is going through a difficult phase. It is suffering from liquidity crunch. Even the increased case of bad assets is hurting the banking industry. With this as background, even when the draft guidelines were released, there was a fear in the industry that it would be difficult to bring in the additional capital, mainly in the form of equity.

Heeding to those fears, the RBI has increased the timeline of implications by one year. (From 2017 to 2018. BCBS has prescribed 2019).

However, having said that, Indian banks under Basel II have CAR of well over the limit prescribed by the RBI and the Basel committee. Hence, experts opine that transition to Basel III will be smooth, the only challenge is raising additional capital not only to support the existing loan portfolio but also for incremental advances over the period.

While five years is a good amount of time to achieve the necessary capital needs on a continuous basis, the

A. Minimum CT1B. Capital conversion buffer (CCB)C. Minimum CT1+CCB (A+B)D. AT1E. Minimum Tier I capital (A+D)F. Tier IIG. Minimum total capital (E+F)H. Minimum total capital + CCB (G+B)Phased in of all deduction from CET(%)

3.6N.A.

3.62.4

639

N.A.

4.50

4.51.5

6399

40

50.635.631.56.52.5

99.63

60

5.51.256.751.5

729

10.2580

5.51.887.381.5

729

10.88100

5.52.5

81.5

729

11.5100

4.50

4.51.5

6399

20

505

1.56.52.5

99

40

5.50.636.131.5

729

9.6360

5.51.256.751.5

729

10.2580

5.51.887.381.5

729

10.88100

5.52.5

81.5

729

11.5100

H. Minimum total capital + CCB (G+B)Phased in of all deduction from CET(%)

2013 2014 2015 2016 2017 2013 2014 2015 2016 2017 2018

Source: RBI


implementation in a phased manner, with lesser compliance in the initial years and more compliance in the later years should only help banks to comply with the norms. According to rating agency ICRA, Indian banks would need `3.9-5 trillion capital over the next six years, out of which the requirement for common equity would be `1.3-2 trillion, additional tier 1 `1.9 trillion, and for Tier II `1 trillion.

Around 80% of the common equity requirement relates to public sector banks (PSBs). Of the total PSBs’ total equity requirement, the government’s share would be `0.3 to `0.8 trillion, considering that the government does not plan to dilute its stake in public sector banks, which on an average, is to the tune of 58%.

PSU banks will be impacted the most by the Basel III norms as they have to depend on government for their capital needs.

Even as the government has assured time and again that it will recapitalize public sector banks as and when required, experts feel that the task is mammoth, considering the weak fiscal health of the government.

This means that PSBs will have to improve operability to fund their capital needs so as to not depend on the Indian government.

Also, as equity capital increases, the return on equity (ROE), which is a ratio of net income to shareholders equity, will reduce. In simple terms, as the denominator (share holders equity) increases, the net income would be distributed among many hands against lesser before dilution.

In addition to the fall in ROE, some sacrifice also has to be done on earnings in the hand of the investors

as the RBI has prescribed restrictions on the distribution of dividend if the capital conservation buffer (CCB) falls below the prescribed level. The bank cannot even give bonuses to employees under such circumstances. LEVERAGE RATIO

The RBI under Basel III has introduced a regulatory leverage ratio. It can be calculated as Tier 1 capital divided by banks on and off balance sheet exposures.

Off-balance sheet items are obligations, liabilities or financing activity which companies tend to keep off their books in order to make their balance sheets look better.

Loan commitments, letters of credit and derivatives are few of the off-balance sheet exposures that a bank has. A leverage ratio has been aimed to contain a build-up of excessive leverage in the system. The RBI has mandated a figure of 4.5%.

According to the RBI, the leverage ratios are not binding until 2018 as banks whose leverage ratio is below 4.5% may try to bring it above 4.5% as early as possible.

Experts are of the opinion that since the off-balance sheet exposure of Indian banks is anyways very small, the impact of these changes in capital regulation on the balance sheets is going to be rather insignificant.

LIQUIDITY COVERAGE RATIO (LCR)

Banks need to maintain a liquidity coverage ratio to ensure that banks have adequate high quality liquid resources to survive a stress-like situation. For the LCR, the stock of high-quality liquid assets is compared with expected cash outflows over a 30-day stress scenario.

The ratio will be introduced from 1st Jan ’15. The liquid assets include cash, reserve with central banks that can be withdrawn in case of stress and corporate bonds with some haircut. Impact

This measure will have a negative impact on profitability as banks will have to hold significantly more liquid and low yielding assets.

FUNDING RATIO

This measure complements LCR. A net stable funding ratio (NSFR) is prescribed by the Reserve Bank of India and calculated as available amount of stable funding against required amount of stable funding over a one-year horizon.

The available amount of stable funding includes capital, liability with effective maturity of more than one year. The required amount of stable funding includes assets and off-balance sheet items that are less liquid over a one-year time horizon. Basically, the ratio ensures that the banks are highly liquid over a time frame of one year. Impact

The funding ratio will see to it that banks have a greater emphasis on long-term stable funding sources such as retail deposits, savings accounts as opposed to short-term bulk deposits and certificates of deposits (CDs), thereby increasing the liquidity profile of the bank.

Overall, Basel III for Indian banks would mean higher capitalization over the next five years. But it would also mean stronger balance sheets and a much safer financial system as Indian banks align themselves with their global peers as financial markets get integrated furtheR.

CARD

o service people with bank accounts in rural and semi-urban areas in India, the Reserve Bank of India

(RBI) has decided to introduce white labelled ATMs in the country. White labelled automated teller machines (ATMs) will be owned and operated by non-banking entities.

What Are White Labelled ATMs Non-banking entities will set up white labelled ATMs and run them like any other business enterprise to earn profits. These ATMs will not display the logo of any particular bank and

TSetting up of white

labelled ATMs will not

only help tap the rural

populace but also aid

�nancial inclusion in

the country

customers from any bank can access these ATMs to withdraw money. However, they will be expected to pay a small fee for every transaction.

In February ’12, the apex bank had released draft guidelines for the introduction of such ATMs. The guidelines are still under review and open for comments. The RBI had so far allowed only banks to set up ATMs. Though there are 87,000 ATMs in India today and a 30% growth in ATMs has been recorded over the past four years, the problem is that majority of these ATMs are still concentrated in Tier I and II cities.



overall costs of banking down. They say it will only be a matter of time before the RBI allows white labelled ATMs because over the last two years banks are already in the process of outsourcing 50% to 60% of their ATM operations to service companies who are performing functions like cash management, switching and technical management for banks.

Concerns That Need To Be Addressed

Despite the benefits that white labelled ATMs are likely to offer, a number of issues need to be ironed out. The first concern is with regards to safety. Precautionary measures need to be taken to ensure that these ATMs do not take unsuspecting customers for a ride.

Currently, a bank customer can use his savings bank account ATM card at any ATM of his own bank free of cost. If he is using the ATM of another bank to withdraw cash, he is not charged for the first five transactions in a single month. Thereafter, he is charged `20 every time he withdraws cash. For every non financial transaction, he will be charged `8-10.

In the draft guidelines, the RBI has said that the first five free transactions are not going to be applicable at all and customers will be informed about the charges for every transaction upfront. This means that charges for each transaction will be displayed on the screen. In addition to this, the white labelled ATM operator will not be allowed to charge any “interchange” fee from the customer.

The interchange fee is a fee that will be paid by the bank, which is the issuer of the card to the white labelled ATM operator for processing the transactions and the cost to do so. This means that the white labelled operator is eligible for a fee from both

the customer as well as the bank. Experts believe that this distinction should be made clear for the benefit of the customers who are likely to use such ATMs.

The other worry is that customers may not be too enthused about the idea of paying a fee for every ATM transaction. Since people from middle and lower income groups use the ATMs most frequently, they are the one’s who are most sensitive to charges levied for such services. Therefore, taking away the benefit of at least five free transactions in a month may not be a good idea.

The chief concern is over the risks involved in this venture. There will be difference in attitude between banks that offer ATMs as a service as against private entities who will set up white labelled ATMs to earn income.

This may increase fraudulent transactions and the protection of customers may be at risk. Also in case of a disputed transaction, the resolution process may take long as it will involve three entities - the white label ATM operator, the bank that is the issuer of the ATM card and the sponsor bank.

Bankers also do not seem overly excited at the idea of white labelled ATMs coming up in India. The proof is they have no plans of easing their ATM expansion drive. Banks treat ATMs as a cornerstone of their alternate channel strategy. It is an extension of their brand and helps in creating awareness about their brand as well as retaining customer loyalty.

Unless rental charges of setting up their own ATMs are very high in particular locations, banks seem to be more compatible with the idea of setting up ATMs on their own rather than depending on white labelled ATMs, at least for the time beinG.

Since the penetration of ATMs in Tier III and IV cities is abysmally low, the RBI feels that the roll out of ATMs by corporates will address this issue. Many large corporate conglomerates like Reliance, Tata, L&T and M&M seem to be interested in setting up such machines across the length and breadth of the country.

The RBI has stipulated that any corporate or non-banking entity that is interested in setting up a white labelled ATM must have a minimum net worth of `100 crore and should be attached to a sponsor bank. In the draft guidelines, the RBI also stipulates that though the location of these ATMs can be chosen by the entities setting them up, they will have to meet the annual targets set by the RBI and also maintain a ratio of ATMs in Tier III and IV cities.

A Step Forward In Increasing Banking Penetration

In principle the idea of expanding the ATM network sounds great. It will be a useful addition to the existing banking network and will also be very effective in inculcating the habit of banking among the rural populace and thus give a much needed shot in the arm to financial inclusion in India.

Commercial banks too are expected to greatly benefit from this move. As white labelled ATMs are expected to serve as the extended arm of banks that will allow customers to withdraw cash at a nominal cost, the banks need not spend on setting up their own ATMs. This is expected to save their costs which will benefit their core banking operations.

Service providers who will set up such ATMs seem gung ho about the decision of the apex bank. They believe that white labelled ATMs will go a long way in bringing about efficiency of ATMs and also bring the


Private equity �rms have started developing their own real estate projects so as to have complete control over their investments


avoided because private equity firms will have better control over the development of the project.

IREO Management Pvt Ltd was one of the first private equity firms to announce its foray into real estate development in the year 2009 with a portfolio of 13 projects located in prime locations around the country.

When the firm announced its plans IREO Chairman Anurag Bhargava said, “As a global investment fund, IREO has been present in India since 2003 and has steadily built a portfolio of high quality executable projects in prime locations across 3,000 acres of owned land with a national footprint. IREO has now evolved as a fully integrated real estate organization that is both the financier and the developer of its projects.”

The interesting fact is that even before announcing its entry into real estate development IREO had started construction and leasing of a 5 million square feet IT SEZ and the sale and construction on 3 million square feet of housing.

This is quite unusual because developers typically announce a project first and then start the construction activity. But the entire USP of private equity firms is to be different and give buyers a better experience than they have had with realty developers.

“We are committed to delivering superior product quality, investment value and a level of satisfaction never before experienced by real estate buyers in India,” said IREO President Madhukar Tulsi when their real estate development foray was announced.

Examples of private equity firms that are developing real estate projects are numerous. UK-based fund SARE was one of the early funds to get into the

development of real estate projects. The fund has developed various projects in Gurgaon, Ludhiana, Jalandhar and Amritsar and is now looking at developing projects in Navi Mumbai.

Milestone Capital Advisors Ltd is another PE firm that has entered into realty development. The fund has bought 65 acres of land on the Delhi-Jaipur highway to set up a warehouse. The fund says it has entered this segment because there are not many players in the business of developing warehouses.

Milestone will look at developing other real estate projects too if the opportunity favourable. Another fund Tishman Speyer already has an operational commercial project at Gatchibowli in Hyderabad called the Wave Rock.

Joining the list of private equity funds developing real estate projects is Mumbai-based Indiareit Fund Advisors, which plans to tie up with land owners across the country in cities such as Bengaluru, Mumbai and Pune to develop properties. The fund says that most private equity funds which have burnt their hands by investing in the projects of realty developers have learnt their lesson the hard way.

Indiareit now wants to play a more active role in real estate development. The fund now has its own asset management team, which includes architect and civil engineers who look after project execution.

Indiareit is developing its first such real estate project in the Southern city of Bengaluru. The fund has entered into an agreement with a land owner in Bengaluru to develop a 17-acre plot in Sarjapur, Bengaluru to develop villas, which will be priced at around `6,000 per sq ft.

n the past three years or so, the real estate industry has seen some real estate private equity (PE) firms turning into

developers by investing the money they had raised from investors into realty projects.

Funds first came into the real estate sector when the government opened up the sector for foreign direct investment (FDI) in 2005. With the opening up of FDI, international and domestic funds such as Blackstone, Lehman, HDFC and Kotak rushed to invest in projects of developers or in real estate companies.

The craze for real estate can be gauged from the fact that between 2005 and 2010, FDI in India’s real estate market jumped 80 times from `171 crore in 2005 to `13,586 crore in 2010. Things changed for the worse in 2007-08, when the slowdown hit the real estate sector.

There was a cash crunch which saw developers delaying the execution of projects. This, in turn, delayed the exit of PE funds from projects and now many of them are stuck in projects till there is a turnaround.

Learning from the experience of the funds that burnt their hands by investing in third-party projects, private equity firms such as IREO, SARE, Tishman Speyer, Millennium Spire and Fire Capital have started developing their own real estate projects with the help of local developers, to have complete control over their investments.

The firms say developing their own projects protects them from the usual problems associated with the real estate sector such as lack of transparency and delay in delivery of projects, which has held back private equity firms from exiting at a profit. Delay in delivery of projects can be

I

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SMS ‘BANG’ to 54646Contact at: 022-3926 9404, E-mail: [email protected]

BSE SEBI REGN No. INB011072759, INF011072759 & INE011072759, NSE SEBI REGN No. INB230939139, INF230939139 & INE230939139 DP SEBI REGN. No NSDL: IN-DP-NSDL-136-2000, CDS(I)l: IN-DP-CDSL-37-99, AMFI REGN. No. arn-49454 NCDEX REGN. NO. 00362, FMC Code-0075, MCX REGN. No. 16590, FMC Code-MCX/TCM/CORP/0490, MCX SX-INE260939139, PMS-INP000002981

Registered O�ce: 38-B, Khatau Building, 2nd Floor, Alkesh Dinesh Mody Marg, Fort, Mumbai - 400 001. Tel: 264 1234 / 3027 2000 / 2005; Fax: 30272006Corporate O�ce: B-2, 301/302, 3rd Floor, Marathon Innova, O� Ganpatrao Kadam Marg, Lower Parel (W), Mumbai - 400 013. Tel.: 39268000 / 8001 Fax: 39268010


Different private equity funds follow different methods of developing a project. While some of them acquire land on their own, funds such as First Indian Real Estate Capital Fund Pvt Ltd, or FIRE Capital, identifies an area where it wants to develop a project and then looks for a potential local partner that owns the land.

Others such as NewGrowth Capital, now acquired by Moonbeam Capital Managers Pvt Ltd, says it will only acquire small portions of land and bring in experts to develop its projects, while taking a majority stake. The fund is scouting for land in Gujarat and Maharashtra to develop premium real estate projects.

Interestingly, most private equity funds are focusing on Tier II and III cities because land price in these cities is cheaper than metros. The funds also feel that while there is high demand for premium homes in Tier II cities, developers have failed to cash in on the opportunity.

Industry watchers say it is natural for private equity funds to get into the development of real estate, given the non-transparent nature of the Indian real estate market.

International investors want land and buyer transactions to be transparent, but developers have failed in both respects. Therefore, funds have decided to take up projects themselves. This would give international investors much more confidence to invest in real estate projects in India.

Investors in the funds can either choose between being a small stakeholder in a large third-party project or being a controlling stakeholder in a small project, for the same investment. Higher returns are a big attraction for investors to put in their money in self-developed projects. Investors say that they can earn up to 30% to 35% in self-developed projects compared to a 15% to 25% return on third-party

realty projects.

There is a higher risk though in self-developed projects. Private equity firms may find it difficult to handle the entire ambit of real estate development right from buying land, securing approvals and construction of the project to sales.

The other problem is expansion. Real estate is a local subject and so if a fund decides to have projects in more than one location, then it would need to invest in manpower and resources, which can be expensive.

Buyers also stand to gain if they buy from private equity funds because the funds tend to deliver the project on time and even the price that they set is not very high. Funds say they are not going in for aggressive pricing because they do not have the brand leverage that leading developers have. Once the brand name is established, funds may gradually increase the priceS.

Registered O�ce: 38-B, Khatau Building, 2nd Floor, Alkesh Dinesh Mody Marg, Fort, Mumbai - 400001. Tel: 3926 8600 / 01; Fax: 3926 8610, Corporate O�ce: B-2, 301/302, 3rd Floor, Marathon Innova, O� Ganpatrao Kadam Marg, Lower Parel (W), Mumbai - 400 013. Tel.: 39268000 / 8001 Fax: 39268010

Contact - Daisee Boga: +91-22-39268244, 7738068289

IDFC’s strategy of accelerating growth and

generating business momentum depending

on the macro environment augurs well for

the infrastructure �nance company

nfrastructure Development Finance Company Ltd (IDFC) is India’s leading integrated infrastructure finance player providing end-to-end infrastructure financing and project implementation services. The

company’s main business is to provide finance for infrastructure projects, including ownership of infrastructure assets.

It is a leading player providing financing for long-term infrastructure projects. The company also has interests in private equity funds, asset management, investment banking and equity broking. IDFC, along with its subsidiaries, is engaged in providing finance and advisory services for infrastructure projects, asset management and investment banking.

The company was incorporated by a consortium of public and private investors and was listed on the stock exchanges in August ’05. It is amongst the first few companies to get the Infrastructure Finance Company (IFC) status in June ’10. The Government of India holds 17.9% stake. IDFC has a solid management team under the Chairmanship of Deepak Parekh, Dr Rajiv B Lall (MD and CEO), Vikram Limaye (Executive Director) and other experienced business vertical heads.

I

AnIntegratedPlayer



INVESTMENT RATIONALE

Uniquely Positioned In Infrastructure SectorIDFC has a strong domain expertise in the infrastructure sector and has positioned itself uniquely to capture significant growth. IDFC is now present across the life cycle of an infrastructure project – debt financing, equity financing through private/project equity, investment banking and strong infrastructure advisory support. We believe such a diversified business model is the biggest differentiating factor between IDFC and its peers.

Besides the above mentioned attributes of its business, IDFC has also established strong relationships with the government, which gives it access to decision makers at government entities. As a result, it has been able to play a significant role in the direction of the country’s infrastructure policy. Its relationship with government entities opens up major financing and advisory opportunities in the infrastructure sector.

Diversified Loan BookIDFC is a diversified player in the infrastructure sector and has developed expertise in financing projects in segments like power, telecom and transportation. Diversity of its loan book helps it to take advantage of favourable investment cycles across sectors and hedge against the risk of slowdown in specific sectors.

In spite of slowdown in infrastructure cycle, IDFC’s loan grew by 28% year-on-year (y-o-y) and 10% quarter-on-quarter (q-o-q) in Q4FY12, driven by disbursals in the telecom and transportation sector. The fresh demand is coming from (1) refinancing of road projects that have completed construction, (2) incumbent telecom operators that are refinancing their loans and (3) disbursal to power projects that are under construction

The management indicated a healthy pipeline of undisbursed sanctions and proposals in telecom and transportation sector, but fresh activity in the power sector remains tepid.

Source: Company Data, Nirmal Bang Research


23%11%

42%24%

Energy 42%

Transpor tation 24%

Telecom 23%

Others 11%

Outstanding Disbursement Mix

IFC Status Gives Access To Newer Avenues of Fund RaisingAs the company is classified by the RBI as an Infrastructure Finance Company (IFC), it has the option to partly access ECBs (50% of net worth) via the automatic route. Access to cheaper borrowings from overseas will reduce pressure on IDFC’s cost of funds and limit the fall in its NIMs in a higher interest rate environment.

2.7%3.0%

3.8%

3.8%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

FY09 FY10 FY11 FY12

Net Interest Margins

Healthy Asset QualityAsset quality has been one of the key highlights of this infrastructure finance company. Given the strong and stringent risk management, coupled with domain expertise and experience in various business segments, IDFC has been able to maintain superior asset quality across cycles despite higher risk of concentration of infra loans. IDFC has been able to maintain its asset quality even at the highest level across interest rate cycles and movements in the macro environment.

IDFC’s credit process involves extensive screening and financial analysis to access potential risks and devising appropriate risk mitigation mechanisms. The company also has a systematic review process to continuously monitor and evaluate the projects in its portfolio. IDFC’s asset quality continues to remain sound with gross and net NPA levels low at 0.3% and 0.15%, respectively as on 31st Mar ’12.

IDFC continues to maintain a cautious stance and has been prudently making provisions for cushion in case of any asset quality shocks.

We believe this makes IDFC better placed compared with its peers in the infra financing space. Considering the current macro environment, the companies financing infra projects is one of the key risk areas. Comparable banks are showing excessive stress in their asset quality (Gross NPAs are in the range of 2% to 3%). In such an adverse situation, IDFC has consistently maintained superior asset quality, which is commendable.


Net Interest IncomeOther IncomeNet IncomeOperating ExpensesOperating IncomeProvisionsPBTTaxPATMI/Associate ProfitConsolidated PAT

928628

1,556367

1,189153

1,036278758

-8750

FinancialsIncome Statement FY09

1,126983

2,109553

1,557128

1,428367

1,0621

1,062

FY10

1,632914

2,546532

2,013235

1,779500

1,2793

1,282

FY11

2,111868

2,979522

2,457285

2,173622

1,5513

1,554

FY12


Source: Company Data, Nirmal Bang Research Source: Company Data, Nirmal Bang Research

Higher Non Interest Income As Compared To PeersTo offer a suite of financing options and to improve its return ratios, it has diversified into asset management (AMC), investment banking (IB) and advisory services (broking), where revenue streams are non-interest income-based and generate higher RoEs as compared to its core business. So, it has comparatively higher proportion of non interest income to total income as against its peers.

Although revenue from broking and investment banking is volatile, income from AMC business has shown steady trends. Non interest income contributed approximately 28.3% to the total income in FY12 as compared to 34.3% in FY11 due to decline in AMC fees, flat investment banking fees and flat loan-related fees. Low Leverage To Be Beneficial For Long-term Asset GrowthIDFC has a lower leverage of nearly 4.3x (asset to net worth ratio) and so has the potential of increasing it in the next 2-3 years. This offers a huge scope for IDFC to grow its loan book aggressively in the future (when the macro environment improves), thus aiding improvement of return ratios. One of the reasons for this lower leverage is a substantial increase in the size of its net worth in FY11 due to raising of `26.5 billion through QIP and `8.4 billion through Compulsory Convertible Preference Shares (CCPS) (has to be converted into equity at a conversion price of `176 within the next 15 months).

As a result, its Capital Adequacy Ratio is healthy at 21% as on 31st Mar ’12 with a Tier 1 ratio of 18.5%. It does not

need to raise capital as it is sufficiently capitalized to meet its expected growth over the next 2-3 years.

VALUATIONSIDFC is well-placed to monetize the huge infrastructure opportunity on the back of a strong management team with expertise and domain knowledge in the infrastructure space, coupled with diversified business segments.

Its strategy of accelerating growth and generating business momentum depending on the macro environment is favourable. Expected monetary easing and reformatory steps by the government would be major catalysts in further improving its growth and profitability outlook.

Healthy asset quality track record and prudent provisioning policy make IDFC better placed compared to its peers in the infra financing space. We believe that the current valuation factors in the concerns over growth and asset quality. Based on the PAT estimates of ̀ 180 crore, the stock is trading at a P/E of 9.7x FY13E EPS of `12.14. We arrive at a Book Value of `90 for FY13E. Based on book value estimates for FY13E, IDFC is trading at P/BV of 1.3x, which we believe is attractive. The stock can generate a return of 20% to 25% over a year.

RISKS AND CONCERNS Higher than estimated slippages in asset quality is a key

risk. The company operates in a segment, which is subject to

stiff competition from banks, other financial institutions and multinational players, which have access to cheaper funds. Hence, due to competition, if the company is forced to reduce its lending rates, then it might impact its NIMs. Slowdown in the infrastructure sector and delay in

projects is another key concern. Significant weakness in capital markets will impact

investment banking and other capital market-related businesses.

0.37%

0.31%

0.21%

0.33%

0.22%0.17%

0.10%0.15%

0.00%

0.10%

0.20%

0.30%

0.40%

FY09 FY10 FY11 FY12

Asset Quality

Gross NPAs Net NPAs

20.4%

24.5%20.8%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

FY10 FY11 FY12

Capital Adequacy Ratio


Equity CapitalReserves And SurplusNet WorthMinority InterestBorrowingsTotal LiabilitiesLoans And AdvancesNet Fixed AssetsDeferred Tax AssetsNet Current AssetsInvestmentsGoodwillTotal Assets

1,2954,8816,176

2823,54829,75220,596

454142980

6,5001,079

29,752

Balance SheetFY09

1,3015,7107,010

626,54433,56125,031

442176

2,0974,6551,160

33,561

FY10

1,4618,948

10,4080

37,14447,55337,652

447248

1,0806,9611,164

47,553

FY11

1,51210,77312,286

1847,27559,57948,183

456248

1,1138,612

96759,578

FY12


NIMsRoERoAGross NPANet NPAEPSP/EBook ValueP/BVDPSDividend Yield

2.70%12.7%

2.6%0.4%0.2%5.80

20.3447.70

2.471.20

1.0%

Financial RatiosFY09

3.00%16.1%

3.4%0.3%0.2%8.20

14.3953.90

2.191.50

1.3%

FY10

3.80%14.7%

3.2%0.2%0.1%8.80

13.4171.20

1.662.00

1.7%

FY11



rival, the euro, accounts for 26.6% of the world’s reserves.

The reserve-currency status depends on three gauges of economic dominance-size of economy, exports and net foreign assets. By 1918, the US had the world’s biggest economy and within few years the dollar also had the lion’s share of the world’s foreign-exchange reserves. If that precedent is anything to go by, the Yuan should soon become the main global reserve currency, and not merely a junior alternative to the dollar or the euro.

The continued growth of China has made it the world’s second-largest economy. Furthermore, the many-fold increase in trade numbers truly validates the case of Yuan as a globally acceptable currency. Moreover, the Chinese government has taken a series of steps on both the current account and capital account fronts to give a global shape to its currency, Yuan.

and offshore separate, the respective supply and demand conditions lead to separate market clearing exchange rates. Hence, the emergence of a new currency code, CNH, to represent the exchange rate of RMB that trades offshore in Hong Kong.

A Wider Trading Band For USD-CNY

The recent widening of the daily trading band now allows for an intraday range of ±1% from the fix, double the previous limit on daily movements. The move is part of a general shift in the exchange rate regime away from an appreciating crawling peg towards a more flexible and market-driven exchange rate.

With a wider trading band – alongside larger two-way flow channels between onshore and offshore – we can expect more volatility, less consistent appreciation and faster internationalization.

This signal that future USD-CNY movements will be less uniform could, in turn, mean more opportunity for USD-CNH to trade in a wider range to reflect changing market demand and supply. Another key impact of greater volatility in the onshore spot rate is that it should necessitate greater FX hedging by corporates, helping to drive the development of the forwards curve.

Convergence In CNH And CNY Exchange Rates

Till there are material regulatory differences between the onshore and offshore RMB markets, there will be two separate exchange rates. The CNY-CNH spread is influenced by two factors: cross-border flow channels and supply and demand in the offshore market. But the fact that cross-border channels are widening means more market participants have

t was not long before China had divulged its intention of making Renminbi (RMB) or Yuan truly international and

more acceptable. It is not any short on the course to achieve its ultimate goal as China is making all the efforts, though in bits and pieces, to make RMB fully convertible on both current and capital accounts.

By allowing RMB to flow in greater quantities through ever-increasing number of channels, Beijing is gradually widening the opportunities to use RMB for trade and investment purposes, both onshore and offshore, with the ultimate goal of making RMB a truly internationalized, reserve currency candidate.

China’s urgency to put Yuan on the international map relates to its over-reliance on the US dollar. Ultra-loose monetary policy and America’s rapidly rising public debt is giving jitters to them. The fear is about the stimulus measures put in place to revive America’s flagging economy, which could sooner or later generate a burst of high inflation and will subsequently extend the secular bearish run in the US dollar.

The depreciation of the US dollar is hurting the US government bond holders, of which China holds a large stake. Approximately $2 trillion, which is more than 60% of its total currency reserves, is invested in US treasuries. On 5th Aug’11, the US lost its triple-A credit rating from Standard & Poor’s in the absence of a credible plan to cap its public debt and thereby accentuated China’s fear of depletion in dollar FX reserves.

The US Dollar, inevitably, continues to dominate the world of finance as it still accounts for 60.7% of the world’s $9.7 trillion reserves, despite a long and steady decline in its value against other currencies. The dollar’s closest

I

Introduction Of Offshore Renminbi (CNH)

In a move towards internationalization, China introduced an offshore Renminbi (primarily in Hong Kong) called CNH, which is in addition to the one in Non-deliverable Forward (NDF) Market (settled in US dollars). However, onshore and offshore (Hong Kong) Renminbi trade at different rates. This is by design as regulation has explicitly kept onshore

Source: Reuters, Nirmal Bang Commodity Research

60

40

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China Trade DataChina Exports China Imports


more avenues through which to respond to any CNY-CNH divergence. Also, with the wider onshore trading band, USD-CNY now has more flexibility to reflect outsized moves in USD-CNH in either direction. This has been notable when USD demand has risen sharply in periods of risk off when the trading band ceiling restricted onshore USD-CNY from following USD-CNH up. Both wider trading band and larger flows between the two markets should promote further CNY-CNH convergence.

Capital Account Liberalization

Fully convertible current and capital account remain the prerequisite for a currency to be called ‘floating’. Beijing policymakers have seen favourable conditions for easing the restrictions on capital inflows after seeing fundamental changes in its current account. Trade is already balanced as trade surplus to GDP ratio already fell to around 2% of the GDP in 2011 from the peak of 7.5% in 2007. Thus, China’s current account surplus to GDP ratio fell to only around 3% of the GDP, within the current account target band of ±4% set during the G20 summit in 2010.

On 3rd Apr ’12, the China Securities Regulatory Commission said it would substantially expand quotas for both USD and RMB qualified foreign institutional investor schemes (QFII) to $80 billion from $30 billion and to RMB70 from RMB20, respectively. This is the latest in a recent acceleration of moves to liberalize cross-border capital flows which include:

Plans by China for a pilot programme to let offshore funds raise RMB onshore for offshore investment – which if implemented would open up a new onshore to offshore cross-border investment channel

The state council has approved a

proposal by Wenzhou (a Chinese province) officials to allow individual offshore investment, which would open up the first individual offshore investment channel

An announcement during the recent BRICS summit that the China Development Bank would extend RMB loans to counterpart development banks. Although still very limited, it is a novel introduction of onshore-to-offshore RMB lending.

More specifically, other steps in the form easing restrictions for foreign investors to participate in domestic bond market, lifting domestic individuals’ quota for foreign exchange purchase (now $50,000 per year), allowing domestic individuals to invest in overseas markets and expanding QFII and ease restrictions on overseas investment are expected towards capital account liberalization.

Increasing Trade Settlement In Yuan

Trade settlement has been a key stepping stone in the bid to making the RMB a global currency. A small pilot RMB trade settlement scheme was introduced in July ’09, which was limited to 365 mainland companies. Since March ’12 all China-based enterprises with import and export qualifications have been allowed to settle trades in RMB.

It is fair to say the scheme has been a success. Total trade settled in RMB increased four-fold in the year 2011 to reach RMB 2.1 trillion ($330 billion), about 9% of China’s total trade last year. To support the programme, China has signed bilateral currency swaps with as many as 19 countries and regions worth RMB 1.6 trillion. With RMB trade settlement being used by more companies - both onshore and offshore, this should help drive future developments in the liberalization and internationalization

of the Chinese currency. For example, more Chinese importers paying offshore suppliers in RMB may increase the demand for offshore deposit and investment products in wider jurisdictions.

Real Presence

The Yuan is not convertible for purely financial purposes unrelated to trade and investment. Trade in RMB has been expanding faster than anyone would have anticipated. Long term, in say 10-20 years, it’s going to have a real presence.

China’s role as the world’s biggest commodities importer would mean that the Yuan would be used increasingly as a settlement currency. To facilitate this, China has also added new currency pairs in its onshore foreign exchange trading, most recently the Australian and Canadian dollar.

RMB internationalization will likely gain further momentum in the coming years. Apart from the surge of renminbi used for trade settlement (representing 8.9% of total trade in 2011), the greater volatility will likely encourage even wider use of renminbi in cross-border trade settlement to minimize exchange rate risks.

More importantly, the expected further liberalization of capital and current account should help speed up renminbi’s cross-border flows, in addition to the PBoC’s RMB1.3 trillion currency swap agreement with 14 central banks.

Japan has got the approval to buy up to $10.3 billion worth Chinese Treasury Bonds, suggesting higher acceptance of renminbi by China’s neighbour countries. Thus, it is clear that China wants its currency to be the next reserve currency and also reduce its dependency on the US dollarS.

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F

A TRAILBLAZER

Jimmy PatelChief Executive Officer,Quantum Asset Management Company Pvt Ltd

Jimmy PatelChief Executive Officer,Quantum Asset Management Company Pvt Ltd

Being credited with many firsts, Jimmy Patel, CEO at Quantum Asset Management Company Ltd believes that an honest attempt to give the best possible returns to investors will bear fruit irrespective of the size of the firm

orty-something Jimmy Patel is the very embodi-ment of ‘Mr Dependable’ in his organization. He is

the CEO of Quantum Asset Management Company Ltd, India’s first dedicated fund house that is direct to investors (it currently manages a corpus of about `200 crore).

He is one of the few leaders in the industry who has the unique distinction of having an experience in all key areas in the functioning of a mutual fund. Patel believes that mutual funds should offer simple and quality products and create wealth for investors.

Jimmy Patel - Chief Executive Officer at Quantum Asset Management Company Pvt LtdJimmy Patel has close to 20 years of experience in the financial services sector and has held various key management roles. Apart from holding a degree in Chartered Accountancy, Mr Patel has also completed his LLB from the University of Mumbai.

Jimmy Patel - Chief Executive Officer at Quantum Asset Management Company Pvt LtdJimmy Patel has close to 20 years of experience in the financial services sector and has held various key management roles. Apart from holding a degree in Chartered Accountancy, Mr Patel has also completed his LLB from the University of Mumbai.

This is a philosophy that he has stood by for the most part of his profes-sional life and has inculcated in the Quantum team, as well. Being a direct-to-investor fund makes the process “slow but rewarding” as Patel puts it. A single lead may take as much as six months to turn into a customer, but Patel believes that once investors are familiar with their style of investing, they are here to stay. True to his working style, Patel has been responsible for the introduction of a paper-less online platform for investing in the schemes of Quantum Mutual Fund, aimed at providing convenience to the investors.

He may have never managed day-to-day investments over the last 20 years that he has been closely associated with the mutual fund industry, but he has done everything else that needs to be done to keep a fund house in order. In the various organizations across the mutual fund industry that he has worked in over the last two decades, Patel has seen the mutual fund indus-try evolve from its stage of infancy

born and brought up in a Parsi family in South Bombay, he was every inch the studious guy who remained a topper all through his academic career. Till date, Patel holds the distinction of becoming the youngest to pursue Chartered Accountancy at the age of seventeen-and-a-half.

When boys his age were having a difficult time sorting out what exactly they wanted to do with themselves, Patel was surging ahead. Not just satisfied with being a chartered accountant, he also opted to do a bachelor’s degree in law, and even while awaiting results, he found himself at his first job in accounting in Rallis India. A part of the Tata conglomerate, the company had several subsidiaries such as pharma, engineering, fine chemicals, agro chemicals and the likes.

India was on the brink of liberaliza-tion at that point in time and most big

and has even been a part of the entire process himself. Having been with the mutual fund industry even before we know it in its current avatar, Patel has been credited with many “firsts”.

He introduced the daily dividend facility for liquid funds and the concept of auto rebalancing in a scheme. Not just that he has been an active member of the Association of Mutual Funds in India, the mutual fund industry trade body (better known by its acronym AMFI) and has been a part of various working group committees constituted by AMFI and been instrumental in the finalization of the compliance manual and drafting of the curriculum for the AMFI Certification test.

EARLY SIGNS OF GENIUS

That Patel would carve out a niche for himself was evident from his childhood itself. An obedient boy


conglomerates were busy putting their houses in order. Restructuring had become quite the order of the day and willy-nilly Patel found himself in the thick of action. In the process, he came to be a Board for Industrial and Financial Reconstruction (BIFR) expert, the experience of which would make him somewhat of a spin-doctor in the later years. Patel considers his experience at Rallis India to be priceless.

“Not only was I gaining valuable experience as a newcomer, it was here that I learnt that honesty and integrity are bound to pay off no matter how large or small your business is,” he says. During his stint at Rallis, he also got his first taste of liaising with the apex bank of India as well as other government bodies.

As a newbie in the world of corpo-rates, Patel considers himself lucky to have worked with two of the biggest conglomerates of those days. After gaining valuable experience at Rallis for a couple of years, he landed up with a job at Mahindra and Mahindra. Patel recalls how Anand Mahindra, who had just returned to India with training in business management from the western world, was brimming with new ideas, and Patel was extremely happy to be associated with any new venture.

Although he was formally a part of Mahindra Ugine Steel Company, Patel was picking up the ropes across all industries that Mahindra’s were just venturing into areas such as real estate and hospitality. Patel says that he was eyewitness to the first line of “budget hotels” being launched by the Mahindra’s across four cities. Patel was closely associated with Mahindra’s attempt at launching an off-shore fund. But just as plans were being readied, the 1992 Harshad Mehta scam rocked the Indian capital

markets and glaring loopholes in the banking system shook the nation. With the off-shore fund plan being scrapped, Patel experienced the disappointment over a failed attempt, for no fault of his organization.

Looking back though, Patel has no regrets. Though he was all over the place in both companies, his wide experiences across all divisions taught him many things that he believes he would never have learnt had he been stable in one division.

THE REAL DEAL BEGINS

His real brush with the mutual fund industry began when he joined the Tata Asset Management Company. The best thing about being associated with the Tata’s was that Patel learnt the true purpose of mutual funds.

“It was genuinely believed that a mutual fund was an effective tool for wealth creation and not just a profit-making venture for a corporate entity,” says Patel.

It was, therefore, that this group was the first among private sector MFs to have launched a young citizen’s fund. This was a long-term interval product that had an insurance component. Other products such as a fixed income fund with a 15% guaranteed return in the first year were also launched. “The idea was to make an honest effort to create wealth, to give genuine returns in the hands of inves-tors,” says Patel.

The Tata’s were the first in the indus-try to launch a corporate trustee company. This was quite significant because it was the first time that unlimited liability was moved from individuals to a trustee company. Under the leadership of KN Atmar-amani, not only was the fund house flourishing, it was also instrumental in bringing about winds of change.

Thanks to his prior experience of working with financial regulators, Patel was nearly interfacing regularly with SEBI, which was still taking its first steps as a capital market regula-tor. Mutual fund product development ideas were being experimented upon till then and Patel found himself handling everything from accounting standards, compliance to taxation norms. Anything to do with customer engagement, accounts, finance or compliance, and Jimmy Patel was called upon. He was only too happy to rise to the occasion.

TAKING THE ROAD LESS TRAVELLED

After working with the Tata’s twice, life took quite a racy turn when he joined Sun F&C Asset Management. Markets and mutual funds were going through a bull phase and Patel found himself in charge of an aggressive product launch strategy.

The fund house had a “one fund per month” strategy for a period of six straight months, including several technology sector funds that caught the fancy of the industry till the tech bust took place. This time Patel was wiser and knew how to handle the lows better.

During this time he was also honing his skills in IT coordination and ensuring the smooth running of the entire back office operations, an experience that would turn out to be very valuable at a later date.

Opportunity came knocking once again in the year 2000. By this time Patel had risen to the senior manage-ment level. He joined IDBI Principal Asset Management as the Chief Administrative Officer. Having received a free hand, he won several accolades in-house and was recog-nized for his efforts. Patel was instru-mental in introducing workflow


imaging for the first time in India, which brought about a technical revolution of sorts.

Though the import of technology and machine was anything but cheap, it had excellent results. Thanks to this new technology, IDBI Principal was recognized as the the least paperwork fund house that very year. Not only was Patel recognized for his efforts, he was also handpicked to head the pension initiative in India that Princi-pal was keen upon. Though he received special overseas training for the same, it never materialized as there was neither regulatory clarity nor initiative in the filed of pension management back then.

A little disillusioned perhaps but not to be outdone, Patel moved again. This time to ICICI One Source. His responsibilities here included deliver-ing back office operations for pension funds overseas, mutual funds, custody houses and the likes associated with asset management overseas.

Despite the somewhat unrealistic expectations of overseas clients, Patel was one of the first in the industry to create awareness about the KPO capabilities of India with regards to outsourcing. That we as a country are capable of product marketability with high standards was exemplified by Patel’s efforts in the development and implementation of KPO plans.

With winds of change coming calling again in the year 2005, Patel moved once again. This time as the COO of JM Financial Asset Management. Within a year he was promoted from COO to CEO and was responsible for the entire operations, growth and development of a fund house comprising 140 employees.

By now leadership came easy to Patel and he handled his responsibilities deftly. Pretty much Mr “Fix It” for

just about anything, be it operations, legal, accounting, customer servicing, information technolgoy or whatever, Patel’s style of functioning was known and appreciated by all.

His initiatives were as much admired by colleagues as by competition and when the time was ripe for change, he found himself at the helm of affairs at Edelweiss Asset Management, a fund house that was starting from scratch. The fund among its peers collected the highest mobilization at the time of its maiden NFO, which was an achievement at that time. Patel, however, has some difficulty narrat-ing his experiences here, because despite best efforts, the recession had

hit Indian shores and the process of letting go of the people was the most daunting task.

“People had quit cushy jobs to come and work with us and to have to let them go was like going through hell,” he says, the regret, writ large over his face. Till date, Patel believes employ-ees are the true resources of any organization and looks out for honest and sincere people while hiring. He truly believes that an honest attempt to give the best possible returns to investors will bear fruit, and the scepticism over the future of smaller fund houses like his will be dispelleD.


he political uncertainty in Greece has increased the possibility of its exit from the European

Union, resulting in risk aversion, which has weighed on the global equity markets.

A negative global economic outlook, weak rupee and the lack of strong policy initiative from the government have turned the Indian equity markets into a negative trend. The Nifty futures has already lost 2.87% (from 8th May to 28th May).

Standard and Poor’s has also cut India’s credit outlook to negative mainly due to the high current account deficit. The negative global outlook, together with deteriorating current account deficit, resulted in the depreciation of the Indian rupee.

The rupee touched its all-time low of 56.38 to the dollar in the month of May. It lost around 25% of its value in the past 12 months. June is likely to be a news-driven month.

The scheduled result of the re-election in Greece on 17th June will provide further cues to the global equity markets.

The India Volatility Index (VIX), which measures the immediate 30-day volatility in the markets, has seen a continuous increase since the start of the May expiry from the level of 18 (as on 2nd May), touching a high of 27.2 (as on 23rd May). The index recently cooled off, coming down and hovering around the level of 24. Going forward, after the outcome of the election in Greece, which is the first since the debt crisis began, we expect VIX to come down and stabilize near the levels of 18-20.

T On the Nifty Options side, for the June series, while additions have been witnessed in 4,500 Put followed by 4,800 Put, 5,000 and 5,100 Calls have the maximum Open Interest standings with ATM IVs near the 22 level.

Hence, one can infer that the Nifty is hovering around the immediate resistance levels of 5,000 and 5,100 and further up-move will be only be triggered after some clarity on the European economic outlook.

Sectorally, there were a lot of long unwinding and short build ups in most sectors in the May expiry. Reliance Infra, GMR Infra and IVRCL Infra from the infrastructure space and RPower, NTPC and Power Grid from the power sector witnessed significant amounts of long unwinding, whereas banking and metal sector stocks such as IndusInd Bank, Bank of India, HDFC Bank, Tata Steel, Hind Zinc, etc witnessed good shorts in the May expiry. The point to be looked at in the last week of expiry is whether these short positions are rolled over or squared off in the expiry itself.

The short-term trend has slightly turned positive but the overall medium trend remains cautious and weak. The Index has observed volatile trading sessions in the past few weeks.

The pattern suggests immediate resistance at the 5,080 level and support at the 4,800 level. The Nifty is also trading below its long-term 100-200 day moving averages, which is not a healthy sign.

The Nifty has managed to close above the Fibonacci retracement (38.2%) level of 4,950 in the last two trading

TECHNICAL OUTLOOK FOR THE FORTNIGHT

sessions. Till the time the levels 5,000-4,950 are intact, there is valid possibility that the Nifty might attempt to scale higher.

However, the Nifty is facing a strong resistance at the 5,080 level i.e. 50% Fibonacci Retracement resistance. Important oscillators - RSI and MACD - on the daily chart have turned positive, giving a sense of a short rally taking place.

Immediate resistance could be seen at the 100-day EMA of 5,130 and any stability above this level could extend the rally to the 5,180/5,230 levels.

Strong support is seen at the 4,780 level and fresh selling will be seen only if the Nifty starts trading below this point.

The overall mood of the markets will turn positive only if the Nifty starts trading above the 5,080 level. Till then any sharp rally in the market should be used as a selling opportunity by market participants.

STRATEGY

Looking at the current levels of VIX (22) and the upcoming Greece re-election outcome, we recommend constructing a Bull Call Spread to the traders at strike of 5,000 and 5,100.

It can simply be initiated by Buying 5,000 Call (at ̀ 120) and Selling 5,100 Call (`55) (Kindly note the net spread cost should not be more than `45).

The maximum profit that the initiator can earn is `55 at or above the 5,100 level where the loss remains limited to the tune of the spread cost (`45) if the June contract expires below the 5,000 leveL.



Source: Capital Line

Company Name Current Market Price11th Nov'10

Book Value Price /Book Value

223.50102.53143.35226.44123.53233.51

92.7239.3924.23

153.89123.52

51.56409.40165.42

51.32116.54409.63114.50

20.4344.23

199.21225.23

28.56120.72141.73

63.84123.76

80.8050.2687.3557.29

114.6513.5337.06

254.57142.78320.56

49.51218.93

41.71112.62147.14199.45137.98188.93

21.8399.2150.0974.6355.25

0.270.280.280.280.290.290.350.350.350.360.380.380.390.400.400.400.420.420.420.430.440.440.450.450.450.470.480.490.500.510.510.520.520.520.520.540.540.540.550.550.550.550.550.550.560.560.560.570.580.60

Source: Capital Line

PRICE TO BOOK VALUE

United Breweries (Holdings) LtdAnsal Properties & Infrastructure LtdGammon India LtdHousing Development & Infrastructure LtdJai Balaji Industries LtdReliance Communications LtdNCC LtdTriveni Engineering & Industries LtdREI Agro LtdShipping Corporation Of India LtdAnant Raj Industries LtdElectrosteel Castings LtdBilcare LtdEscorts LtdSREI Infrastructure Finance LtdPrakash Industries LtdJindal Poly Films LtdPunj Lloyd LtdFirstsource Solutions LtdAlok Industries LtdPatel Engineering LtdShree Ganesh Jewellery House Ltd3i Infotech LtdIndiabulls Real Estate LtdPunjab & Sind BankDeccan Chronicle Holdings LtdJai Corp LtdJyoti Structures LtdUsha Martin LtdHCL Infosystems LtdPeninsula Land LtdUnited Bank Of IndiaSujana Towers LtdMercator LtdChennai Petroleum Corporation LtdRolta India LtdVideocon Industries LtdBajaj Hindusthan LtdGujarat Alkalies & Chemicals LtdMahanagar Telephone Nigam LtdJB Chemicals & Pharmaceuticals LtdGujarat Narmada Valley Fertilizers Company LtdKesoram Industries LtdKarnataka Bank LtdAmtek Auto LtdJM Financial LtdDhanlaxmi Bank LtdS. Kumars Nationwide LtdIVRCL LtdNetwork18 Media & Investments Ltd

Company Name Current Market Price(29th May'12)

Book Value Price /Book Value

60.4028.9540.5564.4535.3567.3532.5013.86

8.5755.5546.3519.65

159.4066.6020.7547.15

170.0047.60

8.6719.0087.0098.5012.7554.6064.4030.1058.9539.9025.1044.2029.0559.05

6.9919.15

133.1576.40

173.3026.80

119.6022.8561.8580.90

110.1076.55

104.9012.2255.9528.6543.3532.90

United Breweries (Holdings) Ltd

Housing Development & Infrastructure LtdJai Balaji Industries Ltd

Jindal Poly Films Ltd

Chennai Petroleum Corporation Ltd

Bajaj Hindusthan LtdGujarat Alkalies & Chemicals LtdMahanagar Telephone Nigam Ltd

Gujarat Narmada Valley Fertilizers Company Ltd

The table represents companies listed on the BSE that are low on Price to Book Value

9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN

+354.88+354.88+354.88+354.88+354.88

-270.91-270.91-270.91

-270.91-270.91-270.91

2,0002,000

4,0004,0004,000

6,0006,0006,000

8,0008,000

10,00010,000

9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN

9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN

9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN9:30A.M. NooN

70.91 16.42 24.56 88.7521.56

88.7521.56

70.91

70.9136.75

24.5658.36

2.5844.68

67.5857.32

88.75 21.5670.91

16.4224.56

44.58 68.9968.99

Arbitrage funds

generate income

through arbitrage

opportunities in cash

and derivatives

markets in volatile

conditions

he situation in the financial markets is gloomy the world over, including India.

In such times investors are caught on the wrong foot due to the lack of direction in the equity markets. The returns on investments in the past two years is believed to have been negative or at par.

Due to the uncertainty in the Indian equity markets since the past few years a large number of investors have stayed away from investing in them. Instead, they have begun looking at traditional investment avenues like bank fixed deposits and term deposits.

However, there are few equity

T products that work during volatile and uncertain periods too. These are known as arbitrage funds. These funds are best suited during volatility in the equity markets, especially when there is no clear indication of decline or surge in the markets.

Arbitrage funds have a history of performing well in uncertain market conditions and volatility is something that arbitrage funds not only resist but actually succeed over. This arbitrage strategy normally acts as protection against market volatility as buying and selling transactions compensate each other.

There are many market participants who identify arbitrage opportunities across asset classes and markets. Such market participants are known



settlement date (that is the last Thursday of every month), the price of equity shares and their futures tend to be similar.

This way, the fund manager hedges risk and such calculated investments do not carry much threat and can earn decent returns in volatile markets.

Advantages And Disadvantages Of Arbitrate Funds

Despite some aversion, arbitrage funds are quite essential in times like these. In the past two years, the markets have not moved anywhere. Arbitrage funds are those which can give decent returns in such unstable equity markets. Many investors believe that it is risky if the funds have a Futures and Options (F&O) strategy. But on the contrary, they have a calculated exposure in F&O. Hence, investors need not worry about the risk of capital erosion while investing in arbitrage funds.

On the taxation front too, arbitrage funds are useful as they are treated as equity funds as they occupy 65% of the portfolio in equity. The dividends and long-term gains (one year and above) from such schemes are free from taxes.

However, there are certain shortcomings too. Arbitrage funds depend heavily on arbitrage opportunities which are sometimes difficult to catch. Due to such reasons, there are times when a fund manager either holds cash or invests in liquid funds, because of which an investor may miss the available opportunities in the equity markets.

Moreover, there are costs involved for fund houses too such as brokerage charges, securities and transaction costs. Hence, there should be enough spreads to cover the costs. These kinds of funds are best suited during

weak or volatile market conditions. They tend to give below average returns during a bull phase.

Good Funds

Few arbitrage funds have managed to give decent returns in the last three to five years. If we look at the performance of equity funds, we find that in the last one year arbitrage funds stand at the top with their positive performance. Currently, there are over 18 arbitrage funds available in the market, which have given an average return of 7% to 9% in the last one year and 5% to 7% in the last three years.

However, before investing investors should look at the track record of such products. One of the top schemes in this category is UTI Spread, which has consistently given decent returns for five years, three years and one year. Despite the global financial meltdown in the past few years, arbitrage funds have managed to give positive returns since 2007. Last year when the Nifty was down by over 25%, UTI Spread gave positive returns of 8.3%. In 2008 when the markets were down by over 50%, the fund managed to give a return of over 10%. However, in 2009 when the markets bounced back sharply, it managed to give returns of only 6.4%.

Investors can also look at SBI Arbitrage and Religare Arbitrage funds, which have a proven track record of over 5%.

If we look at some portfolios of schemes, we find that most fund managers are either on cash or invested in debt. It indicates that a small portion of corpus is used in equity while the remaining money is invested in certificates of deposits (CDs) and cash. It also shows that few managers are not getting enough arbitrage opportunities or are not

as arbitrageurs. Arbitrage funds work on the same principle and basically try and gain on the price disparity of the same security in different markets. This way, they lock the return (which is the difference in prices) at the time of the trade.

In the ensuing pages we have explained what exactly arbitrage funds are and what are the advantages and disadvantage of investing in these funds. We have also listed few funds that have managed to stay afloat in volatile market conditions and whether or not investors should invest in such funds.

What Are Arbitrage Funds

To a layman, arbitrage is a strategy which involves simultaneous purchase and sale of same instruments in two or more markets (one stock can be sold on the Bombay Stock Exchange (BSE) and the other can be bought on the National Stock Exchange (NSE)) and the benefit gained from the difference in pricing. Similarly, arbitrage funds try to benefit on the arbitrage opportunities out of pricing mismatch of stocks in the equity and derivative segments of the stock market.

The following example shows how arbitrage works in the stock markets. Let us assume that the stock of Company ABC is trading at `100 in the spot market and at the same time the stock is traded in the derivatives market where the stock futures is priced at `110. So when a fund manager witnesses such mispricing, he sells a contract of ABC stock futures at `110 and buys the same number of shares at `100 from the cash segment. So, he earns a risk-free profit of `10 per share.

On the settlement day, it would not matter which direction the stock price has moved in the interim. As on the

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willing to take undue risk at this point in time.

What Should Investors Do At This Juncture

As discussed earlier, the current market situation is highly uncertain and difficult to predict where it is likely to move. Arbitrage funds have a proven track record of delivering better returns in volatile conditions. The difference in pricing in the two markets determines the performance of arbitrage funds, which is currently being offered in the market.

Before investing, investors should remember that arbitrage funds are safe but their returns are not as high as pure equity funds. As many investors demand similar returns from other equity or diversified funds, it makes no sense to compare arbitrage funds with pure equity funds.

So when markets are stable, the returns will be very minimal, which makes them attractive only for a short period of time.

An investor should enter arbitrage funds only with a view that it will

give returns similar to short tenure debt funds. Hence, investors who are looking to benefit from arbitrage opportunities available in the equity markets should look into such arbitrage schemes.

Arbitrage funds are purely for those investors with a low risk appetite. They can include arbitrage funds in their core portfolio anytime without distressing about where the markets are moving. While equity investments can pull the overall portfolio returns, arbitrage funds tend to bring a sense of stability to the investoR.

A day trader’s life is full of ups and downs much like the markets he is involved in

f you love the T20 format of cricket, you will surely love day trading. That’s because just as in T20 cricket, day trading

has more twists and turns and edge-of-the-seat excitement.

Moreover, as a day trader you are your own boss, you work at your own pace and there is no limit to the amount of money you can generate especially since there are no targets and deadlines.

But if you are already considering leaving your day job to turn into a full–time day trader, think again. If you think that it is all fun and no work for a day trader, and the only thing that a person needs to do is to buy and sell shares, you are mistaken.

A typical day in the life of a stock trader can be more labour-intensive, pressure-filled, draining and taxing than most other full-time professions. In fact, a day trader has to battle, dodge, overcome and negotiate a host of things while day trading.

I DAY TRADING

Buying and selling of various financial instruments such as stocks, Futures and Options, currencies, commodities, etc with a view to making profits by squaring off that position before the end of the day by exploiting the volatility or price fluctuations during the day is known as day trading. Basically a day trader is one who settles all his trades by the end of the trading session on that day, be it profit or loss, and does not hold any overnight positions.

REQUIREMENTS

Remember that a day trader usually plays for a movement of just a few rupees or even a few paisas in the market. For this, he buys and sells shares in huge quantities and even the slightest movement on either side can mean great profits or extreme losses. Hence, even a slight delay in executing an order can mean disaster. For this a day trader should have certain prerequisites to maximize his

trading efforts.

1. A good computer with a UPS backup in case of power failures is a must. He should have an anti-glare screen on the computer monitor or anti-reflective spectacles to protect his eyes from harmful rays as well as eye strain.2. A fast Internet connection with a secondary Internet connection in case of disconnections is also needed.3. A good charting software with real-time charts proves to be useful.4. A TV with all possible business news channels to be up-to-date with the latest happenings in the market.5. An ergonomically-designed chair since sitting in front of the terminal for hours on end can take a toll on the back and neck.

A TYPICAL STOCK TRADER’S DAY

A typical stock trader’s day can be divided into three different time zones:a. Pre-Market

EasierSaid Than Done



b. During Market c. Post-Market

PRE-MARKET

� The first thing is to get up early in the morning, at least an hour before the market opens. Just like a good cricketer needs some net practice before the match, a day trader too needs to get up early and start preparing for the day ahead. � There is no better tool at a stock trader’s disposal than the morning business newspaper. Everything else that one might come across during the day might be speculation, rumours, tips or views. They are not facts. So the first thing to do in the morning is to diligently spend 15 to 20 minutes reading the newspaper. This involves not just scanning the stock quotes page but also reading about political, economical, global, and industry-related news. These macro factors have a huge bearing on how the trading day will shape up.� The next thing is switching on the television set and browsing though the business news channels. They give a clear picture of what events (both domestic and international) have transpired during the previous night in addition to stock-specific news, expert advice, views, recommendations and outlook.� Next, a trader needs to find out how the other world markets, mainly the Asian indices such as Hang Seng, Nikkei, Kospi, SGX, etc, are trading. Our market opening generally follows the trend of these markets during opening trades. � Next is the pre-opening session, which lasts for 15 minutes just before the market opens at 9:15 am. This session was introduced only a few months ago to reduce erroneous volatility and price fluctuations associated with opening trades. Pre-markets give a sense of the general direction of the normal market opening.

� A trader should be at the trading terminal at least 10 to 15 minutes in advance so as to ensure that the computers and Internet are working without any glitches and he is logged on to his trading site. A day trader must ensure that he doesn’t miss the crucial opening trades. This is the time when there is maximum price action in the stocks.

DURING MARKETS

From the moment the markets start trading, there is constant barrage of news and events that relentlessly lash the markets throughout the trading session. To be a successful day trader, an individual should be aware of all these and understand its impact on the markets and the specific stocks to take full advantage of the same.

� NumbersFrom time to time, important economic numbers such as inflation figures, IIP numbers and other growth numbers are released. All these can cause the markets to rise or fall dramatically within seconds of them being declared. A good number such as low inflation or high growth number is viewed positively and the market shoots up. On the other hand, a bad number is punished severely and the market tanks.

� Corporate AnnouncementsCorporate actions such as stock splits, dividends, bonuses, mergers and acquisitions, with the most important event being company quarterly and yearly financial results, affect stock prices greatly. From a day trader’s point of view these actions are important in deciding whether to go long or short in that particular stock.

� European Markets Opening And Dow FuturesMidway through our trading day, the European markets (FTSE, CAC, DAX, etc) start their trading. Our

markets take direction from these markets too. A weak European opening is immediately reflected in our markets within minutes and, hence, a trader should be aware of this. Dow futures is also a precursor of how the US markets are expected to open and trade in the evening and, hence, is important for our markets.

� Currency Rate MovementsA rising rupee can be a negative for most sectors because it is basically viewed as a sign of weakness of the entire economy. Hence, most sectors tend to experience weakness when the rupee is depreciating too much with the maximum pressure seen on those stocks that rely heavily on imports such as chemical, power plants, fertilizers, oil marketing companies, etc. However, there are certain companies whose major revenue comes from exports and, therefore, stand to benefit from the weakness in the rupee. These sectors are mainly IT, pharma, textiles, engineering, etc.

� Analysis Of Intraday ChartsFor a day trader, minute and hourly charts are of utmost importance. Look for signals such as breakouts, breakdowns, consolidations, reversals, candlestick patterns and stock spikes with huge volumes, among others. Although they are not 100% accurate at all times, yet they serve as supporting tools for a trader.

� Derivatives DataThe maximum volume of trade now-a-days is in the derivatives or the F&O segment. So, understanding and interpreting it and its impact on the cash market is very important for a day trader. The main things to watch out for are Put-call ratio, implied volatility, options premiums, open interest changes, etc. Finding out the net Open Interest in the F&O segment in relation to the stock price move, whether fresh positions are being added on the buy or sell side or


whether existing positions are being squared off, are equally important for market participants.

� NewsThis is the most important parameter from a stock trader’s point of view. Any positive news regarding a stock or a sector such as subsidy, price deregulation, tax refund, new orders, etc, will instantly reflect in the stock price rise. Conversely, any bad news such as a new tax regimen, hostile takeover bid, a new stringent policy, patent rejection, lawsuits, etc, will instantly see the stock or sector nosedive. But if you are an experienced trader you can trade on both sets of news and make money.

� Gold PricesA good trader always keeps an eye on changes in gold prices. Usually when gold prices go up, it signals an underlying problem in the stock markets or the economy with more and more investors shifting from riskier assets such as stocks to relatively safer assets such as gold. Therefore, an upward movement in gold prices means that the stock markets may go down.

� Interest Rate ChangeLowering of interest rates releases money supply into the system and, hence, stimulates growth and the stock markets tend to rise. A rise in interest rate means that money is being sucked out of the system and, hence, growth is hampered and the stock markets fall. Markets react almost immediately to the announcement of such rate changes. Therefore, a trader should always be careful and mindful when trading on these days.

� Crude Oil PricesCrude oil prices have a strong impact on how markets behave. Rising crude prices mean that the prices of petroleum products such as petrol,

diesel, LPG, will go up, which in turn will lead to a rise in transportation and production costs and, hence, prices of almost all products stand to increase. This may lead to a decrease in demand, hurting most sectors, which tend to fall in the face of rising crude oil prices. The only sector that stands to benefit is upstream oil companies (ones that are involved in the search and production of crude oil).

� Major EventsEvents such as Budget day, election results, etc, need to be traded with extreme care because there may be huge swings in the markets on such days. And if a trader gets caught on the wrong foot, the losses he makes may be magnanimous.

� Global EventsIt is a small world, and global events such as 9/11, European debt crisis, political unrest in some part, or war, etc, can lead to a contagion effect in the domestic markets also.

� Expiry DateThis is the last day of the expiry of that month’s derivatives contract. This day is expected to swing violently because there is a scramble amongst market participants to either close out their open positions or rollover to the next month. So, this day can very easily go against the prevailing trend in the markets and a trader should be extra cautious.

� Closing BellThe last half hour of trade is when there is maximum swing in the markets. Most traders look to square off their open positions and, hence, one should be very careful in the last half hour.

POST MARKETS

� The day trader must analyze the trading day by downloading the Bhav Copy and ‘end-of-the-day’ charts. He

should look for high volume trades, channel breakouts, reversal patterns, etc. He must look for bulk deals on individual stocks, shares locked in upper or lower circuit, or where there are only buyers or only sellers, shares in F&O ban period and stocks touching 52-weeks highs or lows.� He should find out which stocks are going ex-dividend, ex-split, ex-bonus the next trading day because that will reflect in the stock price.� He must maintain a daily profit and loss account.� The day trader should allocate additional funds for mark-to-market (if applicable).� He should calculate supports and resistance of the stocks on his radar for the next day using pivot point or Fibonacci calculator by inputting the current day’s high, low, opening and closing rates so as to know his entry and exit points as well as stop losses for the next trading day.� He must check FII and DII figures, that is, whether they were net buyers or net sellers. This indicates whether they are bullish or bearish on the entire market.� He must check the US markets, namely Dow Jones and Nasdaq to get a sense of how the markets are expected to open the next day.

Remember that being a day trader has its own share of risks such as huge losses within minutes or seconds; no guarantee of any fixed income, frustration, boredom, anger, etc. But if you have what it takes, then the rewards can be handsome.

Tips For Successful Day Trading1. Start with paper or dummy trading before committing serious money2. Always trade with the trend3. Only trade in highly liquid stocks for easy entry and exits4. Always trade with strict stop losses5. Do not over-leverage 6. Control your greed and overcome your fearS.

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Disclaimer: Insurance is a subject matter of solicitation. Mutual Fund investments are subject to market risk. Please read the scheme related document carefully before investing. Please read the Do’s and Don’ts prescribed by Commodity Exchange before trading. The PMS Service is not o�ering for commodity segment. *Through Nirmal Bang Securities Pvt. Ltd. ^Distributors #Prepared by Research Analyst of Nirmal Bang Commodities Pvt. Ltd.

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arren Buffett has developed a slightly different approach to looking at earnings

report and calculating earnings. He calls it as “owner earnings” and considers it to be an important tool to gauge the real and more relevant earnings of the company from the perspective of its shareholders.

WHAT IS OWNER EARNINGS

Buffett introduced the concept of “owner earnings” in his 1986 annual letter to the share holders. In Buffett’s words “owner earnings” represents (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges less (c) the average annual amount of capitalized expenditures for plant and

WWarren Bu�ett calls

owner earnings as the

true measure of a

company’s earnings

and therefore it must

be employed by

investors to get a clear

picture of a company’s

operations

equipment, etc, that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment should also be factored in).

Effectively, Buffett tries to add back the non-cash expenses to the reported net earnings of the company, which is also known as cash earnings of the company. However, from the derived figure, Buffett deducts the annual capital expenditure incurred by the company to get what he refers to as owner earnings.

For instance, a company in a particular year reports `100 crore of net profit and `25 crore of

A TRUE MEASURE OF PROFITABILITY



does not lead to a decline in income. This could have a huge impact.

Suppose two companies with identical business models and cost structures report a huge difference in the earnings just because one of them has lots of non cash adjustments could lead to an irrational decision. One should not consider depreciation as the cost for calculating the earnings because it is typically a fixed percentage of an amount spent in the past, which may or may not reflect the true cost of replacing fixed assets when they are obsolete or when they need to be replaced.

However, here Buffett takes care of accounting depreciation with the insertion of the actual capex as deduction. Buffett deducts the capital expenditure (capex) incurred by the company from the cash generated from operating activities.

A company can keep on reporting strong profits, but what if all the cash which is generated in the business is redeployed for maintaining production, maintaining the positioning of the company or for the replacement of the existing capacities? A company, even after incurring all the capex or maintenance, can make free cash that its owners can take home at any time as it is earnings for them.

Buffett calls reported profits absurd as they do not include capital expenditure, which the investors have to find in the cash flow statement under the heading ‘cash flow from investing activities’.

The capex could be both. An asset-heavy business might require a fixed capex, whereas a company with an asset-light business model might require capex in the form of working capital. Many companies need to invest in plants and factories to

remain in the business as their business or revenues grow. In the same way, companies require additional capital or capex like in the case of a construction company. As the revenue grows, the companies need additional working capital, which is again a capex.

The companies which require less capex or no capex are better placed. Further, even if the companies require capex if the returns on investments are good or self sufficient to beat the inflation, the internal accruals should take care of the growth capex.

This is why the non efficient management and company in this process of calculating the owner earnings will be highlighted, which may not have been possible if the business is just valued on the basis of the book value or the price to earnings ratio (P/E ratio).

The book value could be higher because of intangible assets like goodwill or the book value may include the inflated value of plants and machineries.

In the same way the profits could be higher if the company charges less depreciation or capitalizes certain expenses to show them in the balance sheet rather than charging them to the profit and loss account so that it can show higher accounting profit and higher EPS leading to better or attractive PE ratio.

However, this is not possible if one is keeping his eyes on the cash, they will certainly make lesser mistakes.

APPLICATION OF OWNER EARNINGS

A company’s worth today is nothing but the discounted value of its future cash. If a company, say XYZ, is expected to generate `1,000 crore

depreciation and another `25 crore of non cash items like write off of goodwill or amortization of the research and development expenditure or amortization of the advertising expenditure.

Under the owner earnings approach, the net profit will be added back with another `50 crore (non cash transactions). Instead of the reported earnings of `100 crore, Buffett will reckon the company’s earning to be at `150 crore. However to arrive at owner earnings, Buffett will deduct the capital expenditure in that particular year.

If we assume in this particular case that the company spends say `100 crore, then owner earnings will work out to be `50 crore as against the reported earnings of the company of `100 crore.

WHAT IS THE RATIONALE

The basic and the most critical aspect of the concept of owner earnings is that the reported profit or loss could hide many a times the true earnings of the company but the cash a company made in a particular year cannot hide the truth. The companies can play around with certain sets of accounting entries to depress profits or to inflate them. However, cash profit or free cash flows are for real.

Depreciation and other non-cash items such as goodwill are considered merely as an accounting entry because in all cases the cash does not go out. The company does not actually pay it or incur it, which will reduce the cash.

For instance, the depreciation incurred by a company may be a cost from the accounting treatment point of view but that may not be the same from the owner point view because its non cash accounting transaction that

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Over the years, the analytical approach coupled with decades of experience has helped us maximize returns for our

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Disclaimer: Insurance is a subject matter of solicitation. Mutual Fund investments are subject to market risk. Please read the scheme related document carefully before investing. Please read the Do’s and Don’ts prescribed by Commodity Exchange before trading. The PMS Service is not o�ering for commodity segment. *Through Nirmal Bang Securities Pvt. Ltd. ^Distributors #Prepared by Research Analyst of Nirmal Bang Commodities Pvt. Ltd.

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profit over the next five years and is currently selling at `1,000 crore, a rational investor may not buy it.

But if the same company is trading at `200 crore that could be an attractive price, giving an annual return on investment of 38%. It is basically the future cash flow, which is attributable to its share holders or owners of the company that determine the value of its business.

This process of discounting the future cash flow that can be taken out of the business to arrive at the present value is also known as calculating the intrinsic value of the company.

Like in the earlier example of XYZ company, if those `1,000 crore free cash generated (owner earnings) over the next five years is discounted at 8% (risk-free rate), today it will be worth `680 crore. So the intrinsic value at 8% is `680 crore.

Will one buy the business at `680 crore? Obviously one would rather prefer to keep the money in the bank, which will safely yield 8% on the amount. This means that the business should yield more, which is possible if the company is selling at less than `680 crore.

Though it is simple to explain and calculate, the investors need to practice and think. Even more difficult is to calculate the future cash flow and capital expenditure that a company could incur, without which

it is not possible to calculate owner earnings, which Warren Buffett uses to calculate the intrinsic value of a company’s business.

Based on the growth, Buffett will calculate cash profits of the company or the cash profits from the operating business over the next say five years. This is possible if one looks at the current financial profile, business model and the growth drivers of the company. Further, in each of the years Warren Buffett will deduct the capex from the cash generated from the operating business. That will give free cash flow over the next five years.

To arrive at capital expenditure Buffett uses the average annual amount of capital expenditures, taking the clue from growth in revenues and the amount needed to maintain the competitive position of the company.

One can dig into the past and look at the growth in average capex needed by the company to reach a particular scale and project the future capital expenditure required. It may not be an exact figure, but even some clue will be of a great help.

Buffett, in his words, says: “Since capital expenditure must be a guess, one sometimes finds it very difficult to make. Despite this problem, we consider the owner earnings figure, not the Generally Accepted Accounting Principles (GAAP) figure to be the relevant item for valuation

purposes - both for investors in buying stocks and for managers in buying entire businesses. We totally agree with Keynes’s observation: ‘I would rather be vaguely right than precisely wrong’.”

Once the figures are in place, with the help of simple calculations one can arrive at the present value of such cash flows to be generated by the company and compare them with the present market value of the company. Buffett would look at the present value of such cash and compare the price at which the business is selling.

If a particular business is selling at a price which provides good yield, then there is a possibility that he might buy the business. However, one should also note that he buys businesses which are trading at a significant discount to their present value of the owner earnings. What he calls this, he keeps a large margin of safety, he would like to keep enough of safety in terms of price so that it will take care of the market risk, business risk and risk in predicting the future cash flow of that particular company.

So, if a company’s intrinsic value (discounted value of future free cash flows or owner earnings) comes to `100 crore he might buy that business only if it is trading at say `50-70 crore, which is a significant discount and Buffett says that this is possible in the equity markets due to the irrational behaviour of the markets as well as the investorS.

DATE: 5th May, 2012.VENUE: Le Méridien Hotel, Pune.



Beyond MarketVisits Pune

Beyond Market, the new-age equity camp was organized by Nirmal Bang in association with ET Now on 5th May at Le Méridien Hotel in Pune.

Several industry veterans like Mehraboon Irani, Principal and Head of PCG at Nirmal Bang Securities Pvt Ltd; Rajiv Anand, MD and CEO of Axis Mutual Fund and Deepak Mohoni, Founder of Trendwatch graced the occasion with their presence and addressed the audience with the aim of imparting valuable inputs on trading in volatile conditions.

The organizers were also successful in providing a platform to traders and investors to interact with industry experts to enable them to take right investment decisions.

ET Now anchor Niraj Shah introduced the speakers to the audience and informed them about the importance of expert advice in volatile market conditions. He said that the agenda of the camp was to understand the course of the markets in the near term as well as medium term.

Mehraboon Irani kick started the event by giving an overview of the markets. He said, “India’s fundamentals have weakened considerably over the last few years owing to sticky inflation, large deficits and slowing growth.” He also said,“India faces two major problems: Government and governance.”

He expressed grave concern over the GDP growth and commented that India cannot afford a GDP growth of 9%. He also lamented that India is no longer considered as a lucrative destination for investments by FIIs and, hence, there is an urgent need “to put our house in order.”

Globally, most central banks in developed countries are printing money at around the same time, which Irani termed as “state-sponsored counter-feiting on a large scale.”

He also dwelt on the recession in Europe and its implications. Taking it further he said, “People of three major economies - Europe, US and Japan - will have to accept poor standard of living and higher scale of economies, which would lead to lower consumer spending and higher unemployment. This would ultimately result in sluggish economic growth.” However, he felt that there is pleasant news coming from the US in the last 6 months as there are signs of recovery and revival in the US economy.

Through his fact-filled discussion, Irani gave some major headwinds for India. These included inflation, slowing investment, coalition politics, surging deficits and the Indian rupee’s bad performance. According to him, coalition politics is one of the major problems in India and has led to a complete paralysis of reforms. He, however, said: “Recent measures by the RBI like marginal reduction in policy rates kindle some hope in this uncertain market.”

He also advised investors to not bother about predicting indices and urged them to invest in fundamentally strong stocks through thorough analysis. He also cautioned them to be patient and not take hasty

Mehraboon J Irani,Principal and Head - Private Client Group (PCG) at Nirmal Bang Securities Pvt. Ltd

Mehraboon J Irani is the Principal and Head of the Private Client Group at Nirmal Bang Securities Pvt Ltd. Previously, he was associated with FCH Centrum Wealth Managers Ltd. He has over 20 years experience in capital markets. At Nirmal Bang, he works on increasing brand visibility, improving client base, retaining and improving business with the existing client base as well as providing active advisory services. His previous stints include FCH Centrum Wealth Managers Ltd, Darashaw & Company Ltd and Afternoon Despatch and Courier. He holds a masters degree in Financial Management from Jamnalal Bajaj Institute of Management Studies, Mumbai.

Market participants take informed decisions with guidance from industry experts


decisions. He said HDFC Bank, Dabur, Asian Paints, Colgate, ITC and Dish TV are some of the stocks that look good from investment perspec-tives and added that investors should use their discretion while choosing stocks. He told investors: “Wait for good times to come and make good returns because of low base prices.”

The next speaker, Rajiv Anand said, “Make an intelligent choice by investing in mutual funds.” While explaining the current outlook on the market, Anand also said, “The current valuations are supportive of the market rally.”

Explaining the holding structure of the equity markets in India, he said: “The share of retail investors from India is very low and we are all dependent on FIIs. This has led to selling of our blue-chip companies to FIIs.” Not satisfied by this trend he said, “This will have to be changed sooner or later.”

He talked about the monetary policy and its impact on the short-term and long-term yields. He also emphasized on the diversification of one’s portfolio. “There is no secular bull run in any asset class. You will find opportunity in equity, fixed income and gold (as insurance in times of

crisis),” he said. Thereby, a balanced portfolio will ensure sound finan-cial health in volatile market conditions.

Finally, Deepak Mohoni, the last speaker of the day gave a technical view of the markets. He discussed about the process of trading and investing. He bifurcated the investment strategy into short-term and long-term trading, and gave trading tips on the same. He suggested that even short-term traders should go for long-term trading because that is where big bucks come from.

Giving a glimpse of the market, Mohoni said, “Stock prices cannot be predicted and changes in these are very random.” He, therefore, gave a critical element by saying, “You cannot control stock prices, but you can control your losses.”

He advised short-term traders to use risk and money management techniques. He also asked them to go online so that the trades can be triggered. The long-term traders, on the other hand were advised to be slow and incremental, which in turn, will reduce their risks.

He said that technical and fundamental analyses are decision-making tools to help investors to buy or sell a stock. But neither of them can predict where the markets are headed and, therefore, the investor should decide his or her own strategy.

The event ended with a round of questions and answers from the enthusiastic audience.

Rajiv Anand,MD & CEO of Axis AMC, Associ-ate Director

A Chartered Accountant with over 19 years’ experience in the capital markets, Rajiv Anand is currently the MD & CEO of Axis AMC, Associate Director. Prior to this he was with IDFC (erstwhile Standard Chartered) AMC. He has also worked in the Treasuries of HSBC and Standard Chartered Bank.

Deepak Mohoni,Founder of Trendwatch (India) Pvt Ltd

A BTech from IIT Kanpur and MBA from IIM Calcutta, Deepak Mohoni is the founder of Trendwatch (India) Pvt Ltd. He is rated as India’s foremost market strategist by many investors. He popularized the use of technical analysis with his pioneering columns in the print media. He has appeared on several television channels. His comments on the market are often quoted by business newspapers and magazines.

The next event will be held on 23rd Jun ’12 at ITC Rajputana in Jaipur.