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“ The market, like the Lord, helps those who help

themselves. But, unlike the Lord, the market does not

forgive those who know not what they do. ”– Warren Buffett

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M A K E W E A L T H W H I L E O T H E R S T H I N K O F I T

NEED THE DOUGH?M a r c h 2 0 0 6 V o l u m e 1 I s s u e 1 w w w . i i p m . e d u

C o n t e n t s

M A K E W E A L T H W H I L E O T H E R S T H I N K O F I T

NEED THE DOUGH?M a r c h 2 0 0 6 V o l u m e 1 I s s u e 1 w w w . i i p m . e d u

PANORAMA

11 Access to financial services : a review of the issues and public policy objectives By Stijn Claessens, Senior Adviser Financial Sector Vice- Presidency (FSE), The World Bank

Finance is an important component of development, including .......

14 A New Light of Hope: Credit Derivatives

By Imran Contractor, Consultant Reliance Capital

For an institution – the Bombay Stock

42

Exchange that started under .....

GLOBAL PERSPECTIVE

22 The Future belongs to PerformersDr. Philippa Malmgren

President, Canonbury Group

The global financial markets have high expectations ......

27 Fund Managers Find Passage to India By Gareth Lynos Fund Analyst, Morningstar

Diversified portfolio managers typically stick to developed markets .....

TRENDS

30 FIIs Moon Dance in Indian Stock Market

IIPM Think Tank

Whenever we talk about Indian Stock

Market wand its .....

38 Penny Stocks Lethal for Penny Investors by IIPM Intelligence Unit

September 22, 2005 was another brutal day in the history of Indian Stock markets...

46 Sow Less Reap Moreby Sanjay MirankaAVP And Head-capital Markets, Birla Global Finance Ltd.

Continuing buoyancy in the capital market is proving a lot....

48 Cleanchit ?Not Really ! by P. Malhotra, Principal Offi cer, Zuari

Strong macroeconomic fundamentals have kept the capital market buoyant...

RESEARCH

52 Straight Through Processing – Panacea for Securities Settlement Conundrumby S.N. Ghosh Business Law Faculty, IIPM

Liquidity is an important feature of any financial market.

8

IPO Grading a questionable concept

Prithvi Haldea, Managing Director, PRIME Database

The need of the hour is to amend the procedures in order to provide credibility ...

18

34

Welcome to the year 2006 when everything is set for ....

PARTICIPATORY PARTICIPATORY PARTICIPATIONPARTICIPATION

IIPM Think Tank

The Hidd

Until recently, small and

midcap stocks were

under-appreciated as a

class, especially amongst...

By Bhuvana Ravi,Director, Abhay Capital Services (P) Ltd.

Run is institutional investments .....

INFOCUS

76 Regulating the Regulatorby Hari Parmeshwar,Faculty IIPM

As I sit down to write this article on the Republic Day celebrating the .....

84 The Bull’s Betrayal by IIPM Think Tank

Whenever the bulls in the Indian Stock Markets roar the fi rst apprehension which comes

It is the lubricating .....

60 Tobin’s Q & Assets Returns: Implications for Indian Stock Markets

Dr. G. S. Sood, Reader, Department of Commerce, SGTB Khalsa PG (Eve.) College, University of Delhi

Dr. Surjit Kaur, Reader, Department of Commerce, SGGS College of Commerce,University of Delhi

The present study attempts to check the valuations of the Indian stock markets ....

FACE TO FACE

68 Face to Face

Mr. S. P. Singh, Branch Manager (Ex Sr. Manager Investment 1998-05), Punjab & Sindh Bank

Indian economy has matured since the

last bull run of 1998-2000 .....

Lalit K. Khanna Executive Director, Escorts Asset Management Ltd.

It is a known fact that the driver of the Bull

den Gemsby Ashish Chugh, Investment Analyst, Hidden Gems Advisory

All Systems Go..ne!

Parents across India would be at least steering clear of one name .....

by Tareque Laskar, IIPM Bangalore

Research Assistants: Jomey Varghese & Mohammed Zakriya (Management Intelligence Cell, IIPM Bangalore)

80

to the mind of Indian investors .....

87 Indian Brokerage Industry: A Paradigm Shift by Meena Bhatia, Lecturer, IILM Delhi

Effi cient intermediation is of paramount importance in making the capital markets more ......

Putting the Putting the System in System in

PlacePlaceD.N. Das,

Advisor, UTI Securities Ltd.; Ex President, VP & Director of Madras Stock Exchange

Indian Stock Exchanges have undergone a metamorphosis in the recent past.

The catalyst, being Demutualisation .....

92

96 Better Late Than Never!!!

by Society for Consumer’s & Investors Protection

Since Mr. Damodaran took over as SEBI Chief, expectations have been rife ....

Editor’s Page

Dear reader,

Good judgment comes from bad experience, and a lot of that comes from bad judgment. When the moon

is shining the cripple also becomes hungry for a walk. Same is the situation in Indian stock market and the

psychology of Indian investors. Both the primary and secondary markets are attracting not only the domestic

investors but the international investors as well. India appears to have come off those Harshad Mehta and

Ketan Parekh syndrome under the much stronger Securities and Exchange Board of India (SEBI). But, the

growing market will keep throwing scamsters like Roopalben et al as greed is a lasting slavery. It is similar to

spare the rod and spoil the child. This time around Sensex boom is result of increasing market share of foreign

Direct Investments (FDI) and Foreign Institutional Investments (FIIs). India attracting more than $10 billion of

foreign funds sends the clear message that India has arrived.

So far, it is a rosy picture of India. There are areas of concerns also. Unlike China, India is getting short-term

funds more than the long-term ones which enhance the risk factors as there are always chances of investors

backing out without warning and create East Asian type of fi nancial crisis (1997). It should be remembered

that the foreign investors are interested in making hay while the sun is shining. In 1996, fi ve Asian economies

(South Korea, Indonesia, Malaysia, Thailand, and Philippines) received net private capital infl ows amounting to

$93 billion. One year later, they experienced an estimated outfl ow of $12.1 billion, a turnaround in a single year

of $105 billion (more than 10% of the combined GDP of these economies!). The after effects led to fi nancial

crisis in other countries too. India survived this crisis because of its strong domestic investments. The other

area of concern is involvement of controversial Participatory Notes and hedge funds on which the RBI and the

government differ, as both are incapable to trace the origin of this ‘hot money’ in case of any eventuality.

This crisis made Indian policy makers to defer the Current Account Convertibility (CAC) which was supposed to

be implemented by 2000 as per Tarapore Committee suggestions. India’s forex reserves crossing $150 billion

and trade crossing $100 billion has triggered a debate on whether the time is ripe for the country to go in

for CAC. Policy makers should fi rst weigh the considerations, then take the risks. India does need the ‘cross

ventilation’ of funds but the approach should be cautious, not to forget the policy of being too cautious is the

greatest risk of all.

Emerging economies like India do need both long-term and short-term capital fl ows as a fuel for its overall

growth. Clearly, the IIPM Think Tank suggests for strong fundamentals and safety net against crisis situation

before going ahead for full convertibility and opening up of market. Sound banking infrastructure, a healthy

fi scal situation, a subdued infl ation and a proactive monetary policy are must to make India investors’ paradise.

It is always better to grow steadily rather than dynamically to avoid any crunch situation.

Best

Prasoon S. Majumdar

Prasoon S. Majumdar

Roaring BullRoaring Bull

AN IIPM INTELLIGENCE UNIT PUBLICATION

PANORAMA

8 Need the Dough? March - 2006

India –“The Investors’ Paradise”India –“The Investors’ By Bhuvana Ravi, Director, Abhay Capital Services (P) Ltd.


SECURITY MARKET

9March - 2006 Need the Dough?

Journey of Indian equity markets during the last decade has passed the wind and waves sailing through liberli-

sation, Harshad Mehta scam, Information Technology boom, Ketan Parekh scam, UTI (Unit Trust of India) cri-sis, etc., which have augmented more transparency, high corporate governance and regulation. Thus, the story of Indian equity markets is a phenomenon by itself.

BACKGROUND OF INDIAN ECONOMY 2005-2006India’s US $661 billion economy is likely to grow at a 7.5% . It

appears sustainable primarily contributed by heady perform-ance of services and manufacturing industries. Agriculture lagging behind now, could be the surprise next year.

Corporate earnings growth paced at 15% to 20% is on anvil. Robust performance of economy, higher imports of consumption of goods and better performance by the consumer goods signal strong growth.

Among the most important determinants of future economic growth are the interest rates. Their effects are pervasive. Changes in interest rates can impact consumer spending, business expenditures, corporate profi ts, gov-ernment budgets, stock and bond prices, and the value of the currency. Movements in the interest rates often precede recession and economic recoveries.

EQUITY MARKETSEquity markets’ performance has left us with no ad-

jectives evoking sheer disbelief. Sensex marched from 3000 levels to 6000 levels in 2004. And in 2005 equity markets posted handsome returns of 50%. The fear of unrestrained rise in crude oil prices loomed large threatening to derail the growth story. India Incorpo-ration was not deterred by the phenomenon.

Number of Initial Public Offerings (IPO) offered by the companies was 70 during 2005 and around 100 of them were in the pipeline for the coming year. IPO amount likely to be be raised would be more than Rs.500 billion. The year 2005 turned out to be a record year for India as new Global Depositary Receipts (GDRs) worth US $1.3 billion entered into the trading platform. Indian companies opted for GDRs instead of American depositary Receipts (ADRs), as the process of listing laws is more stringent in US after the Sarbanes Oxley Act. Multiple demat account holder and allocation of IPOs shares unfolded IPO scam. Hence, Securities Exchange Board of India announced IPO regulation. This IPO process is another step towards

Robust performance of economy, higher imports of consumption of goods and better performance by the consumer

goods signals strong growthIndia –“The Investors’ Paradise”Paradise”

The sustained growth story of India

is a reflection of highly conducive

economic & political environment.


PANORAMA


being transparent, equitable and investor friendly. Al-lotments to the category of Qualifi ed Institutional Bid-ders comprising Foreign Institutional Investors (FII), domestic institution and Mutual funds will henceforth be made on proportionate basis.

FOREIGN INSTITUTIONAL INVESTMENTSEver since the opening of the Indian equity markets to

the foreigners, FII investments have steadily grown from about Rs.26 billion in 1993 to over Rs.110 billion in the fi rst half of 2001 alone. FII exposure in Indian stocks is to touch

US $50 billion in 2006 (predicted by Associated Chambers of Commerce and Industry of India) from the cumulative in-vestment level that stood at US $40 billion in October 2005. The developed markets promise sluggish returns while the emerging markets like India promise returns.

Net Foreign Institutional Investment for the year 2004 was US $8 billion and that in year 2005 was US $10 bil-lion (Rs.450 billion). Over the past two years, there has also been a signifi cant rise in the number of FII’s regis-tered with the market regulator marking from 600 to 850. The new FII’s are from US, UK, Norway, Kuwait, Malaysia and Singapore.

The most preferred investible fund would be pension fund, as it is clearly long term oriented and discerning type of investment, have committed liabilities in the form of defi ned pension scheme. For this reason, FII are un-likely to pull out the money as long as they feel that the investments are safe and profi table. FII’s ensuing inter-est remains high, as multiple themes and opportunities for Indian companies are unparallel. The transparency levels, accounting standards and the ability of the Indian corporate sector are to scale up and generate higher levels of interest in Indian equity.

M&A ACTIVITYFor the year 2005, India Inc. was high on Merger and

Acquistions front, it turned out to be a two-way street, foreign companies entering India and vice versa. The deal activity was spread across a wide range of sectors namely

telecom, food and FMCG, cement and building material, metals, oil and gas, automotive, pharma and healthcare displaying healthy levels of activity. Fifty percent of the deal volume in the fi nance sector was contributed by Mr. Anil Ambani whose acquisition through the hold-ing company AAA Enterprises of a 52.03% stake in the management company Reliance Capital for Rs.25.6 bil-lion. The largest overseas deal was the Videocon Group’s acquisition of Thomson’s colour picture tube business in China, Poland, Mexico and Italy for a total of US $290 million. IT companies were active acquirers with 13 deals worth over US $89 million. Biocon acquired the intellectual property of its research colloborator Nobex Corporation, which has applied for cover under chapted 11 of US bankruptcy laws. Recently in the biggest ever deal in aviation sector, Jet Airways has acquired Air Sa-hara for US $500 million

US equity markets was unable to fi nd any clear direc-tion as fi rm crude oil prices, weakening dollar and soaring home prices played spoilsport. Euro zone witnessed more than expected profi t growth of corporate majors. A surge in economy, coupled with Foreign Institutional Investors pushed up the BSE’s Sensex and the NSE’s Nifty to all time highs.

TECHNICAL OUTLOOKThe BSE Sensex (9520) and S&P CNX Nifty (2900) recorded

major gain in 2005. The targets of 9800–10300 looks achievable. The possibility of testing support levels at 7400-7700 would be negated only on breaching the resistance of 10500-10700 levels.

CONCERNSThe value of the announced capex plans by the private

and public sector for the next four years is expected to exceed Rs.7,000 billion according to Centre for Monitoring Indian Economy. To sustain this cycle of growth crucial reform decisions are to be decided in the course of 2006 are:1. Foreign Direct Investments in retailing and insurance2. Modernisation of airports, ports, rail and roadways3. Spectrum allocation to mobile operators4. In the oil sector, subsidies to be rationalised5. Power sector reform6. Flexible labour policy7. Privatisation and disinvestment

CONCLUSIONOver the next fi ve years, Corporate India is set to

grow at a steady pace given a supportive macro econom-ic and political environment. Unlike the past, where the Asian tiger economies were predominantly export oriented and therefore vulnerable to external shocks, India will be able to sustain growth rates due to the fact that the domestic demand is likely to be robust. �

Indices as on January 1, 2005

Indices as on January 19, 2006

Brazil 26193 36858

Dow Jones 10783 10880

FTSE 4814 5693

Hangseng 14216 15670

Nasdaq 2184 2301

Nikkei 11458 15696

India 6626 9520

INTERNATIONAL MARKETS


SECURITY MARKET


Primary Market in retrospec t & prospec t

K.K. Sarkar,Secretary General

Indian Council of Small Industries and

Editor, ICSI Herald


PANORAMA


Abstract: In this paper, the author has made an attempt to trace the

etymological meaning of primary and equity market and traced out the

development of the primary market. He has also made an attempt to

see the bubble in the primary market without any alarm and made a

mention of the scam in the IPO market, but, despite so, mood for invest-

ment is high and sensex has been scaling new heights, which is a matter

of pride for our economy as it tends to attract more and more foreign

investors. Let this peak be maintained and investors’ confi dence remain

unchanged and they should treat this as an avenue for better returns in

the days of declining interest rate to the assured depository.

Introduction: Primarily speaking, according to the dictionary

meaning, “primary market = market conveys where new securities or bonds are issued (if they are resold, it is secondary market)1” and whereas equity means “(a) value of the company which is the property of the shareholders (the company’s assets less its liabilities, not including the ordinary share capitals) ….. (b) the ordinary shares in a company: shareholders equity or equity capital…. = a company’s capital which is in-vested by shareholders, who thus become owners of the company (note that preference shares are not equity capital, since they involve less risk and do not share in the profi tability of the company; equity earnings – profi ts after tax which are available for distribution to shareholders in the form of dividends, or which can be retained in the company for future development; equity fi nance – fi nance for a company in the form of ordinary shares paid for by shareholders”

Conceptual framework of Primary Market and its development:

That being the texture of the Primary Market and/or equity market, to start any business venture, whether big or small, the venturist fall back upon the capital market for promoting their business and they do not invest their personal fund. However, initially they borrow funds from relatives and friends and ultimately they fall back upon capital market to do business they go on doing business on borrowed capital or fund raised through market.

The capital market, truly speaking, is divided into two parts; one is fi nancial institution and the other is security market. Again, the security market is divided into primary market, debt market and secondary mar-ket. Prior to Securities and Exchange Board of India (SEBI) coming into the picture, it was controlled by Controller of Capital Issues. So the entire issue market,

i.e., share market was regulated by the Controller of Capital Issues and it has its own rigour; and many sound companies under the old economy were fl oat-ing issues. While undertaking fi nancial and economic reforms, the Government initiated various measures in the capital market conferring statutory status to the SEBI repealing the Capital Issues Control Act and abolition of this Offi ce of the Controller of Capital Issues. It has brought improvement in the regulatory effi ciency of the market. The SEBI was set up with an idea of giving fair, transparent and regulatory structure for effi cient functioning of the Capital Market and protecting the interest of investors which has helped a lot to develop Capital Market in the healthy lines. It also helps to mobi-lise savings, since common citizen fi nding more avenues for investing their surplus funds in the share markets when the bank’s rate of interest as well rate of interest under small postal savings schemes are reduced.

Character of Capital Market:Basically speaking, capital market consists of two

parts, share and debentures and prior to 1992-93, debentures were more popular in raising long term funds and fund investment, and provided almost 70% or more resources to new issues. Accordingly, persons who held the shares are known as share holders or members and owners of the company so they enjoyed certain rights in voting power in respect of declaring dividends. Here again, the company can issue two types of share, equity shares and preferential shares. Under preferential shares, fi xed rate of interest and fi xed rate of dividend enjoy preference in respect of payment of dividends and repaying of capital in the event of the company being wound up. However, in case of equity, share holders are not guaranteed with any dividend and it depends on yearly profi t. Therefore the equity share holders face maximum risk. And here they have got a chance to earn more than preferential shares in the years of prosperity. Presently, as it is evident from the trend of the share market, equity shares are much more favoured form of investment in our country, and it would be clear from the fact that the entire amount raised through shares in recent years has been fl ooded through equity shares.

ReformGovernment of India undertook reforms during

1997-98 including reform in the primary market to give momentum to the market. The Securities and Exchange Board of India (SEBI) took several steps for widening and deepening the market and the main focus was to bring reforms in the primary market ‘to safe guard and stimulate

Presently, as it is evident from the trend of the share market, equity shares are much more favoured form of investment


SECURITY MARKET


investors’ interest in capital issues by strengthening norms for raising standards of disclosure in public issues.’2

It could also be observed that ‘despite reforms, the market remained dormant. The primary market re-mained depressed with substantial decline in number of issues and amount raised.’ It could be noted that it was intended to revamp primary market because of lower fl ow of resources from Government in the form of budgetary support and no surplus was generated by public sector undertakings and they were having investible fund for development and banks and fi nancial

institutions were also in a tight position for lending and as such it was thought fi t to mobilise fund from primary market. The primary market could mobilise fund during the year 1995-96 and 96-97 but there was stiff decline in the resource mobilisation from a high of Rs.208.04 billion through 1,726 issues in 1995-96 to Rs.45.70 billion through 111 issues in 1997-98.

It appears from the present day trend that primary market, i.e., issues particularly in Initial Public Offer-ings (IPOs) of equities achieved a signifi cant develop-ment in security market in 2004 and ‘the volume of public issues rose by roughly fi ve times to the level of Rs.358.59 billion in 2004.

Now market is sophisticated and marked change in the India’s Primary Market has been the introduction of ‘SCREEN BASED BOOK BUILDING where secu-rities are auctioned through anonymous screen based system, and the price at which the securities are sold is discovered on the screen.’3 This eliminates delay and risk and if the system is applied and/or utilised with due care and caution book building would be easy, systematic and quicker.

SEBI is constantly monitoring and devising stricter

and tighter norms for disclosure and connectivity and with this effort now the Sensex index has crossed 10,000 point. It is certainly a refl ection of fi nancial health of the country and if it is so, the foundation of Indian Economy is countable one in the context of the global economy. When the Sensex reaches a peak point, it is certainly an important event and more important is when the Mumbai Sensex reached point of 10,000 from 9,000 within 45 days only. People may cast doubt or be apprehensive about this bubble but actually the Sensex was rising high and getting momentum since last fi ve months. Apprehensions are always there and the reason for rising Senxex in India is investment of foreign investors and they are taking keen interest in investing their funds in India. It would be, therefore, all the more necessary to bring more reform in the share market make it more effective and transparent to attract foreign investors.

Despite so, we face scams in share markets. The IPO scam of Roopalben5 is an eye opener about the system failure and the scam was perpetrated in collusion and connivance with the depository and bankers. However, Finance Minister has assured that no such scam may happen. It is not a new one, earlier we have seen Har-shad Mehta scam and Ketan Parekh scam, which had the effect of destabilising the share market and shaking the confi dence of small investors.

Accordingly it would be our suggestion that IPO market is to be so structured and so fashioned through layers of checkers and checking so that there is no falsifi cation and ordinary investors, i.e., small investors get the benefi t. The Primary Market has certainly suffered a big jolt, but it cannot be denied that during the fi rst quarter of the calendar 20066, the growth of initial public issues is fantastic and small investors would take opportunity to invest their investible fund in the primary market in the declining interest rate regime and here is a word of caution that investing fund in share market is risky one and having that perception of risk, one should opt for the risk for higher return. �

References1Dictionary of Banking and Finance by P.H. Collin - page-183 & page-84 (Indian reprint – Universal Book Stall, New Delhi)2Economic Survey 1997-983Economic Survey – 2004-05, Govt. of India – p/764Business Standard – 13.2.20065Business Standard – 18.1.20066Business Standard – 13.2.2006

Primary Market has certainly suffered a big jolt, but it cannot be denied that during the fi rst quarter of the calendar 20064, the growth of initial public issues is fantastic

Calendar Year

2001 2002 2003 2004

Debt (Rs. bn.) 49.16 34.51 37.90 23.83

Equity (Rs. bn.) 7.26 23.73 28.92 334.75

Of which IPOs (Rs. bn.) 5.25 19.81 19.40 226.11

Number of IPOs 17 6 13 26

Mean IPO size 31 330 149 870

Total (Rs. bn.) 56.43 58.25 66.82 358.59

Number 48 28 42 65

PRIMARY MARKET

Source: SEBI

AN IIPM INTELLIGENCE UNIT PUBLICATION14 Need the Dough? March - 2006

PANORAMA

JOURNEY FROM BAD TO BEST

By Imran Contractor, Consultant Reliance Capital

The endless reforms in the last ten

years have transformed the entire

outlook of Indian stock markets

PANORAMA


SECURITY MARKET


T

For an institution – the Bombay Stock Exchange that started under a banyan tree, more than a century ago, the last decade have been unprec-

edented and the most eventful. As in many of the fi elds in India, the Indian stock exchanges leapfrogged ahead in most of the areas to have one of the most effi cient markets in the world.

The major change has been the replacement of the individual driven trading process to a computer driven. The markets then suffered from various ineffi ciencies and malignant practices associated with human beings and lack of transparency.

This transformation has been all pervasive in terms of trading practices to settlement procedures and com-position of the participants’ involvement. It can be safely stated that the immense popularity of the Indian stocks as an investment decision would not have been possible if the measures for transformation of the mar-kets would not have been undertaken. Indian stock exchanges can today boast of the best procedures and systems in the world, if not better, but equal to the best markets in the world

The overall liberalisation process that started in 1991 covered the capital markets also with several initia-tives like the repeal of the Controller of the Capital Issues offi ce whereby the controls on pricing as well as the issue of securities were relaxed. The liberalisation process was complemented by the early establishment of the Securities and Exchange Board of India (SEBI) in the late 1980s, which got its teeth with the enact-ment of the SEBI Act, 1992. The initial opposition to the regulators diktat led to the brokers’ strike which fi zzled out over a period of time.

The process of relaxation of controls suffered a set-back in the aftermath of the securities scam when the newly appointed regulator adopted stern measures like ban on badla (carry forward) trading, ban on renewal of trades in the cash section where hitherto transac-tions were renewed over an infi nite period of time making short selling possible and rampant at times.

Before the initiation of the computerised trading, the outcry system of trading system had two-way quotes provided by jobbers. Jobbing spreads were exhorbitant, sometimes ranging between 5-10% or higher. The jobbing system seriously affected liquidity at times of crisis as jobbers vanished from the trading fl oor or were prepared to trade only in the minimum of the market lot, which was of 5, 50 or 100 shares. In lighter vein, many a times the jobbers were referred to as robbers. The computer driven model enabled direct input of orders by the clients at their pre-de-termined prices. The jobbing spreads in the initial

stages dwindled slowly with the jobbers being able to manage some scripts. However over the last several years the new system has led to the jobbers being sort of becoming extinct.

The advent of the National Stock Exchange (NSE) in 1994 was a watershed event in the Indian Capital Markets. The computerised trading mechanism facili-tated immediate matching and recording of trades with bid offer spreads dwindling and ultimately leading to elimination of jobbers. The new effi cient exchange challenged the hitherto monopolistic position held by the Bombay Stock Exchange (BSE), where the par-ticipants were resisting the change – computerisation – as the outcry and the recording system facilitated jobbers as well as lacked transparency. The jobbing system worked well for the jobbers as well as brokers as the practice entailed the jobber sharing nearly half of the differences with the brokers. Most of the job-bers monopolised respective counters or had a near monopolistic situation.

With NSE becoming the exchange of choice its turnover topped among the exchanges de-throning the BSE since its fi rst full year of operation. For the fi nancial year ended march 1996, the full year of NSE operation, volumes on the NSE were Rs.800 billion as compared to Rs.501 billion on the BSE and Rs.2,376 billion on all the exchanges in India. NSE’s share which was then a little over one-third has moved to 90% in the fi nancial year ended March 2005. The over-all turnover on the exchanges has grown over 20 times in the last 10 years.

The trading cycle on the exchanges was fortnightly for specifi ed shares and 30 days for the others and the settlement took another fortnight. The long cycle increased the risks and often modifi ed trading cycle by the stock exchanges to suit some of the factional interests lead to abuse and several defaults. The trading cycle was reduced to a week with the computerised trading facilities. The two largest exchanges – Mum-bai and NSE followed different weekly trading cycles which facilitated shifting of positions from one ex-change to another. The different weekly trading cycles were then made uniform.

With the trading system reformed and being one of the best in the world, the settlement system needed to be over hauled. The settlement of the securities was done physically with a transfer deed attached to a and/or a bunch of certifi cates forming a market lot. The transfer deed executed by the seller, witnessed and marked by the selling broker had to be physically delivered to the buyer’s broker. The broker would then mark the transfer deed and deliver it to the buyer.

MUTUAL FUNDS


PANORAMA


The buyer could then hold the shares blank or send it to the company for registration. Holding the shares blank entailed a risk if the company’s book closure or record date for some corporate action would pass. Registration of shares would entail signing it by the buyer, stamping the transfer deed and lodging with the company who were required to transfer the shares in about 30 days. The stamp duty payable is half a percent of the value of the shares. It is evident from the above procedure that the stocks once sent for transfer could not be sold until they are returned and transferred in the name of buyers by the company. This could take a long time, sometimes about two months.

After the book closure for corporate actions, there would be a shortage of the fl oating stock in the market as all the blank stock in the market would go to the company for transferring. This and several other lacunas of bad deliveries, i.e., seller’s sig-nature not tallying were exploited by the several participants in the markets.

The enactment of the Depositories Act, 1996 became the turning point in imple-mentation of the current paperless trad-ing system. The Act led to establishment of depositories for securities to ensure transferability of securities with speed, accuracy and security. To streamline the process, the act envisaged the transfer of ownership of securities electronically by book entry without moving the securi-ties from person to person. The securities of all public limited companies are freely transferable. It restricts the company’s right to use discretion in effecting the transfer, the transfer deed and other procedural re-quirements under the companies act. The incentive to adopt the depository system was the absence of payment of the stamp duty on transfer of securities.

The successful implementation of the act and the paperless trading system implemented brought about a further effi ciency in the trading system whereby the trading cycle was reduced from a week to one day. And lead to the gradual adoption of the current T+2 settlement cycle over a period of time.

India adopted the trading of derivative system from the year 2000 onwards even though ban on the options

on securities was lifted in 1995. Prior to this, a hybrid system of cash and forward market, called badla trad-ing, was followed whereby securities in the specifi ed section could be traded without effecting actual set-tlement at the end of the period, i.e., the transaction can be carried forward on payment or receipt of the contango or backwardation depending on the position of the delivery security in the market for the settle-ment. This hybrid system of cash and future markets was abused several times with participants resorting to absurd backwardation charges and contango several times especially at times of corporate actions when the fl oating stocks of securities was perilously low in the markets. There were several instances of managements

delaying deliveries of the securities after transfer (at book closure times) and thus manipulating the stock prices as well as the carry forward charges.

The derivatives trading has picked up sharply with three month period options and futures available on several securities and indices.

To put things in a bit more of perspective in fi gures the table given below illustrates the transformation of the securities market and its related activities in the last decade.

The improved performance of the economy has, to some extent, been aided by the heavy infl ow of funds to the corporate through the vibrant and effi cient capital markets. FII investments in the markets as on March 2005 have been 8.5% of the market capitalisa-tion. This represents about 20.39% of the Non-pro-moter shareholding in the Indian corporate. �

Period: 1995-96 2004-05 CAGR

Corporate securities issued in the domestic markets

(Rs. bil-lion)

362 1,059 11%

Corporate securities issued in the international markets

(Rs. bil-lion)

13 34 10%

S&P CNX Nifty Index 985.3 2035.65 8%

Sensex Index 3366.61 6492.82 7%

Market Capitalisation (Rs. bil-lion)

5,722 16,984 11%

Turnover (Rs. bil-lion)

2,274 16,669 22%

Turnover in derivative segment (Rs. bil-lion)

25,641

Market Capitalisation (% of GDP)

% 47 119.1

Resource mobilised by Mutual funds excl of UTI redemp

(Rs. bil-lion)

4,810 468,090 58%

FII investments Rs in blns 69 459 21%

Cumulative FII investments Rs in blns 117 1478

The enactment of the Depositories Act, 1996 became the turning point in implementation of the current paperless trading system

AN IIPM INTELLIGENCE UNIT PUBLICATION 17March - 2006 Need the Dough?


PANORAMA


The need of the hour is to apply a pragmaticapproach in order to provide credibility to IPO grading system


SECURITY MARKET


The need of the hour is to amend the proce-dures in order to provide credibility to IPO grading system.

What grades would IPOs like HT Media or Jet Airways have received from credit rating agencies (CRAs) with the track record of the promoters/com-panies, surely very high? However, investors have lost money in these issues, despite a very bullish market. On the other hand, unknown companies like Crew BOS or Bharti Shipyard would not have earned high grades, but have delivered over 500% returns, even one year later. After all, all IPOs should be fi nally judged by the returns and whether they offered an exit opportunity at a profi t.

Grading would be a one-time exercise. What if a fundamentally-strong, highly-graded IPO lists below the offer price for any reason – delay in expansion programme, changed industry scenario, or govern-ment policies or a stock market downturn? Should the investor hold on because it is fundamentally strong and lose more money? Despite disclaimers, investors would hold CRAs accountable for losses.

Welcome to the new world of IPO grading, be-ing introduced in response to the “fl ooding” of bad IPOs. There is no fl ooding – in the last three cal-endar years, there have been just 90 IPOs, which is insignifi cant, all the more when one considers the 1994-96 period that saw 3,515 IPOs – many fl y-by-night, the memories of which probably are the reason behind this proposal. As for the future, only 30 plus IPOs offer documents are currently fi led with SEBI.

In any case, bad, small, illiquid or overpriced IPOs are diffi cult now. As a result the entry norms for is-suers are higher, the retail investors are more mature (look at their poor response to several IPOs), there are fewer merchant bankers, there is more policing, and incompetent regional exchanges are closed. Few cases of rank bad issuers have faced incessant ques-tioning by the regulator, leading them to withdraw. So, the rationale for grading is weak. But most im-portantly, are we rejecting the institutionalisation of the market done precisely to safeguard the small investors, unlike the 1990s, when the issues were sold only to the retail, companies have to compulsorily sell half their issues to Qualifi ed Institutional Buyers (QIBs), which acts as a validation of the company and the price?

There have hardly been any overpriced IPOs as al-most all have given phenomenal returns. There could be some cases of aggressive pricing in the future and some retail investors may want to know whether they should invest in an IPO at its offer price, because at a high price, even a good company is a bad investment. Pricing, however, is outside the domain of CRAs who will assign a grade based on various parameters except the issue pricing. That is a major drawback. But even grading parameters like promoters, business prospects, etc., is hazardous

IPO Grading - a questionable concept ?

There could be some cases of aggressive pricing in the future and some retail

investors may want to know whether they should invest in an IPO at its offer price

by Prithvi Haldea, Managing Director, PRIME Database


PANORAMA

Moreover, what is of real concern cannot and will not be assessed by the CRAs – companies misusing is-sue funds and promoters acting against the interest of minority shareholders. The evaluation of a company at the closely-held level cannot capture this.

The proposal in any case appears to be a non-start-er as grading has not been made mandatory (and that is probably a saving grace). Good companies would not opt, as the strength of their business should see their issues sail through, and then why run the risk of not getting a high grade for any reason, and also delay the issue process by two to three weeks. The not-so-good companies would not opt (why invite trouble?), as a bad grade will only harm their issue prospects.

So, would some issues be unoffi cially forced to go for grading or be selected upon a small size (a wrong premise – ‘what is small?’ – is bad; also a small issue hurts at best a couple of thousand investors, a Rs.5 billion issue on the other hand affect millions) or such other untenable subjective parameters? Worse,

if good issues do not go for grading, there would be no benchmark for the investors when they look at the grade of a not-so-good issue. Incidentally, if an issue gets a very low grade, will it still be allowed? In addition, as the selection is left to the issuers, would the least competent of the four CRAs be their automatic choice?

Grading is not an academic exercise. It has to be about giving a comfort level about the post-listing performance. However, share prices are decided by millions of investors collectively, and it is impossible for CRAs to predict that. If rating was that easy, why not get CRAs to grade stocks in the much larger secondary market, where in any case continuing disclosures are minimal and disorganised or grade the Follow-on Public Offers (FPOs)? No one would ever lose money.

On another front, can empirical research and calibration of prospects be translated into a grad-ing opinion? Also, is the bias against small size fair? Many companies become very large after their IPOs. Present parameters may get small companies bad grades and hence kill their IPOs, and hence the growth (remember Infosys small IPO that went abegging). Will the grading system prevent poten-tial dark-horses?

Equity investing is a science and an art, it is subjective, and it is market-driven. Equity is about huge rewards and huge losses. Equity cannot and should not be rated, and no wonder, no model ex-ists worldwide for this. IPO grades can lull small investors about the risks and rewards of equity investing. They may apply solely on the basis of the grades. Grading does not promote informed decision-making.

Moving forwards, we should further strengthen the entry norms. And implement an effective system for monitoring issue funds utilisation. Also improve quality, quantity and format of disclosures. We do not need the protection of a fi fth level of scrutiny in a CRA…, the fi rst four being investment bankers, stock exchanges, informal yet detailed scrutiny by SEBI and public comments. Moreover, instead of reducing time and processes, we are adding one more layer!

Expertise of CRAs can surely be used. For exam-ple, for doing a crisp summary of the offer docu-ments, as these are now becoming too voluminous and tend to conceal critical information in the maze. Or meeting promoters/visiting plants and disclosing findings. Or why not singly vetting the offer documents, thereby saving huge duplication of efforts? �

Equity cannot and should not be rated, and no wonder, no model exists worldwide for this


PANORAMA

Russ Kinnel, Director – Mutual Fund Research, Morning star

Those who foresee the invisible

can achieve the Impossible….

AN IIPM INTELLIGENCE UNIT PUBLICATION 23

SECURITY MARKET

March - 2006 Need the Dough?

The global financial markets have high expecta-tions for India, perhaps too high. This is both a

blessing and a curse. Investors around the world are confident that India will revolutionise services in the same way that China has transformed manufac-turing. This helps explain why the Sensex recently tipped over to a record high of 10,000 and is ex-pected to keep hitting new highs. Investors around the world have poured capital in record amounts into India and emerging markets in recent weeks. Almost all Indian IPO’s (Intial Public Offerings) are oversubscribed. Flush with cash, Indians are feeling confident and optimistic about the future.

Meanwhile, economists in the industrialised world now firmly believe that India, in conjunction with China, will together eliminate inf lation from the world economy. Some even argue that the Fed-eral Reserve and the European Central Bank (ECB) do not have to raise interest rates very much any more because India is eliminating inf lation from the world economy. India, therefore, has become a crucial component of the domestic economy in the US and in Europe. There are those, of course, who complain about the loss of jobs from the United

States or Europe to India. But, the efficiency gains being made in India are vastly improving produc-tivity globally.

After all, nearly 70% of Gross Domestic Products (GDP) in the United States comes from services. Consider the impact of China’s manufacturing success on the US economy. Less than 10% of US GDP is in manufacturing these days. The room for improvement in services is enormous.

There is both fear (among workers) and joy (among investors) that India is producing engineers and entrepreneurs of the highest quality who are setting the global standards in their fields.

The Indian economy is producing vibrant inno-vations in a number of different fields. Contrary to the popular perception in the West, software is not the only game in India. Already India has es-tablished herself as a global leader in the provision of medical services. Many of the most advanced medical facilities and surgeons are no longer in the US. They are in India. India is also increasingly becoming a leader in pharmaceuticals. Many believe that India will become a world leader in biotech as well.

The Future belongs to Performers

Dr. Philippa Malmgren President, Canonbury Group

Those who foresee the invisible can achieve the Impossible….


GLOBAL PERSPECTIVE


In response to all these opportunities, US and European pension funds are ever increasing the amount of capital they are willing to allocate to India and emerging markets. More and more fund managers are finding that an excellent track record will be rewarded with the opportunity to take on the emerging market portfolio. The idea is that a fund manager who can handle the NYSE can handle the SENSEX. This may not turn out to be true. It may not be smart that people who have had little personal experience in India increasingly manage financial portfolios in India. Local fund managers, especially local hedge fund managers are a new and fairly small breed. Without true local knowledge one can expect foreign fund managers to have their missteps. India would be better off with its own hedge funds and local traditional managers rather than simply relying on the foreign fund managers.

But, as long as India de-pends on foreign capital and foreign expertise in the asset management are-na, there will be a vulner-ability to global financial conditions. Indeed, some of the boom in India’s capital markets may be at least as attributable to global financial conditions as to organic growth. India may have a fabulous story to tell but it is still only one of many characters on the global financial stage. Even as many Indian businessmen are hard at work building the future world economy, policy makers in central banks are increasingly concerned that there is simply too much cash in the world economy chasing too few genuine investment op-portunities. Risk premia and volatility are at record lows in almost every asset class from commodities to foreign exchange to equities to bonds. The Fed-eral Reserve, the ECB and even the Bank of Japan are all slowly withdrawing liquidity from the world economy. Recently the new Federal Reserve Chair-man, Dr. Ben Bernanke, warned that there are more rate hikes and more inf lation risk to come. All this will, sooner or later, have an impact on India.

There are several simple questions which now confront India: first, why would an investor hold an emerging market portfolio that now returns an average of 5% when Fed Funds cash is going to pay the same? Or, put another way, can India outper-form all the other emerging markets once cash is

less cheap and less freely available? Another way to think about this issue is to ask whether India’s companies have the discipline to pursue business plans then will remain profitable even if the cost of capital goes up. Finally, one has to ask whether India’s economic boom is fundamentally organic whether it is fundamentally dependent on global financial conditions.

No one likes being asked these questions. It dis-rupts the party. After all, India is about to replace China as the darling of the front pages of business magazines around the world. This, of course may be exactly the source of the problem. In recent years, the private equity returns in China have been f lat to negative while those in India have tripled. That’s

what usually happens when a country is a me-dia darling. Being on the front page kills your mar-ket. Already the world’s retail and institutional in-vestors have decided that India is the right place to be. Whether India follows China’s example and al-lows the weight of capital to break down discipline

and cause returns to diminish, depends on how businesses and entrepreneurs put this huge wave of capital to work.

Some businesses will be much disciplined as they prepare and pursue their business plans. Smart managers will not assume that today’s easy money will be available tomorrow. But, some businesses will assume that the good times are here to stay. They will say that India is no growing at about 7% but it is capable to 20%. The reality is that a good deal of work will have to be done before India can reach a higher growth potential. It is possible to achieve this. But, one of the most important tests will be how India handles a downturn in the world economy.

Until now, investors have been rewarded for buying absolutely every business they can find in India. Going forward global conditions may cause investors to start distinguishing between good qual-ity and poor quality management. While this will be painful for some, it is also important to push capital away from the weaker players and towards the stronger ones. Businesses that cannot generate cash f low should not survive.

The US is currently sorting the weak from the

There is simply too much

cash in the world economy

chasing too few genuine

investment opportunities


SECURITY MARKET


management intelligence centre.

strong. Chairman Bernanke has now given all of us fair warning that interest rates in the US are likely to rise. The Federal Reserve has been es-pecially impressed with the way in which many small and medium sized businesses are growing strongly. These firms generate more than two-thirds of the 200,000 jobs that the US is creating every month. Their growth is supporting and sustaining the US economy. These small entities are the source of all the IPO’s, which are now as numerous as they were during the dot.com boom. But, some large, not well-managed firms, including Amtrak, United Airlines and General Motors are finding that rising interest rates are slowly pushing them toward the cliff of insolvency. And one must keep in mind that the spread between high credit risk bonds and low credit risk bonds is very small. In other words, some firms are in trouble even be-fore interest rates really rise. Many more will be in trouble once credit spreads starting to widen.

Is India preparing to compete for capital or are Indians assuming that capital will continue to

f low freely into their businesses? When US, European and Japanese pension funds, institu-tional and retail inves-tors are making record allocations to emerging markets in general and to India in particular, it becomes easy to take this fact for granted.

India has some genuine advantages over China and many other emerging markets. For one thing, India has a strong tradition of accountancy. Some may say that having too many accountants around is generally a problem. But, the reality is that most business people in India fundamentally understand cash f low. This is in sharp contrast to China, for example, where business managers are focused on market share, scale and production. The more you make, the bigger you are, the more successful you are. As a result, many Chinese businesses are losing money at an alarming rate in spite of their cheap labour costs. Size is not the same as profitability. The discipline required to make this important distinction is well in place in India.

There will those who argue that global condi-tions have nothing to do with India’s situation. The growth of Indian businesses is not dependent on global liquidity conditions. But, it is hard to dismiss the fact that emerging market investors are cur-rently maximum long India, Turkey and Brazil. All these countries appear to many to be a one-way bet. The only problem is that there is no one-way bet in financial markets. The likelihood is not that the Indian economy will stumble. The likelihood is that the global financial markets will stumble under the pressure of higher interest rates and this will have an effect on India. Again, if interest rates are going up in the US, Europe and Japan and even China is trying to slow down the extension of credit, then one has to assume that investors will not remain long emerging markets or long US domestic credit market or long any other so-called “high yield” investment forever.

Of course, even without a global liquidity ad-justment there are important pressures at work in India. There is an old joke about the “Indian rate of growth” which is that this rate was inherently very low. But, if one looks around the world, it is easy to see that the rate of growth of Indian owned businesses in any location other than India

India has some genuine

advantages over

China and many other

emerging markets


GLOBAL PERSPECTIVE


is astonishingly high. Indi-ans are now the wealthiest immigrant group in the United States. The Indian rate of growth is very fast indeed, as long as it is not bogged down by the various constraints that are present in India itself.

The growth rate is obvi-ously being slowed by lack of infrastructure, especially transportation infrastruc-ture. Expectations abroad are high. If India does not get smart new airports and spanking clean trains to ferry you from the airport to the city centres within a couple of years, foreigners are bound to be disappointed. This will eventually affect the pace at which foreign capital f lows into the country. Frankly, even Indian busi-nesses have begun to reach the limits of growth in India. We are already seeing more and more acquisi-tions of foreign firms by Indian firms. It is simply faster to buy into foreign markets than to wait for India to build infrastructure and grow its markets at home.

Lucki ly there are many Indians who have been educated abroad and who have extensive man-agement experience are increasingly incl ined to return home in order to launch the next wave of companies, which wi l l eventual ly go publ ic. The domest ic educat ion system has now become a model of achievement. The Americans and Eu-ropeans who know about the high standards in India are also wel l aware that the people you reject from your universit ies go to MIT as a backup. What hope does an American or Euro-pean have of gaining entry into one of India’s best universit ies?

While education is essential, entrepreneurship is even more important. The entrepreneurial spirit is perhaps India’s greatest asset. But entrepreneurs will still need more energy and more infrastructures in order to build tomorrow’s companies.

Perhaps the most interesting recent development is the nuclear deal the US and India is proposing to enter into. Interestingly many foreign fund man-agers are unaware of this proposal. It has not yet been fully discounted by the financial markets. Basically, the US is offering to allow India access to all high tech associated with the nuclear fuel cycle even though India in not a signatory to the

Non Proliferation Treaty (NPT). Ever since India began testing its nuclear capability the US and other countries have pe-nalised India by cutting off the access to high tech in a variety of ways. Now, the US believes that India is clearly in need of a more reliable energy supply and also very unlikely to pro-liferate nuclear technol-ogy to the wrong people.

India should be able to now be able to pursue the nuclear fuel cycle without constraints. Of course, this would allow India to leapfrog a generation in technology and infrastructure. You can build as many shiny new airports as you want if you have unlimited supplies of nuclear power.

The nuclear deal also reveals that both the US and India want India to have a greater voice and a greater capability in global affairs. The US is es-sentially supporting India as a regional superpower. India too wants relatively greater role to play on the global stage.

One would have to bet that more IPO’s and more growth will emerge as a result of this nuclear deal, should the Congress, in both the US and India, vote for it. The combination of an enhanced en-ergy capability, plus technology transfer, plus a greater role for India to play in global diplomacy will together create amazing opportunities for risk taking.

The final infrastructure issue that India must address is water. Both India and China suffer from enormous water shortages. One can easily see that growth in India will raise incomes and living stand-ards. People will want to eat more and better qual-ity food. Without water, the agricultural system of India will not be able to keep pace with rising demand. This has the potential to generate bottle necks and inf lation in India which would under-mine the activities of all businesses. It sounds odd, but India’s ability to keep generating new IPO’s will eventually be threatened by the lack of reliable water. Of course, this practical problem will no doubt attract the attention of some of India’s best risk takers who will figure out how to solve this. But, in the meantime, water shortages are as seri-ous a constraint on growth as the lack of reliable energy. �

The combination of an

enhanced energy capability,

plus technology transfer,

plus a greater role for India

to play in global diplomacy

will together create amazing

opportunities for risk taking


SECURITY MARKET


Fund Managers Find Passage to

Should you Follow?

By Gareth Lynos Fund Analyst, Morningstar


GLOBAL PERSPECTIVE


Diversified portfolio managers typically stick to developed markets when sizing up opportunities. Lately, however, an

increasing number of managers are venturing be-yond the cozy confines of the United States and Western Europe and are snapping up shares of emerging-market companies. As a result, Indian stocks are cropping up with increasing regular-ity in nonemerging market funds. At the top of the list is Janus Contrarian Fund JSVAX. A fund that has typically stayed within US borders, it cur-rently has devoted 21% to Indian stocks. Sibling Janus Overseas JAOSX has lots of exposure to the country, too – although this is less of a surprise, as emerging-markets have always been an active hunting ground for this aggressive foreign-growth offering.

The macro-economic backdrop for India is cer-tainly alluring. And while the country doesn’t get the same level of media at-tention that China does, its huge population and rapid economic growth make its potential just as strong. What’s more, unlike Chi-na, India is a democracy, and capitalism seems more apt to f lourish in a coun-try where there is at least some respect for property rights. India’s explosive growth has owed more to entrepreneurial initiatives than government-sponsored programmes. It doesn’t hurt that it has a well-edu-cated labour force made up of many English speakers. That makes it particularly attractive for US- and Brit-ish-based multinationals that wish to do business there. The country’s po-tentially huge consumer market is perhaps its big-gest draw, however. India’s burgeoning middle class, which has been responsi-ble for the surge in loan and mortgage activity in recent years, has been beefing up its consumer spending at

a rapid pace. The numbers back up the anecdo-tal evidence, too; the Indian economy grew by a whopping 8% in 2004 and is expected to grow at a similar rate in 2005.

Is the Timing Right? As enticing as all that may sound, there’s plenty

of room for skepticism – at least in the near term. For starters, the Indian stock market has more than doubled in value over the past three years. And even though earnings growth has accompanied the rise in stock prices, many experienced international managers who are longtime observers of the region are beginning to reduce rather than add to their India holdings. Frances Dydasco of T. Rowe Price New Asia PRASX (a Morningstar Fund Analyst Pick) is bullish for the long term, for example, but she has been taking profits, as valuations have risen. Dennis Stattman, who runs Merrill Lynch

Global Allocation MD-LOX, has grown cautious, too, pointing out that the rapid ascent in Indian stocks’ rally has caused their valuations to rise to a level commensurate with those of US equities. Stattman remains posi-tive on India, although he has been selling some names into strength. Ben Inker of value shop GMO (Grantham, Mayo, Van Otterloo), who sub-advises Evergreen Asset Allocation EAAFX, isn’t buying the hype, either. Although he’s bullish on emerging markets overall, he thinks company valu-ations are not attractive in India.

Of course, emerging-market bulls – especially those from the growth camp, including Brent Lynn of the aforemen-tioned Janus Overseas – aren’t as stressed out about valuations as some of the value hounds men-tioned in the previous

India’s explosive growth

has owed more to

entrepreneurial initiatives

than government-

sponsored programmes


SECURITY MARKET


paragraph. They argue that picks such as Reliance Industries and Tata Iron & Steel are global businesses growing at a much faster pace than most other US stocks.

Paper Tiger? That may be so, but

they’re also bound to be much more volat i le, mainly because most of the risks inherent to other emerging markets st i l l ap-ply to India. The govern-ment cont inues to enforce extremely protect ionist pol icies, l imit ing foreign ownership in many Indian companies to about 25%. Having come to power in early 2004, the Congress Party of India has dramat i-cal ly slowed down the pace of privat isat ions, too. In-dustries, such as banking and insurance – the back-bone of most f inancial markets – remain heavi ly restricted and government control led.

The logist ics of doing business in India can be extremely chal lenging, too, due to the country’s abysmal infrastructure. Inadequate transporta-t ion routes have deterred many foreign manu-facturing companies from sett ing up faci l it ies there.

India certainly isn’t immune to external shocks, either. Sustained higher oi l prices could spel l trouble, for example. Over the past year, India’s trade surplus has disappeared, thanks to the rising cost of oi l imports. Further deteriora-t ion in its balance of trade could sway foreign investor conf idence.

And that’s not al l. R ising US interest rates could present another potent ial f ly in the oint-ment. Higher yields in the US or the Eurozone might wel l inspire investors to reduce their ex-posure to far-f lung risky asset classes such as emerging-market stocks and bonds. And while

the possibi l ity appears to be extremely remote, an outbreak in avian f lu would be part icularly crippl ing for India, given its high populat ion den-sity and poor health-care system.

Liquidity RisksIndia’s somewhat

pokey stock market could easi ly exacerbate those risks. Its market has gained more depth and eff iciency over the past few years. Trading can st i l l be thin, though, making it hard for man-agers to init iate or l iq-uidate posit ions without negat ively impact ing stock prices. We con-t inue to hear concerns from managers about how many Indian stocks lack the broad share-holder base of other de-veloping markets, such as Hong Kong or South Korea. That means fast-er-money players, such as hedge funds, can sway the market signif icant ly

when trouble hits and they run for the exits. In May 2004, the market tanked 25% in one day amid surprising elect ion results.

The Takeaway Given the risks, India fans would be much bet-

ter off invest ing in a broader diversif ied emerg-ing-markets fund than in an India-only fund. Our Analyst Picks in the diversif ied emerging-market categories and Pacif ic/Asia ex-Japan offer a great way to get started. That said, now is not the t ime to jump in with both feet. The growth prospects for emerging markets are compel l ing, but there are bound to be some bumps along the way. For that reason, we suggest investors dol-lar-cost average their exposure and devote only a smal l port ion of their overal l portfol ios to this rout inely volat i le asset class. �

The logistics of doing

business in India can be

extremely challenging,

too, due to the country’s

abysmal infrastructure


TRENDS


Management Intelligence CenterFIIs Moon Dance in Indian Stock Market

by IIPM Think tank

Indian growth story needs sustained

foreign capital which comes through FDI to

complement hot FII


SECURITY MARKET


Whenever we talk about Indian Stock Market wand its performance the much-roared-buzzword which comes to

anybody’s mind is Foreign Institutional Investors (FIIs). For the past few years, Indian markets have acted as a tantalising dance f loor for the FIIs whose steps have been rocking incessantly. Continuing the bull trend, 2005 was another remarkable year in Indian stock market history when the party began with the Sensex beginning at 6680 mark and ending near to 9450 marks registering whopping 41% growth. But, before one starts cherishing the way Indian Stock Markets have behaved, there is a l ittle cause of worry which needs a slight atten-tion. With a deeper probe one can conclude that the entire party hosted by the Indian Stock Markets was honouring the foreign guests popularly named as “Foreign Institutional Investors (FIIs)”.

When we say Foreign Institutional Investors it is not a new phenomenon in the Indian Stock Mar-kets. FIIs have been optimistic about India since their entry in 1992; but the honeymoon appears to have begun only after 2003. During the past three years (as can be seen from the graph below) phenomenal investment has been poured in by FIIs in the Indian Stock Markets.

Movements in the Sensex during the past three years have clearly been driven by the behaviour of foreign institutional investors, who were respon-sible for net equity purchases of over US $8.5 bil-l ion in 2004 and US $10.7 bill ion. 2005. One can easily look at the positive correlation between the movement in Sensex and the inf lows by FIIs. The FIIs investment increased from meagre US $0.74 bill ion in 2002 to whopping US $10.7 bill ion in

2005, recording a compounded annual growth rate of 142%. During the same period Sensex increased from 3000 levels to 9000 levels. There is no doubt that FIIs are the prime drivers behind this Bull Run, but at the same time they are also the ma-

jor cause of volatil ity in the market. For instance in the month of October 2005 itself Sensex lost around 1100 points or around 13% from its peak of 8799. FIIs sold only half a bill ion US dollar worth of stocks which led to 13% fall in Sensex. It is not difficult to imagine that what could have happened had they sold US $3-4 bill ion worth of stocks. Besides, it is not a rare possibility as death carries no calendar.

The situation becomes perilous when one looks at the sources of the FIIs f low in India. The major FII inf lows are from USA, UK and West Europe. US alone accounts for about 42% of FIIs f low in India which makes Indian Stock Markets vulner-able to US markets.

The major reason why these FIIs are investing in India is the high net disposable income, bear-ish market, and low interest rates in their respec-tive countries. It is a great risk to India since once the interest rates in their countries will increase then we will see a profit booking and move away

(Source: SEBI)

(Source: SEBI)

FIIs investment increased from meagre US $0.74 bn in 2002 to whopping US $10.7 bn in 2005, recording a

compounded annual growth rate of 142%


TRENDS


trend from these FIIs. The year 2005, indicated the optimistic sentiment of the worldwide inves-tors towards India.FIIs from Japan and Taiwan are now sustaining the romance, going past telecom and IT to sectors like autos, gems and jewellery and media to take the FII inf low to a whopping US $10.7 billion in 2005. The trend continues in the New Year 2006 as Sensex approaches a landmark 10500 points.

So what if more dollars f low in? The Finance Minister P. Chidambaram may not bare his wor-ry, after rejecting a proposal on capping FIIs from Reserve Bank of India Governor Y.V. Reddy in 2005. Chidambaram hopes that the market would respond in a measured manner. Now he seems to be much concerned for the Sensex rally to touch 10000 marks, as a result of which the regulatory body is now set to allow the short selling by FIIs (which was banned after the market crash on May 17, 2004, the so called “BLACK MONDAY”).

Regulators are in a state of dilemma, as on the one hand FIIs provide liquidity to the market but on the other hand they can take the market to ransom by creating a situation of boom and slump. On the other hand Retail investors cannot match the finan-cial resources of FIIs, who take blue-chip stocks like National Thermal Power Corporation (NTPC), Oil and Natural Gas Company (ONGC) and Tata Consultancy Services (TCS) to glorious heights and make a success of their mega public offers.

With huge stakes by these funds in Indian com-panies, they can cause havoc in the markets once they start disposing their stake due to unfavourable circumstances. It is more lethal for the small inves-tor who, enticed by upswings, puts his hard-earned money into the stocks only to lose when stocks crash after FIIs pull out.

This experience sends out two messages. The first is that, if market expectations can turn so whimsi-

cally, the signals or rumours on which they are based must lack any substance as any ‘’fundamen-tals’’ like growing corporate Profits, on which they could be anchored have not shifted so violently. The second is that there must be some unusually strong force that is determining movements in the market which alone can explain the wild swings it is witnessing.

The combination of these two factors is indeed a confusing phenomenon, since if some force has the ability to lead the market and the others can be taken along without much resistance, the market is in essence being subjected to manipulation, even if not always consciously. Not surprisingly, recent market developments have once more focused atten-tion on the volatility that has come to characterise India’s stock markets. The economic and political risk in the western countries could well be the title of the saga of Bull Run on Indian bourses, being directed by foreign institutional investors (FIIs).

The increasing investment by Foreign Institu-tional Investors can not only become a cause of worry for capital markets but it can also create economic instability. It can make our balance of payment position more turbulent.

Relation between Fii investment and exchange rate

It has been seen over the past four years that the relation between FII investment and exchange rate is highly negatively correlated (-0.8). The rupee value appreciated as FII investment increased and vice versa. Moreover, over the past two years the hot money by FIIs as a percentage to total Forex Reserves has increased to about 10% which can be a major sign of worry for our balance of payment position. As can be seen from the graph that as FII

(Source: SEBI-2004)

(Source: BSE, SEBI)


SECURITY MARKET


investment has increased over the past few years the exchange rate declined which led to apprecia-tion of rupee in comparison to dollar, resulting in cheap imports. But being hot money we can never say when this money will f low out and whenever it will happen it will create havoc on our balance of payment. In a way we can say if the trend continues FIIs will not only capture our capital markets but also play with our economic system.

So, at this juncture it is worth thinking about a solution if we don’t want to put ourselves in a jit-tery situation like in early nineties. The solution is not difficult to understand if we put our attention to the most happening country in the world today, China. Being an Asian country and with similar demographic conditions one wonders how come one country (China) from same region has grown at such a huge pace while for the other (India) it is still a utopian dream. Secondly, the question is not only of achieving a certain growth rate but of sustaining that growth rate. The answer is short and simple “Foreign Direct Investment” (FDI). Last year, China was able to attract US $60 billion FDI investments while India attracted only about US $5 billion.

If we look at the FII and FDI comparison in In-dia over the past four years we can see that FII investment has always been more than that of FDI

investment.We can see from the figure that FII investment

has been almost doubled to FDI investment in In-dia in almost every year from 2002 to 2005. Here is a major difference between the two countries. India is totally dependent on FII but China on the other hand has sustained tremendous growth though FDI.

By any means, FDI is far better measure than FII

as FDI comes with a lock-in period so it cannot go out of the country. Moreover, it helps in stabilising an economic system, unlike FII which can put the entire economy into trouble. If we compare the FDI investment in China with that of India the scenario becomes crystal clear as to why China is “The China’ today.

India has not been able to attract as much FDI as China has because India is not as attractive as China mainly due to the poor infrastructure and political restrictions. The Chinese infrastructure is really world class and alluring the western countries and their political environment is really favourable for FDI. Besides, one of the most important factor behind huge FDI in China is the f lexible labour laws. In China, labour laws are very f lexible and soothing for foreign investment which helps it to attract a colossal Foreign Direct Investment. In contrast, India has a very rigid labour law system which prevents us to attract FDI.

To conclude one can say that though FIIs at present are enjoying their moon dance in the Indian capital markets but it can prove out to be an extravagant party hosted by Indian capital markets as they can start dancing on a different tunes at any time. l

(Source: SEBI, RBI)

(Source: Govt of China & SEBI)


TRENDS


Foreign participation is always

welcomed provided the origin of such

investment is genuine

PARTICIPATORY PARTICIPATIONPARTICIPATORY


SECURITY MARKET


Welcome to the year 2006 when everything is set for record highs to be reached. Eve-rything, be it in political front or in social

front or in economic front, is indicating only one fact that this time India is going to become the front run-ner Asian Tiger. From the past six months sensex has witnessed a northward trajectory in the most sustained bull run of Indian capital markets ever. The major contributor owing to it comes from none other than Foreign Institutional Investors (FIIs) which have always acted as a catalyst in the sensex movement. With an investment of US $10.7 billion in 2005, the highest ever investment in any single year, FIIs are acknowledging the Indian growth story. Any potential investor would believe that this is the most favourable time to invest when he looks at the way FII’s have behaved in the past one year.

A very bight future for investments indeed. Eve-rything seems perfect, and why not, when even the FIIs have shown their high level of interest in Indian Corporation. All said and done, but the reality lies that the source of FIIs investment is still unknown.

FIIs can access the Indian capital market through three routes. Depending upon the nature of invest-ment and investors these recognised routes are classi-fi ed fi rstly by registering themselves as full-fl edged FIIs with Securities and Exchange Board of India (SEBI), secondly by registering themselves as sub-accounts of a sponsoring FII with SEBI and fi nally indirectly through Participatory Notes (PN, offered by regis-tered FIIs or FII sub-accounts). The deepest loophole that still remains to be seized is the Participatory Note route of FIIs investments. Participatory Notes are in-struments used by foreign funds/investors who are not registered with the SEBI but are interested in taking exposure in Indian securities PN are generally issued

overseas by the associates of India-based foreign bro-kerages. Participatory Notes account for almost 44% of the US $10.7 billion invested by FIIs. How astonish-ing it sounds that even at such a high percentage of foreign investment the real identity of the investor is not known even to the regulatory body, leave aside a glimpse of it to the retail investors. The enquiries by

SEBI with regards to disclosure of Participatory Notes are confi dential in nature and the details of the same are not available in public domain.

Quite often investors who are eligible to get a FII or FII sub-account registration do participate in the Indian market through PN. The determinant of this very fact lies in the procedural issues relating to registration, establishing broker and custodian rela-tionships, undertaking forex transactions and more importantly, dealing with tax certifi cations, fi ling of income-tax returns and getting tax assessments com-pleted. A consequence of this has led PNs preference to avoid procedural hassles and uncertainties about tax. A drastic simplifi cation of these procedures can be the death knell of PNs. PNs do increase transac-tion costs for the genuine investor. The existence of robust competition ensures that the additional trans-action costs are in line with the level of comfort and convenience of on offer.

Having said all that one apprehends that are our

securities secure enough to any manipulation with the existing mechanism of this PN route? Practically not! First of all we do not know exactly what makes FIIs interested in India owing to no particular trend being witnessed. So we do not know when they will make the investment and when they will withdraw from the market. It creates a lot of volatility in the market. Secondly, to complicate the matters further we do not have a trace of their identity. So, we do

not know who exactly is fl owing in and fl owing out. Although PNs should not be considered as a fruitful easy mean of undesirable money to be channeled into the Indian market, the popularity of PNs even after the new stipulations and reporting requirements has not seen a decline. This is despite the additional risk that an investor using the PN route assumes on the

How astonishing it sounds that even at such a high percentage the real identity is not known even to the

regulatory body leave aside a glimpse of it to retail investors

PARTICIPATORY PARTICIPATION PARTICIPATIONby IIPM Think tank


TRENDS


credit worthiness of the PN issuer. Thus, we are just a mere spectator of a game in which neither we can see the players nor we can understand the rules of the game.

There should be no doubt that the pace at which the Indian markets have moved so far this year has left regulators worried about possible misuse of P-Notes. FII investments, directly and through the PN route, have provided the biggest liquidity support to the cur-rent Bull Run. FIIs are not allowed to issue P-Notes to Indian nationals, persons of Indian origin or overseas corporate bodies. This is done to ensure that the P-Note route is not used for money laundering purposes In recent years, with the number of FIIs getting regis-tered in the country shooting up, the government has, on occasions, mulled on the issue of market integrity. The market integrity concerns could get heightened when funds of unknown source or arising out of laun-dered money are involved. This in turn can attribute to the very fact that the market regulator would have a bias in favour of FIIs from those countries, with which India has a co-operation accord.

In order to seek a better probe and insight to the PN issue the government has rightly exercised the three-year time frame which has come into effect from February 2004, when SEBI issued the notifi cation bar-ring FIIs from issuing PNs to any unregulated entities. According to it the existing non-eligible PNs must be permitted to expire or be wound down within fi ve years. Whittling the time frame to three years is felt desirable on the condition that the life line is too long. The proposal to work out a list of negative tax havens recommended still has not worked out well and has

left many stones unturned. Unregulated entities are not controlled by market regulators in the originating countries and follow little disclosure norms in the In-dian capital markets. In order to protect the interest of its own retail investors, much more emphasise should be laid down in bringing out more transparency to the whole route and mechanism of participatory notes.

Sustaining and stabilising interest rates, price levels and exchange rates by prudent monetary policies can provide a check on market volatility of FII invest-ment .As a mere step of banning PNs and generating complications than simplifying the ways can hardly be a solution to what is essentially a problem of opera-tional rigidities in the system. The biggest advantage of foreign investment is supplementing the domestic savings to accelerate the economic growth of the coun-try. Therefore in order to safeguard the interest of the economy and retail investors in the capital market, a better and improved net should be put into place so that the large as well as small unnoticed but important FII fi sh can be trapped and traced properly. The need of the hour is to provide a stable and concise plan of action to strengthen the system against any kind of volatility. One has to admit a fact that there is a clear correlation between effi cient capital markets and eco-nomic development.

For the optimal functioning and performance of capital market it is essential to have a diversity of investors with differing investment philosophies and investment horizons. One is always driven by dreams but should always abide by reality. When the stakes are so high the returns and risks should not be a matter of chance but a refl ection of right decision and alert mind. After all, the securities are meant for keeping an investor ‘secure’ rather than exposing him to the realms of those whose motives fl uctuate and most importantly their identities are neither traceable nor reliable……! �

Much more emphasise should be laid down in bringing out more transparency to the whole route and

mechanism of participatory notes


T H E I N D I S P E N S A B L E F A C T O R

THE HUMAN FACTOR

Perf

orm

ance

... . . .Beyond the pyramid


TRENDS


Penny Stocks Penny In


SECURITY MARKET


September 22, 2005 was another brutal day in the history of Indian Stock markets when the Sensex fell by 266 points or 3.31% to close at

8,221.64 on the rumors of income tax raids on a few brokers in Gujarat. The entire market was in panic and then suddenly news started coming out from the Finance Minister from New York – where he was attending an investor conference – that markets are in comfort zone since profit to earning (P/E) ratios are within limits, in order to cool down the atmosphere. Similar statement came from Securi-ties and Exchange Board of India (SEBI) chief M.

Damodaran that there is no evidence of scam or financial irregularities.

But fire can not break out without a spark. Be-hind all this hue and cry there was a foul play being played that came into light in the days to follow. SEBI banned promoters and directors of Minal Engineering and IFSL Ltd. from dealing in these stocks and it also banned various stock broking firms like India bulls Securities Ltd., Fortis Securi-ties ltd, to name a few, from dealing in securities of IFSL. Bombay Stock Exchange (BSE) suspended trading in 13 companies from October 4, 2005. All this was the result of a probe done by SEBI in small companies which are known as – “Penny Stocks” – a word which was little known in the Indian Capital markets before this crash. SEBI, which intensified market surveillance in September, 2005 analysed 900-1000 penny stocks for unusual movement in share prices during a short span of time.

Lethal for

vestors

All this was the result of a probe done by SEBI in small companies which

are known as – “Penny Stocks”

Time and again it has been proved that

fortunes can be made by fundamental

investments, and not by greedy speculation

by IIPM Intelligence Unit


TRENDS


Penny Stocks as the name suggests are the stocks of companies that have a market price less than its par value. The fundamentals of these compa-nies are very week and their turnover is very low. In some cases, these companies have no physical presence which means they have no offices and no operations. Most of the times, these stocks remain illiquid and technically speaking they come under B2, S, T and Z categories.

In 2005, these penny stocks were portrayed as the golden feather in the cap of booming stock

markets in India. But the entire shine of these sparkl ing diamonds dwindled within a short span of one year.

If we look at the growth rate of penny stocks as compared to large cap stocks some shock-ing f igures creep up. The Compounded Annual Growth Rate (CAGR) in Price Turnover for A group stocks in BSE for the period of January 2003 to January 2006 is 17% while CAGR for B2 and Z group of securit ies which comprise penny stocks for the same period was 116% and 345%. Not only in price turnover but in volume turnover also the story is no different. If we look at the number of shares traded during the same period

A Group stocks have shown a negative CAGR of –1.5% while the B Group and Z Group stocks have shown CAGR of 46% and 208% respectively.

The turnover volati l ity of B2, S, T and Z group of BSE in 2005, which comprised the penny stocks, was much higher than the A and B1 category com-prising of large cap and mid cap stocks. It shows the enormous activity done in these companies to generate momentum in order to attract retai l investors. Now, looking at this huge growth in penny stocks the obvious question which arises is what was the regulator doing during this t ime period? Could they have not probed these things earl ier when such a huge growth was happening in these i l l iquid stocks?

Another dimension to this i l legit imate growth story is the role played by Foreign Institutional Investors (FIIs), Promoters & unscrupulous bro-kers in rigging prices of the penny stocks during this period. Since the major force lying behind this bull run which started from mid 2003 is FIIs, one need to know their concealed investment objec-t ives in India besides the projected growth story of India. They have pumped in huge money in our markets during the same period in which these penny stocks have seen some strong growth. This high degree of correlat ion between the FII invest-ment and the increasing valuations of worthless penny stocks needs some amount of exploration. If one analyses the entire situation, then the nexus between promoters, FIIs and the operators in ma-nipulating the prices of penny stocks inevitably creep up. Even if we try not to bel ieve it the facts in front of us indicate that the manipulation at large scale was done in such stocks. The cal lous steps taken by SEBI l ike barring promoters of companies from trading and barring some brokers to trade in companies; stock exchanges suspend-ing trades of some companies; and news of block deals being done by FIIs in penny stock companies

Sour

ce: B

SE

Source: BSE

Then all of a sudden SEBI aroused and

started probing these stocks and came

out with plethora of reform measures like

putting circuit filters on these stocks and

de-listing some of these stocks just to

aggravate the situation for retail investors

by making them illiquid


SECURITY MARKET


indicate that again a major f law in regulat ion of stock markets led to another stock market scam “The Penny Stock Scam”.

It is a well planned scam and was committed through a pecu-l iar modus operandi. Init ial ly the promoters of these penny stocks sold their stake to big players l ike FIIs and operators in order to create l iquidity in theses stocks. These players started heavy trad-ing in such stocks which created l iquidity and brought them into l imelight in order to attract re-tai l investors. In the meantime, these companies came out with big news of Mergers or American Drawing Rights (ADR)/Global Drawing Rights (GDR) issues or in some cases declared dividends. Through al l these they manipulated and rigged the prices to such an extent that these stocks became darl ing of the market and retai l investors started investing in these stocks at exorbitant prices. This was the ripe t ime for these manipulators to get out of the market mak ing the penny investors the k ing of the penny stocks. This is how this ent ire fake k ingdom was created. Then a l l of a sudden SEBI aroused and started probing these stocks and came out with plethora of reform measures l ike putt ing circu it f i lters on these stocks and de-l ist ing some of these stocks just to aggra-vate the situat ion for reta i l investors by mak ing

them i l l iqu id. Now, it becomes very d iff icu lt for reta i l investors to get out of th is k ingdom as there are no takers. On the other hand big boys have taken their f lesh and current ly they have entered into large cap stocks.

But , fortunately or unfortunately, the ent ire euphoria about th is new avatar of stocks met a

trag ic end with in a short t ime span of one year in 2005.

It is qu ite evident from the graph that the penny stocks (four companies on which SEBI has ordered invest igat ion are taken as a sam-ple) were at rock bottom levels in the start ing of 2005, but with the pr ice r igg ing mechanism their pr ices were r igged which peaked at around September-October 2005. It was the same period when SEBI started probing these companies, after which their pr ices started dwindl ing and current ly they have met their dest iny. Look ing at the pattern of ownership in most of these penny stocks one rea l ises that the majority of ownership of these stocks is with the publ ic today.

To conclude one can now analyse and enter into an unending debate whether th is was a scam or not; whether regulator wake up at t ime or not and so on. But the rea l ity remains that the invasion has been done in the same manner in which it has been done through out the h istory of India. The nomenclatures have been changed but the ways are same. Earl ier invaders used to come with the names of Timur Lenk or Alex-anders who with the support of t ra itors l ike Ja ichands used to invade the country and the only sufferer was the common man. In the same manner, with a l it t le bit of sophist icat ion and technologica l advancement, Foreign Inst itut ion-a l Investors (FIIs) invade us with the support of unscrupulous operators and promoters, but the sufferer remains the same – the common man – technical ly ent it led as the gul l ible reta i l investor. �

Then all of a sudden SEBI aroused and

started probing these stocks and came

out with plethora of reform measures like

putting circuit fi lters on these stocks and

de-listing some of these stocks just to

aggravate the situation for retail investors

by making them illiquid


The Hidden Gems

Are Small and Mid Cap stocks for you

TRENDS

by Ashish Chugh, Investment Analyst, Hidden Gems Advisory


SECURITY MARKET


Until recently, small and midcap stocks were under-appreciated as a class, espe-cially amongst institutional investors.

This was primarily because of a number of fac-tors – most common being the herd factor – the tendency to imitate others without thinking of the results which most fund managers and investors tend to follow. A few years back most funds had investments only in the frontline stocks and the small and mid caps found hardly any place in most fund portfolios.

It is no wonder that fund managers tend to be squeamish in their stock selection. This is prima-rily due to the fact that the performance of the fund and the fund manager is evaluated on daily, weekly and quarterly basis putting the fund manager under extreme pressure and stress. The fund is expected to outperform the peer group by greater increase in the Net Asset Value (NAV) of the fund compared to the peer group. The fund manager thus feels more comfortable in buying the better known stocks since the other funds are also buying them.

A Fund Manager may not be fired if he has bought Infosys or Reliance and the price drops but he may lose his job if he buys a Karur KCP Packaging or Kothari Product or for that matter any second rung stock and the stock goes down. The most common human behaviour in the event of price a large cap stock dropping and a small or mid cap stock dropping is given below:

• If the price of Infosys goes down – WHAT IS WRONG WITH THE COMPANY?

• If the price of a second rung stock goes down – WHAT IS WRONG WITH THE FUND MANAGER?

Investment in Small and Mid cap stocks has its advantages, however the risks associated with in-vesting in such stocks should also be understood by investors before they take a plunge into buying these stocks.

The benefits first – The first place you can start is the obvious: the most successful companies today started as small companies. Did you know that when Infosys came out with its IPO at Rs.95 in 1994, there were hardly any takers and the issue devolved on the underwriters? The market capi-talisation of Infosys was just under Rs.350 mil-lion when the company came with the IPO, the company today commands a market cap close to Rs.800 bill ion.

Who knows where the next Infosys is coming from, but it will certainly start out as a small com-pany.

Here are some other good points about small cap stocks: • It is easier to double the sales of a company

doing Rs.500 million per year than it is to dou-ble the sales of a company doing Rs.20 bill ion in sales. Rapid growth is easier for small cap stocks.

• Smaller companies can “f ly under the radar” of intense market attention longer. This keeps the price from being bid up too high or knocked down too low. Most mutual funds, for instance, don’t invest in small cap stocks. (The excep-tion, of course, would be funds that specialise in small cap stocks.)

• Small companies tend to be more nimble and react quicker to market and technological con-

ditions. Small companies can exploit opportu-nities that larger companies cannot afford to chase because of their huge overhead. Moreo-ver, with decision making centred around one or two persons, decision making process is much faster.

When investing in stocks, the risk that you will

Smaller companies can “fl y under the radar” of intense market attention longer


lose some or even all of your money is very real. This is true regardless of what kind of stock you own – blue-chip, small-cap, market leader, what-ever. But in general, investing in small-caps – espe-cially stocks of fast-growing small companies – is considered to be on the highest end of the risk scale primarily because of the following factors:

Company RiskInvesting in Small and Mid Caps is based on

the premise that these companies will increase their earnings and grow into larger, more valuable companies. However, as with all equity investing, there is the risk that a company will not achieve its expected earnings results, or that an unexpected

change in the market or within the company will occur, both of which may adversely affect invest-ment results.

VolatiltyHistorically, small and mid-cap stocks have ex-

perienced greater volatil ity than other equity asset classes, and they may be less liquid than larger cap stocks. Thus, relative to larger, more liquid stocks, investing in mid-cap stocks involves potentially greater volatil ity and risk. The biggest risk of eq-uity investing is that returns can f luctuate and investors can lose money.

Liquidity risk

Mid-cap stocks in general, trade in lower volumes than Large-cap stocks, and this would render them more i l l iquid. Especial ly in the event of the market turning bearish, investors f ind the Smal l and Mid Caps diff icult to sel l due to the absence of buyers. This may result in the stock price coming down substant ial ly even on sl ight sel l ing.

Besides, the other factors that increase risk are: (a) Lack of Information on what’s happening in

the companies – since in most cases, the in-formation dissemination platform for most companies is the Annual Report. Further, the disadvantage of Small and Mid caps over Large caps is that the media actively covers the Large caps.

(b) Earnings Volatility – Owing to their relatively small size, volatile growth/de-growth patterns are almost immediately refl ected in their stock prices and valuations of Small/Mid Caps.

(c) Management Concerns – Incase of many Small and Mid Cap companies, the management concern may be a major factor in the minds of shareholders since very less is known and written about them.

Someone rightly said “Small cap stocks can del iver a big pop, which can be either the sound of your investment going up many t imes or the sound of your investment blowing up”.

Conclusion Are small cap stocks for you? If you are risk averse,

probably not. However, if you are up for some volatil-ity and have a small portion of your portfolio you are willing to put at risk for a potential payoff, you may want to give them a careful look. �

Especially in the event of the market turning bearish, investors fi nd the Small and Mid Caps diffi cult

to sell due to the absence of buyers

TRENDS

AN IIPM INTELLIGENCE UNIT PUBLICATION 45March - 2006 Need the Dough?


“ If a man is proud of his wealth, he should not be praised until

it is known how he employs it ” Socrates

NEED THE DOUGH?M A K E W E A L T H W H I L E O T H E R S T H I N K O F I T

D e c e m b e r 2 0 0 5 V o l u m e 2 I s s u e 4 w w w . i i p m . e d uRs. 250

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www.iipm.edu

InnovatorsVolume 1 Issue 1 Rs.450w w w . i i p m p u b l i c a t i o n s . c o m

Strategic

Strategies to escape the vicious trap of cutting costs and consequently losing core strengths & competencies

STRUGGLING FOR SURVIVAL: KIM WARRENLONDON BUSINESS SCHOOL

40

Investing in today’s innovation will not only create market value, but also will create tomorrow’s jobs.

LEARNING TO DESTROY: FRANK DEMMLERCARNEGIE MELLON UNIVERSITY

22

The relevance of corporate governance and theinstitutions that provide control measures for the same

CORPORATE GOVERNANCE: TOM KIRSCHMAIERLONDON SCHOOL OF ECONOMICS

12

How foreign technology firms should pace their R&D investments in China

THE KNOWLEDGE ECONOMY: GEORGES HAOURIMD LAUSANNE

18

A rethinking is necessary on the basic foundations of collaboration and competition

COMPETING TO DEATH: ADRIAN SLYWOTZKY, C . HOBANMANAGING DIRECTORS, MERCER CONSULTING, BOSTON

54

Creating sustainable advantages and competencies

Co-opetition


INSIDE THIS ISSUE

Competition and

T H E I N D I S P E N S A B L E F A C T O R

THE HUMAN FACTORwww.iipmpublications.comFebruary-April 2006, Volume 1 Issue 1


Perfo

rmanc

e... . . . B e y o n d t h e p y r a m i d

GLOBAL OUTREACH: Performance Management: The Art and Science of Control: Performance management is critical to ... 23

LOCUS FOCUS: A humble yet an enterprising persona...14

VOICE VOTE: Are youMoney Talks... Does It Really??!It is a good old understanding ...61


TRENDS


Sow Less Sow Less Reap MoreReap MoreAll it takes is an alert mind and timely decision

Continuing buoyancy in the capital market is proving a lot of opportunit ies to the investors in the both primary as well as

secondary markets. Init ial Public Offerings (IPO) f inancing works as an enabler to encash opportu-nit ies in the primary market to the ful lest.

A large number of public issues are attracting huge oversubscription in the current Bull Run. This reduces the al lotment quantum to the inves-tors, which could mean – lower absolute return. IPO financing provides leverage to make large size applications in public issue (Init ial Public Offer-

ing or Follow-on Public Offering or FPO).IPO financing is nothing but margin f inancing

in the primary market. An investor has to only provide the margin amount, which can vary in different public issues based on expected over-subsription. The f inancier f inances the remaining amount. If the margin of a part icular IPO is set at 20%, the application size would be four t imes bigger than the application that could have been made by the investor with his/her own money. This eventually would mean higher al lotment of shares. This can be explained further by the fol-

by Sanjay Miranka(AVP And Head-capital Markets, Birla Global Finance Ltd.)


SECURITY MARKET


lowing example:The current IPO boom started in June 2003

with Maruti Udyog IPO. With correspondence to the Bombay Stock Exchange (BSE) Sensex rang-ing from 8600 to the current 10000 plus as com-pared to 3607 at the end of June 2003, a number of IPOs/FPOs have hit the market during the last two and half years. There has been a marked improvement in the qual ity of public issues being offered to the investors.

This per iod has been character ised by IPO’s of a number of industry leaders l ike Marut i Udyog, Tata Consultancy Services (TCS), Na-t ional Thermal Power Corporat ion (NTPC), Infrastructure Development Finance Compa-ny ( IDFC), Suzlon Energy and Jet Airways. In fact , NTPC and TCS have f igured among the top f ive companies on the basis of their market capita l isat ion.

Most of the issues have received very good over-subscr ipt ion and shares have y ielded hand-some post l ist ing ga ins. The higher a l lotments through IPO f inancing route have added sig-n if icant ly to the investors’ wealth.

Like any other leverag ing tool , IPO f inanc-ing a lso has its drawbacks band and an inves-tor need to take a ca lcu lated cal l . The superior returns through IPO f inancing would depend completely on the premise that l ist ing price or post-l ist ing pr ice of the scr ip is h igher than the acquisit ion cost of shares a l lotted in an IPO.

The acquisit ion cost per share a l lotted is noth-

ing but the issue price plus interest cost per share a l lotted. The acquisit ion cost has a d irect correlat ion with the over-subscr ipt ion. Higher the over subscr ipt ion, lower the a l lotment and higher the acquisit ion cost per share. So, in case a publ ic issue gets huge over-subscr ipt ion, the acquisit ion cost can be rea l ly h igh, leaving l it-

t le room for appreciat ion. Also, in case a publ ic issue is not pr iced attract ively, the same can change the ent ire dynamic leading to f inancia l loss. Therefore, it is important that an investor takes an informed decision.

During the last two and half years Birla Glo-bal Finance Limited (BGFL) has partnered with investors in their wealth creat ion efforts by pro-

vid ing IPO f inancing for a number of qual ity of IPO’s .Simi larly on many occasions, suggest ions were not to avai l of IPO f inancing when either the issues was steeply pr iced or expected over-subscr ipt ion was rea l ly large leaving the l it t le scope for further appreciat ion. It is extremely important to take an informed decision whi le

invest ing in the pr imary market especia l ly when f inancing is involved.

A number of wel l managed companies are planning to launch their publ ic issues during the coming months. This would def in itely provide good investment opportunit ies to the investors and a lso the f inancing opportunit ies. �

Own Investment

Through IPO fi nancing

Investor Funds (Rs.) 1,000,000 1,000,000

Financing (Rs.) 0 4,000,000

Application Size (Rs.) 1,000,000 5,000,000

No. of shares applied(Issue price of Rs.100 each)

10,000 50,000

No. of times oversub-scribed

50 50

Allotment (No. of shares) 200 1,000Assuming margin of 20%

Company Issue Price (Rs.)

Listing Price (Rs.)

Returns on listing day (%)

Current market price (Rs.)

Maruti Udyog Ltd 115 164 42.61 660TCS 850 978 15.06 1,691NTPC 62 75 20.97 114IDFC 34 70 105.88 72Suzlon Energy 510 690 35.29 892Jet Airways 1,100 1,304 18.55 1,190

IPO Return Analysis

Like any other leveraging tool, IPO financing also has its drawbacks band and an investor

need to take a calculated call

TRENDS


Cleanchit ? Not Really !

The retail investors should adopt a cautious approach while investing in

IPOs if they don’t want to burn their fingers again

by P. Malhotra, Principal Officer, Zuari Investments Ltd


SECURITY MARKET


Equity And Debt MarketsStrong macroeconomic fundamentals have kept the

capital market buoyant during the last three years. The primary segment benefi ted from the positive sentiment is the secondary market and an upbeat investment climate. Equity issues by corporates through Initial Public Offerings (IPO) recorded a substantial increase. Privately placed debt issuances by public sector com-panies dominated the primary market segment. Issu-ances in international markets by Indian corporates also increased during the year. Stock markets have seen an unprecedented bull run which does not show signs of abatement as yet. The benchmark BSE Sensex has risen from the level of 3000 in March 2003 to around 10000 currently.

The rise in Sensex and other major indices has been accompanied with a sharp increase in turnover in a market fl ushed with liquidity. The rally in the stock markets has been broad-based and spread widely across small and mid-cap companies from various sectors. FIIs have continued to evince keen interest in the Indian capital market.

The booming secondary market has had a spill over effect on the primary capital market. Resource mo-

bilisation from the primary market through public issues (excluding offers for sale) almost trebled dur-ing 2004-05. The average size of a public issue was substantially higher at Rs.3.71 billion in 2004-05 than Rs.1.68 billion in 2003-04 and Rs.1.06 billion during the fi ve-year period 1999-2004. The amounts raised through public issues more than doubled to 0.7% of GDP in 2004-05 from 0.3% in the previous year.

The share of the IPOs by unlisted companies in-creased substantially during 2004-05, both in terms of number of issues and amounts raised. Out of 59 public issues, 23 issues were IPOs, constituting 24.4% of the total resource mobilisation. All the IPOs generated enthusiastic investor response. Equity issues consti-tuted 82.3% of the total resource mobilisation through public issues during 2004-05 as compared with 43.7% during the previous year. Out of the 59 public issues during 2004-05, only fi ve were debt issues.

Resources mobilised through debt and equityOf the two major means of raising resources, eq-

uity and debt have seen wide fl uctuations in respective

shares during the last 10 years.

A notable feature of the IPO market is the huge demand for almost all the IPOs. Investors from all the segments – QIBs, Non-Institutional Investors and Retail Individual Investors have made a beeline for the IPOs and FPOs. Part of this demand can be attributed to the handsome premium on the issue price that was fetched by shares of some companies in the secondary market upon listing. In essence, the IPO boom is not different from the mania ob-served during the most recent bull runs observed during the last fi fteen years. The procedure of is-suance of securities through IPOs has, however, undergone a qualitative change. This change has occurred through:(i) Issuance of securities in the electronic form as

against the physical form prevalent earlier(ii) Shortening of the time taken in listing a security

to about 35 days from the closure of subscription list from earlier 70 days

(iii) More transparency about investor response to IPOs brought about by the online system of issuance of securities called the book-building route.

This qualitative change is unparalleled in the an-nals of world capital markets considering the rela-tive ease and smoothness with which the change has been brought about in a short span of about 10

31.03.03 31.03.04 31.03.05 07.02.06

Sensex Value 3048.72 5590.60 6492.82 10082.28

Change over the period

83.37% 16.13% 55.28%

April – Nov. 2004 April – Nov. 2005

Issue Number Amount Number Amount

Public 15 141.96 51 93.62

IPOs 13 106.88 41 58.90

Issues by Listed Companies

2 35.07 10 34.71

Rights Issues 19 28.38 20 10.31

Total 34 170.34 71 103.93(Amount in Rs. billion)Source : SEBI Bulletin, September 2005 Issue

2003-04 2004-05

Issue Number Amount Number Amount

Public Issues 14 188.31 11 108.91

IPOs 21 34.34 23 137.49

Issues by Listed Companies

36 198.38 37 145.07

Rights Issues 22 10.07 26 36.16

Total 57 232.72 60 282.56(Amount in Rs. billion)Source : SEBI Bulletin, September 2005 Issue

Resource Mobilisation from Public Issues


years for an investor population which is one of the largest in the world and yet remains largely illiterate about nuances of the capital market. The change has been heralded by Securit ies and Exchange Board of India f irst via the process of demateri-al isat ion of securit ies under the depository set up and then through an ongoing system of issuance of updated guidel ines for Disclosure and Inves-tor Protect ion (DIP) Guidel ines f irst issued in the year 2000.

Trading / Settlement in Dematerialised Securities

The procedure for sel l ing dematerial ised se-

curit ies is very simple. After one has sold the securit ies, he would instruct his DP to debit his account with the number of securit ies sold by him and credit h is broker’s clear ing account. This del ivery instruct ion has to be g iven to h is DP using the del ivery instruct ion sl ips g iven to h im by his DP at the t ime of opening the account.

For receiv ing demat securit ies the investor may g ive a one-t ime standing instruct ion to h is DP. This standing instruct ion can be g iven at the t ime of account opening or later. Alterna-t ively, he may choose to g ive separate receipt instruct ion every t ime some securit ies are to be received. The transact ions relat ing to purchase of securit ies are summarised below.

‘Market Trades’ and ‘Off Market Trades’

Any trade sett led through a clear-ing corporat ion is termed as a ‘Market Trade’. These trades are done through stock brokers on a stock exchange. ‘Off Market Trade’ is one which is sett led d irect ly between two part ies without the involvement of clear ing corporat ion. The same del ivery in-struct ion sl ip can be used either for market trade or off-market trade by t ick ing one of the two opt ions.

The Depository set up has been es-tabl ished with the twin object ives of mak ing the Indian security market trading and sett lement systems world class and improving survei l lance over securit ies transact ions. There is no denying the fact that the trading and sett lement systems have improved vast ly. As regards survei l lance, the underly ing themes have been to en-sure genuineness of transact ions and the transact ing part ies.

The IPO market , as it operates today, has the fol lowing two main act iv it ies:1. Payment of money by the ap-

pl icants through their bank ac-counts

2 . Al lotment of shares in the deposi-tory accounts of the appl icants

The bank accounts are regulated by the Reserve Bank of India whereas the depository accounts are regulated by the Securit ies and Exchange Board of India. In order to ensure that the transact ions carried out through these accounts are made by ident if iable per-sons, guidel ines cal led “Know Your Customer” or “KYC” guidel ines were introduced. According to these guide-l ines, the capital market intermediar-ies should adopt written procedures to implement the ant i money laundering provisions as envisaged under the Ant i Money Laundering Act, 2002. Such procedures should include inter al ia, the fol lowing three specif ic param-eters which are related to the overal l “Cl ient Due Dil igence Process”:

Percentage ShareYear Equity Debt

1995-96 72.39 27.611996-97 55.99 44.011997-98 41.17 58.831998-99 15.34 84.66

1999-2000 58.41 41.592001-02 16.88 83.122002-03 18.00 82.002003-04 80.47 19.532004-05 83.96 16.04

Source : Prime Annual report

In order to ensure that the transactions carried out through these accounts are made by identifi able

persons, guidelines called “Know Your Customer” or “KYC” guidelines were introduced

TRENDS

51

SECURITY MARKET


a. Pol icy for acceptance of cl ientsb. Procedure for ident ify ing the

cl ientsc. Transact ion monitor ing and

report ing especia l ly Suspicious Transact ion Report ing (STR)

The handsome prof its that are being made by investors in the pr imary capita l market , v iewed in the l ight of the fact that a l lotment of shares in the IPOs is made via a system of reservat ion in favour of the reta i l investors has made it qu ite attract ive for an appl icant in the reta i l investor category to try and get as many a l lotments in the IPOs. According to the ru les, an in-div idual cannot get more than one a l lotment in the IPO. So, the a l lot-ments are sought to be obta ined in the names of fami ly members. But, since th is route has a l imited scope, enterprising persons have sought to create f ict it ious persons. These f ict i-t ious or benami accounts have been opened by g iv ing forged documen-tary proof of ident ity or residence at the t ime of opening bank or deposi-tory accounts. Once the accounts have been opened, then movement of funds or securit ies through the system is organised in connivance with bank or depository off icia ls. Recent ly, instances of thousands of such benami accounts being oper-ated by a single or a smal l group of individuals have come to l ight.

It indicates that despite the “KYC” guidel ines being in place, ways have been found by persons to c i rcum-vent these. The main at t ract ion is the easy prof it being made in the IPOs. On the day of l ist ing, a scramble is usua l ly seen for those scr ips that have been heav i ly over-subscr ibed. Par t of th is scramble can be ascr ibed to short cover ing being made by operators who have sold these shares in the grey market in the pre-l ist ing per iod in ant ic ipa-t ion of lower subscr ipt ion but are

forced to buy from the market in case the a l-lotment received by them is less or the share l ists at a h igher than expected pr ice. Thus, it is an at t ract ive proposit ion to apply in the IPOs under the reta i l category. The decision of the Government to ra ise the monetary cap for appl icat ions being made in the reta i l investor category from Rs.50,000 to Rs.1,00,000 a lso seems to have reduced the chances of a l lot-ment in the category as more and more persons apply for the h ighest number of shares in the category.

The solut ion to such aberrat ions being present in the system l ies in st rengthen ing the survei l lance system of the regu lators and imposing st r ingent pena lt ies for non-compl i-ance by the par t ic ipants. �

These fictitious or benami accounts have been opened by giving forged documentary proof

of identity or residence at the time of opening bank or depository accounts



RESEARCH


by S.N. Ghosh Business Law Faculty, IIPM


SECURITY MARKET


Liquidity is an important feature of any fi nancial market. It is the lubricating agent of any fi nan-cial market that facilitates a frictionless smooth

functioning of the fi nancial markets. Liquidity of an asset is very precisely defi ned by Keynes that `an as-set is more liquid than another, if it is more certainly realisable at short notice without loss. Effi ciency is, thus, an integral part of a stock market as much as the liquidity is. Effi ciency means the speed with which securities transaction is captured at the time of invest-ment decision and to process order creation and ensure requisite compliance, trading confi rmation, settlement and reconciliation of account of the related parties, concluding with channelising the payment to the seller in the most cost effective, fl exible and accurate manner. Manifestly, one of the core operational processes that underlie a securities market is the process of Clear-ance and Settlement. The clearance and settlement process determines, to a large extent, the effi ciency and effectiveness of a securities market. Weaknesses in clearing and settlement arrangements can be a source of systemic disturbances to securities markets and to other systems, creating negative externalities that need to be internalised by effective regulation. An effi cient Securities Settlement System (SSS) is thus critical for establishing a robust and vibrant securities market.

Globalisation, Liberalisation and Corporatisation of the securities market have considerably increased trading volumes.1 No more the barriers and the com-petition that used to prevail in the traditional days are applicable. Adding to the complications are the recent developments that have taken place in the capital mar-kets wherein the mergers, acquisitions and other phe-nomena have changed the entire equation of the global capital markets. Under such dynamic market driven trading, Securities Settlement Systems are a critical component of the infrastructure of global fi nancial markets. Ineffi ciencies in such systems can result in

higher costs to the securities issuers and lower returns to the investors, which can impede capital formation. Securities Settlement Systems have had to adapt to cope with the growing volume of transactions and the demand for faster and more effi cient settlement. As transactions have become more complex, so has risk management become more diffi cult. The value at risk has quadrupled in the recent years. Studies show that around 15% of the total trades fail to mature due to mismatch of trade data. This is a substantial price the market has to bear to an ineffi cient processing system. Responsibility for proper risk management lies with the system participants themselves, who need to con-sider the types of risks that arise, their scale and how they can be kept within prudent limits.

In the Indian context, domestic fi nancial markets have undergone rapid changes since the country em-barked on a programme of economic reforms in 1991. Change has become a ubiquitous phenomenon. Multi-tudes of economic developmental activities have put the two top Indian bourses almost on par with the best in the world, in terms of their structure, systems and regulation. They have embraced technology, seen a substantial increase in the variety and volume of capi-tal market transactions, and witnessed the emergence of securities and new instruments like derivatives as important instruments in fi nancial intermediation. Savvy market players now have new opportunities to profi t from the markets – by deliberately assuming risks. The changing roles of the market intermediaries and the industry as a whole is compelling the securities institutions to focus on delivering the rapid and re-sponsive customer service that will secure their global

Straight Through Processing –Panacea for Securities Settlement Conundrum

An effi cient Securities Settlement System (SSS) is thus critical for establishing a robust and

vibrant securities market


RESEARCH


competitiveness. As they do so, however, they need to have in place superior risk management systems as well – because if they fail to manage their risks adequately, they could pose a threat to the system itself. Thus, there has been an urgent need to localise risks by preventing the contagion from spreading from a failed counter party to others. This is attainable by leveraging technology to achieve effi ciency, thereby improving liquidity in the market and providing the necessary framework scalable for achieving the objec-tive of attracting retail investors.

International StandardsThe international standards have been instrumental

in improving safety and effi ciency of the SSS. There are two major streams of standards – one initiated in the private sector and the other in the public sector, which culminated in the International Securities Services Association (ISSA) Recommendations 2000 and the BIS-IOSCO Recommendations 2001 respectively.

G-30 Recommendations 1989: In the wake of failures in the market around the world in 1987, G-30, a pri-vate sector group, laid down in 1989 the clearing and settlement standards. These standards aimed at reduc-ing risk, improving effi ciency and performing greater standardisation in securities settlement. The standards included comparisons of trade between direct market participants by T+0, an effective and fully developed Central Securities Depository, a trade netting system, a Delivery versus Payment system, `same day funds convention for payments, T+3 rolling settlement, Se-curities Lending and Borrowing mechanism, adoption of ISDO standard for securities messages and the ISIN

numbering system for securities transactions. The Federation International des Bourses des Valeurs

(FIBV) updated G-30 recommendations in 1996.ISSA Recommendations: ISSA reviewed G-30 rec-

ommendations in the light of changes in key risks in the clearing and settlement and infrastructure and replaced them by ISSA Recommendations 2000. These recommendations cover issues for securities settlement systems governance, technology, technical standards market practices, settlement risk, market linkages, investor protection and legal infrastructure.

BIS-IOSCO Recommendations 2001: The initiatives in the public sector have genesis in the 30 principles of securities regulations enunciated by IOSCO in 1998.2 The Committee on Payment and Settlement Systems (CPSS) of BIS evolved core principles for systemati-cally important payment systems in 2001. The task force, constituted for the purpose, made 19 recom-mendations in 2001 covering legal risk, pre-settlement risk, settlement risk, operational risk and other issues relating to securities settlement. It has developed a comprehensive methodology for assessing progress towards implementation of these recommendations. In May 2003, it has released a new version of `Objectives and Principles of Securities Regulation 3 (supersed-ing the one released in September 1998 and February 2002). Principle 30 deals with the systems for clearing and settlement of securities transaction. The princi-ples state “the systems for clearing and settlement of securities transaction should be subject to regulatory oversight and designed to ensure that they are fair, ef-fective and effi cient and that they reduce the systemic risk.” The Indian SSS seems to have met G30 as well

Process Improvements:

� Automates settlement processes� Business users defi ne rules in the process� Escalation procedures defi ned by business users� Absolute and relative time out procedures� Processes as fl exible as business changes Benefi ts:

� Achieving maximum operational effi ciencies through near real-time processing� Eliminating redundant operations, systems, and interfaces, replacing them with scalable operational processes� Minimising risk by better managing exposures across multiple markets and currencies� Reducing transactional processing costs� Reducing reliance on paper-based payment mechanisms and paper documentation� Minimising opportunity costs through timely trade execution� Sharing technology investments and operational expertise� Better regulation by systematic audit trial� Enhancing e-business infrastructure

STP – A STRATEGY FOR VIBRANT GLOBAL MARKET


SECURITY MARKET


as ISSA recommendations.

GSCS BenchmarksGSCS Benchmarks is one international yardstick

that assesses the settlement effi ciency in emerging markets in the form of a single number. These bench-marks, which are expressed as a score out of 100, pro-vide an indication of the aggregate level of post-trade operational effi ciency in securities markets and track the evolution of settlement performance over time. Higher the score, higher is the effi ciency.

STP – market effi ciency driverStraight Through Processing (STP) is the industry’s

lingua franca for the system integration and the basis on top of which a compressed settlement will be de-livered. Primarily, STP involves the automation of the complete trade lifecycle and the information fed at one front automatically gets captured and processed at the other front also. This avoids the duplication of work, errors in data feeding and facilitates quick us-age of the data for processing and report generation. The underlying impact of an STP environment is to automate the entire process without any manual in-tervention. STP treats the trade cycle as a single unit, instead of a series of loosely related messages. Thus, once a determination is made to buy or sell securities, the scalable order processing and execution system – from the point of interest to order routing, execu-tion and confi rmation, linking the front, middle and back offi ces, linking clearing, settlement, custody and safekeeping – is achievable in near real-time while hav-ing connectivity at every point without any manual intervention. Operational and reference data are stored in a centralised repository, eliminating redundancy, enabling access across functional units and enhancing performance measurement and reporting tools across asset classes. Besides, enrich information among dis-parate applications within a fi rm, as well as globally to trading partners, exchanges, depositories, clearing agents, and other securities participants. Integration of technology by adequate leveraging, recent mathemati-cal advances into the securities market is exquisitely critical for rapid incorporation of informa-tion into securities prices for calculating and implementing inter-market arbitrage relationships besides effecting fi nal settle-ment of funds transfers on a continuous transaction-by-transaction basis through-out the processing day. ‘Exception Manage-ment’ is the key to achieving STP.

STP has been further strengthened by

the recommendations of Real Time Gross Settlement System (RTGS). Previously, securities were generally netted on end of the day settlement basis and pay-ment used to be routed through Automated Clearing Houses. Now, with the globalisation of the securities market in an integrated seamless trading environment, the settlement is possible through out the day on real-time basis. Liquidity has to be ensured at the right time in the right place and in the right currency too. Therefore, clearing and settlement of securities besides sharing of information on real-time basis are crucial in this environment.

STP - vehicle for systemic control of Anti-money laundering

Globally, Corporate entities have been identifi ed by the fi nancial services industry as among the most likely vehicle for money laundering. Now with the increasing cross-border trading, banking channels are being utilised for various nefarious activities. Many countries including India have put in place effective legislative enactments and procedures to curb this glo-bal menace. Market intermediaries are mandatorily required to obtain suffi cient ‘Know Your Customer’ information to verify customer identity and the related transaction in particular, in an acceptable manner. STP system without face-to-face customer contact is the answer to this ever-increasing threat looming large on the global citizen.

Indian legislative initiative and proactive SEBIAs a precursor to uniform fully automated inte-

grated Clearance and Settlement System for the secu-rities market around the globe, the IOSCO adopted Objectives and Principles of Securities Regulation and Clearing and Settlement in Emerging Markets – A Blueprint. This laid the roadmap for further legisla-tive developments in the member countries. SEBI is a member of this global organisation of the market regu-lators and as a forward-looking step to surge Indian capital market to integrate into international securities market. SEBI has gradually over the years issued vari-ous guidelines in this direction. Some of the following


RESEARCH


legislative initiatives from SEBI may be noted:Depositories Act 1996: It lays the foundation for

dematerialisation of securities and provides for the regulations of depositories in securities. Ownership and trading in securities is permitted through book-entry system. Pledge and hypothecation of securities in dematerialised mode has also been permitted.

Companies Act 1956: In this Act, legal recognition to the concept of ‘benefi cial owner’ was inserted. Shares of a public limited company were made freely transferable. Share transfer refusal was empowered to SEBI. Other enabling legislative provisions were also inserted.

Securities Contract Regulation Act 1956: It has now been mandated through 2003 amendment that all recognised stock exchanges shall be corporatised and demutualised. The scheme and procedure thereof shall be approved by SEBI. Upon failure to comply with the SEBI directions, the stock exchange shall loose its recognition. Further, the clearing and settle-ment work of stock exchanges shall be transferred to Clearing Corporation, which shall be a corporate.

Information Technology Act 2000 and Evidence

Act, 1872: IT Act provides a legal framework for fa-cilitating business or concluding any transaction in the electronic form. The Law of Evidence, which is based on paper records, oral testimony and written signatures, has been amended accordingly.

STP-centric SEBI Regulations issued under the SEBI Act 1992

SEBI pursuant to Section 29 and 30 of the SEBI Act 1992 has issued certain enabling regulations, e.g., Custodian of Securities, Depositories and Participants, Central Listing Authority, Ombudsman Regulations have been notifi ed. Following STP-centric regulations have recently also been issued. The highlights of these regulations may be recapitulated: � SEBI (Central Database of Market Participants)

Regulations, 2003: Every market participant (specifi ed intermediary, listed/to be listed com-pany, investor and other entity) shall not buy, sell or deal in any listed securities or in units of a mutual fund or a collective investment scheme or subscribe to securities unless it has obtained a Unique Identifi cation Number (MAPIN) in the

METAMORPHOSED INDIAN MARKETThe National Securities Clearing Corporation Ltd. (NSCCL), a wholly owned subsidiary of NSE, incorporated in August

1995, is the fi rst clearing corporation to be established in the country and also the fi rst clearing corporation in the country to introduce Settlement Guarantee. It also undertakes settlement of transactions on other stock exchanges like, the Over the Counter Exchange of India. Clearing Mechanism:

� Two categories of clearing members – Trading members and Custodians � The trading member may pass on its obligation to the custodians if the latter confi rms the same to NSCCL. Each

trading day is a trading period.� On completion, multi-lateral netting concept is used for determining pay-in or pay-out obligations of counter parties

on T + 1 days basis. � These obligations are forwarded to the members to settle their obligations on the settlement day (T+2).� Direct pay-out to clients’ account on both the depositories Counter party and other Risk containment measures:

� On-line monitoring – member performance, track record, stringent margin requirements, position limits on capital adequacy norms, automatic disablement from trading when limits are breached, etc., as risk containment measures

� Counter-party risk guaranteed through on-line position monitoring � Settlement Guarantee Fund a self-insurance mechanism for members for Equity and derivatives market

Revised Activity Schedule (SEBI Circular dated September 2, 2005)

S No. Day Time Description Of Activity

1 T Trade Day

2 T+1 By 1.00 p.m. Completion of custodial confi rmation of trades to CC/CH.

By 2.30 p.m. Completion of process and download obligation fi les to brokers custodian by the CC/CH

3 T+2 By 11.00 a.m. Pay in of securities and funds

By 1.30 p.m. Pay out securities and funds


SECURITY MARKET


prescribed manner 1. Trade details from Exchange to Clearing Corpora-

tion (real-time and end of day trade fi le)2. Clearing Corporation notifi es the consummated

trade details to CMs/Custodians who affi rm back. Based on the affi rmation, Clearing Corpoation applies multilateral netting and determines obliga-tions

3. Down load of obligation and pay in advice of funds/securities

4. Instructions to clearing banks to make funds available by pay-in-time

5. Instructions to depositories to make securities available by pay-in-time

6. Pay-in of securities (Clearing Corporation advises depository to debit pool account of custodians/CMs and credit its account and depository does it)

7. Pay in of funds (Clearing Corporation advises Clearing Banks to debit account of custodians/CMs and credit its account and clearing bank does it). Clearing Corporation transfers funds between clearing banks to meet the pay-out requirements at each bank

8. Pay-out of securities (Clearing Corporation ad-vises depository to credit pool account of custo-dians/CMs and debit its account and depository does it)

9. Pay-out of funds (Clearing Corporation advises clearing banks to credit account of custodians/CMs and debit its account and clearing bank does it)

10. Depository informs custodians/CMs through DPs

11. Clearing banks inform custodian/CMs� SEBI (STP Centralised Hub and STP Service Pro-

viders) Guidelines, 2004: SEBI on May 26, 2004 issued guidelines (STP Guidelines) prescribing the eligibility criteria and conditions of approval for the STP centralised hub and the STP service pro-viders; their obligations and responsibilities and code of conduct. A model agreement between the STP centralised hub and the STP service providers have also been prescribed.

� Mandatory use of STP system for all institutional trades: It is now mandatory that all the institution-al trades executed (a trade which is settled through a custodian) on the stock exchanges would be proc-essed through STP with effect from July 1, 2004. Issuance of physical contract note by the brokers banned w. e. f. December 1, 2004. In order to bring about uniformity in documentary requirements

across different segments and exchanges and also to avoid duplication and multiplicity of documents, SEBI in consultation with stock exchanges (BSE and NSE) has prescribed uniform set of documents – Client Registration Form; Member-Clients Agreements.

� Securities Lending and Borrowing: A clearing cor-poration/clearing house, after registration with SEBI, may borrow securities for meeting shortfalls in settlement, on behalf of the members.

� Transaction Work fl ow for the system of STP in the Indian securities market and standardisation of the messaging formats – this been prescribed by SEBI on June 10, 2004. The prescribed messaging format is based on the internationally accepted ISO 15022 messaging standards.

� STP Messaging Format for Securities Transaction Tax: The messaging format on account of imple-mentation of the Securities Transaction Tax (STT) has been further modifi ed.

� Discontinuation of Hand Delivery Bargains/De-livery Versus Payment: SEBI on September 25, 2005, in consultation with stock exchanges, cus-todians and other market participants directed that all transactions executed on the stock exchanges shall be settled through the Clearing Corporation/House of the stock exchanges.

STP was launched in India with the inauguration of STeADY [Securities Trading Information easy Access and DeliverY] solution provided by National Securities Depository Ltd on November 30, 2002.4 Since STP has been introduced, many fi nancial institutions real-ised its potential but few had taken in full plunge. And due to lack of critical integration of technology within the system, the deployment of STP within institutions had been rather sluggish. After some initial hiccups, the market participants have adopted the system.

Measuring Indian Securities Market through global prism

In this section, we will discuss the results obtained from the econometric analysis of the data obtained from the securities market of India and important stock exchange of the world.

Table 1 and Table 2 are the Annual Settlement Sta-tistics of CM Segment and F &O Segment of NSE from the year 2001-2002 to 2005-2006 (Annualised). Trading of shares in demat mode during the year 2002-2003 improved to 100% against 99.89% in the previous

After some initial hiccups, the market participants have adopted the STP system


RESEARCH


year. The menace of bad del ivery has been com-pletely eradicated. The increasing confidence of the investors in the system bolstered the turnover and trade volume, which grew around twice after implementation of STP. Short del ivery has also

been reduced by around 25%. The substantial ben-ef iciary of STP is the Future and Options trading segment – l ifeblood of the securit ies market. There has been more than around 1400% growth in this

segment. This is phenomenal by any matrix. Now with the STP in place around the globe, India ranks third with transaction cost at 35 and 58 basis points for MF and FII segment respectively, fol lowed by UK5 with transaction cost at 70 basis

points. Table 4 is the performance indicator of the

economic impact of certain scalable init iat ives introduced by SEBI from time to t ime in the do-

Table 2: Annual Settlement Statistics of F&O Segment (NSE) – after STPYear Index/stock Futures Index/stock Options Total

Mtm Settlement Final Settlement Premium Settlement Exercise Settlement2005-2006 (Annualised)

307.09 1.74 4.02 1.79 340.01

2004-2005 130.24 2.28 9.42 4.56 146.492003-2004 108.22 1.39 8.59 4.76 122.962002-2003 17.38 0.46 3.31 1.96 23.112001-2002 5.05 0.22 1.65 0.94 7.86

* All fi gures in billion

Trading Costs USA Hong Kong Australia Singapore Indonesia UK India (MF, FII)

Brokerage 0.006 30 85 63 75 20 26, 42

Regulator’s Fee 0.0003 0.03 0.03

Custody 0.00006 5 5

Safekeeping/Clearing 0.01 0.01 1 5 8 Pound 2.5 **

Stamp Duty 15

VAT+ Tax 5

Total 0.01636 35.04 101 73.03 88 70 35, 58

Total rounded off to nearest number

0.01636 35 101 73 88 70 35, 58

Rank I II VII V VI IV III

Table 3: Performance Indicators - International Comparison of Transaction Cost

** Per Trade. (Safekeeping varies with Contract Size). Figures in basis points except for USA, which are in percentage.Source: SEBI-NCAER Survey of Indian Investors, March 2003.

Year No. of Trade (Rs. /million)

Turnover(Rs./bil-

lion)

DELIVERABLE

Qty (mil-lion)

% of Demat deliverable Qty To Total Dlivered Qty

% of Short Delivery

To Delivery

Unrectifi ed Bad Delivery (mil-

lion)

2005-2006 (Annualised)

566.6 13,539.84 23,804.6 100.00 0.46 0.00

2004-2005 449.6 10,514.62 20,227.6 100.00 0.42 0.00

2003-2004 374.9 10,909.63 17,554.6 100.00 0.57 0.00

2002-2003 240.2 6,215.69 8,235.3 100.00 0.57 0.00

2001-2002 172.0 508,121 59,299 99.89 0.61 0.08

Table 1: Annual Settlement Statistics of CM Segment (NSE) – after STP


SECURITY MARKET


Transaction Cost 1994 1999 Global Best

Trading (%)

Fees 2.50 0.25 0.25

Impact Cost 0.75 0.25 0.20

Clearing

Counter Party Risk Present Nil Nil

Settlement (%)

Paper Work 0.75 0.10 0.00

Bad Delivery 0.50 0.00 0.00

Stamp Duty 0.25 0.00 0.00

Total (%) 4.75 0.6 0.45Source: SEBI-NCAER Survey of Indian Investors, March 2003.

Table 4: Performance Indicators - Reduction of Transaction Cost

mestic market; besides the global best transaction cost – the benchmark for the market regulator. The avai lable data (Handbook on stat ist ics on the Indian securit ies market – 2004) indicates a sharp decl ine in transact ion cost from 4.75% in 1994 to 0.60% in 1999 – a decrease by 8 t imes. It was 0.15% higher than the global best , which is pr imari ly due to paper work. Now that STP has been fu l ly integrated into our clearance and sett lement system, it would be a prudent con-clusion that th is cost has a lso been absorbed and the cost of securit ies t ransact ion at Indian bourses is comparable with the best global prac-t ices and standards. India has a lso done wel l with regard to GSCS Benchmarks for assessing the sett lement eff iciency.

Concluding ObservationsSTP is a phantom concept. To rea l ise the true

STP, there is plethora of changes that needs to occur and successfu l ly absorbed by a l l the actors of the securit ies market. The amount of manual reconci l iat ion and processing that st i l l takes place clearly does not a l low for rea l-t ime clear-ance and sett lement. A clear sign that we are moving towards fu l l STP in provid ing trade data to a l l interested part ies wi l l be the el iminat ion of paper and faxes from the processing chain.

At the end of the day, STP is indeed the means to an end by which our very compet it ive market rea l ises opt imal ly eff icient transact ion process-ing and we see the most dramat ic increase in eff iciency, service to cl ients and perhaps most relevant- a dramat ic enhancement to how we control operat ional r isk and thus, increase prof-itabi l ity. �

References

1 The total number of transact ions in the uni-verse grows at a rate of around 4 mil l ion per annum across more than 50 countries. (GSCS Informat ion Services – Issue 5; July-Sept 2005)

2 IOSCO recognises that sound domest ic markets are necessary to the strength of a developed domest ic economy and that domest ic securit ies markets are increasingly being integrated into a global market.

3 The Financial Sector Assessment Programme (FSAP), a joint IMF and World Bank init iat ive introduced in May 1999, aims to increase the effect iveness of efforts to promote the sound-ness of f inancial systems in member countries. FSAP inter al ia, assess the securit ies markets on the basis of the 30 Principles of Securit ies Regularit ies enunciated by IOSCO.

4 STeADY is a faci l ity which enables the brokers to del iver/submit contract notes to custodians/ fund managers electronical ly by transmitt ing digital ly signed trade informat ion with en-crypt ion. It further enables fund managers to enrich the contract note and convert it into instruct ions for the custodian. In order to use the STeADY faci l ity, brokers, custodians and fund managers have to access ‘STeADY’ with smart card, bearing digital signature cert if icate issued by l icensed Cert ifying Authority (CA), approved by NSDL. Further al l batches and up-loads from brokers/custodians/fund managers are digital ly signed by the respect ive users and accepted by STeADY only after it successful ly verif ies the digital signature. Al l downloads obtained by brokers/custodians/fund manag-ers also bear the digital signature of STeADY site

5 CRESTCo has run a Sett lement Discipl ine re-gime, which consists of standards relat ing to matching and sett lement of FTSE 350.

STP is indeed the means to an end by which our very competitive market

realises optimally effi cient transaction processing and we see the most dramatic

increase in effi ciency, service to clients


RESEARCH


Tobin’s Q & Assets Returns: Implications for Indian Stock Markets

Dr. G. S. SoodReader, Department of Commerce, SGTB Khalsa PG (Eve.) College, University of Delhi.

Dr. Surjit KaurReader, Department of Commerce, SGGS College of Commerce,University of Delhi.


SECURITY MARKET


AbstractThe present study attempts to check the valua-

tions of the Indian stock markets so that the same can be used to make informed investment decisions. The investment ratio propounded by James Tobin – winner of the noble prize for economics in 1981 – was used for the purpose. Called Tobin’s ‘Q’, the ratio compares two different parameters of corporate valuation – stock market value (market capitalisation) and net worth. ‘Q’ has been widely used to calcu-late whether a market is overvalued or undervalued and decide as to when should one buy or sell one’s equity holdings. ‘Q’ for Nifty was calculated for a period of six years starting from April 1999 till April 2005 on a monthly basis giving a total number of 73 values. ‘Q’ ranged between a low of 1.44 calculated as on September 2001 with the corresponding value of Nifty at 913.85 and a high of 3.99 calculated as on February 2000 with the corresponding value of Nifty at 1654.8. A simple average of ‘Q’ across these 73 values was 2.29 with median and mode being 2.26 and 2.20 respectively. It was found that ‘Q’ ranged between 1.70 and 3.40 in as much as 85% of the time and same was taken to be the reference range. On this basis, a simple trading rule a cautious investor can follow is to start buying when the ratio is nearing any of the averages, say 2.29, i.e., the mean value and can continue to increase his position if the ‘Q’ value falls till it reaches 1.70. Though, the buy signals by this rule are conservative but are effective and resulted in stupendous gains being made by those who fol-lowed this strategy which clearly outperformed the buy and hold strategy for the period of study. The ‘Q’ based strategy can be used to minimise the dam-age by suggesting the market tops and also when the prices are cheap. However, it may not be effective in the long-term bear market. Also, it may not pick up a sustained rally in a long- term bull market where the prices may remain overvalued for long periods. It may make you sell out long before a bull market actually reaches the top.

Tobin’s Q & Assets Returns: Implications for Indian Stock Markets

Introduction Great amount of research efforts have been devoted

to fi nd valuation measures to evaluate the worth of a company or to fi nd an indicator/benchmark as to when to buy or sell in the market. Most popular amongst these are certain fi nancial ratios used by analysts and market players with a reasonable de-

gree of success. However, in the recent past, many popular ratios have proved to be poor guides in this respect particularly in the developed markets of US and Europe. For instance, dividend yield and price-to-book value measures have been strongly suggest-ing a sell, when some other market indicators have not favoured it. There are a number of problems to be faced by those who rely on ratios. The fi rst is the possibility for a change in the relative importance of the measures over time. For instance, a change in the tax laws might change the importance of dividends to investors. However, there are other factors also that can change its importance. During the decade of 1990s, dividend yield has not been very signifi -cant in the US mainly because of two reasons. First, the US companies have been growing fast and were re-investing their profi ts in their business. Second, companies have been returning cash to shareholders through share buy-backs which are more tax effi -cient than dividends. The second problem may arise due to changes taking place in the economy. For in-stance, a shift in favour of service industries relative

to manufacturing ones might lessen the importance of tangible asset-dependent measures. This would alter the valuation of companies and their stocks in the market.

In view of the above mentioned problems, the re-searchers and stock analysts have for long been look-ing for a rational measure of underlying value. Many of them are of the view that the one measure which best meets the requirement is the ‘valuation ratio’, or Tobin’s ‘Q’ – named after James Tobin, the Noble-laureate professor of economics at Yale University. The ‘Q’ measure is the ratio of stock market value to net assets of companies at replacement cost. In other words, the ’Q’ ratio compares the stock prices with current value of the underlying assets. In essence, it equals the market value of corporations (stock prices plus estimated debt) divided by the replacement cost of their factories, equipment and inventories, land values and net fi nancial assets. Since infl ation has driven many assets’ replacement cost well above origi-nal cost, the Financial Accounting Standards Board (FASB) recommended procedures that would take into account the impact of infl ation. Until 1985 large companies were obliged to report these ‘current cost’

A simple average of ‘Q’ across these 73 values was 2.29 with median

and mode being 2.26 and 2.20 respectively


RESEARCH


adjustments. Since then, it has become a voluntary inclusion in the fi rm’s fi nancial statements and one need to adjust historic asset costs for infl ation before one can calculate ‘Q’.

Previous ResearchA selective review of literature throws some light

on the use of ‘Q’ ratio for various purposes by re-searchers. Given below is a brief account of how useful the ratio is for the researchers, analysts and investors in analysing various aspects of corporate decision making and taking crucial economic and investment decisions.

Marris [1964] summarised the motives of takeovers in terms of a single variable and chose ‘valuation ra-tio’ for the same. Marris suggested that corresponding to the market’s valuation ratio (Qim) of any fi rm i there also exists some other fi rm j’s subjective valu-ation ratio (Qij) refl ecting j’s valuation of i if it were to acquire i. Other things being equal, the fi rm i is likely to be taken over by fi rm j if j’s valuation ratio for i is higher than the market’s and any other fi rm’s valuation ratio for i. Firm j’s valuation ratio for i would normally be higher than the market’s,

only if it expects (by providing better management or pursuing different fi nancial policies) to obtain a higher rate of return than the market expects to be achieved by the existing management. In practice, it is very diffi cult to fi nd out a fi rm’s valuation of the target company. However, it is suggested by Marris that the lower a fi rm’s valuation ratio, more likely it is to be taken over.

Thomadakis [1977], Lindenberg and Ross [1981], Smirlock et al. [1984], and others investigated the relationship of Tobin’s Q to industry market struc-ture. Lindenberg and Ross found that the Q ratios of fi rms are stable over time and that fi rms with high Q ratios tend to have unique products and factors of production, all of which contribute to earnings in excess of the minimum necessary to induce the fi rm to produce in the short run. Firms with low Q ratios are typically in relatively competitive or tightly regulated industries. Lindenberg and Ross fi nd a high correlation between price-cost margins and Q, but a low correlation between Q and concen-tration ratios.

Salinger [1984] estimated the relationship between

‘Q’ and barriers to entry, industry concentration, and unionisation. The study pointed out that without barriers to entry, there is no reason for market pow-er to arise just because an industry is concentrated. Therefore, a relationship, arising from market power, between ‘Q’ and concentration should be present only when entry barriers exist. Further, if concentration arises because the most effi cient fi rms get large, then there should be a negative effect on price from concentration. Finally, unions may capture any mo-nopoly rents and would reduce the strength of the relationship between ‘Q’ and market power.

Servaes [1991] analysed the relationship between takeover gains and the ‘Q’ ratios of targets and bid-ders. The study examined the returns of 704 targets and 384 bidders involved in 704 complete takeovers (mergers and tender offers) over the period 1972-1987. Balance sheet information was used to compute Tobin’s ‘Q’ ratios and additional information was gathered from the Wall Street Journal to identify the characteristics of the offer and the contest that might infl uence abnormal returns, such as, the form of payment, the number of bidders and the reaction of target management (hostile or friendly). In cross sectional regression, relative measures of ‘Q’ can explain target, bidder and total abnormal returns generated in the takeovers. The abnormal returns of targets and bidders were larger when targets have low ‘Q’ ratios and bidders have high ‘Q’ ratios. If ‘Q’ was interpreted as a measure of managerial per-formance, the results indicated that target, bidder and total takeover returns were larger if the target was performing poorly, and the bidder was perform-ing well. The signifi cance of the relation between ‘Q’ and takeover gains was actually enhanced, after controlling for the characteristics of the offer and the contest. The returns were also related to the form of payment, the number of bidders, the reaction of target management, the time period of the takeover, and relative size of targets and bidders.

Chari and Henry [2002] tested the hypothesis that if there is no signifi cant relationship between countries investment to GDP ratio and measures of capital account openness, it is possible that overall macroeconomic ratios fail to capture the link be-tween investment at the fi rm level and their access to global resources. They made two predictions about the time series behaviour of prices and quantities of capital during capital market liberalisation. Firstly, fl ow of cross border funds into a liberalising country reduces the cost of capital and drives up Tobin’s Q – the market value of fi rms’ assets relative to their

Lower a fi rm’s valuation ratio, more likely it is to be taken over


SECURITY MARKET


replacement cost. Secondly, because of this, fi rms will respond to the increase in Q by investing more capital till the asset market value of fi rms and their replacement cost are equalised once again. Investment will decline to a rate that is suffi cient to maintain this equality. Further, opening the stock market to foreign investors also alters the systematic risk for the rep-resentative investor, because liberalisation switches the relevant benchmark for pricing individual stocks from the local market index to a world stock market index. Consequently, prices should rise in sectors where systematic risk falls and prices should fall in sectors where it rises. Relatively more investment is observed by fi rms whose risk falls and less by those whose risk rises. They also concluded that the capital market liberalisation has reduced the cost of capital to corporate sector and reduced risk.

Pandey [2002] provided new insights on the way in which the capital structure and market power and capital structure and profi tability are related. We predict and show that capital structure and mar-ket power, as measured by Tobin’s Q, have a cubic relationship. That is, at lower and higher ranges of Tobin’s Q, fi rms employ higher debt, and reduce their debt at intermediate range. This is due to the complex interaction of the market conditions, agency problems and bankruptcy costs. The study also show saucer-shaped relation between capital structure and profi t-ability because of the interplay of agency costs, costs of external fi nancing and debt tax shield. The study claims to be the fi rst to uncover these results.

Relevance of the StudyThe review of literature reveals that Tobin’s Q has

been extensively used for purposes as varied as valua-tion of takeover targets, impact of liberalisation and FII investment on the stock markets of countries which have chosen the path of liberalisation, stock market valuations of individual companies vis-à-vis their capital structures, diversifi cation and corporate concentration as also for judging the comparative performance of fi rms. It has been extensively used by researchers and analysts in advanced markets to predict market movements and take investment de-cisions based on that. However, no such systematic attempt has yet been made in context with Indian stock markets. The present paper therefore makes a modest attempt to check the valuations of the Indian stock markets so that the same can be used to make informed investment decisions thereby minimising the risk and maximising the returns. This has become all the more important, since with the spread of the

investing habit over the years, society’s stake in the well being of the stock market is much higher now, than ever before.

Looking to the current valuations of the Indian stock markets, the investors appear to be the most confused lot today due to the markets not being able to take a decisive direction. After having touched a high of 6900 in March, the markets witnessed a healthy correction of about 700-800 points and is again looking up. Most of the small investors who missed the bus earlier are looking for an opportune time to enter the markets. But, the fact of the matter is that the market pundits are equally divided about the future direction and have strong arguments to support for what they say. Those holding a bearish view about the market’s claim about the rising crude prices, the increasing Fed rates, the rapidly rising rate of infl ation, unsustainable corporate perform-ance of recent quarters in future, sustained weakness in dollar vis a vis rupee, some corporate unfriendly provisions in the Union Budget…... as the main vil-lain for markets. The chronic bulls however feel that India with a likely growth rate of 7% plus is a market different from most of the emerging markets due to a strong focus on reforms. It will therefore continue

to receive increased FII infl ows. They say that the current bout of buying in the stock market was on account of it being undervalued. Though, at the cur-rent levels with Sensex ruling at 10000 plus and Nifty at around 3000 plus it is something diffi cult to feel comfortable about.

For the last two decades, stocks have gone through boom-bust cycles. Although these moves have been studied by some of the best and the brightest minds, a general formula to judge how long a cycle will last or when it will turn, has proved to be elusive. Though at this point, the most basic question that is frequently asked is, whether, it is actually possible to be a suc-cessful investor without having the least notion of what the market is liable to do. However, stock mar-ket, over a long period of time seems to produce high returns. All you have to do is to remain passively invested in a diversifi ed portfolio, and patiently watch your net worth grow. The problem with passive ap-proach is that downturns can be severe – and last for long periods.

The chronic bulls however feel that India with a likely growth rate of 7% plus is a market

different from most of the emerging markets due to a strong focus on reforms.


RESEARCH


‘Q’ Ratio and Market Valuations: The Experience Abroad

Two British fi nancial economists, Andrew Smith-ers and Stephen Wright, suggested that there is in-deed a method to judge whether stock markets are overvalued or undervalued. Although they didn’t go so far as to say that their method can predict turn-ing points accurately, they contend that it can judge whether stock markets are more liable to snap up or down. In their signifi cant work “Valuing Wall Street: Protecting Wealth in Turbulent Markets” (2000), Smithers and Wright show that many rational valuation methods can be reduced to mathematical variations on their new method. Further, sometimes these traditional methods did not work, whereas their method did.

The authors used the investment ratio propounded by James Tobin. As mentioned earlier, Tobin devised this ratio in 1969 and called it ‘Q’ by comparing two different parameters of corporate valuation – stock market value (market capitalisation) and net worth. Unfortunately, there wasn’t suffi cient data available in 1969 to test ‘Q’ over a long period. The same being available now, the authors have exhaustively tested the ‘Q’ over periods exceeding a century.

Stock market value is the market price of an indi-vidual share, and by extension, of a company and an entire market. Net worth of a company is the sum of its paid-up equity and reserves, excluding revaluation reserves. Market value is what investors are prepared to pay at a given point in time; net worth is what they receive. If the market value of every paid up share is

summed up and divided by the total net worth of the market, we have ‘Q’ for the market. Usually, both the numerator and denominator of the ratio are reduced to per share values to make the calculations.

In a perfect world, the ‘Q’ should be equal to 1.0, though Tobin did not expect perfection in the real world. When ‘Q’ is much below one, the market values companies at less than their assets – and the cheapest way to acquire a factory is to buy one on the fl oor of the stock exchange. When it is well above one, it is correspondingly profi table to build a new factory and sell it on the fl oor of the exchange. When the ‘Q’ value is equal to one, ‘Q’ is in equilibrium, and the value of the shares should equal the replace-ment cost of net assets. The return to equity holders will then be equal to the return on the company’s underlying assets. In the short-to-medium term, how-ever, return to equity holders can deviate sharply from that on corporate capital, because of changes in market valuation.

Of course, it is possible to think of cases when the existing assets are worth much more than their cost but there is no scope for further profi table invest-ment. Nevertheless, a high market value is usually a sign that investors believe there are good opportuni-ties in your business. The reverse is also true. Just because an asset is worth less than it would cost to buy today, it does not necessarily mean that it can be better employed elsewhere. But, companies whose assets are valued below replacement cost ought to look over their shoulders to see whether predators are threatening to take them over and re-deploy the assets. The ‘Q’ is usually higher for fi rms with a strong competitive advantage. The table bears this out. The companies with the highest value of ‘Q’ tend to be those that have had very strong brand images or patent protection. Those with the lowest values have generally been in highly competitive and

shrinking industries. The US Federal Reserve Sys-

tem (Fed) has calculated the ‘Q’ ratio of American non-farm, non-fi nancial companies since the year 1945. The calculation shows that the ‘Q’ value for the US equity market has soared to a historical high value of about 1.7 in 1996. The highest previous level of about 1.2 was in the late 1960s which refl ected a previous phase of very high prices on the Wall Street. But, for most of the

High Q’s Low Q’sAvon Products 8.53 Cone Mills 0.45

Polaroid 6.42 Holy Sugar 0.50

Xerox 5.52 Federal Paper Board 0.52

Searle 5.27 National Steel 0.53

MMM 4.87 Graniteville 0.55

Schering- Plough 4.30 Publicker Industries 0.59

IBM 4.21 Medusa Corp. 0.60

Coca- Cola 4.21 Lowenstein 0.61

Smith Kline 4.19 U.S. Steel 0.62

Eli Lilly 4.02 Dan River 0.67

Nevertheless, a high market value is usually a sign that investors believe there are good

opportunities in your business


SECURITY MARKET


1980s ‘Q’ value bumped along between 0.4 and 0.6. It took the protracted bull market of the 1990s to take it into the new high of 1.7. In the UK too, the ‘Q’ ratio ruled as high as 1.3 during the same period as was revealed by a study conducted by Bank of England.

THE INDIAN EXPERIENCE

Methodology Though, it is theoretically possible to value an aver-

age share in a given market by taking the total market value and dividing by all outstanding shares. In prac-tice, it would be a tall order, to do the same for the market, given the large number of companies listed on an exchange. The viable alternative, therefore, is to assume an average share value by using a repre-sentative market index. Nifty, being one of the most popular market benchmark to value Indian markets, is chosen for the purpose. Launched in 1994, Nifty represents 50 major companies on the basis of their respective market values. It is fairly representative and covers 60% of the total market capitalisation of all Indian listed companies. Hence, it provides us a viable alternative for the total market valuation. Likewise we need to work out the net worth of the index. Net worth of a company is relatively stable and doesn’t change frequently. The net worth of a company changes when it transfers retained profi ts to reserves or when it raises equity.

The calculated value of ‘Q’ will obviously be high when share prices are high, and low when prices are low. Price-Book value ratio is frequently used to judge whether companies are overvalued or undervalued. The problem with using ‘Q’ for individual shares is that growth rates vary widely. A company whose profi ts are growing at the rate of 100% every year will obviously be valued higher than another with 10% growth. So, judgment must be used to decide whether an individual company deserves high ‘Q’ or not.

But by defi nition, if ‘Q’ includes the entire mar-ket, all implicit growth rates are averaged out. While every individual share in the market may be above or below the average growth rate, in aggregate, the sum must be average. By the same logic, while a given company can perform well regardless of the mac-roeconomic scenario, the corporate sector cannot. Therefore, if ‘Q’ is taken for an entire market, these considerations of above or below average perform-ance cancel out and become irrelevant. Then, ‘Q’ can be used to calculate whether a market is overvalued or undervalued. The authors suggest that investors

should sell their equity holdings during periods when the ‘Q’ is high (market is overvalued) and scale up equity investments when the ‘Q’ is low (market is undervalued).

Studies based on the US markets over various time periods have shown that investment strategies based on ‘Q’ outperform passive buy and hold strategies, as well as those based on the PE (price to earnings) ratio. An important point here is that stock prices cannot climb or fall indefi nitely across the market. Hence, in the long run, ‘Q’ will always tend to close in on an average value. This makes it possible to measure for overvaluation or under valuation which otherwise would be impossible.

Different markets may have different average val-ues of ‘Q’, and an exact average will always be guess-timate. However, the longer the time period under

consideration, the more accurate the guess will be. But Benjamin Graham, who also used the concept of comparing book value to stock prices, highlighted two major problems about this concept. One is that the method is too conservative. Another problem is that making an investment call via ‘Q’ is extremely subjective when it concerns a single company. The company may be high growth or low growth. The ratio is much more accurate when a big population of stocks is considered.

Actually, ‘Q’ is a better indicator in unusual cir-cumstances. In more normal circumstances, ‘Q’ gives similar results and signals as other valuation models. The ‘Q’ ratio works better than PE ratio when both prices and earnings are low, e.g., during economic turnaround. At those points, the PE is deceptively high, and wrongly suggests a sell. But, ‘Q’ is low and suggests a buy because the denominator (net worth) is an accumulation of earnings of many years. The ‘Q’ outscores dividend yield valuations when dividends are not paid at all by a high growth company. Most high growth companies, especially in the IT sector, may not pay dividends because retained earnings are the cheapest growth fuel.

It may not be possible to judge whether the mar-ket is overvalued or undervalued at any given point of time by just looking at the absolute index values – Sensex or Nifty. Observing ‘Q’ values can be a use-ful way to do the same. The ‘Q’ value for the Sensex

While every individual share in the market may be above or below the average growth rate, in

aggregate, the sum must be average


RESEARCH


fl uctuated between 10.25 and 1.67 during January 1991 and September 2000. However, there is little correlation between ‘Q’ and Sensex values. The high-est ‘Q’ value of 10.25 was recorded at the height of the securities scam in April 1992. The lowest was in October-November 1998, when the market was trad-ing close to its four- year bottom of 2742. In February 2000, when the Sensex topped 6000 for the fi rst time, its ‘Q’ value was just around 4.

Empirical FindingsWe calculated ‘Q’ for the past six years starting

from April 1999 till April 2005 on a monthly basis giving us a total number of 73 values (see Annexure). We found that the ‘Q’ ranges between a low of 1.44 calculated as on September 2001 with the correspond-ing value of Nifty at 913.85 and a high of 3.99 calcu-lated as on February 2000 with the corresponding value of Nifty at 1654.8. A simple average of ‘Q’ across these 73 values is 2.29. However, an arithmetic average can be misleading since it would be markedly affected by the extreme values. The median (the exact geometric centre of all the values) and the mode (the number most frequently seen) were also calculated with the values being 2.26 and 2.20 respectively. Fur-ther, the value of ‘Q’ ranges between 1.70 and 3.40 in as much as 85% of the time. The ‘Q’ value outside the 1.70-3.40 range can therefore be considered to be unusual and extraordinary.

On this basis, we can lay down a simple trading rule an investor should follow. A cautious inves-tor should start buying when the ratio is nearing any of the averages, say 2.29, i.e., the mean value and can continue to increase his position if the ‘Q’ value falls til l it reaches 1.70. The application of this trading rule throws up interesting possibili-ties. The buy signals are conservative but effective. Since we do not have the data before April 1999, any one who would have bought in at that time with the ‘Q’ value at 1.60 and the corresponding value of Nifty at 978.2 and sold at around January 2000 when the ‘Q’ value was at 3.40 or immediately after that say in February or March 2000 when the ‘Q’ value was actually at its highest for the period under consideration, being 3.99 in February and 3.59 in March 2000, would have made stupendous gains. The annualised average returns in this case

would have been 100% since the Nifty values were at 1546.2 in January 2000 and 1654.8 in February 2000 respectively.

Further, the ‘Q’ value fell to a low of 1.44 with the corresponding Nifty value at 913.85 in Sep-tember 2001 and rose to 3.12 in December 2003 giving an annualised compounded return of ap-proximately 37%. Assuming the investor could not time the markets so perfectly and worked in the reference range of 1.70 and 3.40. This would have made him enter the market in November 2001 when the ‘Q’ value was at 1.72 with Nifty at 1067.15 and exit in December 2003 with ‘Q’ value at 3.12 and corresponding Nifty value at 1869.75. That still works out to an annualised compounded return of more than 29%. Again, the ‘Q’ value suggests buying in May 2004 at 2.15 with Nifty at 1483.6 and selling in December 2004 with ‘Q’ value at 3.22 and Nifty at 2080.5 or any time after that, til l March 2005. That works out to an annualised compounded return of 70% or more depending on the timing of exit.

The ‘Q’ based investment strategy outperformed the buy and hold strategy over six year period. A passive investor who entered the market in April 1999, the starting month of the period of analysis, and is holding on till date would have picked up a return of 1020 Nifty points over a period of 73 months. That works out to an annualised compound return of just 13% – healthy, but no where near the returns provided by ‘Q’ based strategy. An interest-ing aspect of ‘Q’ based strategy vis-a-vis index can be illustrated by the fact that ‘Q’ at 3.40 in February 2000 gave strong sell signals with Nifty at 1546.2 points. However, in May-June 2004, the ‘Q’ was at just 2.15 and strongly suggested buying when Nifty was hovering at around the same level, i.e., 1500.

The ‘Q’ based strategy can be used to minimise the damage by suggesting the market tops and also when the prices are cheap. However, it can not be used to make money in the long-term bear market. In that case one has to wait until the market turns. Also it may not pick up a sustained rally in a long-term bull market. Prices can remain overvalued for long periods. The ‘Q’ may thus make you sell out long before a bull market actually reaches the top. At the current level of Nifty being at a level of 2000 plus, the ‘Q’ ratio is slightly more than 3.00. This suggests that though investors can still wait for some more time before they take a decision to sell their holdings, this is essentially not the time to take fresh positions in the market. �

The ‘Q’ based strategy can be used to minimize the damage by suggesting the market tops

and also when the prices are cheap.


SECURITY MARKET


Month Market Capitalization Of Nifty( Rs. billion )

Net Worth( Rs. billion )

Q Multiple

Corresponding Index ( Nifty )

Apr-99 2412.00 1510.57 1.60 978.2

May-99 2828.65 1510.57 1.87 1132.3

Jun-99 2948.70 1510.57 1.95 1187.7

Jul-99 3354.49 1510.57 2.22 1310.15

Aug-99 3658.79 1510.57 2.42 1412

Sep-99 3842.50 1510.57 2.54 1413.1

Oct-99 3707.13 1510.57 2.45 1325.45

Nov-99 3974.49 1510.57 2.63 1376.15

Dec-99 4585.87 1510.57 3.04 1480.45

Jan-00 5140.07 1510.57 3.40 1546.2

Feb-00 6031.10 1510.57 3.99 1654.8

Mar-00 5419.54 1510.57 3.59 1528.45

Apr-00 4630.60 1683.19 2.75 1406.55

May-00 4105.66 1683.19 2.44 1380.45

Jun-00 4594.87 1683.19 2.73 1471.45

Jul-00 4055.21 1683.19 2.41 1332.85

Aug-00 4425.71 1683.19 2.63 1394.1

Sep-00 3897.22 1683.19 2.32 1271.65

Oct-00 3587.24 1683.19 2.13 1172.75

Nov-00 3921.02 1683.19 2.33 1268.15

Dec-00 3873.37 1683.19 2.30 1263.55

Jan-01 4322.08 1683.19 2.57 1371.7

Feb-01 4228.84 1683.19 2.51 1351.4

Mar-01 3426.28 1683.19 2.04 1148.2

Apr-01 3419.85 1948.98 1.75 1125.25

May-01 3624.49 1948.98 1.86 1167.9

Jun-01 3416.67 1948.98 1.75 1107.9

Jul-01 3357.99 1948.98 1.72 1072.85

Aug-01 3302.50 1948.98 1.69 1053.75

Sep-01 2803.92 1948.98 1.44 913.85

Oct-01 3009.75 1948.98 1.54 971.9

Nov-01 3356.63 1948.98 1.72 1067.15

Dec-01 3402.75 1948.98 1.75 1059.05

Jan-02 3481.95 1948.98 1.79 1075.4

Feb-02 3834.23 1948.98 1.97 1142.05

Mar-02 3916.96 1948.98 2.01 1129.55

Apr-02 3955.54 2194.44 1.80 1084.5

May-02 3752.95 2194.44 1.71 1028.8

Jun-02 3921.99 2194.44 1.79 1057.8

Month Market Capitalization Of Nifty( Rs. billion )

Net Worth(Rs. bil-lion )

Q Multiple

Corresponding Index ( Nifty )

Jul-02 3632.57 2194.44 1.66 958.9

Aug-02 3805.32 2194.44 1.73 1010.6

Sep-02 3575.44 2194.44 1.63 963.15

Oct-02 3672.75 2194.44 1.67 951.4

Nov-02 3953.45 2194.44 1.80 1050.15

Dec-02 4105.06 2194.44 1.87 1093.5

Jan-03 3978.48 2194.44 1.81 1041.85

Feb-03 4064.44 2194.44 1.85 1063.4

Mar-03 3762.71 2194.44 1.71 978.2

Apr-03 3647.96 2493.92 1.46 934.05

May-03 4102.10 2493.92 1.64 1006.8

Jun-03 4543.72 2493.92 1.82 1134.15

Jul-03 477627.6 2493.92 1.92 1185.85

Aug-03 5633.83 2493.92 2.26 1356.55

Sep-03 5849.53 2493.92 2.35 1417.1

Oct-03 6343.68 2493.92 2.54 1555.9

Nov-03 6568.62 2493.92 2.63 1615.25

Dec-03 7773.81 2493.92 3.12 1879.75

Jan-04 7534.97 2493.92 3.02 1809.75

Feb-04 7519.44 2493.92 3.02 1800.3

Mar-04 7634.53 2493.92 3.06 1771.9

Apr-04 7805.38 2999.90 2.60 1796.1

May-04 6438.26 2999.90 2.15 1483.6

Jun-04 6502.24 2999.90 2.17 1505.6

Jul-04 7054.07 2999.90 2.35 1632.3

Aug-04 7530.81 2999.90 2.51 1631.75

Sep-04 8039.48 2999.90 2.68 1745.5

Oct-04 8288.92 2999.90 2.76 1786.9

Nov-04 9092.71 2999.90 3.03 1958.8

Dec-04 9657.58 2999.90 3.22 2080.5

Jan-05 9552.43 3195.30 2.99 2057.6

Feb-05 9798.39 3195.30 3.07 2103.25

Mar-05 9798.07 3195.30 3.07 2035.65

Apr-05 8886.39 3195.30 2.78 1902.5

167.12

Mean 2.289315

Median 2.26

Mode 2.198446

Annexure*

*For the companies included in the Nifty for which the fi nancial results for the year ending 2005 were not available, the net worth was arrived at by adding quarterly profi ts and any additional capital that was raised to the net worth as shown by the fi nancial statements for the year 2004


FACE TO FACE


FACE to FACEFACE to FACE


SECURITY MARKET


Q. How the current Bull Run is different from the previous Bull Runs? Is there any possibil ity of scam this t ime?

Ans. Indian economy has matured since the last bull run of 1998-2000 and now it has laid down a substantiated, stable and consolidated platform of making India a real success story and not a f luke one. This bull run is def initely sustainable as it has a ref lection of the government’s init iat ive in strengthening its key sectors l ike infrastruc-ture, agriculture and service. This ref lection was not there in the earl ier bull runs and hence their credibil ity and most importantly sustainabil ity was not assured. The CSO’s (Central Stat ist ical Organisation) projection of GDP at 8.1% for the year 2006-2007 adds to the credentials of Indian economy and thus the current bull run can be acclaimed as a true “Barometer of the Indian economy’s health”.

What followed every t ime in the earl ier bull runs was the scam which led to the devastation of the gull ible retai l investors. Each such scam proved how easy it is to play with the sentiments of investors and how manipulation in the mar-ket is a trick that any Tom-Harry or Dick can master on.

Harshad Mehta’s scam, UTI (Unit Trust of In-dia) f iasco and Ketan Parekh’s dot com bubble highlighted the loopholes that existed in the In-dian stock market. The regulatory body, Securi-t ies and Exchange Board of India (SEBI), has been reactive than being proactive when it comes to investor protection as a result of which the retai l investors are losing their trust with the market. It doesn’t seems l ike this t ime that any such major scam wil l follow, the reason primarily being that

most of the part icipation this t ime has come from institutions following strict SEBI norms l ike mu-tual funds which again was a non existent identity in the earl ier bull phases. The only concern this t ime is perhaps penny stocks which do not come under a strict control and are diff icult to keep a scan on. Let’s keep our f ingers crossed so that at least this t ime our own retai l investor develops a confidence in his own country’s monitoring body and owing to a well complied regulatory frame work gets a transparent picture to assist his investment decision so that he has a share of his due returns.

Q. Do you think the primary market plays an important role in developing the secondary market? How wil l the primary market behave in years to come?

Ans. Surely it is the primary market that gives a good credential to the secondary market. The current Bull Run can also be seen as a strong con-tribution from the investors in the primary market especially in the last two years. Only selective and quality issues have come out in these years as com-pared to earlier years when almost any company of low profile decided to f low its Initial Public Offer (IPO). As a result, the primary market has wit-nessed a warm response and good support from the market. Strict norms, transparency and cupid price determination mechanism is sure to strengthen the secondary market in future. As I can see the primary market is the safest market to invest and is currently just on a tip of the iceberg in terms of its maturity. The increasing confidence of investors has actually thrown upon the idea of companies now preferring to raise their funds through IPOs. To sum it up sensex will continue to move in the north direction til l the time it gets full support from primary market in terms of quality and quan-tity contribution from investors and make the bulls competent enough to thrash out the bear.

Sensex will continue to move in the north direction till the time it gets full

support from primary market

Mr. S. P. Singh, Branch Manager (Ex Sr. Manager Investment 1998-05), Punjab & Sindh Bank

FACE to FACE


FACE TO FACE


Q. Are you satisf ied with the regulation of SEBI? What are the reasons for current ‘Demat Scam’ and how can it be checked in the future?

Ans. SEBI has to be proactive than being reactive both in the case of primary as well as secondary mar-ket to make them more effi cient. Although some of the aspects like ratings of IPO’s, removal of discretionary allotment for Qualifi ed Institutional Buyers (QIB’s) and price discovery of primary market has witnessed due consideration, still it is quite a distance away from where it intends to go. Further liquidity, fl uctuation in the sensex level and unjustifi ed rift which the retail investor has to swallow are still needed to be worked upon.

Everything comes at a price but what matters is the fact that whether this price is justif ied or not. When the posit ive signals of Indian corpo-rate strength and maturity were gett ing across the globe owing to Foreign Institutional Investors’ (FII’s) increased investments into India , one was also gett ing an imbedded message that yes this t ime no scam, no mirage, no makeup is needed to prove Indian corporations worth. The regulators have at last locked the right knob with the right lock with the perfect key in their own control and no duplicate key with any outsider. But al l said and done, there is nothing in this world as perfect that cannot be duplicated. Same is the case with our so cal led well regulated market. To gain from this current Bull Run the multiple demat account strategy was exercised to such a perfection that even anything of such kind was unimaginable. Competit ion among depositories to gain on volume of demat accounts with them has completely made them neglect this crit ical aspect of identifying such kind of query. Thus, signal ing Indian corporate strength at a price of such a scam in the highly regulated primary market has fai led to justify its potential.

In order to keep a check on the execution of such strategy Know Your Customer (KYC) norms have been issued to banks. The same should im-ply to depositories to t ighten such lacuna and become more eff icient in the back off ice opera-t ions. Even heavy penalt ies should be imposed if the said norms are not exercised properly.

Q. Do you think corporate governance buzz is real ly going to affect the company structure? Your view on Clause 49 with regards to the inde-pendent directors.

Ans. The effectiveness and real benefit of Clause 49 can only be real ised if few considerations are put into practical frame. It means that the pur-pose of this clause wil l not be served by having independent directors just for the sake of bring-ing more transparency to the system but if they are given both stake and voting power, only then it will be served. As per the current structure the

top position like CMD (Chairman and Managing Director) rests in himself the final verdict, i.e., he is the ultimate decision maker. So, the independent director should be taken as an asset rather than liability. His stature should be a contributory per-sonnel having ample interest for the well being of the company’s interest as well as its shareholders. Industry should welcome his involvement rather than developing a negative image of undue and

The independent director should be taken as an asset rather than liability

The regulators have at last locked the right knob with the right lock with the perfect key in their own control and leaving no

duplicate key with any outsider


SECURITY MARKET


unwanted interference. Finally, it all depends upon the execution rather than the formation.

Q. Where do you f ind Indian capital market to be when compared to developed markets l ike US?

Ans. We are still in a nascent stage when com-pared to developed markets like US and London Stock Market to mention a few. The biggest compar-ison that one can draw is the very fact that Indian companies are always eager to get listed in the above mentioned capital markets but there are hardly any foreign company that may find it appropriate to get listed in Indian stock market. The reason may vary from legal obligations to underdeveloped market than that of US and London. Although one sees that the only determinant factor to be interested in Indian capital market is a better return than their home countries are being provided but the real story is something different and as a result, our markets resembles to be so called ‘semi-efficient’. This critical aspect is the f low of information from the corporate to the general public. In India, the inside information has resulted in recording su-pernatural profits by either buying in advance at low prices or by leaving early at high price. This is how scam takes place. In the so called ‘efficient markets’, this lead time is negligible and as a result has a much more transparency, worthy and trusted capital market structure.

The other critical aspect is the stature of inves-tor. In developed or effi cient markets, almost 90% of the investments are made by institutions, like mutual funds and hardly 10% by retail investors directly. Thus, the investments are managed in a more effi cient and safer manner. But in Indian sce-nario, this aspect of greater participation through institutions has not yet caught up. As a result, direct investment by retail investors is not safe in terms of even the principal amount invested and more of-ten than not yields negative return. Even the Prime Minister, Finance Minister and SEBI have advocated the increased participation in mutual funds by retail investors to hedge their risk in a professional man-ner so that they do not go for a complete loss when

market falls. Indian capital markets are slowly but steadily moving in a right direction to become both effi cient and developed.

Q. What role have FIIs played in Indian stock

market? In your opinion, are FIIs boon or bane for Indian capital markets?

Ans. No one can doubt the role of FIIs in the Indian stock market. It seems that it has become a favourite destination to park the investments for a better return. It is a fact that stock markets performance are dependent on FIIs investment, but one should be clear that this dependence is not the only resort of giving a good stock market performance. This degree of dependence should al-ways be monitored so that they do not, at any point of time, become market makers or breakers. Even if they leave today, the sensex being at 10000 levels, it would not bring down sensex below 8000 levels.They should be treated as a guest but not as a fam-ily member. Our retail investors should be the ones on whom our markets should rely upon. But, sadly, till now they have not got the attention they are supposed to get. They are our undervalued assets. Steps are taken to involve them as an active investor and increase their shareholding in the sensex. Their faith in domestic institutions should be increased and encouraged for this very purpose.

Q. Which sectors are going to rule the markets in near future?

Ans. Infrastructure, health equipment, au-tomobiles and banking have a good potent ial to move on a growth trajectory. Although the banking sector has witnessed a good growth but st i l l what it needs is consol idat ion. Out of the total number of publ ic sector banks, only four or f ive are performing. Others are just putt ing the excessive pressure on the rest to perform. If the disinvestment of ‘Navratnas’ is al lowed which in itself has number of unjust if ied constraints such as pol it ical interest, lefts opposit ion, etc., con-sol idat ion can take place and which wi l l direct ly get ref lected in the stock market. The priority of any economic act ivity should be value addi-t ion for the cit izens of the country and above al l individual interests. �

Even the Prime Minister, Finance Minister and SEBI have advocated

the increased participation in mutual funds by retail investors to hedge

their risk

Our retail investors should be the ones on whom our markets should

rely upon


FACE TO FACE


Lalit K. Khanna Executive Director, Escorts Asset Management Ltd

Q. How the current Bull Run is different from the previous Bull Runs? Is there any possibility of scam this time?

Ans. It is a known fact that the driver of the Bull Run is institutional investments. This time the story is same, i.e., FII’s and domestic mutual funds have been the major contributors, the only difference being the degree of investment. Prior to 1991, the only players were LIC and UTI but as our economy has developed and become liberalised the number of participants and their activeness have increased manifold. Commercial banks and domestic banks have at last realised the real potential which the FII’s have already cashed upon. This Bull Run will surely be sustainable.

It doesn’t look like any major scam will be wit-nessed this time as our market has matured consid-erably in terms of the nature and structure of the investors. The only worry is about overvaluation that may lead to misleading investment decision. Further, leaving aside the institutional investor even the retail investor has enough information to assist his decision which was missing in the earlier times when only sentiments and even rumours shaped the decision making. The difference this time is that money is fl owing in from various countries and moreover, if one segment sells the stocks the other segment is standing there to buy it. So, this way manipulating market in one direction becomes very diffi cult which reduces possibility of scams. In short, it is a good time for smart investors.

Q. Do you think primary market plays an impor-tant role in developing the secondary market? How will the primary market behave in years to come?

Ans. Of course, the primary market is important to develop the secondary market but one should be very clear that it is the secondary market which acts as a tool of ‘price discovery’ for the primary market. The

Primary market is thus the refl ection of the secondary market. It relies more on the secondary market and when secondary markets are zooming the primary markets are fl ooded with new issues. We have seen in the last year itself, a number of good IPO’s being fl oated in the market and receiving a good response from the market. Although the profi le of such com-panies is good but the other and the most important determinant of such warm response has been the fact that the sensex has performed consistently well over the past year and so, and has substantially generated a confi dence about its sustainability and undoubtedly credibility.

As long as the secondary market keeps on perform-ing well to meet the desired level of investment sat-isfaction, the primary market will keep on getting a healthy subscription. After all, both markets need to correspond each other competitively and effectively to sustain the much awaited Bull Run.

Q. Are you satisfi ed with the regulation of SEBI? What are the reasons for current ‘Demat Scam’ and how can it be checked in future?

Ans. SEBI has done reasonably good job in terms of monitoring the stock market and keeping a check on its operating activities. As a matter of fact, it has not got the kind of appreciation that it should get for considerably exercising its role of making the whole stock market mechanism a safe and well informed place for investor to invest. In practice, there is nothing that can be claimed to be ‘perfect’. The degree of SEBI’s effi ciency and effectiveness are its real parameters to judge its authenticity. As far as scams are concerned they are bound to happen and SEBI can only reduce

It is the secondary market which acts as a tool of ‘Price discovery’ for

primary market.


SECURITY MARKET


them and not eliminate them. There is a popular say-ing in New York Stock Exchange that in a boom you can sell rubbish. In a booming stock markets scams are bound to happen because of excessive valuations and heated up investors tend to buy on rumours rather than on fundamental values.

Demat scam brings into the light the various areas of importance which have gone unnoticed till now. With the growing participation in the market, com-plexities have also increased. To keep a track of each and every activity and aspect of market is really im-possible. Considering this very fact, SEBI can ensure that frequencies of such kind of manipulations are reduced which is much more appropriate and attain-able than covering the minutest of minute loopholes in the market. The regulator has done substantially well to send down the right message through right medium to the system that no one will go without punishment and unnoticed if it is against the interest of the society and its members. The surveillance and control is much better and well equipped to meet any kind of challenge.

Q. Do you think corporate governance buzz is really going to affect the company structure? Your view on Clause 49 with regards to the independent directors.

Ans. The main objective of corporate governance is to protect shareholders against the unjustifi ed practices of the management. In corporate govern-ance, we are stuck with the regulatory aspect of improving effi ciency like clause 49 about independ-ent directors. Clause 49 is just a part of the proc-ess to meet this objective. But, the real objective is to protect shareholders against management. The idea of taking independent director defi nitely brings transparency in the system, but it can be futile if the independent director does not have operational knowledge of the company. Thus, an initiative taken to bring more transparency may actually lead to a compromise in the business’ competence. The present day investor is quite alert and has a well re-searched knowledge to determine his future course of action. Any management cannot even attempt to mislead its shareholders because they know that in this competitive arena even a small wrong move can lead to the end of its business once their assets (shareholders) become indifferent to the interest of

the company. We are moving in a right direction and surely would achieve a best practice of shareholder’s protection to ensure an active share market.

Q. Where do you fi nd Indian capital market to be when compared to developed markets like US?

Ans. Comparison on what basis – income levels, savings level or size of trade? India is much smaller as compared to US, the income of people are less. Number of investors in India is large but number of trades is very small. It is very diffi cult to compare the two economies. As an investor, ideally US should be my favourite destination to make an investment but why even a US investor favours India? The answer to this very question can be understood by looking at the Enron story. How astonishing it seems when a company that made the headline of almost every news daily took actually a complete year to fi nd its

Number of investors in India is large but number of trades is very small


FACE TO FACE


“true level” after its prices broke down. In the capital market, a year’s time is truly a long period taken to attain a right level. So, when one urges of Indian capital market developed or not, whether effi cient or not in comparison to US, there is no way does these com-parisons really fi nds a justifi ed mean. No market can be attributed as effi cient or developed when one looks at the earlier cited example in the so called developed or effi cient market.

Therefore, the only realistic basis for comparison lies in the potential of the country’s economy to give a momentum and boost to its capital market. Although, one cannot challenge the strength of US economy but one can without any doubt acknowledge the huge potential Indian economy has stored for investors seeking a better, continuous and profound investment returns. In true sense, India is developing into a charismatic performer in the world economic arena.

Q. What role have FIIs played in Indian stock mar-ket? In your opinion, are FIIs boon or bane for Indian capital markets?

Ans. Practically speaking, FIIs have brought large amount to small market. They come to our markets in pursuit of profi ts. They differ in their origin of country, the economic scenario, investment sources and motives and most importantly the complexities

in their market movements. Imperative decisive as-pects such as their inclination and timing of entering market leading to a momentum have always been the key area of concern, and interest been analysed by the analysts. Still no optimal conclusion has been possible to derive upon. They have the ability to make the market subject to a bull run if they decide to invest and also to a bear phase if investments are sucked backed from the market. FIIs are boon to the markets when they put markets on a roar and bane when they take out their money. But, we have to live with it. We need foreign investment, so we have to welcome them, but at the same time we have to live up also with the volatility being created by such an investment. It’s a double edged sword.

Q. Which sectors are going to rule the markets in near future?

Ans. Capital goods, infrastructure, power, equip-ment suppliers to power and cement are the sectors, investors should look upon. Banking is also a good investment to invest but it seems to be moving at historically high multiples and does not look to have a tremendous potential. With strong fundamentals in place, it seems that the real investment at last has arrived. If disinvestment of ‘Navratnas’ takes place it will initially bring down the market, but in a long run it will signal out to the world that economy is opening up and it is truly on its way to become a superpower. It will be a major indicator of India’s building strength and will thus make India a much hotter destination for FIIs investments. But, such a disinvestment should be a continuous and sustain-able process and not a one time bustle. �

Therefore, the only realistic basis for comparison lies in the potential of the

country’s economy to give a momentum and boost to its capital market


IN FOCUS


The Midas TouchOld is go ld t i l l the t ime i t is “Gold”.

by Inder Preet Singh, IIPM Think Tank


SECURITY MARKET


Centuries have past, kingdoms have changed, kings have changed , economic scenarios have changed, demographic and diplomatic relations

have changed but what has remained constant is the de-sire of holding, acquiring and exhibiting the most sought after precious commodity “ Gold”. It is quite astonishing to acknowledge the fact that as the time has passed the surge of gold has not only formed an indispensable part of the jewellery collection but is also a major component of any country’s rich reserves. From the earlier exchange of it in a barter system to a globally operated, functional, systematic, regulated and most importantly the liquid market gold has taken the upsurge of differentiating it-self completely from rest of the commodities. It acts as a synonym to a persons or even nations ideal diversifi er against any other asset-class because economically and fundamentally the forces determining the prices of it are much more sustainable to the forces driving the infl ation. The volatility of prices of some precious metals, currencies and even the other government backed instruments do not depict a good deliverable value preposition as compared to gold which is secure asset that can be cashed upon in any circumstance at any time. It shares a cushioning effect at the time of both stable and unstable prevailing fi nancial periods and hence a desirable and constant mean of much anticipated return.

Current Scenario- Gold demand is driven by categoriz-ing broadly demand as an investment demand where the consideration is risk & return, secondly the desire to wear and exhibit the perfect blend of beauty and quality as a form of Jewelry demand and fi nally the bigger contributor of surging demand i.e. industrial demand. In the context of current scenario, there is a high price volatility as a result of which the institutional investment has lead to a high demand whereas for jewelry purchasing it still seems a dicy situation. With the prices soaring high and the momentum going up gold seems to be a good investment opportunity to invest for a minimum of one year with around 25% of price appreciation ex-pected. Exchange traded funds have also contributed signifi cantly in this demand generation. Furthermore with the availability of other investment in-struments available like shares, mutual funds, and debt bonds etc. on whom the macroeconomic factors such as interest rates, GDP and even forex makes them quite vulnerable to risk-return profi le, gold is not vulnerable to such changes. Although the returns may be much high but the degree of

risk is incomparable to that of investing in gold which is al-though a conservative but a viable investment to be made about. Approximately there has been 53% increase in the exchange traded funds in tonnage terms and around 67% in dollar terms. Finally there stood around 83% of the total infl ow attributed by the WGC-backed street Tracks gold share listed at NYSE. The highly conducive world economic environment is sure to give, in a long run, boost to the prices of gold attributed by investment demands rather than the conventional supply-demand gap.

With the ever changing fashion trends one has to adapt himself to the latest style statements. The designer jewelry industry has witnessed a double digit growth in the last decade itself. Nationally as well as internation-ally gold has been the fl avor of the jewelry community with diamond and other pearls catching up to it. Three key attributes contribute to jewelry demand. Firstly, the quality in terms of both purity & design have improved considerably owing to global standards ,secondly the will-ingness or the purchasing power to afford such highly priced have also increased and fi nally the variety of offer-ings have increased manifold providing a greater choice across different sections of the society. The only concern in this kind of demand is the price volatility rather than price increase.

One may be astonished to know the fact that gold is used for various critical and high end conventional indus-trial applications such as nanotechnology, dental, biomedi-cal, electronic and integral part of non-conventional appli-cations such as aircraft engines, recordable compact discs and cockpit window of jet aircrafts to name a few. Catalyst for industrial reactions and ambient air purifi cation are some of the upcoming spheres in which the integrity of gold used is been currently analysed.The consumption for the above listed and related applications contribute to about 450 tonnes per annum. Thus one can clearly see

that gold has a strong cross-demand-supply relationship to even the upcoming technology developments. The graph be-low depicts owing to the above listed facts the increase in gold prices across the world.

SupplyWith the economic funda-

mentals strong, especially the Asian economy looks set for driving the demand among other nations. With China and India forming the largest share of potential biggest mar-

It is quite astonishing to acknowledge the fact

that as the time has passed the surge of gold has not only formed an

indispensable part of the jewelry collection but is also a major component

of any country’s rich reserves


IN FOCUS


kets with high population, supply looks almost adequate in meeting such demand. The major produc-ers of gold include South Africa, US, Australia, Indonesia, Russia and China. Supply is also needed to meet the upcoming, economi-cally developing and liberalizing countries like Turkey, South East Asia and Saudi. Italy posses a great need for gold as it is one of the major nation of employing gold in fabrication. India is the biggest consumer of gold followed by US and Saudi Arabia. With the development taking place and the economy booming South Africa, Australia and US are set to be the major players set to meet these soaring demands.

According to the Tablr1.1

HoldingAfter looking deep inside the supply equation it be-

comes vital to look at the offi cial country wise allocation of gold holdings, it suggests an indirect but defi nite indi-cation to which nation will execute the biggest supply demand. Another factor that has contributed to the hold-ing is the fact that as a result of better income, investments rate have witnessed a better trend against the traditional better income-high savings rate. It should be properly indicated that the following table should not be taken as a sole indicator of supply generation.

Having a presence, dominance and huge investments as its attributes, gold is priced in US dollars per troy once. Commodity Exchange Inc (COMEX) was the fi rst ex-change at which gold future was introduced in 1974, since then it has been merged with New York Mercantile Exchange (NMX). After receiving a good response and appealing strongly to the fi nancial community options were developed in Mocatta Metals Corporation which is presently known as Scotia Mocatta along with CSFB in

the year 1970. This is how gold’s derivative market developed and since then has become the hot-test place to park the investment of strategic investors. Having a large quantity of above ground stocks makes generally its forward prices rise as the maturity of the contract extends. Trading through an exchange such as the COMEX division of NYMEX is effected though futures brokers who act as independent agents. The source of

the deal may therefore remain anonymous. COMEX trad-ing is centrally-cleared, which technically eliminates coun-ter-party risk as the client is trading with the Exchange, which has matched him with an equal and opposite trade from other counter-party. COMEX options. These are options on COMEX contracts and are therefore options on futures. As with futures, these are standardized con-tracts rather than the bespoke transactions in the OTC market, and are freely tradable. These instruments, like the futures contracts themselves, attract a high degree of speculative activity. The online screen based trading has increased the participation in this very segment to a very high volume. Slowly but gradually gold is acquiring the status of the “hottest commodity’. In terms of both the volume and value of gold contracts are increasing owing much to the retail investment & participation.

Especially in the Indian context it is catching up with the old fl avored stock market. As the market is gradually settling down as a sustainable and mature market investors are looking for new avenues. With the commodity market still in its nascent stage gold has been the most sought after target. One cannot deny the fact that Indian stock market has come a long way but still the truth lies in the fact that the retail investor is still left at the mercy of big players. The exposure of mutual funds to commodities can be seen as a positive step in identifying the next generation in-

vestment instrument. Gold has maintained its value in terms of real purchasing power in the long run and is thus particularly suited to form part of central banks’ reserves. In contrast, paper currencies always lose value in the long run and often in the short term as well. The volatility associated with the stock market is not a regu-lar sight to witness in com-

Three years ending 5 April 2006

Gold BSE 200 Index

CRISIL Composite Bond

Index

India 6 Month Deposit Rate

Gold 1.000 -0.036 -0.072 0.110Bombay Stock Exchange 200 Index

-0.036 1.000 0.227 0.155

CRISIL Composite Bond Index

-0.072 0.227 1.000 0.048

India 6 Month Deposit Rate

0.110 0.155 0.048 1.000

Note:Red text denotes that correlation coeffi cient is not signifi cantly different from zero

With China and India forming the largest share of potential

biggest markets with high population, supply

looks almost adequate in meeting such demand


SECURITY MARKET


modities market. No doubt the ‘shine’ which gold shares in the eyes of Indian families to have a pick has been the most encouraging factor of its purchase especially when it has seen a sharp increase in its prices. Being the largest consumer of gold it seems no surprise that in the com-ing years there will be any country overtaking this very trend. Another interesting fact is that within the last one year stock market, real estate as well as gold have seen a northward trend but it is only gold which seems to have the most promising and even ideal risk-return profi le.

It is always desirable to look at all the possible factors infl uencing the gold price directly as well as indirectly. Some of the much apparent factors include reclaimed scrap and offi cial gold loans, producer / miner hedging interest. world macro-economic factors such as US Dol-lar, Interest rate., comparative returns on stock markets and fi nally the most important domestic demand based on monsoon and agricultural output. It is primary traded across the world through major trading centers such as London which acts as a clearing house, New York re-nowned as a home of futures trading, a physical turntable Zurich and fi nally important potentially rich consuming regions comprising Istanbul, Dubai, Singapore and Hong Kong. Except Mumbai Hong Kong Gold Market, Zurich Gold Market, London Gold Market and New York Market are all 24-hour gold markets.

In India, gold is traded in Mumbai and Ahmedabad. It is also traded in three of India’s major commodity exchanges namely National Commodity & Derivatives Exchange ltd, Multi Commodity Exchange of India ltd and National Multi Commodity Exchange of India ltd. The way equity market is performing it seems quite evi-dent that the next big thing on every investors, brokers and fund managers is the unexplored effectiveness of the commodity market and gold sharing the top priority in it. Finally the only risk that gold has to its attribute is the very fact that although its industrial demand seems to be on an upward trend its jewelry demand may see a dip owing to the popularity of diamond & gems taking over its unquestionable glittering charm.


IN FOCUS



SECURITY MARKET


“Derivatives like these are dangerous and we were badly burned. We won’t let this happen again”—‘P&G announces after tax charge’, PR Newswire, April 12 1994

It’s great to think of derivatives like futures and op-tions as risk management tools, but there remains an ever lurking danger that their complex nature and

misreading of benefi ts by the investor could lead to dis-astrous consequences. A host of big companies, gigantic reputations and sophisticated models have come crashing down as a result of ‘irrational exuberance’ exhibited with respect to derivatives.

Even the International Monetary Fund (IMF) in its re-cently published report (April 11, 2006) has warned: “De-velopments in credit derivatives, which have distributed fi nancial risks to a wide range of fi nancial players instead of banks, increase the chance of “unpleasant surprises” from the less-regulated market players.”#

Let’s dig up a bit of history to begin with.

History Lessons In the US, a man named Tino De Angelis was behind

a scam popularly known as the ‘Salad Oil Swindle’1 in the 1960s. His plan was to corner the world’s vegetable /

salad oil market. At that time commodities like salad oil sold briskly in international market and futures traded at the commodity exchanges almost as heavily. De Angelis managed to con everybody into thinking he owned pretty much the most amount of salad oil as compared to any-body in the world by maintaining water fi lled tanks in Bayonne, New Jersey.

He used this premise to raise loans (pledging his ‘oil’ as collateral) and invested them to buy up futures contracts on the Chicago Commodity exchanges, knowing that he was going to drive the prices up as soon as people real-ize he has virtually bought all the salad oil supply in the world through the obligation of the futures. He would then making a killing by selling off the futures contracts (and squaring off his position) he had bought now at very low prices. But his bluff was called by traders who investigated his suspicious actions in the markets and ultimately salad oil prices crashed. The De Angelis con game went bust and Tino went bankrupt and predictably enough, headed to prison.

But the fact that De Angelis planned an elaborate scam using derivatives as the cog, around which his diabolical wheel of (mis) fortune would revolve, highlights that the instruments in the wrong hands can have devastating consequences. Investors thus would be advised caution

DERIVATIVESThe Other Side

“Derivatives like these are dangerous and we were badly burned. We won’t let this happen again”

by Tariq Laskar, IIPM Bangalore


IN FOCUS


before they get into too much speculation using futures, options and other derivatives.

Its All About Loving Your RisksThere are fi ve general types of risk that are faced by all

businesses: market risk (unexpected changes in interest rates, exchange rates, stock prices, or commodity prices), credit/default risk; operational risk (equipment failure, fraud); liquidity risk (inability to buy or sell commodi-ties at quoted prices); and political risk (new regulations, expropriation). Derivatives which have developed over the ages are a way of managing the risks stated above. Simply put, derivatives are contracts that derive their value from other securities and / or commodities. These contracts can be used to transfer and consequently manage the aforementioned risks in a business.

That is perhaps the primary reason for their popularity in the fi nancial universe but then, as with all fi nancial instruments, speculators are not far behind.

The most commonly used de-rivative contracts are forward con-tracts, futures contracts, options, and swaps.

A forward contract is an agree-ment between two parties to buy (sell) a specifi ed quality and quan-tity of a good at an agreed date in the future at a fi xed price or at a price determined by formula at the time of delivery to the location specifi ed in the contract. For example, a wheat farmer may agree to deliver a mil-lion kilos of wheat to a buyer, during the fi rst week of July 2006 at a price of Rs.13.20 per kilo.

Forward contracts have problems that can be serious at times. First, buyers and sellers (counterparties) have to fi nd each other and settle on a price. Finding suitable counterparties can be diffi cult. Discovering the market price for a delivery at a specifi c place far into the future is also daunting. Third, one or the other party’s circum-stances might change. The only way for a party to back out of a forward contract is to renegotiate it and face penalties.

Futures contracts solve these problems but introduce some of their own. Like a forward contract, a futures con-tract obligates each party to buy or sell a specifi c amount of a commodity at a specifi ed price. Unlike a forward contract, buyers and sellers of futures contracts deal with an exchange, not with each other. For example, a pro-ducer wanting to sell wheat in December 2006 can sell a futures contract for 1,000 kilos of Wheat to the National Commodities Exchange (NCX), and another buyer (let’s

say a company like ITC) can buy a December 2006 wheat future from the exchange. The December futures price is the one that causes offers to sell to equal bids to buy—i.e., the demand for futures equals the supply. The December futures price is public, as is the volume of trade. If the buyer of a December futures fi nds later that he does not need the wheat, he can get out of the contract by selling a December wheat future at the prevailing price. Since he has both bought and sold a December wheat future, he has met his obligations to the exchange by netting them out. In fact, that’s what most investors do!

Several features of futures are worth emphasizing. First, a party who elects to hold the contract until maturity is guaranteed the price he paid when he initially bought the contract. The buyer of the futures contract can always demand delivery; the seller can always insist on deliver-ing. As a result, at maturity the December futures price for Wheat and the spot market price will be the same. If

the Wheat price were lower, peo-ple would sell futures contracts and deliver oil for a guaranteed profi t. If the Wheat price were higher, people would buy futures and demand delivery, again for a guaranteed profi t. Only when the December futures price and the December spot price are the same is the opportunity for a sure profi t eliminated.

Second, a party can sell wheat futures even though he has no access to wheat. Likewise a party can buy wheat even though he has no use for it. Speculators routinely buy and sell futures contracts in anticipation of price changes. Instead of delivering or accepting wheat, they close out their positions before the contracts mature. Speculators perform the useful func-tion of taking on the price risk those producers do not wish to bear. That was in effect what Tino De Angelis was trying to play around with.

Third, futures allow a party to make a commitment to buy or sell large amounts of wheat (or other commodities) for a very small initial commitment, the initial margin. Consequently, traders can make large profi ts or suffer huge losses from small changes in the futures price. This leverage has been the source of spectacular failures in the past not least of which was the Tino De Angelis affair. And as you will soon fi nd out some of the biggest names in the fi nancial world too have gotten badly burnt!

Lastly, you have another category of derivatives—the option. An option is a contract that gives the buyer of the contract the right to buy (a call option) or sell (a put option) at a specifi ed price (the “strike price”) over a speci-





SECURITY MARKET


fi ed period of time. American options allow the buyer to exercise his right either to buy or sell at any time until the option expires. European options can be exercised only at maturity. Whether the option is sold on an exchange or on the OTC market, the buyer pays for it up front. Options are used successfully to put fl oors and ceilings on prices; however, they tend to be expensive.

Derivatives Of A Complicated KindAnother set of slightly more complicated yet attractive

derivatives are swaps. Swaps (also called contracts for dif-ferences) are the most recent innovation in fi nance. Swaps were created in part to give price certainty at a cost that is lower than the cost of options. A swap contract is an agreement between two parties to exchange a series of cash fl ows generated by underlying assets. No physical commodity is actually transferred between the buyer and seller. The contracts are entered into between the two counterparties, or principals, outside any centralized trad-ing facility or exchange and are therefore characterized as OTC derivatives.

Because swaps do not involve the actual transfer of any assets or principal amounts, a base must be established in order to determine the amounts that will periodically be swapped. This principal base is known as the “notional amount” of the contract. Swapping avoids the expense of selling the portfolio and buying the bond. It also permits the investor to retain any capital gains that his portfolio might realize. But then, whether its wives or assets, swaps are generally troublesome as P&G found out in the early 1990s.

Many of the benefi ts associated with swap contracts are similar to those associated with futures or options contracts.

Although swaps can be highly customized, the coun-terparties are exposed to higher credit risk because the contracts generally are not guaranteed by a clearinghouse as are exchange-traded derivatives. In addition, custom-ized swaps generally are less liquid instruments, usually re-quiring parties to renegotiate terms before prematurely terminating or offsetting a contract.

The P&G CaseThe controversy surrounding

the Procter and Gamble (P&G) swap losses, and losses suffered by a number of other fi rms on swaps constructed and sold by Bankers Trust in 1993 and 1994, had threat-ened to undermine the widespread

use of fi nancial derivatives by corporates in general. These swaps had been entered into under the guise of hedging, but were now characterized as purely speculative.

P&G announced on 12 April, 1994 that it had incurred a $157 million loss from closing out an interest rate swap transaction that it had entered with bankers trust. The write off obviously dented its bottom line, but at the same time set alarm bells ringing for other companies that were entering into similar arrangements. Technicals aside, P&G had entered this agreement for ‘managing interest rate and exchange rate exposures’2. What the agreement entailed was what is popularly called a ‘leveraged’ swap as opposed to a ‘plain vanilla’ swap. A ‘leveraged’ swap is a fi nancial derivative in the form of a swap where counterparties agree to exchange the difference between short term and long term interest rates.

P&G’s main aim was to balance its fl oating and fi xed rate interest payment obligations without incurring sig-nifi cant interest rate risk. But things went downhill when interest rates rose in the economy and P&G realized too late that there was no way they could ‘lock-in’ to the swap without incurring signifi cant losses. All hell broke loose and P&G slapped a suit on Bankers Trust saying it was misled and its payments were calculated differently by Bankers Trust than what was agreed upon prior to the swap inception.

P&G stated, “The issue here is Banker’s Trust’s selling practices. There is a notion that end users must be held accountable for what they buy. We agree completely, but only if the terms and risks are accurately disclosed.”3

Bankers Trust retaliated, “Although P&G would like this court to believe that it is a naïve and unsophisticated user of derivatives transactions, the fact is that as a part of its regular course of business and with authorization of top management….P&G’s treasury department man-aged a large and sophisticated portfolio of derivatives transactions.”4

So was Bankers Trust the glib talking unscrupulous fi nancial institution that had taken a naïve and unaware

P&G for a ride or did P&G take a risk it shouldn’t have? We will perhaps never know as the par-ties reached an out of court set-tlement. P&G made it clear that ‘Our philosophy about the use of fi nancial instruments is to manage risk and cost….(and) not to engage in speculative leveraged transac-tions’5 But it did raise an impor-tant question: When it comes to managing risk or speculating us-





IN FOCUS


ing derivatives, where do you draw the line?

Ltcm Had A Great FallIf you are Long Term Capital

Management (LTCM), the answer is, you don’t! LTCM was one of the most spectacular fi nancial crashes ever known to man. And deriva-tives feature very prominently in their story.

LTCM was a bond trading fi rm founded by John Meriwether, a star trader himself at Salo-mon Brothers previously. The uniqueness of the fund was based on the fact that it had a group of intellectually superior (well, actually, obscenely intellectually superior) arbitrageurs who consisted of the best of the best (includ-ing two Nobel Prize Winners!) from the fi nance world. Since its beginning in 1993 the fund returned around 40% annually becoming the envy of the fi nance world.

The genius that powered its decisions seemed to have reduced the uncertain world to a cold blooded math-ematical model. And then, suddenly, in the autumn of 1998 it collapsed. As Roger Lowenstein explains in his bestselling ‘When Genius Failed’: This one obscure fund had amassed an amazing $100 billion in assets, virtually all of it borrowed…. As monstrous as this indebtedness was, it was by no means the worst of LTCM’s problems. The Fund had entered into thousands of derivatives con-tracts…essentially side bets on market prices…(with) more than $1 trillion (!) worth of exposure.’6

Derivatives had blurred the lines between investment fi rms, banks, and other fi nancial institutions. In this seamless world of derivatives anyone could assume the risk of loaning money or of providing equity simply by structuring an appropriate contract. The inter linkage meant that if LTCM collapsed, the entire system would follow. And it almost did, before banks bailed LTCM out. LTCM’s undoing was that its bets on Interest rates through Interest rate derivatives had gone horribly wrong notably in Russia where it had a lot of exposure as well as in some other emerging markets.

A Last WordDerivatives in general increase the effi ciency of fi nan-

cial market by unbundling various types of risks so that fi rms can select as to what risk they want to bear and what risks they want to pass on. Derivatives redistrib-ute the risks and hence make the fi nancial system more resilient.

But then, there is one important facet of derivatives that is ignored out here. Derivatives do not eliminate risk,

they only redistribute it. Thus, the risks hedged are only passed on to somebody else. And that some-body else should have the appetite for that risk. Otherwise, the sys-tem comes under threat, just like in the LTCM case.

More cases like the ones cited above are abound, most famously the one of how Nick Lesson sunk Barings Bank thanks to over ex-posure in derivatives. P&G got

badly burned, LTCM and Barings Bank collapsed, De Angelis landed in prison. Are derivatives like a light that attracts the fi refl ies from the fi nancial world? Those, who like Sharon Stone in ‘Basic Instinct 2’ suffer from ‘Risk Addiction’?

Whatever it is, one thing is clear—they may have been invented to mitigate risk, but speculative uses of deriva-tives will stay. The only thing to be kept in mind is to regulate the greed that leads to disasters. They are like the parachute, invented initially for safety purposes, but has now gone on to spawn a host of risky sports like base jumping and sky diving.

As Fortune wrote in 19957: When they are employed wisely, derivatives make the world simpler, because they give their buyers an ability to manage and transfer risk. But in the hands of speculators, bumblers, or unscrupu-lous peddlers, they are a powerful leveraged mechanism for creating risk.

How true!

References1. The Tino De Angelis story is adapted from ‘The Mes-

sage of The Markets’, By Ron Insana Harper Business Books, Published in 2002 (pp 5-6)

2. 1993 Procter and Gamble Annual Report, Page 57/58

3. Edwin L Artzt, the then Chairman and CEO, P&G in the hearing

4. ‘The Bankers Trust Tapes’ published by Business Week on October 16, 1995

5. P&G Annual report, 19946. The Long Term Capital Management (LTCM) case

is adapted from ‘When Genius Failed: The Rise and Fall of Long Term Capital Management’, by Roger Lowenstein, Random House Books

7. ‘Untangling the Derivatives Mess’, Fortune, March 20, 1995

# Storm clouds seen over markets: IMF By Greg Robb, Market Watch Apr 11, 2006




Who we are..The IIPM Think Tank, an independent, India-centric research body, is inspired by Dr. M.K. Chaudhuri’s vision of India as an economic powerhouse in the 21st cen-tury; a modern nation state where poverty becomes history and the underprivileged are not consigned to the dustbin of amnesia. The national presence (across seven nodes, News Delhi, Mumbai, Chennai, Pune, Ban-glore, Hyderabad and Ahemdabad), makes our understanding of the economy superior, where is many research fellows, senior re-search associates, research assistants, pro-gram coordinators, visiting fellows and etc embark on research assignments and net-work with global intelligentsia.

IIPM - Think TankWho we believe..The IIPM Think Tank is wholly free of ideology and looks at the Indian Develop-ment Paradigms, Purely modeled upon the basis of ‘Objective Reality’. We passionately believe in the credo that we constantly seek to follow: rethink, edify and delineate. This enduring commitment has helped us fos-ter and broaden the parameters of public policy debate and alternatives. Toward that goal, it strives to archive greater involve-ment of the intelligent, concerned change agents (reform minded politicians, public servants, media, socially responsible firms and citizens) in questions of policy and the ideation, furthermore, we ardently believe that the managers of tomorrow that are being groomed at IIPM today will play a decisive role in India’s renewed tryst with destiny.

What we do..As a premier ‘ideas organization’ in Asia The IIPM Think Tank is committed to enhance public awareness of policy issues an economics and management and to en-gineer solutions that will fulfill the ‘Great India Dream’. By publishing the finding of its research, and though the active partici-pation of its senior researchers in the media and policy, it aims to bring new knowledge to the attention of policy makers. Every year, The IIPM Think Tank commissions and publishes three quarterlys reviews and an annual review, on a wide range of policy issues including education, health, poverty, unemployment, agriculture, industry, ser-vices, FDI, external trade, infrastructure and environment. All these outputs meet the highest standards of scholarship, are accessible to a broad readership, and ex-plore policy alternatives consistent with the philosophy of ours. The central theme of our issues are devoted to assess where the critical predicaments are, analyzing what needs to be done to annul the element of development deterrents in the economy and offer concrete proposals on how to accelerate welfare everywhere towards achieving inclusive development. The India Economy Review is a small manifestation of that vision. More than 1,000 students (seven nodes of IIPM0 have---and continue to-spent endless hours conducting primary and secondary research on contemporary issues that confront the Indian Economy. This research is then analyzed threadbare by at least 50 knowledge workers across the seven campuses. Brand new insights and policy recommendations that are provided by this core team are then crafted, honed and polished by 20 members Economy Re-search Group (ERG). This massive effort is spearheaded and led by the renowned economist and management guru, Profes-sor. Arindam Chaudhuri.

delineaterethink edify

web : www.iipmthinktank.com


IN FOCUS


Whenever the bulls in the Indian Stock Markets roar the f irst apprehension which comes to the mind of Indian investors is

the possibility of some major scam. Throughout the history of the Indian stock market it has been seen

that all major bull runs have been succeeded by one or the other scam. From Harshad Mehta to Ketan Parekh, from Unit Trust of India (UTI) Fiasco to Penny Stock imbroglio, the numbers of scams are countless. Securities and Exchange Board of India (SEBI), the main regulator of the stock market, since

its inception, in 1992, has miserably failed to regulate the stock markets properly. The biggest lacuna found in the operations of SEBI is its reactive approach in

regulating the markets. Time and again it has been proved that Indian investors have always suffered due to such reactive approach of the regulator.

The f irst major scam in the history of Indian stock market broke out in April, 1992 popularly known as The Harshad Mehta Scam. It was the day of April 23, 1992 when the Sensex crashed by 500 points in a single day sending scary waves in the entire dalalstreet. Sensex opened f ive days later but by then mil-lions of investors became bankrupt. The entire scam was the brainchild of Harshad Mehta; the biggest manipulator Indian markets have ever produced, who alongwith some notorious bankers and company of-f icials made the great Indian loot. The entire market was taken for a toss through market manipulations, lack of transparency and insider trading. It was a classic case of lack of regulatory control in Indian markets.

It was only after this devastation happened that SEBI was put into enactment replacing Capital Issue Control Act. The pace of legal proceedings can be judged from the fact that the scam happened in 1992 and till 2001 the verdict was yet to be received when the Big Bull met with mysterious end.

One of the major reasons for this scam was lack of transparency due to non-electronic trading. In order to bring transparency into the system, electronic sys-tem of trading was introduced after it.

If one thinks that replacing the regulatory body can make markets eff icient one needs to think twice before reaching at such a conclusion. Not even eight years had passed by when Indian markets witnessed another scam in 2000-01. This time again Sensex crossed an all time high level of 6000 when it re-ceived a bolt from the blue in the form of IT scam or Ketan Parekh scam as it is popularly known as. It also showed how dependent our markets are on the US markets. Here again Mr. Ketan Parekh, a chartered accountant by profession, manipulated the prices of media companies through insider trading. This time again it was the broker-banker relationship

Indian markets have witnessed an endless list of scams like Bhansali Scam, UTI Fiasco and the

latest Penny Stock and Demat scams

Source : BSE


SECURITY MARKET


Indian Brokerage Industry: A Paradigm Shift

The need of the hour is to apply a pragmatic approach in order to provide credibility to IPO grading system.

by Meena Bhatia, Lecturer, IILM Delhi


Effi cient intermediation is of paramount importance in making the capital markets more vibrant and dynamic. To sustain the growth of the markets

and to crystallise the increased awareness and interests of discerning and growing pool of investors, it was essential to overcome the inadequacies and curb the malpractices in the market. Traditionally in India, the dominant fi nancial intermediaries have been banks and stock markets, which have been the chief constituents of the fi nancial services sector. With fi nancial innovation, the distinction between various forms of fi nancial intermediation has been broken down.

With the removal of administrative controls on bank credit and the primary market for securities, the capital markets came to occupy a larger role in shaping resource allocation in the country. Our stock exchanges were not functioning in a very effi cient manner. There systems, pro-cedures and infrastructure were outmoded. Brokers were partnerships or proprietary concerns. There was practically no corporatisation among Indian brokers. The governing boards consisted wholly of brokers. Exchanges were of brokers, for brokers and by brokers. The Bombay Stock Exchange (BSE) was a monopoly. It was an association of brokers, and imposed entry barriers, which led to el-evated costs of intermediation. Membership was limited to individuals and limited liability fi rms could not become brokerage fi rms.

Trading took place by ‘open outcry’ on the trading fl oor, which was inaccessible to users. A variety of manipulative practices abounded, so that external users of a market often found themselves at the losing end of price move-ments. Floor-based trading, the ineffi ciencies in clearing and settlement, entry barriers into brokerage, and the low standards of technology and organisational complexity that accompanied the ban upon corporate membership of the BSE led to an environment where order execution was unreliable and costly.

Retail investors and particularly users of the market outside Bombay, accessed market liquidity through a chain of intermediaries called “sub–brokers”. It was not uncommon for investors in small towns to face four in-termediaries before their order reached the BSE fl oor, and to face mark-ups in excess of 10% as compared with the actual trade price.

The fi nal leg of the trade was physical settlement, where share certifi cates were printed on paper. This was intrinsi-cally vulnerable to theft, counterfeiting, inaccurate sig-nature verifi cation, administrative ineffi ciencies, and a variety of other malpractice.

And now ....The stock markets worldwide have grown in size as

well as depth over last one and a half decade. The kind of growth our fi nancial markets are undergoing right now and is expected to zoom out in coming future will result in changing patterns in stock broking services. More im-portantly, the focus will shift on to fi nancial planning or investment advisory services. As India progresses and indi-viduals grow wealthier, the complexities of their fi nancial needs would increase as well. Tax structures are likely to become more complex; short and long-term fi nancial and lifestyle goals would certainly change. This brings in the need to build a cadre of securities market professionals through training and certifi cation.

The creation of the new exchange, clearing corpora-tion and depository were important accomplishments of institution building. The pressure of competing with NSE, and access to the services of the depository, helped existing exchanges also to transform their functioning. Roughly speaking, these changes gave a ten-fold improvement in market liquidity – the one-way transactions cost faced by retail trades is estimated to have dropped from 5% to 0.5%.

There are 22 stock exchanges in India which are geographically widespread. However, other than NSE,

BSE, Ahmedabad, Calcutta and UPSE, the remaining exchanges had negligible or nil turnover. During 2004-05, the total turnover at regional exchanges increased by 4% over the previous fi nancial year. Many brokers of re-gional exchanges trade on the terminals of NSE and/or BSE through their regional subsidiary. The total turnover in all stock exchanges rose modestly by 2.86% in 2004-05 as compared with 67.25% in the previous year. The NSE and BSE combine accounted for more than 99% of the total turnover in 2004-05. The turnover at BSE and NSE rose by 3.2% and 3.7%, respectively in 2004-05 on top of 60% and 77.9% in the previous year.

It is expected that Indian brokerages should decrease in number due to the recent policy change. Further, they may need to turn themselves into fi nancial shopping malls, where the investor can shop for not one, but several fi nan-cial products; such as equity research, distribution of insur-ance products, mutual fund products, etc. Clearly a major shakeout will happen in our stock broking industry.

Reasons for ShakeoutTechnology: NSE brought in the new technology with

With fi nancial innovation, the distinction between various forms of fi nancial

intermediation has been broken down

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SECURITY MARKET


itself. Technology, i.e., electronic trading has played the biggest role in the rapid growth of corporatised brokers at the expense of smaller ones. In the online model, the physical network is not important, but infrastructures like call-and-trade facilities are essential for making sure that customers stick.

Closure of regional bourses: Technology rendered the regional bourses redundant. Their members had to shift business, shut shop, or become sub-brokers of NSE or BSE brokers. The obsolescence of the regional bourses encouraged the larger brokers to look at a national play more enthusiastically. Thus, players like ICICI Web Trade, HDFC Securities, Indiabulls Securi-ties and Motilal Oswal began to expand nationally.

Branding: Branding has become very important as firms try to cut through the clutter with the help of a differential. Smaller players have found it dif-ficult to cope with the expenses of research, investor seminars, and aggressive advertising – things that are common place in today’s broking business. Brand-ing becomes more critical because of the impersonal nature of online trading.

Reduction in brokerage commission: NSE worked towards the reduction of transaction costs, even if it involved reduced profit rates for brokerage firms. Broking commissions have gone down (from 1% to about 0.5% in the last five-six years), making the survival of independent brokers more difficult. Lower margins mean small brokers have become even more dependent on day traders.

Diversity of services: The policy changes has re-sulted in lower margins and increased competition. To survive in this kind of market a broker need to increase its volume. To increase the volume the broker needs to have: (i) Various branch off ices in different parts of the

country so that they can tap retail investors(ii) Need to venture into other services like portfolio

management, equity advisory, commodities trad-ing, derivatives trading, depository services, IPO-funding and investment, distribution of insurance and mutual fund products, wealth management, etc. High Net worth Individuals (HNIs) are of-fered premium service, which gives them access to qualif ied relationship managers who handle specif ic accounts and give personalised advice

Go global: Indian brokerages need to go global and get a share of the global pie by setting up offices abroad. By doing so they could tap the burgeoning non-resident Indian population and even aim for a share of the FII orders emanating from overseas.

Increased business costs due to SEBI: As SEBI

is becoming stringent day-by-day, the smaller players are facing extra costs. Tightening compliance and risk management norms, which have become tougher off late has increased business costs like support staff. As a result, sub-brokers infamous for their lack of compliance for basic stuff l ike books of accounts and issuing proper contract notes have suffered. The same has helped the bigger players differentiate themselves. It is possible for a large broker-franchisor to reduce costs by centralising the back office, research and marketing functions.

Capital gains exemption: Although corporatisa-tion of brokerages started in 1992, but there was no major incentive to corporatise. In 1997, the allowance of capital gains exemptions on becoming a corpo-rate broker removed the major disincentive towards corporatisation. Corporatisation encouraged profes-sionalism.

There was an increase in the number of corpo-rate brokers during the year, up from 2,360 in year 1996-97 to 2,976 in year 1997-98 to 3,173 during 1998-99. This was because brokers took advantage of the exemption on capital gains on corporatisation of individual membership on the stock exchanges. An exchange-wise analysis reveals that relatively a large number of brokers registered with Mumbai, Delhi, Hyderabad, Bangalore, Vadodara and Uttar Pradesh Stock Exchanges converted into corporate broker to avail of the benefit of exemption. Maximum advantage was taken by brokers of the Stock Exchange, Mum-

bai, where the corporate percentage share went up to 55.26% from 15.46%.

Entry of banks: As stockbrokers are venturing into other territories, other fi nancial service providers are mov-ing into the broking business. The broker-franchisor faces

Technology, i.e., electronic trading has played the biggest role in the rapid growth of corporatised

brokers at the expense of smaller ones

Corporate brokers & total brokers in 2004-05:

Source: SEBI


his biggest challenge from banks, which can get into bro-king using their network of branches. Even PSU banks have joined the race. Their vast network and brand name provide them an excellent launching pad.

Dematerialisation of shares: It is a big player, only which can provide services like depository. To provide depository services high setup costs are in-volved and to achieve economies of scale high volume is needed which can be provided by big players only. Currently big players like Indiabulls, ICICI, HDFC Geojit,…, etc., have their own depository services.

What brokers are doing to face the challenge?Big shift to online transactions: Globally, today,

every second trade that goes through in the stock market is an online trade. The online trading portal of Kotak Securities, www.kotaksecurities.com, was recently revamped as a one-stop shop for investors. Kotak has seen a robust growth in investors transact-ing through the Internet since 2004. At Kotak, an av-erage online trading turnover was Rs.250-300 million in 2003. Today, it stands at about Rs.5 billion. Geojit Financial Services, a Kerala-based f inancial services company, has joined the bandwagon of online trading portals with the launch of Mercury Online. In the next 18 months, there will be a ten-fold increase in online trade,” predicted Mr C. J. George, Managing Director, Geojit Financial Services.

There is a big saving on infrastructure costs when clients shift to online mode. Off line mode requires a f inancial consultant team in each city or centre where they have presence. They also need dealers in every centre to execute client orders. This can be avoided with online trading.

Opening various branches across country: Bu-oyed by booming stock markets and growing retai l interest in equity and equity-related investments, Indian stock broking f irms are on an expansion drive to increase their network into more cit ies and towns to lure cl ients into stock investments. Indiainfoline, one of the biggest stock broking concern, has 160 branches in the country. Motilal Oswal Securit ies plans to expand its network across the country from the present 600 outlets to 1,000 over the next 12 months. Bajaj Capital plans to open another 50 branches during the current f iscal in the southern region.

SBICAP Securities Ltd., a wholly-owned subsidiary of SBI Capital Markets Ltd., is aggressively trying to expand its branch network. This retail broking company has, within three-months of being hived-off as a separate business unit of SBI Capital Markets, managed to bring 22 branches within its fold and is aiming to increase the same to about 35 branches by March 2006.

Raising money from equity market: During 2005, broking f irms including IL&FS Investsmart, India Infoline and Indiabulls tapped the markets through IPOs to raise funds for expansion. This year will see several small and big players raising funds through the IPOs. The Kochi-based JRG Securities Ltd. has already f iled its draft prospectus with market regulator SEBI.

Stock exchange listed brokerages: JM Financial Securities, Geojit Financial Services, Fortis Securi-ties, Prime Securities and the recently listed IL&FS Investsmart, India Infoline and Indiabulls, etc., have seen big rise in their stock prices over the last 12-month period, mainly due to increased business and rising stock markets.

Acquisition: Acquisitions are also being consid-

ered as a method of expansion. Motilal Oswal Secu-rities recently acquired Gayatri Capital, a broking f irm with a presence in Andhra Pradesh. It is also considering doing so in the North India, where the company intends to expand its network to leverage the large opportunities present in the region.

Tie-ups with banks: Online brokers such as ICICIdirect and kotaksecurities.com said to have an advantage in the shape of their close connec-tions with the parent banks. These days most of the

The broker-franchisor faces his biggest challenge from banks, which can get into broking using their network

of branches. Even PSU banks have joined the race

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SECURITY MARKET


Year Number of

brokers

Corporate brokers as

% of total brokers

1998-1999 9,069 34.98

1999-2000 9,192 36.07

2000-2001 9,782 38.93

2001-2002 9,687 39.86

2002-2003 9,519 40.28

2003-2004 9,368 40.43

2004-2005 9,128 41.33

Number of Brokers & corporate brokers as % of total brokers

Source: SEBI

brokerage houses are trying for tie-ups with banks. Centurion Bank of Punjab has tied up with IL&FS Investsmart Ltd. for offering equity broking services to the bank’s customers. SAR ASWAT Co-opera-tive Bank has tied up with India Infoline to offer equity research, broking and portfolio management services to its clients. R Trade, the f inancial serv-ices brand promoted by the Anil Ambani group, has tied up with UTI Bank which will serve as its main banker. Transactions done through R Trade Securities and R Trade Commodities, respectively the stock and commodity broking outf its set up by the group, will be supported by the bank.

Having branches abroad: JRG Securities Ltd. has joined hands with United International Trading Company (UITC), with the intention of extending JRG’s f inancial services to Saudi Arabia and other Gulf Cooperation Council countries. This will form part of JRG Securities Ltd. business and expansion plans for Africa, the entire Middle East, sub-conti-nental Asia, Australia and New Zealand.

Range of services: Equity broking business being cyclical, many players are also entering new areas of activity such as commodity broking, distribution of mutual fund products and insurance schemes, to

guard against fall in the stock markets. Firms like Indiabulls are also entering the real estate business. KOTAK Mahindra Bank is looking to expand its branch network and give greater impetus to Wealth

Management Services. The bank is hoping to widen its network to 90-100 branches by March 2007 in the f irst phase, from over 50 branches at present. Bajaj Capital offers its clients a large spectrum of investment advisory products such as mutual funds, life and general insurance, government bonds, pen-sion schemes, etc. and f inancial planning services such as investment planning, retirement planning, tax planning, children’s future planning and insur-ance planning under one roof.

Big players joining the wagon: R Trade, which has set up separate companies to offer stock brok-ing, commodity broking and non-banking f inancial services, has placed big bets on the market’s growing penchant for online trading. The idea is to offer at competitive costs, online facilities that will ulti-mately cover a host of activities.

These will, among other things, embrace online distribution of retail investment and savings prod-ucts, including insurance and mutual funds.

Concluding Observations

Discussions in the previous sections support that the Indian broking industry has undergone structura l changes during the recent years and is expected that there are sti l l more changes to come. Greater emphasis has been given on consolidation and restructuring in the broking segment.(i) Numbers of brokers have come down.(ii) Corporate brokers wil l keep on increasing.(iii) They need to widen their reach through wide-

spread terminals across country and across globe and must offer variety of services. �

Indian broking industry has undergone structural changes during the recent years and is expected

that there are still more changes to come


IN FOCUS


Putting the System in PlacePutting the System in Place

Demutualisation & Corporatisation: A midcourse correction for Indian Stock Exchanges

D.N. Das, AdvisorUTI Securities Ltd.; Ex President, VP & Director of Madras Stock Exchange


SECURITY MARKET


Putting the System in PlaceIndian Stock exchanges have undergone a metamorpho-

sis in the recent past. The catalyst, being Demutualisa-tion and Corporatisation, as envisaged by Securities

and Exchange Board of India (SEBI) under the guidance of Ministry of Finance, Government of India.

Background Historically, the Indian Stock Exchanges are conglomer-

ates promoted by individuals over a period of time. The oldest of the Stock Exchanges of India is 125 years old and the youngest one being 10 years old. The Stock Ex-

changes have different structures in different areas, right from Association of Persons to Companies limited by guarantees to companies initiated by equity shares. As such there is no uniformity of structures of Stock Ex-changes.

The oldest of the stock exchanges like Bombay, Calcutta, Delhi and Madras were started with a noble objective of providing the required capital for indus-trial development of the country. Alongside, the stock exchanges conducted themselves to provide the much-needed liquidity to the stocks listed in them. Thus, the stock exchanges had to enroll members who were called stock exchange members or stockbrokers. They were regulated by Memorandum of Articles and supervised by Bye-laws incorporated by members themselves. A duly constituted Board of Directors, the members of which were elected amongst members of stock exchange, governed the conduct of the Stock Exchanges. These exchanges were regulated, monitored and controlled by Securities Contract Regulation Act of 1956 and Rules implemented in 1957.

Later Development:The functioning of stock exchanges was carried on

for quite some time till about early 1990s, in the same fashion. The Indian stock markets also grew substan-tially during the period and the performance of stock markets was regarded as a barometer to economic performance of the country. Huge amounts of capital were raised through the means of stock exchanges and stockbrokers.

The development of stock markets had its own down-side, as far as the regulatory framework was concerned. The activities of stock exchanges have become complex and complicated. The owners of the stock exchanges who were stock brokers had to play a dual role, one as

the owner and other as the regulator. This duality has raised concerns of confl icting interests. Meanwhile, the population of investors has also grown multifold. In the earlier periods, only couple of lakhs investors were present. In comparison now, Indian investors have grown to ten million investors. This growth in investor population led to more activity in the markets and resulted in defi ciency in service levels consequently.

Sensing that there is a need for proper regulatory frame-work in not only regulating the stock exchanges but also

In the earlier periods, only couples of lakhs investors were present, in comparison now, Indian

investors have grown to ten million investors


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regulating the intermediaries in the markets, Govern-ment of India, in the year 1992, under an Ordinance gave the markets, a Regulator in the form of Securities and Exchange Board of India. The objective of forming this regulatory body was to regulate, monitor and control functioning of stock exchanges, intermediaries, ensure transparency in all its functioning and protect investors.

Traditionally stock exchanges used to conduct business of buying and selling shares through outcry system. The trades so executed were on one-to-one basis. This system had inherent inadequacies and invariably majority of the investors used to get a raw deal, as far as the rates for the stock traded was concerned. Added to this, settlements of traded stocks were executed by exchange of share cer-tifi cates along with share transfer forms. The settlements were delayed and even if settlements were done, the de-lay in transfer of shares and due defective deliveries were abundant. In view to plug this inadequacy, SEBI’s fore-most objective was to encourage trading through electronic medium, i.e., trading through computers. Thereafter the settlement of trades was also conducted electronically by way of dematerialisation of shares through services of de-positories. These two acts of SEBI gave salutary effect in giving the much needed encouragement to the market by

creating transparency in transactions, faster and effec-tive transfer of documents and realisation of payment in much less time.

The stock exchanges had undergone very trying times during this period also. One such aspect, which jolted the traditional stock exchanges, was incorporation of National Stock Exchange promoted by public sector fi nancial institutions, public sector banks, public sec-tor insurance companies, etc. The owners of this stock exchange are only institutions. The stockbrokers only had a trading right with deposit schemes. Thus, a truly demutalised and corporatised stock exchange came into existence. The onslaught of time and the need to change had fi ne-tuned this exchange into a world class trading platform spread across the nation. This experiment gave impetus to the government and SEBI, to encourage other stock exchanges to follow suit and insisted during the recent years to put in place the mechanism of com-puterisation and mechanisation of trades by removing the counter party identity.

Current Scenario

As per the guidelines issued by SEBI all the stock exchanges have to demutalise and corporatise their in-stitutions in a said time frame.

What Does It Mean?This act would mean that all stock exchanges would

have a uniform structure across the country. As men-tioned earlier, the stock exchanges in India have mul-tiple structures.

Guidelines and its Impact:As per the guidelines issued by SEBI certain actions

by the Stock exchanges had to be undertaken by them to ensure that their structures become stable and grow into a professional bodies.1. The fi rst step towards this process is that all stock

exchanges have to corporatise themselves into a com-pany limited by equity shares.

2. The stock exchanges have to convert themselves into a profi t making companies.

3. The shareholding pattern should strictly follow that only 49% of the capital is to be held by the mem-bers of stock exchange and investors must hold the balance 51% at large or through strategic business partners.

4. The constitution of the board has to undergo a change, which refl ects that the member representa-tion should not exceed 25% of the board strength. Public Representatives and the balance 50% by the majority equity partner who is holding more than 51% of the stake should fi ll in Balance 25%.

5. Voting pattern has also been limited to 5% 6. All the mandatory committees like Arbitration, Dis-

ciplinary, Defaults and Investor Services shall not have more than 20% of the strength from trading members.

Its Impact:The ongoing change in structure of stock exchanges

shall ensure that the ownership rights and trading rights for members shall be de-linked. Which means that a member of stock exchange can be only an owner and need not be a trading member. Similarly a trading mem-ber can remain a trading member and not have owner-ship right. With this act in place there is a clear-cut demarcation from ownership and trading right.

Traditionally the management of stock exchanges were under control of members, which had clash of in-terests. With demutualisation the management of stock exchanges lies entirely with majority shareholders and the administration of stock exchanges.

Members of stock exchange will have very minor say

With demutualisation the management of stock exchanges lies entirely with majority shareholders

and the administration of stock exchanges


SECURITY MARKET


in matters of day-to-day administration and shall be able to participate only on business development and certain policy matters.

Challenges Ahead for Stock Exchanges

Its Role Post Demutialisation and Corporatisation

The Stock Exchanges in India have to undergo a dramatic change over a period of next two years at the maximum and re-invent and re-engineer themselves into a dynamic and profi t making companies.

Traditionally, stock exchanges had revenue streams through listing of companies in them. Apart from that the other revenue stream being subscription by members, turnover fees on trades executed and revenue generated from savings and assets created over a period of time. Also, earlier stock exchanges had the big advantage of tax benefi ts, as most of them were section 25 companies. Another factor which is noteworthy is that as per the new guidelines under demutualisation the stock exchanges can-not use and distribute the reserves built up over a period of time in the pre demutualisation period as the reserves and assets were created by taking the advantage of exemption of income tax. The contention of SEBI is that the build up of assets and reserves are directly possible only by taking the advantage of income tax and hence the money belong to the government and other stakeholders. The other chal-lenge would be is taxation angle. From this fi nancial year all the stock exchanges shall have to pay the income tax like any other corporates.

The stock exchanges, especially the regional stock ex-changes, across the country will have different and uphill task in re-inventing themselves into new entities. There are two aspects, which had also contributed to this scenario. National Stock Exchange that started operation in 1995 had built up competition across the board and across the country. They had opened terminals all over the country and this factor has contributed to dwindling volumes in the regional stock exchanges and most of them had become redundant in their existence. Adding fi re to the fuel was another expansion undertaken by Bombay Stock Exchange that also had put up terminals all over the country.

The dual expansion of National Stock Exchange and Bombay Stock Exchange had sealed the fate of majority of regional stock exchanges that are now struggling to stay afl oat.

Another guideline, which also hampered and dented into revenue packages of regional stock exchanges, was that any new public issue being fl oated in the market had to be routed only through stock exchanges where the terminals

are placed across the country. This act had effects on the fresh listing of companies in the regional stock exchanges. In their anxiety to protect the investors and reducing the revenue expenditure of corporates for which demands were raised, SEBI issued further set of guidelines to allow and permit existing companies to delist voluntarily from the multiple stock exchanges. This started the exodus of many companies to delist from the regional stock exchanges. The concept of regionality for listing had also been removed tht added more woes to the regional stock exchanges as far as revenues are concerned.

ConclusionPresent scenario is that, that all regional stock ex-

changes do not have adequate revenue model for suste-nance. The challenges are more thrown up for regional stock exchanges in the new scenario. The Demutualisa-tion and Corporatisation had removed most of the am-biguity as far as the role of stock exchanges is concerned. They have to re-invent themselves and fi nd a business model for onward growth and development.

They also have to fi nd an equity partner for the 51% stake within the said time span. They have to retain their

trading platforms to continue as stock exchanges. This is a big challenge facing the stock exchanges in India. One should not miss the fact that tremendous amount of energy and monies have been spent by these stock exchanges for all the technological upgrades. Almost all of them are equipped to meet the challenges of the future. The mindset of the powers that they have to undergo a change and come down to a pragmatic level and try to establish themselves by forging alliances and form strategies for the development. There is a need to shed inhibitions and start thinking afresh. The sharing of resources and expertise are such areas where synergies can be found. It needs a radical thinking and outlook moving ahead of traditional thinking, if these stock exchanges have to meet the challenges and re-invent themselves in the new dispensation.

Times ahead are exciting with new vistas to be ex-plored and it is a challenge galore. The game to be played is not a waiting one but to meet imposing challenges and to look for the positive side. In cricketing parlance, loose balls have to be hit and tough ones to be played cautiously on the merit of the ball bowled. �

The stock exchanges, especially the regional stock exchanges, across the country will

have different and uphill task in reinventing themselves into new entities


IN FOCUS



SECURITY MARKET


Since Mr. Damodaran took over as SEBI Chief, ex-pectations have been rife about the way the market watchdog goes about its business. He was a key

personality involved in the restructuring of UTI. In the previous stint at UTI, he did not restrict himself to the functioning of mutual fund but had been vocal about the practices of certain other competitors. He is sure of making his mark and correct the perception that the entire system is in favour of manipulative brokers and business houses. Since the time he took over, SEBI has taken up a series of steps, including permitting short selling of securities by the institutions, increasing the position limit for deriva-tives and stricter regulation of mutual fund intermediaries to make the capital market more attractive and safer for investors the regulator would also put in place a system of stock borrowing and lending to facilitate this. Regulator has been started strictly enforcing laws and empowering investors as means to protect them. Following are some of the measures SEBI has initiated in the recent past:

Changes in IPO NormsSEBI has recently revised the minimum public share-

holding requirements as well as norms for Qualifi ed In-stitutional Buyers (QIBs) participating in book-building issues. All listed companies will be require to maintain at least 25% shareholding with the public for the purpose of continuous listing. This will not, however be applicable to companies which are permitted to make an IPO of at least 10% to the public in terms of the rule 19(2)(b) of Securities Contract (Regulation) Rules 1957 (SCRR).Such companies will be required to maintain at least 10% public shareholding for the purpose of continuous listing. The minimum public shareholding requirement will not be applicable to government companies, infrastructure com-panies and companies registered with board for Industrial

and Financial restructuring (BIFR). Listed companies, which are presently not complying with the minimum public holding requirement as mentioned, will be given a period of two years for compliance, from the date of is-suance of circular in this regard. Listed companies which may in future fall short of requisite minimum level as mentioned on account of reasons like Corporate Debt Re-structuring (CDR) packages will be given a period of one year for compliance from the date of non-compliance.

The objective is to ultimately reach a single level of minimum public shareholding requirement for listed companies, in the course of time. Moreover, it will im-prove liquidity and price discovery, besides enhancing the depth and attractiveness of the market. It will also ensure that stocks with low fl oats do not trade at substan-tial premium to peers due to the scarcity factor, and that there is no bunching of IPOs. Many multinational have embarked on the delisting process, but little headway as the reverse book-building offer leaves scope for bids at outlandish prices that defeat the very purpose of exercise; a few investors manage to hold a company to ransom with exorbitant bids. SEBI must provide an exit route to listed companies, at prices that would be fair to them and the shareholders.

SEBI has removed the discretionary allotment for QIBs and also imposed 10% margin on them. It also decided to keep 5% of the QIBs category reserved for mutual funds registered with it. Under SEBI public issue norms, up to 50% of the issue is reserved for QIBs on discretionary basis, while 35% for retail investors and high net worth investors (HNI) get 15%. The allotment for QIBs will now be done on a proportionate basis like in the case of retail and HNI category. MF could also compete for remaining 45% in QIB quota. QIBs will be required to provide a margin of 10% while bidding for shares in an

Better Late Better Late Than Never!!!Than Never!!!

SEBI: Some Recent Initiatives for Investor Protection

by Society for Consumer’s & Investors Protection


IN FOCUS


IPO. Currently QIBs are not required to pay any money while bidding through a book-building process. Retail and HNIs are required to pay the full amount when they apply for shares in an issue.

Allotment to the category of QIBs comprises foreign institutional investors, domestic institutions and mutual funds will henceforth be made on proportionate basis. Hitherto the merchant bankers to the offer made allotment to these investors on a discretionary basis. Once the new regulation area in place, the QIBs will have to pay 10% of the value of the shares they are applying for, along with the application. The existing system discriminated between institutional and retail investors; while the former did not have to pay any money upfront, the later had to pay the full value of shares they were applying for. The result was that in their desire to secure maximum allotment institu-tional bidders collectively bid for disproportionately high number of shares in relation to those on offer, exploiting the fact that there was no need to commit money upfront. Such speculative bidding had the twin effect of skewing the response pattern to the offer and infl uencing the price decision. When the number of shares bid for the upper end of the price band exceeded those on offer, tempta-tion was to price the IPO at that level. It is doubtful if a

10% margin will be enough to curb speculative bidding by QIBs. A margin of at least 50% may be necessary to ensure that institutional bidders do not resort to specula-tive bidding by the QIBs, a margin of at least 50% may be necessary to ensure that institutional bidders do not resort to speculative bidding. However, a start has been made and, hopefully, SEBI will review this threshold based on responses to future IPO’s

SEBI may have to soon focus on yet another aspect of the IPO process funding by banks and other institutions. With funds easily available a number of investors, particu-larly in the HNI category, and also some retail investors borrow short term to invest in IPOs. Their strategy is to secure allotment and dump the shares on the listing day to book profi ts. This category of non-serious bidders ends up skewing the pictures as they disproportionately high bids to maximise their speculative gains. They have to make enough profi t when they dump their shares to cover the interest charge they pay to the fi nancier. The vested interest that they, therefore, have in the stock listing at a price substantially higher than the allotment price, has led to allegations of rigging of the listing price. Easy bank

fi nance is also a cause for larger number of speculative bids in the IPO process.

Retail investors in India generally enter the primary market, and only if their experience is satisfying they start looking at the secondary market. Hence, all possible steps should be taken to encourage retail investors to invest di-rectly in the primary market. The growth of the strength of the Retail Individual Investor (RIIs) has been stunted in recent years. In fact, between 1998-99 and 2000-01, the number of investor household was almost half from 12.1 million to 6.5 million, representing a meager 3.7% of the Indian households. According to a survey of Indian investors by SEBI-NCEAR, out of the top of the 100 leading companies (in terms of market capitalisation), public shareholding in as many as 94 companies across all sectors declined in the last three years.

Retail equity investors should be encouraged and their number should grow, but increasing the quota of them in primary issues is not the real solution to the prob-lem. Encouraging retail investors requires taking a broad and long term view of the equity market’s development. The most essential aspect of such development has to be strengthening of the retail investors’ confi dence in equi-ties as a vehicle for accumulating savings over lifetime, irrespective of whether such equities are purchased from the primary market or the secondary market. The Indian market authorities have equated the market’s development with the high trading volumes rather than the market’s ability to attract larger amount of domestic household saving. Hence, the whole structure of market regulation has become distorted. According to National Accounts Statistics 2005, released by the Central Statistical Organi-sation, while the household sectors total saving has been increasing every year from 1993-94 to 2003-04, there is a persistent decline in the amount of such savings going into shares and debentures in every year from 2000-01 to 2003-04. The bulk of trading volume in India is purely speculative and not delivery based. It leads to high volatil-ity of share price.

It is fair enough to acknowledge that small investors should come only through MFs, in which case we should urgently proceed to reform the industry which has done little to reach out to them both physically and in terms of confi dence. Yet all pronouncements still talk only of increasing and enabling direct participation of small in-vestors. Between January 2003 and June 2005, as much as Rs.428.79 billion was raised through public issues. Signifi cantly, this worked out to a meager 14% of these companies total capital of Rs.3,069.09 billion of the to-tal public issue amount, as much as 96% or Rs.412.88 billion was through book-building issues. Of these, the allocation to small investors was only 3% of the issu-

Once the new regulation area in place, the QIBs will have to pay 10% of the value of the shares

they are applying for, along with the application


SECURITY MARKET


ing company’s total capital. And, we want our investing population to grow.

Signifi cantly, it is the policies that, over the years, have edged the small investors out from the primary market. On one hand, over the last three decades, public issues as a percentage of a company’s equity capital has been brought down in steps, from 75% to 60% to 40% to now 25% (in most cases now even to 10%), while on the other hand only 25% of an issue is reserved for small investors. That means when a company offl oads 10%, small investors get only 2.5% of its capital. Recently after much persuasion, the reservation has increased to 35%. Though book-build-ing is essentially a mechanism to obtain a market-driven ‘best price’, it is in reality being used to make allotments to chosen big investors, that too, for as much as 60% of an issue. Normally, the poor and the deprived deserve and are granted reservations. In our primary market, reservations have been made for the rich and the mighty.

There are more than Rs.700 billion worth of public offerings lined up. For any expansion of the investor base, the primary market will have to play a pivotal role. Enlarging the size/percentage of capital offerings, mak-ing greater reservations (75%) for the small investors and earmarking PSU divestments entirely for them will rapidly expand the investor base and channelise house-hold savings into the capital market. Economies grow when household savings get invested in new projects and expansions (primary market) rather than being used in trading(secondary market).

Rating of IPO’sSEBI is working with credit rating agencies to introduce

the grading of the Initial Public Offerings. The aim is to enable more realistic pricing of shares and help inves-tors make an informed decision. SEBI cannot make it mandatory but if investors respond better to a graded IPO it would prove an incentive for promoters to opt for rating. It will ensure greater retail and domestic in-vestor involvement in the equity market. It is only the domestic investor who can bring in greater stability to the stock market. Minority shareholder does not mean passive shareholder.

Reducing Transaction CostSEBI is working on bringing down transaction cost

for the investors and is talking with depositories to en-sure free transfer of accounts between NSDL and CDSL. This would also help investors to choose a better service provider. SEBI is working on reducing transaction time and simplifying procedures so that companies will make shares available to the domestic investors rather than opt for the GDR (Global Drawing Rights) or ADR (American

Drawing Rights) market. It is also addressing issues in mutual fund, the ‘best entry level vehicle’ for the investor aiming to reform fee structures and prevent distributor malpractice. SEBI is not yet regulating distributors but is looking at ways to do it. SEBI is working to getting more stocks into the market. Ultimately it is the demand and supply that is at work and markets go up because there are not enough stocks to meet demand. Regulation of the Indian capital market is always a work in progress.

Keeping Check on Penny StocksSEBI recently began an investigation into the spurt

in price and trading volume of certain companies often referred to as ‘mad cap’ or ‘small cap’ companies. It identi-fi ed a few cases of price manipulations in small-cap stocks. It is trying to ascertain where price movements in these stocks are the result of unfair trade practices. The market regulator has taken action against promoters of around eight companies, including Mega Corporation Limited, IFSL, Konkan Tyres, Eltrol, Prime Properties, Minal Engineering, etc. It has also asked some of the brokerage fi rms not to conduct trades on behalf of certain clients in these stocks. The securities regulator has proposed to set

up its surveillance activity on whether there has been any ‘wrong motive’ in some quarters with regard to such stocks whether a stock has shot up or has sharply declined in a manner that is questionable, without any immediate ex-planation. The issue is to ascertain whether there has been manipulation. SEBI has proposed to encourage the use of stock options, which has found support in the desired manner, unlike single stock futures, which has been more popular with investors. Talks are also on with exchanges to introduce compulsory delisting of shares of companies that have not been trading or are in default. This would help ensure that investors do not get taken in by ‘penny stocks’. But here, it is the investor who has to be cautious and not get away with greed drive investment.

Regulating Speculative Activities and Insider TradingSEBI is working on a scientifi c approach by developing

a sophisticated predictive model for the insider trading on the lines of the fraud detection model in credit card indus-try. Finally, to curb the aggressive speculative activities, the gapping holes in the market microstructure, underlying both the cash and the derivative segment, must be plugged. Like many developed countries we should gradually phase

SEBI has proposed to encourage the use of stock options, which has found support in the

desired manner


IN FOCUS


out cash settlements, curb the practice of day trading by ownership transfers and develop a network of market mak-ers who would rationalise the price by providing two-way quotes. We must recognise that the speculators are the life-blood of the market and that speculation is the proc-ess by which price discovery happens. Therefore, investors should be ready to accept certain amount of volatility in the market and also recognise the fact that in a nearly ef-fi cient milieu, it is virtually impossible to beat the market all the time. Nevertheless, it is also the role of the market regulator to differentiate the healthy price-discovering speculation from aggressive manipulating activities and develop a mechanism for early detection of aberration and penalising the manipulators.

Though, SEBI continues to warn small investors to make informed investment decision, it must do more to educate the investors. A few small steps such as checking the balance-sheets of the company for last three years, enquiring how many times the company has changed its name in the last year, or at least making a phone call to their offi ces to check the existence of the company before investing, can save a few investors. First time investors should be guided to take the mutual fund route and expose them to the concept of profi t booking. It must also urge

them to take a long-term view of the market rather than trying to beat it in the short-term.

Permitting Short Selling and Reviving Stock Lending and Borrowing Mechanism

SEBI is considering bringing institutional players un-der the margining system. It may also revive the stock lending and borrowing mechanism. The move comes on the back of the regulator’s plan to allow short sells in the stock market. SEBI is considering permitting market players, including institutions like mutual funds, FIIs, insurance companies, etc. to short sell stocks. At present, institutional players are not required to pay any margin as they allowed to do only delivery based transactions. When institutions are also allowed to do non-delivery trades, they will also be brought under the margining system. They will then be required to pay upfront and market-to-market margins like other players. Short selling stocks without owing them will be feasible only if market play-ers have the facility to borrow shares to meet settlement obligations. SEBI had banned short sale after the market

crash in 2000. It had also discontinued the stock lending and borrowing mechanism. Short selling allows players to sale stocks by borrowing them when they expect prices are going to crash. And, when the stock price comes down, they can pick up them at lower levels. The liquidity in the market will also improve once short sell and borrowing and lending of stocks are permitted.

Removal of all restrictions on short-selling would be the single most important step towards making Indian capital markets cleaner, safer and more effi cient. Almost all the scandals in our stock market involve alleged attempts by the companies and their promoters to rig up the share prices of their own companies. In a free market, aggres-sive short-selling by rational investors would be powerful weapon against them. With short-sell restrictions, however the best that rational investors can do is to sell all their holdings. Once they have done so, they make no further contribution to price discovery. Market prices are then determined by the alleged manipulators and less rational investors. Banning short-sell does more harm than good. The premise that short sellers cause a permanent fall in the share price is suspect. Any security which is short-sold has to be bought back and there is no permanent supply of shares by short-sellers. There are three types of participants in the stock market. They are investors, arbitrageurs and speculators. Investors buy and sell shares according to their investment or fund requirements. Arbitraguers do not have any net short or long position. If they are short in one segment of the market, say the cash segment, they have a corresponding long position in some other seg-ment like futures segment. Speculators take a view on the movement on the stock prices, and accordingly, go long or short. On account of prohibition on share borrowing and lending, investors are deprived of the opportunity to make additional return on their holdings by lending shares to short sellers. Arbitrguers can only go long in cash and short in futures. This distorts the future market as many futures trade at a discount to the cash market. This is a sign of an ineffi cient market. Also, speculators who wish to take a bearish view are put at a disadvantage, as many times futures are traded at a discount to the cash market. In my view removal of the prohibition on share lending and borrowing will help in making price discovery more effi cient without affecting the basic course of the market. It may also curb volatility by giving an equal opportunity to both the bulls and bears.

Introduction of Separate Window for Block DealsSEBI has asked stock exchanges to provide a separate

window for block deals. This window will kept open for trading for a limited time period of 35 minutes from the beginning of trading hour’s, i.e., from 9.55 am to 10.30

On account of prohibition on share borrowing and lending, investors are derived of the opportunity

to make additional return on their holdings by lending shares to short sellers


SECURITY MARKET


am. A single stock deal order in this window has to be for a minimum quantity of 500,000 shares or a minimum value of Rs.50 million. The order placed in this window would be at a price not exceeding 1% from the ruling market price or previous day closing price. Every deal executed through this window must result in delivery and shall not be squared off or reversed. Disclosure of all trades through this window and its dissemination in general public has been mandated. SEBI said that stock exchanges have to ensure that all appropriate trading and settlement practices as well as surveillance and risk containment measures, etc., at present applicable to the normal trading segment will be made applicable and implemented in respect of the proposed special window also. The exchanges should disseminate the information on block deals such as name of the scrip, name of the client, quantity of shares bought/sold, traded price, etc., to the general public on the same day after the market hours.

The rational for the move, these deals disrupt the mar-ket as they lead to sudden fall or rise in the price of shares. New system for block deals would check intra day volatility and protect the interest of both buyers and sellers without disrupting normal trading. Block-deals mean simultane-ous large-scale buy and sell transactions in scrip, often at a pre-set price. This is unlike the usual price discovery mechanism where a large number of buyers and sellers compete against each other. The block deal window on the BSE and NSE would be transparent. It will show the names of buyers and sellers in scrip beyond a threshold limit. Indian capital markets now rank fi rst in the world in terms of transaction effi ciency and the cost of transactions, which is why the FIIs are fi nding the markets attractive.

Delisting through Reverse Book-buildingSEBI’s decision to facilitate easier delisting of small

companies is a welcome step, but minority shareholders must be protected. There are over 7,000 scrips listed on the Bombay Stock Exchange, out of which only 2,500 are traded. Many of the dud stocks are in the ‘Z’ Group for non-compliance of listing norms. Easier delisting will help cleanse the system of deadwood and provide an exit option to the investors in such stock. The only issue is an equitable price. Rarely traded scrips have no price history to offer a benchmark, leaving reverse book-building as the most equitable way of arriving at a price. Even in cases where price history is avail-able, because of ease of manipulation in penny stocks, reverse book-building is more investor-friendly way of fi xing the offer price. Unfortunately not many small companies see any advantage in delisting because they suffer no disadvantage in remaining listed (and un-traded), leaving the poor shareholders to carry the can.

Therefore, SEBI will have to decide whether it should make reverse book-building mandatory unless it can come up with a most equitable criterion for arriving at a price. An independent valuation could possibly serve as a benchmark.

Other Surveillance Measures for Market Safety SEBI has asked the stock exchanges to prepare

a suspect list of market players in order to curb ma-nipulation. It asked bourses to make a list of entities, brokers and clients according to past trading pattern to enable prompt identifi cation of such entities and facilitate quicker understanding of their activities across the market. Based on the fi ndings of the exchanges, brokers would be short-listed for further scrutiny. An entity based investigation would be more effective than scrip based investigation. Special Surveillance Inspec-tion Teams (SSIT) comprising both surveillance and inspection offi cials have been formed. The teams have commenced surprise and special inspections on the premises of suspected entities. It was felt that the ear-lier surveillance measure used to focus on individual scrip based on feed-back from exchanges. This led to a

situation where there was a fl ood of information given by the exchanges to SEBI which, however, did not capture or provide any meaningful information regarding entities who had undertaken manipulations. It has taken several measures to improve market safety and integrity through better surveillance measures including shifting of scrip to trade-for-trade segment, reduction of circuit fi lter, impositions of additional margins, etc. SEBI has also mandated the stock exchanges to carry out daily analysis of market activities. Client-wise analysis of market par-ticipants is being undertaken at the end of the day itself who have traded in the cash and F&O segments. This will facilitate identifi cation of major market players on a daily basis. The stock exchanges have also been advised to undertake a patch (time slot) analysis when volatility of more than one percent in the sensex/nifty is noticed. This would enable identifi cation of major market play-ers’ scrips, clients and brokers in time slots of increased volatility. During 2004-05, 130 new cases were taken up for investigation as against 121 in the previous year. About 84.6% pertained to market manipulation and price rigging as against 79.3% in the previous year. �

The stock exchanges have also been advised to undertake a patch (time slot)

analysis when volatility of more than one percent in the sensex/nifty is noticed

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