Understanding random market behaviour

For an investor, the pain of selling a stock at a loss far exceeds the pleasure of selling the stock at an equal amount of gain.

Strange but true!

Such behavioral aspects of investing and many more are brought out in the study of behavioral finance, that was introduced in the late 1980s, owing to anomalies in stock price prediction by the two main existing theories of academic finance, i.e. Modern Portfolio Theory’ and ‘Efficient Market Hypothesis’.

According to the ‘Efficient Market Theory’, put forth by Eugene Fama, financial markets are believed to be efficient and investors are understood to make rational decisions. Further, market participants are supposed to be sophisticated, informed and known to act only on available information. Since market participants are believed to have equal access to information, it is implied that stock prices always reflect the best information about fundamental values of the stocks. According to the efficient market theory and Capital Asset Pricing Model (CAPM) the price of a stock is the Present Value (PV) of all the entire future earnings of the company i.e. the future dividend paid by the company. 

The ‘Modern Portfolio Theory’ pioneered by Harry Markowitz suggested that an investor can maximise returns by holding a diversified portfolio of assets with different levels of risk.

However stock prices were found to exhibit more volatility than efficient market hypothesis could explain.  The market price of a stock often grossly varied from the price arrived at by efficient market theory.  This unexplained volatility and the difference between the market price and the rational price of the stock became a subject of research. It was also found that as compared to the individual stocks, the aggregate stock price (index) showed a higher variance from the values predicted by the efficient market theory.

The research brought out interesting aspects of behavioural finance. In the paper ‘From efficient market theory to behavioral finance’, Robert J Schiller explains the reason for the apparent randomness in the movement of stock prices using models such as feedback model, smart money versus ordinary investors and prospect theory.

Feedback model

As expectations of rise in a stock price increase, more and more people start buying the stock. As a result a momentum sets in, which takes prices farther away from the levels predicted by the academic finance models. Similarly when there is an expectation of a fall in price, more and more people join in to sell the stock, driving prices lower than supported by the financial models. This is one of the strong reasons for bubbles and bursts. Feedback may be one of the essential sources of the randomness seen in stock prices.

Obstacles to smart money

Recognizing the difference between smart money and the ordinary investors, the efficient markets theory asserts that when the irrational optimist buys a stock, the smart investor sells and vice versa. However in reality every investor has the shades of an ordinary investor and a smart investor.  Many times when most owners of a stock are too optimistic about a stock, they may not be willing to lend shares to short sellers; so there may not be enough shares available for short selling.  The lack of short selling can push the stock price further upwards, amplifying  the effect of irrational optimism and can cause financial anomalies in bubbles and bursts.  

Prospect Theory

Prospect theory is used to explain deviations from the traditional paradigm of rational behaviour. According to this theory since people value gains and losses differently, an investor feels more difficulty in selling shares at a loss than the exuberance the person experiences when selling the stock at an equal amount of gain.

Understanding how other market participants may act can help investors in making good investment decisions. Traders often experience a varied range of emotions from exuberance to despair during different stages of a trade with abrupt changes in the stock price movement, with negative emotions weighing much heavily than the positive emotions. Viewing the random and unexpected market movement in light of behavioral finance theory can prepare investors better to ride out the volatility by inculcating trading discipline, while minimizing the emotional impacts. It can prevent investors from buying overpriced shares or from dumping oversold but still valuable stocks at a huge loss seeing other investors rushing for the exits and thus avert committing gross wrong trades that are to be regretted later.

Related articles

• Eugene Fama, King of Predictable Markets (nytimes.com)
• When are markets "rational"? (mpettis.com)

Bottlenecks plaguing the coal sector in India

The import of coal has been one of the significant factors contributing to the Current Account Deficit (CAD) in India that touched 4.8 per cent (approx USD 88 billion) of India’s Gross Domestic Product (GDP) in 2012-13 period. Rising imports, coupled with fall in value of rupee, resulted in a drain of foreign exchange from the country. It is surprising to note that although India has the fifth largest reserves of coal in the world totaling up to 235 BT in 2011, the gap between production and consumption of coal has been increasing over the years from 72 MT in 2009 to 82 MT in 2011. India imported around 135 MT of coal in the 2012-2013 and is currently the second larger importer of coal after China.

Here we look at some of the issues pertaining to the coal sector in India.

Issues related to import of coal

India needs to import substantial amount of coal from countries like Australia, New Zealand, South Africa and Indonesia. Indonesian coal accounts for a bulk of India’s thermal coal imports, while steel-making coking coal is imported largely from Australia and South Africa. Owing to the increase in environmental concerns, coal exporting countries such as Indonesia imposed coal tax and Australia levied carbon tax in 2012.  The imposition of taxes increased the cost of coal for the plants in India that are especially designed to use imported coal, This resulted in power producing  companies such as Tata Power and Adani Power to demand for rate revision in their power purchase agreements (PPA). However the government upheld the PPA, while agreeing for a temporary upward revision in price in some cases.

Issues related to domestic production of coal 

Domestic production of coal is beset with challenges both in terms of quality and quantity. Problem of quantity relates to environmental, rehabilitation and technological issues in opening up of new mines and in increasing recovery from currently operating mines. Sustainable solutions are needed to address the environmental and rehabilitation concerns. Since most of the coal deposits lie underneath forests and tribal regions, mining requires felling of forest and resettlement and rehabilitation of affected people. Mining in such areas, if left uncontrolled, can cause environmental and social havoc. Environmentally sustainable mining is costly which is bound to reflect on the cost of electricity. Increasing prices of electricity is as much a political decision as a business one.

By and large, domestically produced coal has problems associated with grade and ash content. The Indian coal mines produce coal that has higher ash content, and hence more impurities, which increases the cost of cleaning, High ash content imposes a limitation to that coal being used in metallurgical processes. Around 70% of the coal in India is used to produce power and around 7% of the coal is used in the steel industry. Though the high ash coal can be used in power plants, but it produces substantial quantity of ash (both solid and fly), thus increasing the costs associated with cleaning and storing such ash. Additionally plants have to invest in capturing fly ash to adhere to flue-gas emission standards. Some older power plants also have limitations of space required for disposing ash. High ash content increases the cost of transportation per unit energy value of the fuel, further increasing the cost of production of electricity and metallurgical process. There are technological issues associated with plants which have been designed to work on lower ash content. Local coal needs to be blended with imported low ash content coal for use in such plants.

Coal India Ltd (CIL) is the only public sector company that mines and sells coal in the local market. In addition some companies like steel and power companies have their captive mines. Of late, due to supply constraints, CIL has not been able to fulfill the domestic requirement of power plants, after entering into Fuel Supply Agreements. Further, FSAs are waiting to be signed with many other power companies that are under development or have been awarded permission to set up new power plants. Domestic coal demand touched 772.84 million tonnes (MT) during 2012-13 period whereas production was at 557.60 MT. In the wake of the local shortages, coal imports have been increasing and are projected to increase further.

Issues related to government policy on coal allocation

In 2012, the policy of the Government of India on allocation of coal blocks came under scanner due to allegations by the Comptroller and Auditor General of India (CAG) office, accusing the government of allocating coal blocks in an inefficient manner during the period 2004–2009. In spite of the government’s policy to open coal sector to private players, the coal allocation has been ineffective and has created a situation where coal is not available to power generators as and when required. On one hand few generators are occupying huge mines, whereas the newer ones are not able to start mining as they still haven’t got the mandatory clearances.

This has put the burden for supplying coal on CIL, the sole public sector coal producer. Current slowdown in the economy has adversely impacted the power producers as plant load factor (PLF) has reduced and short-term power rates are depressed. Rupee’s slide against the dollar has further driven up the cost of imported coal. The Indian buyers of coal are unwilling to shoulder the additional cost burden, and have cancelled contracts or sought to renegotiate contracts, causing coal cargoes to pile up at Indian ports. As nearly 60 % of country’s electricity generation is from coal-based plants, better power prices would have incentivized power producers to purchase costlier imported coal for generating more power.

All these factors have added to the increase in demand and supply gap, and have been deterrents in the country’s progress towards energy sufficiency.

Related articles

• India likely to be the largest coal importer in 3-5 years
• Stop the Destruction of Indian Rainforests for Coal Mining (forcechange.com)
• How sustainable is coal mining in India
• Indonesia's 25% tax plan on coal exports to hit Indian power firms

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Investor Participation in Corporate Governance

                             

Shareholder engagement : Adapting Global Practices To The Indian Context from SChakrabarti

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Monetary Policy and Inflation

The announcement of monetary policy is awaited by businesses and investors alike, who are eager to know the impact of the change in policy on their savings or on their business. Here we look at how monetary policy impacts the economy.The objective of Monetary policy is to control the supply of money to boost economic growth while keeping inflation within acceptable limit. 

Some tools of monetary policy that are used by the central banks are: 

1.      Lowering of short-term Interest Rates: 
This is the first tool used by the central banks around the world. When interest rates are lowered, it becomes cheaper to borrow money and less lucrative to save.  This brings about a decline in savings; individuals and corporations are encouraged to spend, more money is borrowed, and more money is spent, thus increasing the overall economic activity.

2.      Open Market Operations: Under OMO, the central bank buys bonds (from banks or general public) in the open market.  By exchanging bonds for cash, the central bank increases money supply in the economy. Due to increase in the supply of money relative to demand, money can be borrowed at lower interest rates. This means that the short term interest rate for borrowing decreases. Conversely, if the central bank sells bonds, it decreases the money supply, drains liquidity and increases short term rates. Different countries have different ways of conducting OMOs. In India, effective instruments for OMOs are Liquidity Adjustment Facility (LAF) and Market Stabilization Scheme (MSS). Repo and Reverse Repo rate constitute the LAF system. Securities purchased and sold in OMOs are dated securities, T bills.

3.      Reserve Requirement: The central bank has the ability to adjust banks' reserve requirements, which determines the level of reserves a bank must hold in comparison to specified deposit liabilities. By adjusting the reserve ratios, the central bank can increase or decrease the amount of money that banks can lend.

4.      Quantitative Easing: When interest rates are near zero but still the economy remains stalled, then central banks start supplying money from their reserves to the financial institutions by purchasing assets. The central bank purchases assets (government securities or other securities from the market) by spending the money it has created.  Through QE, the central bank increases the quantity of money supply and that results in increased spending and in increased consumption, which increases the demand for goods and services, fosters job creation and, ultimately, creates economic vitality. Quantitative easing is generally used a last resort by policy makers. Though both QE and OMO involve purchase of assets, but QE involves purchase of longer duration assets, and mortgage backed securities.

  

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Other effects of monetary easing:

• Since it takes time for productivity to increase (due to policy bottlenecks, lack of infrastructure, technology constraints etc), till the time productivity increases, supply of goods and services remains more or less the same. So with more money available to buy a finite set of products, prices go up, resulting in inflation.  For this very reason, central banks tend to hold back rate cuts or even hike interest rates when inflation data is high.
• When the interest rates on bank deposits go down, investors move to the stock market and buy shares in hope of higher returns. As a result markets tend to react positively to the news of a interest rate cut or to QE. But, when continued for a long time expansive monetary policy has led to creation of bubbles in stock markets and real estate markets, as had happened in Japan in the early 1990s. Withdrawal of QE, takes cash out of circulation and tightens the money supply. That is the reason why markets react negatively to the news of reduction in QE. 

Related articles

• The earthquake begins as Fed prepares to switch off the printing press (telegraph.co.uk)
• http://www.moneycontrol.com/news/economy/rajan-to-fm-fight-inflationme-or-walk-alone_953608.html

The Case for Raghuram Rajan and Economy of India

Recently in an article in the Economic Times, the popular Indian columnist and novelist Ms Shobha De, touted the newly appointed Reserve Bank of India (RBI) governor Raghuram Rajan, as the 'rock-star economist', and ‘Poster Boy of Banking’ who can easily top easily top 'India's Most Desirable' lists and is also expected to pull India out of the financial mess. 

The post has attracted lot of media attention and has succeeded in flaring up imagination and varied emotions of the readers, ranging from interesting, to disgusting or even revolting! To add substance to the article it might have made better sense to also look at some of the problems facing India’s economy and the challenges that Rajan has to deal with while he tries to walk his talk. Let's have a go at those less appealing aspects that are actually the areas of concern for all Indians.

The economic problems in India can be attributed more to the country’s fiscal policy and other government policies than to monetary policy of the Reserve Bank of India (RBI). The central bank often finds itself reacting to the consequences of inaction and policy conundrum of the government.

In fiscal year 2013, the Indian economy is characterized by an annual GDP growth rate of 4.4 percent in the first quarter (April-June) of the current fiscal year 2013-14, the lowest in four years, a high current account deficit upto 4.8 per cent of GDP and overdependence on hot money and short-term debt for financing the CAD. Crisis in the resources industry - coal / petroleum-gas, severe supply-side constraints, stalled infrastructure projects and stagnation of employment, all put together have resulted in the depreciation of Re against the dollar from Rs 54.77 at the beginning of 2013 to the current level of about Rs 64 after touching a record low of 68.83 on 28th August.

After taking over as the RBI governor, Raghuram Rajan has announced a number of steps to stabilize the rupee, measures to attract inflows from overseas investors, including the NRIs. Under the leadership of Raghuram Rajan, RBI policy is expected to first cushion the negative impacts as much as it can, control the volatility of Re and to lower the cost of doing business till growth cycle picks up, and monetary policy starts to work to increase the pace of broad based and inclusive growth.

Continued slump in growth, delay in structural reforms, impediments in project execution, and high perception of corruption can erode confidence of the world in India's growth story, Rajan’s proposed steps towards reduction of price inflation and monetary policy for supporting India’s growth were well-received by the markets with the rupee recovering by 6 per cent and the Sensex rallying nearly 10% in four days between September 3 and 6. It may however take time for him to translate his words into action for the simple reason that monetary policy takes time in transmission.

Related articles

• http://economictimes.indiatimes.com/opinion/guest-writer/economy-with-raghuram-rajan-will-be-sizzling-hot/articleshow/22533265.cms
• The Case for India by Raguram Rajan
• http://www.moneycontrol.com/news/economy/rajan-to-fm-fight-inflationme-or-walk-alone_953608.html

Shareholder Engagement or Activism ?

Continuing from my last post ‘Is shareholder engagement good for companies?’, here we look at the scope of shareholders engagement and different approaches to shareholder engagement.

What is the scope of shareholder engagement? 

Shareholders have a legitimate role in areas pertaining to

• Corporate Strategy – such as mergers, diversification, restructuring, non core asset sale.
• Capital Structure – such as capital allocation discipline, use of cash on balance sheet.
• Governance – such as audit-related issues, board structure, managerial remuneration

However shareholders are not expected to micromanage companies. Nor is it desirable that shareholders push for short term profitability over sustainability and long term value creation. It is important that shareholders and board members engage effectively in the shared pursuit of high quality governance.

What are the different ways in which shareholders engage with companies?

Shareholders can either have a proactive approach for engagement with a company or may adopt a passive approach towards a company.

 Passive investors sell off their shares if they are dissatisfied with the corporate decisions.

On the other hand, active investors engage proactively with the management, prior to a corporate decision being affected, in order to change the outcome of the decision. While the term ‘shareholder engagement’ is used to describe a collaborative approach, ‘shareholder activism’ refers to the use of a more assertive approach by the minority shareholders to affect changes in management and strategy of a firm.

The approach to shareholder engagement varies in different countries.  Depending upon the business environment, legal contexts, and their own investment objectives, shareholders may adopt a collaborative, confrontational or mixed approach. Institutional investors like mutual funds and pension funds who tend to hold onto their investments for long-term returns adopt a cooperative approach with management, whereas hedge funds, with short term objectives, may adopt a more confrontational approach. Some countries provide more legal tools for shareholder activism than others. For example in UK, shareholders have a greater influence in questioning management activities and dealings than in the US. 

Global trends and practices in shareholder engagement 

Some global trends and practices in shareholder engagement include 

·         Disclosures.

·         Shareholder voting.

·         Shareholders say in appointment of auditors and directors.

·         Shareholders say in remuneration of the directors.

·         Shareholders’ approval of related party transactions.

·         Class actions that allow a group of investors with common interest in a matter to sue the management of a firm, its auditors or a section of shareholders in case of suspected wrongdoing.

·         Shareholder engagement through proxy advisory firms that analyze corporate proposals placed for shareholder approval and give their recommendations regarding the proposals.

While there are different ways in which shareholders engage with companies, shareholder participation in corporate affairs remains a function of business environment, legal contexts and ownership structures of companies.

Related articles

• Investor Participation in Corporate Governance
• Is shareholder engagement good for companies? 
• Companies Bill 2012 - Giving Voice to Minority Investors in India (prepforum.wordpress.com)
• Shareholder Activism Run Amok (wnyc.org)

Is shareholder engagement good for companies?

Shareholder activism has increased significantly in the last few years, particularly after the financial crisis of 2008. However, it has since then been it has been a debatable topic, as it is difficult to quantify “appropriate” level of shareholder engagement, which is desirable for achieving effective governance, while adding to business value. Quite often there is an apprehension that excessive shareholder intervention may consume a lot of valuable management time and result in short term profit orientation. 

Why should shareholders engage with company management and boards?

A business needs capital to finance its growth Shareholders are the providers of capital to a business and as such are part owners of the business. Shareholders invest in the business hoping for a higher potential return from the investment, while accepting a greater potential risk than other providers of capital. As shareholders own a share of the organization in which they have invested, this entitles them to ownership rights (i.e. rights to profits and assets in proportion to their shareholding) and in most cases control rights (i.e. rights to have a say in the running of that company, e.g. they may vote on key issues).

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Management makes use of the capital to run the business and has an obligation to do so in a fair and transparent manner while maximizing value for the shareholders. However in practice management may take actions that benefit themselves, at the cost of dispersed shareholders, who are not involved in the day to day operations of the company. 

The board of directors oversees management to ensure that it is allocating capital appropriately. As a result, the board has a responsibility towards all the shareholders of the company to represent, manage and protect their interests in the company. Shareholders engage with company management and boards to ensure that their interests in the company are protected. If shareholders are not satisfied with the performance of the directors, they may remove the directors or refuse to re-elect them.

Can all shareholders influence corporate decisions?

All shareholders are not alike. Shareholders can be either private individuals or large corporations such as mutual funds, hedge funds, bank trust departments, insurance companies or private equity funds.Due to the differences in their portfolio types, investment objectives, nature of information available to them and their ability to influence the management, different types of shareholders have different priorities and motivations for engagement with companies. Where promoters are the dominant shareholders in the company, they have substantial power and control over the enterprise. Minority shareholders being dispersed, generally lack the resources required for coordination and active engagement with the companies. In contrast, the institutional investors are often in a position to exercise considerable influence in corporate decisions. 

Is shareholder engagement good for companies?

Though there is no empirical evidence about impact of shareholder engagement / activism on long term performance of companies but it is believed that effective shareholder engagement does help in strengthening corporate governance practices within companies. Board-shareholder engagement gives companies a better sense of shareholder concerns and allows them to gauge shareholder interest on significant proposals. Reliable information from companies, transparent disclosure policies and insight into management’s priorities, allow investors to balance risks and to allocate their capital accordingly. In turn, better governance practices augment the companies’ ability to attract risk capital from domestic and foreign investors for funding new or expansion projects. So overall we tend to believe that effective shareholder engagement is good for companies.

In the next article we will discuss the scope for shareholder engagement and different approaches to shareholder engagement.

Related Articles:

• Investor Participation in Corporate Governance
• Companies Bill 2012– Giving Voice to Minority Investors in India
• Role of-independent directors 
• The value of activist shareholders (lawprofessors.typepad.com)