Co-Author: Mallikarjun Gaddam

This article was originally published in the business section of rediff.com on April 13th, 2012

http://www.rediff.com/business/slide-show/slide-show-1-special-value-investing-and-the-margin-of-safety/20120413.htm

During early 2009, a mutual friend, Nicky, who is an expert on Value Investing, asked us to invest in the shares of Patni Computer Systems Limited.

Each of us bought 100 shares on his insistence. The share price of Patni was around Rs 97 on the day we traded. Today, the price of Patni shares are Rs 490 each and each one of us has made a cool profit of over 400 per cent in about two years.

Of course, we are grateful to our friend. But we are also very intrigued by the concept of value investing. We went back to Nicky with loads of questions.

Nicky: Value Investing is basically putting your money in stocks which are trading at prices lower than they are worth.The important thing to keep in mind is that, the market may take a long time to realise the worth of the stock and hence you might have to wait for a long time before you can sell the stocks and realise the profits. During this period, you must not panic even if the stock price falls, as that would be a temporary phase.

Nupur: But how do you know which stocks fall in this category?

Nicky: The key is the balance sheet. Start looking for smaller companies, small-to-mid-cap, that are trading at a discount to their intrinsic values. These stocks are generally.

Mallikarjun: But how do we know which stocks are trading at a discount to their intrinsic value?

Nicky: Let me take you through how I discovered that Patni was a ‘value’ investment. Patni had a market capitalisation of Rs 1,300 crore (Rs 13 billion) in February 2009, with almost zero debt. They had investments and cash worth Rs 1,177 crore (Rs 11.77 billion) and Rs 293 crore (Rs 2.93 billion) respectively. This alone translated to Rs 108 per share, 11 per cent more than its market price per share at that time.

Nupur: That is excellent from our investment perspective. But why was their stock price lower than Rs 108 then?

Nicky: That is because a lot of really good companies are often neglected and are out-of-favour with the investors due to their lack luster performance in a particular period. They are often a misunderstood group of companies.

Mallikarjun: So we must thank you for identifying Patni and believing in the company and its long-term potential.

Nicky: Actually Benjamin Graham would frown on me for asking you to make the investment at Rs 97.

We both looked at Nicky, perplexed by his last statement. We clearly thought that we bought at a great price!

Nicky: Graham, the father of value investing, believed in a rule of thumb. He called it the “margin of safety”. He would buy companies which traded at a minimum of 33 per cent discount on their Net-net working capital.

Mallikarjun: Net-net Working Capital?

Nicky: Yes. Graham calculated Net-net Working Capital as the difference between the Current Assets of a Company and its total liabilities (long term plus short term). Then he would take 67 per cent of this value to calculate the stock price at which he would want to buy the stock.

Adopting this method, Graham would buy the shares of Patni at Rs 90 only, calculated as per the balance sheet of Patni on December 31, 2008.

Graham did this to avoid any risk of losing money. Intrinsic value is often very subjective, and depends on the assumptions of the person doing the calculation. In order to protect ourselves from the uncertainty of the true intrinsic value, the margin of safety should be large enough.

You must not feel that you took any unnecessary risk though. As in the case of Patni, the investments and cash made up for almost 65 per cent of the total assets. This means that the quality of assets that Patni had, was very high.

In contrast, there are other stocks which might meet the margin of safety requirements as per Graham, but their assets might constitute more of inventory and debtors. Inventory might become obsolete and debtors might become bad debts.

Thus the quality of assets and the industry also needs to be considered before deciding if the stock is a ‘value stock’ or not.

Nupur: Your explanation does not mention earnings anywhere. Does it mean that earnings are not a consideration in value investing?

Nicky: No way am I stating that earnings are not relevant to value investing. Earnings reflect the efficient use of assets deployed, represented by asset turnover, inventory turnover ratios.

The analyses of these are important to know if the company has the potential to perform in the long term. Earnings and balance sheet figures together go a long way in ensuring that as investors we do not lose.

Nupur and Mallikarjun chuckle together: Well, as the sage of Omaha says: “The first rule is not to lose. The second rule is not to forget the first rule”!

Nupur Pavan Bang is a Senior Researcher at Centre for Investment, Indian School of Business, Hyderabad. Bang can be reached at Nupur_bang@isb.edu. Mallikarjun Gaddam is a Researcher – Value Investing, Indian School of Business, Hyderabad. Gaddam can be reached at mallikarjun_gaddam@isb.edu.

Co-author: Dhruva Raj Chatterji, Senior research analyst at Morningstar India

This article was originally published in the Economic Times, April 12th, 2012

http://economictimes.indiatimes.com/personal-finance/savings-centre/analysis/do-cash-holdings-impact-funds-performance/articleshow/12631347.cms?curpg=2

The debate whether cash calls of actively managed funds have worked in their favor or not has been on for a long time. We tried to delve deeper and check if equity funds in India observe better performance when holding higher cash during market downturns; or do they end up missing out on sudden upturns in the market.

In India, fund houses like Escorts, Reliance, Sahara and Taurus are known to take cash calls, with cash holdings in excess of 20% on many occasions. It should be noted here that the excess cash holdings played out mostly in the period of 2008-09, when the financial crisis was underway.

Post that period, cash calls by most funds have tempered down substantially-but then again, so has the adversity in stock markets.

On the other hand, fund houses like Fidelity, Franklin Templeton, HDFC and Tata have maintained lower cash holdings, in the range of 4-8%, over the past five-year period, across most of their funds.

Taking two categories of equity funds -large-cap and small- & mid-cap -we compared the highest cash holding funds with the lowest cash holding funds. In the case of large-cap funds, the numbers reveal that the top 20 high cash holding funds held about 9% more cash on average than the bottom 20 cash holding funds over the past five years, but have earned about 1.2% lower returns (annualised) than them over the same period.

The performance is particularly poor over the 3-year period, where their returns are about 7% lower than those funds with lesser cash holdings, within the large-cap category.

We find a similar pattern in the case of small- & mid-cap funds – although much starker. It seems that the top 10 funds with the highest cash holding within this category earned about 5.5% less (annualized) than the bottom 10 funds with lower cash holding over a five-year period. Over three- and one-year periods, they earned approximately 9% (annualized) and 6% lesser, respectively.

Cash also seems to have a varying impact, depending on the category of funds. Large-cap funds, by virtue of investing in more large and liquid stocks, are able to buy and sell the shares quickly, and hence the role of cash becomes less important.

On the other hand, in the case of small- or mid-cap funds, keeping excess cash might mean losing out on an upswing, as the lower liquidity of these shares would result in the prices zooming up due to any sudden demand. The vice-a-verse is also true.

That is, in the case of illiquid stocks, selling might not be easy when there is a redemption pressure or a downturn. This probably explains the higher historical average cash holdings of mid-cap funds when compared to their large-cap peers.

We observe that the key risk in taking cash calls lies in deploying it at the right time. Fund managers often miss out on a sudden upturn.

Clearly higher cash holdings have resulted in lower fund returns in the following months, especially when the markets have turned around very suddenly. Again, here the impact seems to be starker within the small/mid cap fund category, where there are instances when the funds with high cash holdings have underperformed those funds with lowest cash holdings, by more than 3% (on average) in the following month.

On a closing note, besides the cash holding, there are other important factors, too, which have a bearing on the performance-like the quality of the fund management team, the processes in place etc.

However, avoiding high cash calls and remaining more invested across market cycles do point towards a more disciplined approach in investing. Moreover, the approach helps to neutralize the risk of being caught on the wrong foot, especially in the event of a sudden upswing in the market.

As legendary fund manager Peter Lynch once said: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Dhruva Raj Chatterji is senior research analyst at Morningstar India

Nupur Pavan Bang is senior researcher at Centre for Investment, Indian School of Business, Hyderabad

Five things you did not hear the Finance Minister Pranab Mukherjee say in the budget speech.

By

Vivek Kaul[1] and Nupur Pavan Bang[2]

“Statistics are like a bikini. What they reveal is suggestive, but what they conceal is vital,” said Aaron Levenstein, an American professor of business management.  And not Navjot Singh Sidhu as we Indians tend to believe. The annual budget of the government of India is also like a bikini. A lot it is revealed about it through the budget speech made by the Finance Minister, but the vital aspects lay hidden in the budget document. Here are five things you did not hear the finance minister Pranab Mukherjee say in the budget speech he made a few weeks back.

1. The government of India in the financial year 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) spent 65% more than what it earned:

That the government spends more than it earns, we all know. This difference, known as the fiscal deficit, is expressed as percentage of the gross domestic product (GDP). For the financial year 2011-2012, the fiscal deficit of the government of India stood at 5.9 per cent of GDP.  But this number somehow does not convey the grimness of the scenario that the government of India is in.

The expenditure for the year 2011-2012 has been estimated to be at Rs 1,318,720 crore (Rs 13,187.2 billion). In comparison the government’s income for the year is at Rs 7,96,740 crore (Rs 7,967.4 billion). This works out to a difference or fiscal deficit of Rs 5,21,980 crore (Rs 5,219.8 billion). Hence in simple English the government spends 65.5 per cent more than what it earns.

When we compare the situation in this way we come to realize that the government is spending much more than what it earns. If you or me were to do that we would be in trouble pretty soon. The government as we shall see has a longer lifeline.

2. The fiscal deficit of the government of India has gone up by more than 300% in the last five years:

For the financial year 2007-2008 (i.e. the period between April 1,2007 and March 31, 2008) the fiscal deficit stood at Rs 1,26,912 crore (Rs 1269.12 billion), against Rs 5,21,980 crore (Rs 5,219.80 billion) for the financial year 2011-2012. Now what does that tell you? In a time frame of five years the fiscal deficit has shot up by nearly 312 per cent.

During the same period the income earned by the government has gone up by only 36 per cent to Rs 7,96,740 crore (Rs 7,967.4 billion).

When expenditure is expanding nearly 9 times as fast as your income, it can’t be a good thing. No wonder, the finance minister gave that piece of information a miss.

3. The fiscal deficit target for the financial year 2012-2013 (i.e. the period between April 1, 2012 and March 31,2013) is likely to be missed:

When the finance Pranab Mukherjee gave his budget speech in February last year, he had set the fiscal deficit target for the financial year 2011-2012, at 4.6 per cent of GDP. He missed his target by a huge margin when the real number came in at 5.9 per cent of GDP. The major reason for this was the fact that Mukherjee had underestimated the level of subsidies that the government would have to bear.

He had estimated the subsidies at Rs 1,43,750 crore (Rs 1,437.5 billion) but they ended up costing the government 50.5 per cent more at Rs 2,16,297 crore (Rs 2,162.97 billion). The finance minister had underestimating the subsidy level of the three main categories of food, fertilizer as well as oil.

This has been the case in the past as well. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) he had estimated the oil subsidies to be at Rs 3,108 crore (Rs 31.8 billion). They finally came in 20 times higher at Rs 62,301 crore (Rs 623.01 billion). Same was the case in the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010). The estimate was Rs 3,109 crore (Rs 31.09 billion). The real bill came in nearly eight times higher at Rs 25,257 crore (Rs 252.57 billion) (direct subsidies + oil bonds issued to the oil companies).

Similar underestimates have been made for the financial year 2012-2013, to project a fiscal deficit of 5.1 per cent of GDP. The total subsidies bill has been estimated to be at Rs 1,90,015 crore (Rs 1,900.15 billion) a good 12 per cent lower than the subsidy bill for the year 2011-2012.

The government has constantly underestimated the cost of subsidies and there is no reason to believe that it would not be the same for this year as well. Oil prices are unlikely to go down, and inflation is also not seen slowing down. Hence it is most likely that the government will miss its fiscal deficit target for this year as well. The only way to cut this bill is to cut the level of subsidies, and that is unlikely to happen. As a known stock bull said on TV the other day, even Saudi Arabia doesn’t sell kerosene at the price at which we do. And that is why a lot of kerosene gets smuggled into neighboring countries and is used to adulterate diesel and petrol.

4.  The government is in a huge debt trap:

The fiscal deficit target for the financial year 2012-2013 has been set at Rs 5,13,590 crore (Rs 5,135.9 billion). The government raises this money from the financial system by issuing bonds which pay interest and mature at various points of time. Of this amount that the government will raise, it will spend Rs 3,19,759 crore (Rs 3,197.59 billion) to pay interest on the debt that it already has. Rs 1,24,302 crore (Rs 1,243.02 billion) will be spent to payback the debt that was raised in the previous years and matures during the course of the year 2012-2013.

Hence a total of Rs 4,44,061 crore (Rs 4,440.61 billion) or a whopping 86.5 per cent of the fiscal deficit will be spent in paying interest on and paying off previously issued debt. What this means is that new debt is being issued to pay off old debt and pay interest on it.

The situation is similar to that of an individual who takes new loans to pay off older loans or rotates credit card debt across his various credit cards. The government can keep doing this for a long period of time because in the worst possible scenario it can print money and repay the debts that have accumulated and in the process reduce the value of the domestic currency. This is what many governments in the developed world are doing right now. You and I can’t do this and ultimately will fall prey to debt collectors or will end up behind bars!

5. Interest rates will continue to be high:

As explained above the government finances its fiscal deficit by issuing bonds on which it pays interest.  Who buys these bonds? These bonds are primarily bought by banks which by law need to invest 24 per cent of their deposits in such bonds. At the same time the government is also competing with private companies and you and I for this money. The banks have the option of lending their deposits to companies and also give it out to individuals in the form of car loans, home loans, credit cards, personal loans etc. Hence the government has to offer a higher rate of interest on its bonds.  Given this, the rate of interest charged by banks on all other forms of loans goes up because they are more risky than lending to the government. Hence if the government is offering a rate of interest of 8 per cent on its bonds, then the banks are likely to charge more on all other forms of loans that they make. So the next time the finance minister talks about the interest rates going down, be skeptical. The interest rates cannot go down as long as the fiscal deficit doesn’t go down and that doesn’t seem to be happening any time soon.

The article was originally published in www.rediff.com on April 10th, 2012

Laxmiamma has been putting away the Rs500 that she saves every month, under her mattress. This has been going on since 2002. She likes the smell of money whenever she picks up the mattress. She likes to keep counting them. She likes their fading color; it indicates that she has been saving since really long and speaks volumes about her discipline!

Somewhere in her heart, Laxmiamma has the desire to buy back the gold bangle that she had to sell off when her husband took seriously ill some 25 years back and the family needed the money for his treatment. The bangles were a wedding gift from her grandmother and had 25 gms of gold. They were her pride. She felt like a queen when she wore them.

Alas, there is still a long way to go. She only has Rs61,500 (500*12*10yrs3months)under the mattress. Two years back when she had gone to the Jeweller, he told her that it would cost her Rs40,000. When she went with Rs40,000 to him, he said that the price of gold has gone up and it will cost 60,000. Three months back when she went with Rs60,000 to him, he said that now the bangle will cost Rs70,000. “If this is the way the price keeps going up, I’ll never be able to buy those bangles”, thought Laxmiamma with tears welling in her eyes.

This is the story of a lot of us. While prices keep going up, our income and savings do not go up in the same proportion. And this is where Prof. Nicky enters the scene.

Prof. Nicky does not promise to solve all your financial problems or make money grow on trees. Prof. Nicky gives simple tips on money and investment, which might help ease your situation.

Enter Laxmiamma and Prof. Nicky.

Prof. Nicky: Laxmiamma, why do you keep your money under the mattress? Does it grow there? And what if there is a thief in the house one day? Why do you take the risk of keeping it at home? Why don’t you invest it? In this way, the money is not only safe, it grows too! Yes, money can grow if invested well.

Laxmiamma: “You mean keep it in the bank?”

Prof. Nicky: That is the easiest way to invest. You could at least start by putting your money in the bank. In fact, you would have been able to buy your gold bangles by now if you had invested your money in a recurring deposit with a bank every month. By now you would have Rs84,682/- (using 6% p.a. interest and the Future Value of Annuity Formula) in your account instead of Rs61,500/- under the mattress.

With popping eyes, Laxmiamma asks, “Really?”

Prof. Nicky: Really. You might actually have earned even more, if you had invested in other assets like Equities, Mutual Funds, Bonds, and Derivatives. In the past ten years, the Equity indices have given over 400% returns in India. Of course with return comes risk, but one must balance the two and invest in asset classes where they are comfortable with the risk.

Laxmiamma: I understand that I should invest. And I am going to start by putting my money in the bank from now on, rather than under the mattress. But pray do tell me more about risk and return and these other asset classes that you have mentioned.

Prof. Nicky: I will tell you that in this column some other time. Till then, why don’t you think about risk and return in our day to day affairs?

This article was first published in Postnoon on April 6th, 2012
http://postnoon.com/2012/04/06/let-your-money-grow/41858

The Union Budget of FY2012-13, presented by the Finance Minister Mr. Pranab Mukherjee, resulted in the market closing 1.19% in red. Most of the sectoral indices, except FMCG and Consumer Durables closed in red. India Inc has called this budget “a missed opportunity”.

The expectations from the Budget were low to begin with. But, while the expectations were low, wishlist was long. The table below is an example of the wish list of a few industries.

Source: Compiled from various industry associations and news reports

Everyone wanted this budget to be “not a populist maneuver”, but in the same breath, they would roll out a series of exemptions and sops that they wished for from the budget.

One thing is for sure. This budget is not a populist maneuver and as the market reactions point out, Mr. Finance Minister has not been able to satisfy everyone. And this is exactly what works in his favor.

As we can see, almost every industry wanted tax sops to continue, duties and taxes to reduce or be removed. But the finance minister has stuck to tackling the burgeoning fiscal deficit and concentrating on key areas of infrastructure, education, health and food. There is effort to contain the outflows on subsidies, containing them to 2% of the GDP. There is emphasis on removing bottlenecks for the coal, mining, roads and energy sectors, and various customs reliefs and duty cuts have also been proposed for these sectors. Create capacities for storage, increasing supplies, reducing duties and customs in the agricultural sector are truly welcome. The allocations for education and health related schemes have also gone up by more than 20% overall.

The ‘aam aadmi’ does not get too much, but should not be disappointed as well. Within limits, the budget has put something in their pockets too without taking away much. The income tax exemption limit has gone up to Rs2,00,000/- The limit for tax exemption on interests earned has gone up from Rs5,000 to Rs10,000/- The retail investor gets an incentive to invest in the stock markets, through the Rajiv Gandhi Equity Savings Scheme. Service Tax had been increased by 2% but then it was inevitable as the service tax was reduced in 2008 as sops given to tide over the financial crisis.

Black money and tax avoidance have been frowned upon. Amendments to Fiscal Responsibility and Budget Management Act, 2003, have been announced.

The government is embroiled in corruption charges, the mandate of the people in the recently held state elections was not encouraging, and the so called allies are not being too helpful either. Not much is expected from the financial year 2013-14 budget as the country goes to elections in 2014, assuming that the UPA government manages to hold on till then. This was the only chance for Mr. Pranab Mukherjee, to push for reforms, save some face by doing it, and bring India back on the growth trajectory. While there are many sectors that are disappointed for not getting any sops, the finance minister has done a pretty good job within his constraints.

The government is embroiled in corruption charges, the mandate of the people in the recently held state elections was not encouraging, and the so called allies are not being too helpful either. Not much is expected from the financial year 2013-14 budget as the country goes to elections in 2014, assuming that the UPA government manages to hold on till then.

So the budget being presented tomorrow by Finance Minister Pranab Mukherjee, might be the only chance to push for reforms, save some face by doing it, and bring India back on the growth trajectory. One of the primary concerns this year is to rein in the Fiscal Deficit.

Last year, Mr. Mukherjee had said that the government would target a budget deficit of 4.6 per cent for 2011-12, compared with the 5.1 per cent expected for 2010-11. We are nowhere close to the targeted figures. Subir Gokarn, the Deputy Governor of RBI has predicted that the Fiscal deficit would be close to 7% by the end of March 2012. The government badly missed their own revenue and expense predictions. Government borrowing has been increasing. This has resulted in high interest rates. On the one hand the government is not able to control expenses; on the other hand, it is not doing much to improve revenues.

The four areas, which are being talked about and are very likely, the budget may target to rein in the fiscal deficit are Subsidies and welfare schemes, Foreign Direct Investment, non-tax revenues and tight fiscal management policies. Let’s look at the state of and the challenges facing each one of these areas.

Subsidies and welfare schemes: Year after year, the government has rolled out more and more subsidies (fuel, food, fertilizers) and welfare schemes (MNREGA, NHRM) for the people that have now turned into giants, with ever increasing appetite for cash. Various subsidies account for close to 3% of the GDP!

On the one hand, the government spends close to Rs55,000cr in food subsidies every year, on the other, the estimated wastage of food in an year is close to 60 million tones, approximately 20% of the total production. The prices of diesel and fertilizers are far from reality and decontrolling them or reducing the subsidy might result in early polls. Apart from this, there is lack of transparency about how the money is spent on various welfare schemes. Accountability and achieving the targets should be the key words in such schemes, but they are not!

Foreign Direct Investment: FDI in aviation, retail, insurance, and infrastructure are all pending since long and need urgent attention. There are benefits to be gained from FDI apart from the capital, in terms of technology, expertise, backward and forward linkages etc. Simplifying processes for the foreign investors, reducing the number of days taken to conduct business and set up operations could all go a long way in attracting investors. Though it might now be difficult to build consensus in the Parliament and it may be impossible to push through bills like FDI in multi- brand retail.

Non-tax revenues: Divestment or sale of stake in Public Sector Undertakings is one way to raise money without putting burden on the common man. The Government failed miserably in this last year. The recent example of investors shying away from ONGCs follow-on public offering and LIC being ordered to pick up the shares to save the offer from falling through is a case in point.

Tight fiscal management policies: Except the Non-Direct Tax collections, the government has fallen short on almost all other forms of Revenues collection. The estimated shortfalls for the FY2011-12 are Rs20,000cr in Direct Taxes, Rs35,000cr in Non-Tax revenues, Rs27,000cr in Divestments and Rs37,000cr in Non-Debt Capital. The expenditure has been as budgeted to a great extent, in fact it might be lower than budgeted as on the year end. With transparency and good governance, proceeds from divestment could go up. Measures to improve the tax and non-tax collections have to be put in place, including coming down heavily on corruption, which might be leading to money going into private coffers rather than the exchequer. Voluntary Disclosure Schemes or Amnesty Schemes could be put in place to encourage people to bring back the black money stashed away in tax havens.

Overall it seems that the fiscal deficit situation that we have gotten into is mainly due to mismanagement and poor planning. Taking calculated and tough stand and having clarity in the policies will definitely help rein in the fiscal deficit.

The Union Budget of FY2011-12, presented by the Finance Minister Mr. Pranab Mukherjee, resulted in the market going up by close to 3% and breathing a sigh of relief for not having been burdened with more taxes or duties. Ofcourse, there was nothing to rejoice about at the same time. But at least status quo does not imply being worse, if not better!

The expectations from the Budget of FY2012-13 are low and the stage is set with the monetary policy review dampening the sentiments of the markets today. While the expectations are really low, wishlist from the Budget is long. And that might work in Mr. Mukherjee’s favor, if his budget shows even a slight sliver of hope for reforms.

Everyone wants this budget to be “not a populist maneuver”, but in the same breath, they roll out a series of exemptions and sops that they wish for from the budget. One thing is for sure. This budget will not be a populist maneuver, because whatever Mr. Finance Minister does, he will not be able to satisfy everyone. The table below is an example of the wish list of a few industries.

Source: Compiled from various industry associations and news reports

As we can see, almost every industry wants tax sops to continue, duties and taxes to reduce or be removed. But the finance minister has no magic wand and must tackle the burgeoning fiscal deficit. Hence, exemptions and indirect-tax reductions may seem farfetched. Though, the budget may actually pave way to implement the Direct Tax Code (DTC), taking at least small strides this year.

Increasing the personal income tax limit from Rs1.8/1.9 lakhs to Rs3 lakhs, increasing the Sec80c exemption limits, hiking the slabs for tax rates will all put more disposable income in the kitty of the common man.

Rising inflation, rising prices of food, petrol, LPG, had the households scrambling to cope throughout the last year and they do not expect this year to be different. The common man is worried about the sky rocketing education and healthcare costs, rising housing costs and declining amenities. They are looking at Mr. Pranab Mukherjee to ensure that they can plan their monthly budget with more precision and have improved standards of living.

Create capacities, reduce wastage, improve infrastructure, to increase supply in the agricultural sector. Have more clarity on the prices of fuel. People are confused. Are the Oil prices really independent? Will the diesel prices be deregulated? Why are we paying more and getting less of everything?

All these questions concern the common man and giving income tax sops alone may not be enough to enthuse them to vote you back Mr. Finance Minister.

If you are wondering why such trading hasn’t taken off in India, it is because these transactions need a lot of ground work to be put in place first.

“Why don’t we have a futures contract on real-estate to hedge the risk of land prices going down?” asked Rahul, a quiet but sharp student. Professor Nicky was taken aback by his question. Where most of the students in her class had difficulty understanding the basic concepts of hedging, this young boy was asking about an instrument which was, well, not so simple, to say the least.

Professor Nicky turned the question to the class to test how much the class knew. And she was in for a pleasant surprise. There were a few hands in the air.

Rachna: “It will be difficult to introduce real-estate futures because the valuation of the underlying product would be difficult. The real-estate market in India is highly fragmented. The prices of land differ widely based on factors such as location and usability, that is commercial, industrial, residential or agricultural”

Praveen added: “Besides, such a market would be very illiquid in India as only prime commercial and residential properties would probably be traded.”

Index of prices

“But, what is the problem here?” interposed Rajshree. “Can’t we create an index of real-estate prices? Just like we have stock indices? We can club the properties belonging to a particular city according to property types”.

Professor Nicky saw a few perplexed looking faces and decided to intervene even though she was happy with the way the discussion was proceeding. She took over from where Rajshree had left.

“See, just like we have an index for FMCG companies or IT companies or banks, similarly, we can create an index of real-estate Prices. Of course these indices will be city or region-wise indices. We would need to determine a base year”.

“Since it would be very tiresome to include all residential property transactions in the index, we take transactions that are above a minimum amount of, let’s say, Rs 25 lakh. Now we can take a weighted average of all the transactions on a weekly or a fortnightly or monthly basis to find the changes in the index.

“However, the index may not give a true and fair picture as the recorded value of these transactions with the government is generally very low to save taxes. But then, it will still be better than having nothing. And slowly, as we move ahead and learn, the issues of heterogeneity and pricing will be sorted out”.

“Ah! If I recall correctly, Chicago Mercantile Exchange and Chicago Board of Trade have such futures traded on such contracts for cities such as New York and Los Angeles. In fact, they also have futures contracts on Real Estate Investment Trusts” exclaimed Richa.

“The students have really started reading,” thought Professor Nicky. “With the job scenario being bleak, many students have become serious and are trying to read more so that they can have an edge over their batch mates in an interview”!

Benefits of futures

“Yes, both the US and the UK have real-estate futures traded on their commodity exchanges for most of the major cities in the country. But can somebody tell me what the benefits of real-estate futures are?” asked Nicky.

Before Nicky could point towards a raised hand, Rohit rattled off, “Hedging for investors and builders, diversification, price discovery, increased information availability and flow, investment tool…”.

“Okay…okay…enough…so all of you are aware of the benefits of real-estate futures. But who has heard of the London Fox?” Thankfully no hands went up this time. Nicky was almost beginning to feel that she was not required in the classroom at all as the students had answers to all her questions.

Keeping them at bay

“London Futures and Options Exchange (FOX) started trading in four property futures contracts in May 1991 and had to suspend trading in October 1991. The reasons were mainly that these contracts were not economically viable. Arbitrage was not possible as short-selling is not allowed in the underlying spot market, which is true in India also.

“Also, the housing indices for various cities would be highly dependent on each other, albeit with lagged effect, due to the cascading effect in the real-estate markets. The transaction costs were also huge, which kept the investors and hedgers at bay.

“Hence, before introducing these futures, the government will have to do a lot of ground work to ensure that they work efficiently and provide the desired benefits to investors and hedgers”.

The class looked satisfied. Everyone had contributed something and everyone had learnt something new. Nicky looked proudly at her students and called it a day.

By Nupur Pavan Bang with inputs from Praveen, Rachna, Rahul, Rajshree, Richa and Rohit.

About the contributor: Nupur is a Post-Doctoral Fellow at the Indian School of Business. She obtained her Doctoral degree from Icfai University, Dehradun. Nupur is a Fellow of the Association of Chartered Certified Accountants, UK. She has also taught Theories of Corporate Finance to undergraduate students at Syracuse University. Nupur writes regular columns for Hindu BusinessLine, DNA Mumbai and rediff.com.

(Praveen, Rachna, Rahul, Rajshree, Richa and Rohit are all alumni of IBS Hyderabad, class of 2009.)