Investing in dreams

This article (here) in CNN Money Fortune is worth a read. Authored by Andy Serwer, the article comprises of excerpts to an interview with Larry Page on "how to change the world". Page talks extensively about breakthrough ideas that are round the corner but people fails to take a chance on them. Sighting his own example, he says, "Even when we started Google, we thought, "Oh, we might fail," and we almost didn't do it. The reason we started is that Stanford said, "You guys can come back and finish your Ph.D.s if you don't succeed."

Some thoughts Larry Page left behind in the interview :

1. Over 40,000 people a year are killed in the U.S. in auto accidents. Is there a chance of making this number zero or a very very small number. People are working on it - on making cars automated like the car by Infiniti which will kick you back when you change lanes (a large source of accidents). Using technology to save lives is not costly .. but there are very very few people working on it.

2. People think Moore's Law is a description of what happened. But Moore's Law actually caused people to do the right thing. Everyone was organized about it - making things better quickly.

3. Solar thermal is an area Google has been working on; the numbers there are just astounding. In Southern California or Nevada, on a day with an average amount of sun, you can generate 800 megawatts on one square mile. And 800 megawatts is actually a lot. A nuclear plant is about 2,000 megawatts.

4. Back in time .. everyone said Sam Walton was crazy to build big stores in small towns. But this turned out to be a breakthrough idea and Walmart is today the world's largest retailer. Almost everyone who has had an idea that's somewhat revolutionary or wildly successful was first told they're insane.

So who kills innovation? In the investment community, analysts are the first people who put the sword on any breakthrough innovation drive. The uncertain nature of the investment and the capital required to pursue the innovation activity deals a death knell for the stock price of the company. With most CEO compensation (and tenure in a company) linked to increase in shareholder value (read: price of share), it's evident that executives will work towards short term goals ranging from one quarter to the other .. to keep analysts happy and a uniform rise in price.

Investing in companies which can give a breakthrough idea is defined by high risks. Probably a value investor will not tread this path - as he cant see into the future as much as he can see a mismatch in the price and value of a stock. So a value investor might not invest in an Apple, Google, Starbucks, Zara, Pixar, IBM, Bionade, Iridium, P&G, Intel etc. because the PE ratio would never add up.

A couple of thoughts I leave here:
1. Is there a method of factoring innovation to our methodology of stock valuation?
2. How many Indian companies are there who have made such breakthrough ideas? (I can think of Infosys in outsourcing and Bharti Airtel is low cost telecommunication)

Bond insurance

Weekend Reading : I read a couple of excellent articles on Berkshire Hathaway's participation as a bond insurer. An article in the NY Times (here) tracks how a phone conversation between Eric Dinallo and Berkshire's Ajit Jain paved the way for Berkshire to insure NY municipal bonds.

Ajit Jain, in a finely worded text (here), talks about how bond insurance helps bring stability to the price of bonds, offer protection to the investor in these bonds and keeps the interest rate low for bond issuers (as the bond is backed up by a AAA rated insurer).

Indian Premier League : A financial perspective

Alchemy released a report on the economics involved for teams participating in the IPL (here). I have heard a lot about franchisees overpaying for teams, players, rights ... and blaming BCCI for being non-transparent. Incidentally BCCI has itself called on franchisees to be patient and enjoy the fruits of their investment (read : ROI) after 3-4 years. Alchemy's report paints an optimist picture of the T20 cricket league and explains how much BCCI, the franchisees and supporting institutions (like Sony for media rights) tend to gain from the venture.

Surprisingly, the report claims that an individual franchisee will be profitable from year 1 onwards (page 7), scoring an EBIT of Rs. 4 crores. A bulk of the revenue (Rs. 90.2 crores) will come from global media rights (Rs. 25 crores), supported by ticket sales (15 crs), lead sponsor (15 crs) and in-stadia advertising (10 crs). From the cost angle, the franchisee cost takes the wind out of the financials with a Rs. 40 crs charge followed by player acquisition cost (Rs. 24 crs). The assumptions (on page 8) have not factored a number of things like cost of capital, or financing of the acquisition cost, or trading of players etc. These things happen a lot in soccer leagues around the world (Real Madrid finds it hard to survive until they have purchased the most expensive player in the world; am not sure where Jose Mourinho is headed but expect some big signings there too)

The report has drawn a number of parallels between the English Premier League (with two clubs - Tottenham Hotspurs and Arsenal) and the IPL. Not to mention, a number of these EPL teams are also listed on the stock exchange. Manchester United was listed in the London Stock Exchange (1992) at GBP 47 million. In 2005, American businessman Malcolm Glazer acquired a controlling interest in the club in a takeover valuing the club at approximately £800 million (approx. $1.5 billion) (here).

Perhaps, IPL is the alchemist's secret portion afterall !

If you like this content, then do check out my new blog on investing and stock markets for lots more information on the Indian equity markets

Conflict of Interest & Credit Rating agencies

For people who use the services of financial advisors (also referred to as Private Banking Relationship Managers or Financial Consultants or Wealth Managers), it would seem odd that not one of them have actually advised the client to "hold on" to cash especially when there are not enough opportunities to invest in the markets or sure-shot stock picks. Often, the relationship managers find enough reasons to stash off this idle money in a single-premium insurance policy or a debt mutual fund or is an 'under-valued' sectoral mutual fund.

The only explanation I could come up for this is, conflict of interest. A relationship manager earns his fees (revenue for the bank) by getting clients invested in various financial products. He might view cash as a wasted opportunity for personal gain, although it might be in the client's best interest to show restraint in investing (esp. during tumulus times like these). Likewise, an RM will be eager to sell you an insurance policy as opposed to a mutual fund - as the former gives him a 30% commission as opposed to a meagre 2% commission for mutual fund investments.

Which makes me wonder - aren't research houses also in the same business? Isn't it in the interest of brokerage houses to inflate stock recommendations - so that investors put their money in the stock through their brokerage channel? At about 0.1% (average of delivery / intra-trade) for every rupee invested, a stock recommendation holds a lot of value. Motilal Oswal (here) has over 400,000 retail clients today and does broking revenue (FY2008) of 562 crores. Taking a ballpark of 0.1% revenue per rupee trade, they do about Rs. 562,000 crores of trades in a year (or Rs. 2,300 crores per day).

I would additionally suggest a reading of the latest Roger Lowenstein article on Moody's published in the NY Times (here).

The scribe starts off with an apt remark by Thomas Friedman in 1996 : "There were two superpowers in the world — the United States and Moody’s bond-rating service — and it was sometimes unclear which was more powerful.". (We now know who turned out the superior one !)

The article takes a hard look at how Moody's evaluated mortgages bundled as securities and assigned a rating to it. It also talks extensively of the mistakes they made in valuation of these securities and how the market crumbled due to lack of foresight, greed and trasparency (well, the lack of it). There is also a paragraph on conflict of interest - where rating industry's closeness with banks (whose securities they rate), often distorts their assessment of the instrument.

Boiler Room

Boiler rooms operations are nothing but share scams. The stock operator will sell worthless shares at inflated prices to investors that are impossible to sell. (seems like a script from "Not a Penny More, Not a Penny Less", doesn't it?)

Here's how it works :

1. A broker, usually operating from an overseas firm, will cold call an investor and propose they buy shares in a particular company.

2. To avoid being ill prepared for the nosy web-savvy investor, the share would usually have been ramped on online message boards.

3. The company they are share dealing in will probably be - a) listed on an illiquid market or, b) could be a small, unquoted company that the broker claims is planning to list

4. So, one of two things will happen - a) the shares cannot be sold as there is hardly a market for it or, b) the company will not exist at all and the broker is simply selling shares in thin air before taking the money and running (extreme case)

The firms operate from boiler room 'hotspots', such as Spain, Switzerland, Dubai, Japan, Bermuda etc. They will always have a listed address and a grand sounding name to give an air of legitimacy.

These are called 'boiler room' scams because of the highly pressurised sales technique employed by the broker. They can be forceful, persistent and highly aggressive. A common tactic is to create a sense of urgency about a stock, such as telling the investor it will explode any day so they need to invest quickly.

Additional resource : The boiler room boys are back with a new 'bargain' (here)