Niveshak January 2013

Niveshak The Road Unpaved

THE INVESTOR

VOLUME 6 ISSUE 1

January 2013

SENSEX

United State’s Fiscal CliFF Deal, PG. 18

New Banking Licenses: Should RBI bite the bait?, PG. 25

FROM EDITOR’S DESK Dear Niveshaks, Niveshak Volume VI ISSUE I January 2013 Faculty Mentor Prof. P. Saravanan

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Anchal Khaneja Anushri Bansal Chandan Gupta Gourav Sachdeva Harshali Damle Himanshu Arora Ishaan Mohan Kailash V. Madan Kaushal Kumar Ghai Nilkesh Patra Nirmit Mohan Rakesh Agarwal Creative Team Anuroop Bhanu Kritika Nema Neha Misra Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

The year 2012 witnessed many big events. The top in the list included passing of verdict on the long lasting debate over 2G scam, Facebook Inc. marking the third largest IPO in the history of US with an offer price of $38, LIBOR Scam hitting the global economy, suspension of the flying license of Kingfisher Airlines by the Aviation Sector regulator DGCA, leadership transition in China and last but not the least, the retirement of Mr. Ratan Tata. This issue brings to you ‘The Year That Was’ which takes you through the big happenings of 2012.

2013 marked its beginning with a growth forecast of around 2.4% by the World Bank for the world economy. According to a report, emerging economies will lead growth in 2013 as the global economic outlook remains challenged by the Eurozone’s debt crisis and high unemployment in the United States. Growth rates in and around Europe are expected to look weak over the next 12 months with an expected expansion of 0.2 percent in the Eurozone and 1.1 percent in the United Kingdom.

The GDP growth rate for Indian economy has been predicted to be around 5-6%

by India’s Finance Minister P. Chidambaram. Due to the hike in import taxes on gold to 6% from 4%, the last week of January saw a reduction in imports.

The government passed the decision of partially deregulating the diesel price allowing a hike of 40-50 paise a litre per month for retail customers and nearly Rs.11 for bulk consumers. This decision is expected to cut the subsidy bill by Rs.12900 crore on account of hike in price of fuel sold to bulk consumers like Railways and state transport undertakings.

With forward looking policy reforms like opening up of FDI in many sectors, formulation of Cabinet Committee on Investments and more such in the pipeline like GAAR and new banking licenses, the markets have entered the New Year with renewed zeal and optimism. In this issue’s Cover Story, we technically analyze the journey of Sensex so far and come up with buy and sell strategy for this year. A critical analysis and top picks for Banking and Auto sector have also been touched upon.

Further, the issue brings to you some more interesting and insightful issues.

The Article of the month deals with the demerger decision taken by Wipro and Pantaloon and whether these decisions are a route to unlock value for the shareholders as well as the company. Other articles in this issue deal with Fiscal Cliff Deal being agreed upon by the US lawmakers and new banking licenses being issued by the Reserve Bank of India. The Finistory section takes you back to time of late 1920’s and tries to explain the causes and impact of the stock market crash of 1929. Lastly, the Classroom this month explains the concept of Ponzi schemes.

We would also like to thank our readers for their constant support through wonderful articles and appreciation. It is your endless encouragement and enthusiasm that keeps us going. Kindly send in your suggestions and feedback to niveshak.iims@gmail.com and as always, Stay Invested!

Team Niveshak

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Year That Was

Article of the month

08

Demergers: The Route to Unlock Value

11 Sensex 2013: The Road Unpaved

FinGyaan

18 United State’s Fiscal Cliff

Deal

Finsight

25 New Banking Licenses: Should RBI bite the bait?

Finistory

21 Stock Market Crash 1929:

Causes And The Impact On The Economy

CLASSROOM

27 Ponzi Schemes

The Year That Was

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www.iims-niveshak.com

The Niveshak Times Team NIVESHAK

IIM Shillong 2G Scam verdict lasting debate FEB ‘12 Inoverthethe long 2G license scam, the Supreme Court of India finally ordered the 122 telecom licenses held by eight operators to be revoked. Though the ruling potentially affected only 5% of the users, it built confidence in the role of the judiciary and efforts to crack down on corruption. This verdict was also seen as a setback for Prime Minister Manmohan Singh’s Congress led UPA government.

According to the Comptroller and Auditor General, the scandal over the alleged allocation of telecom licenses at a price below the market prices could have cost the treasury an estimated amount of INR 1.76 lakh crore.

The licenses cancelled by the Supreme Court included 22 of Uninor, 21 of Videocon, 9 of Idea, 21 of Loop, 6 of S-Tel, 21 of Sistema, 3 of Tata Teleservices, 13 of Swan and 2 of Allianz. TRAI was ordered to make fresh issue of the licenses that were cancelled. Indian stock markets were seen to react better than expected to the ruling and the larger and established players benefitted. Allegations were also imposed upon Mr. P. Chidambaram, India’s then Home Minister, for his due indulgence in the scam during his tenure as the Finance Minister which was later overruled by the court. Banking sector was also affected by this verdict as the loans to telecom sector account for 3% of the portfolio of the banking industry. Those loans given in respect of 2G licenses were seen as a threat of becoming NPA’s. It was also debated that this verdict would be a big blow to India’s reputation as a preferred foreign investment destination.

Facebook went public After 8 long years of its existence, Facebook finally came up with the IPO in May’12 but the much awaited offer did not go as anticipated. The huge valuation by the social networking company combined with a 30 minute delay in the opening of trade and trading glitches due to high volume of orders resulted in the stock price staying sticky to its offering price of $38 at the close of the market. The Facebook share opened 11% higher than the offering price but after the highest point of $45, it fell rapidly to close at $38.23.

The IPO of Facebook Inc. was the third largest in

MAY ‘12

January 2013

the history of US after Visa and General Motors and resulted in $104 billion valuation of the eight year old company. This unexpected scenario led to a setback for the lead underwriter on the deal, Morgan Stanley. It had to buy shares on the open market to secure the $38 price level. The company was, however, valued at $32 a share by Morningstar but Krapfel expected Facebook shares to trade over $50.

FB’s Chief Executive Mark Zuckerberg, who founded the company from his Harvard dorm room in 2004, had a net worth of $19.25 billion at the time of IPO. Libor Scam revealed In June 2012, the British multinational bank Barclays revealed the significant manipulation of interest rates by the various banks which led to the Libor Scam. This scam was touted as the mother of all scams due to its wide impact on global economy.

LIBOR (London Interbank Offered Rates) is used as the benchmark rate in the markets such as US Derivatives market. As per the committee reports, the participating banks reported the manipulated interest rates from 2005 to 2010 or may be longer.

All this led to a loss to the tunes of thousands of dollars.

By lowering the reported rate, the banks were made to appear healthier than they were and committed a fraud on the market as a whole. The scandal when unfolded rocked the global financial markets. UBS and Barclays Bank are some of the biggest banks that have been found guilty for their insider role in the scam. Recently, RBS became the third victim of the American watchdogs which levied a penalty of around $800 million on the bank for its alleged role in Libor scam with nearly all the money going to the United States.

Foreign Direct Investment Policy As per the notification issued by the government on September 2012, the foreign direct investment policy now allows up to 51% FDI in multi-brand retailing with prior permission from the government and subject to certain conditions imposed. Earlier in January 2012, the Indian Government had permitted 100% FDI in single brand retailing. Similarly, the FDI policy in other sectors was also changed. To mention a few, civil aviation sector will be allowed a FDI of up to 49% , broadcasting segment up to 74% and

JUNE ‘12

SEPT ‘12

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NIVESHAK

power exchanges up to 49% ( FDI investment of 26% and FII investment of 23%). Reactions to this policy change were mixed. Bombay Stock Exchange showed immediate optimism and Sensex jumper to a 14 month high by gaining 443 points on the day the announcements were made. Shares of companies like Kingfisher (airlines) and Pentaloon (retail) went up to nearly 20%. Rupee also went up by 1.13% against the dollar. FDI as a strategic component of investment is desired for a sustained economic growth and development through creation of jobs, expansion of existing manufacturing industries, short and long term project in the field of healthcare, education, research and development (R & D) etc.

Kingfisher license suspended The Aviation Sector regulator DGCA suspended the flying license of Kingfisher Airlines in Oct’12. The airlines had failed miserably to come up with the viable plan for its revival which led DGCA to pass the suspension orders. This resulted in cancellation of any future bookings on Kingfisher Airlines w.e.f. 20th December and the situation has worsened since then. The airlines has seen regular strikes from its employees on failing to pay them salaries. The result could also be seen in the stock market where the shares of Kingfisher fell by around 5% in a single day.

The airlines has also not been able to bear other operational expenses in the recent past. As a result, the airlines has been saddled with a loss of Rs. 8000 crores and a debt burden of another Rs. 7524 crores, a large part of which it has not serviced since Jan’12.

The liquor- baron Vijay Mallya is trying hard to garner the support of foreign airlines but chances are very bleak seeing the heavy debt-laden balance sheet of the airlines. Recently, the Kingfisher CEO Sanjay Aggarwal had informed DGCA that the airlines would require Rs. 652 crores in the coming 12 months and the amount would be paid by the parent company UB group. Out of this, Rs. 120 crores would be required to meet the salaries of its employees.

Leadership transition in China China, world’s second largest economy, witnessed the nomination of Mr. Xi Jinping who will take over the reign from the current leader Mr. Hu Jintao, in March 2013. Xi Jinping has been responsible for the successful organization of Olympics and his familiarity and openness towards western economies signal that a much needed change in the functioning

OCT ‘12

NOV ‘12

of the economy that is driving the world economy might be a possibility. Mr. Xi Jinping faces a lot of challenges in this coming year which include slow economic growth, a public clamor to end corruption and demands for change in the political system that threatens the hold on power. In his first address to the nation, Xi promised to provide better social services along with making sure that China stands tall in the world economy. Xi will need to rethink about the international relations, as China’s external environment has been weakening significantly and its relations with the major powers of the world and its neighbors are at the worst since the days of Tiananmen Square crackdown in 1989. China goes into transition at a time when reforms and policies can breathe a new life into the sentiments of the people of China and put the global economy on a rising trajectory.

The legacy of Ratan Tata Ratan Tata, on 28th December retired as the chairman of Tata Group. He steered the group for 21 years after he succeeded the iconic figure of Mr. JRD Tata. This paved the way for Cyrus Mistry to head one of the most reputed organizations of the world. During his stay as the chairman of Tata Group, Ratan Tata played an instrumental role in taking the organization to new heights. Ratan Tata has been credited with the title of ‘a man who could take bold decisions’ which is evident from the fact that the group has crossed the $100 billion (around Rs. 475,721 crore) mark in 2011-12 from a mere turnover of Rs. 10,000 crore in 1991.

Mr. Tata led the group into some notable acquisitions, starting from Tetley by Tata Tea for $450 million in 2000, steelmaker Corus by Tata Steel in 2007 for GBP 6.2 billion to the landmark Jaguar LandRover in 2008 for $2.3 billion by Tata Motors. Currently, over half of the group’s revenues come from outside the country.

Not limiting himself to big-ticket acquisitions, Mr. Tata also displayed sensitivity to the needs of the burgeoning middle class with the launch of the Rs. one lakh Nano battling the odds in West Bengal.

DEC ‘12

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

The Year That Was

The Niveshak Times

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Article Market of Snapshot the Month Cover Story

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

6,864,893 3,166,830 1,652,684

LENDING / DEPOSIT RATES Base rate Deposit rate

9.75%-10.50% 8.50% - 9.00%

Source: www.bseindia.com

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling

53.85 71.72 60.30 85.26

CURRENCY MOVEMENTS

RESERVE RATIOS CRR SLR

4.00% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

8.75% 7.75% 6.75%

Source: www.bseindia.com 21st Decemebr to 24th January 2013 Data as on 29th January 2013

JANUARY 2013

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BSE Index Sensex

Open 19453.92

Close 19923.78

% change 2.42%

MIDCAP Smallcap AUTO BANKEX CD CG FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY TECK

7101.79 7434.86 11406.99 14343.78 7723.79 10916.42 5949.40 8198.73 5637.90 11241.04 8469.24 1981.27 7276.75 2123.08 3405.37

6848.68 7069.84 10834.39 14396.88 7423.32 10617.55 5780.34 7873.41 6355.87 10435.61 9499.14 1959.89 7583.87 2091.28 3803.68

-3.56% -4.91% -5.02% 0.37% -3.89% -2.74% -2.84% -3.97% 12.73% -7.17% 12.16% -1.08% 4.22% -1.50% 11.70%

% CHANGE

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article Market of Snapshot the Month Cover Story

Market Snapshot

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DEMERGERS

THE ROUTE TO UNLOCK VALUE Anurag Mishra & Neeraj Gupta

XIME Bangalore Demerger, by definition, is a business strategy in which a business is segregated into one or more components, either to operate on their own, to be sold or to be dissolved. A demerger allows a large company to split its various brands to invite or prevent an acquisition, to raise capital by selling off components that are no longer part of the business’s core product line, or to create separate legal entities to handle different operations.

One of the prime reasons why large corporate houses go in for demerger is to increase the role of specialisation in the particular segment. In case of large conglomerates, demerging entities are often the departments/businesses which are growing at an impressive rate and have substantial potential. Therefore, in a sense a demerger is the reverse of a merger.

Therefore, demerger is a form of restructure in which shareholders or unit holders in the parent company gain direct ownership of the demerged entity or the subsidiary entity. The company or entity that ceases to own the entity is called the demerging entity. If the parent entity holds a majority stake in the demerged entity, the resulting company is referred to as the subsidiary.

India Inc. has recently witnessed a spurt of demergers like Provogue, Zee Telefilms, Cinemax, Wipro, Reliance Industries etc. In this writeup on demergers, we shall have a look at the demergers of Wipro and Pantaloon because they are the most recent ones. We shall also have a look at questions like – Is demerger a route to unlock value? What is there for shareholders and the company in the demerger?

Wipro’s Demerger: A Win-Win Deal

On November 1st, 2012, Wipro had announced a demerger plan to hive off its non-IT businesses into a separate company. As per the announced plan, Wipro wished to hive off its three units - Wipro Consumer Care & Lighting, Wipro Infrastructure Engineering and Wipro GE Healthcare Private Limited - into a separate unlisted company called

JANUARY 2013

Wipro Enterprises. Together, the three units contributed 14 per cent to Wipro’s revenue. The IT business, which contributes 86 per cent of the revenue, will remain a publicly listed company.

In FY12, IT business contributed 96 per cent to the operating profit and on December 29th, 2012, Wipro got shareholders’ nod for demerger.

The demerger step looks obvious at this stage because Wipro’s non-IT businesses have achieved a critical mass. A delay would have made it difficult for Wipro to separate its IT & non-IT businesses. Another reason which could have prompted Wipro’s board to take the demerger route is that when it comes to acquisitions, IT companies come cheaper than FMCG companies in terms of price/sale. Normally, an IT company is valued at 1 to 1.5 times its annual sales turnover, while an FMCG company costs 2-3 times, at times even 7-8 times. This is because the brand value weighs more when it comes to FMCG business.

Since, Wipro’s shareholders come with an IT mindset; they are unlikely to take kindly to the high valuations for acquisition of FMCG companies.

It is pertinent to mention here that Wipro’s Consumer Care business has made numerous acquisitions. It has bought brands like Glucovita, Chandrika, Yardley and North West Switches & Unza Holdings. WCCL acquired LD Waxson Group, a Singapore-based FMCG company, as recent as in December 2012. Therefore, there is a little doubt in the fact that a demerger would make both the IT & the non-IT businesses leaner and meaner.

Another rationale that supports Wipro’s demerger is that all the three non-IT business units generate enough cash in their balance sheets every year.

This is the reason why once the separation is complete, Wipro Enterprises would be a debtfree company with healthy cash flows. This will give Wipro Enterprises necessary impetus to go all out with acquisition opportunities coming its way in the future.

Apparently, low profitability of Wipro’s non-IT

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Article of the Month Cover Story

Fig 1: Contibution of Wipro’s various segments to Revenue and Operating Income

business was also a big reason for the demerger.

Wipro’s non-IT business accounts for 14 per cent of the company’s turnover but only 6 per cent of its operating profit. Thus, it was widely presumed that Wipro’s non-IT business was pulling back Wipro’s bottom line. The reason behind this is that Return on Capital Employed (ROCE), for the IT and non-IT business is quite different. For example, ROCE in case of Wipro Consumer Care & Lighting’s is about 19 per cent, much lower as compared to its IT business.

Coming to the terms of the deal proposed by Wipro, the terms of the demerger are complex enough to keep the shareholders thinking.

Wipro has offered its shareholders the following options – 1. Receive one equity share with face value of Rs.10 in Wipro Enterprises for every five equity shares with face value of Rs.2 each in Wipro Limited that they hold.

2. Receive one 7% Redeemable Preference Share in Wipro Enterprises, with face value of Rs.50, for every five equity shares of Wipro Limited that they hold. Each Redeemable Preference Share shall have a maturity of 12 months and shall be redeemed at a value of Rs.235.20.

3. Exchange the equity shares of Wipro Enterprises and receive as consideration equity shares of Wipro Limited held by the Promoter.

The exchange ratio will be 1 equity share in Wipro Limited for every 1.65 equity shares in Wipro Enterprises Limited.

Digging deep into this complex deal, Wipro investors, if they choose preference shares, will get roughly Rs 47.7 after one year for each share of Wipro. At today’s prices, this is roughly Rs 43.4 per share. Investors thus get 12.1 per cent compensation for letting go of the non-IT business. And if they opt for equity in Wipro

Enterprise and swap it with the promoters, they would again make a gain of about 12.1 per cent on the transaction.

Rough calculations carried out for the deal shows that Wipro is valuing its non-IT businesses at about Rs 10,900 crores, which means a priceearnings multiple of about 29-30 times the net profit for the business. Now, this is a generous valuation taken up by Wipro and this valuation is aimed at providing investors a good price for their exit.

Needless to say, the demerger as proposed by Wipro is a win-win deal for promoters. If the investors opt for the preference shares, Wipro will get access to preference capital at the cost of 7 per cent a year, which is more or less at par with the market rates for preference capital.

But more investors opting for preference shares will also mean a smaller equity base, boosting Earnings Per Share (EPS) for Wipro Enterprises.

And if the investors opt for equity shares instead of preference shares, promoters of Wipro will get a chance to reduce their own holdings in the listed IT Company. This will make sure that they meet the government’s minimum public shareholding norms of 25 per cent, without selling in the market.

In conclusion, we can say that the demerger deal is happening at the right time for Wipro.

And because Wipro’s non-IT business is a part of an IT giant, these businesses didn’t get as much visibility as the other companies in their sectors have enjoyed. Also, the shareholders are not taken for a ride with the demerger. They are well compensated for letting go off the non-IT business. The valuation of the non-IT business also is quite generous. On the other side, the demerger deal is a win-win deal for Wipro. There is no doubt in the fact that the deal has been

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well crafted to suit each and every stakeholder.

Pantaloon’s Demerger: Synergising Operations

Another demerger to have happened recently is that of Pantaloon. Future Group demerged the fashion business of its two entities, namely Future Ventures India Ltd. (FVIL) and Pantaloon Retail India Ltd. (PRIL), into a new entity named ‘Future Fashion’. This will help the companies to focus on their respective businesses more effectively. The appointed date for the deal is January 1, 2013 and it will take around 6-8 months to complete the deal. After the demerger, PRIL will focus on its core business brands like Big Bazaar and Food Bazaar while FVIL will focus on the food and FMCG sector which includes brands like Fresh & Pure, Premium Harvest etc. Also, the new entity Future Fashion will focus on operating retail chains with domestic and global brands. FVIL will transfer f a s h i o n brands like Scullers, U r b a n a , Urban Yoga etc. to Future Fashion. Key financial aspects of this demerger are as follows: • The new entity Future Fashion Ltd. will be listed.

• The share exchange ratio will be 1 equity share of Future Fashion Ltd. for every 3 equity shares held in PRIL and 1 equity share of Future Fashion Ltd. for every 31 equity shares of FVIL. • Post demerger, 49.8 % in the new entity will be held by PRIL, 30.5 % by shareholders of FVIL and 19.7 % will be held by PRIL as a corporate entity.

• Post demerger, face value of the shares of Future Ventures India Ltd. will change from Rs. 10 per share to Rs. 6 per share.

The major reason for this demerger is that PRIL’s management wants to deleverage the company.

Currently PRIL has a debt of Rs. 3700 crore on its book. It will transfer debt of Rs. 1226 crore to the new entity Future Fashion. Fashion business already has debt of Rs. 200 crore. So the total debt on the books of Future Fashion will be of Rs. 1426 Crore and PRIL’s debt will come down to Rs. 2474 Crore. Another reason for demerger is the interest that Aditya Birla Nuvo Ltd. has shown in owning a majority stake in PRIL. ABNL would invest Rs. 1600 crore in Pantaloon’s retail business. This

JANUARY 2013

deal got the approval of Competition Commission of India (CCI) on December 27, 2012. Another rationale for demerger is the new challenges and opportunities that the company awaits after the approval of 51 % FDI in multi-brand retail.

For the shareholders of PRIL and FVIL, it is a beneficial move as they will get shares of this new entity in addition to their existing shares in PRIL and FVIL. After the clearance of the demerger

by CCI the share price of Pantaloon Retail India Ltd. (PRIL), has reached to Rs. 255 per share on December 30th from 235 per share as on 27th December which shows investors are bullish in this stock. It is also beneficial for the existing stockholders of PRIL as now the company is less leveraged; so on one hand their dividend earnings will increase because now there will be less interest expense and on the other hand it will decrease the risk involved in the investment as now debt equity ratio of the company will also reduce Also, PRIL sold its investment of worth R s . 2 9 5 Crore in the quarter ended 30th September, 2012. This shows that the company is in desperate need of cash to reduce its debt. Now after transfer of some debt to the new entity and after Rs. 1600 Crore investment by ABNL, PRIL doesn’t need to sell its existing investments. Therefore PRIL will be in a better position to provide more returns to its shareholders.

The only concern for the Future group as a whole is that it is transferring a debt of Rs. 1426 crore to a new entity. If this entity fails to operate as intended or if it fails to generate profit due to economic slowdown, Future Group as the parent company would be in trouble. The other concern for the shareholders of FVIL is that company is reducing face value of its shares from Rs. 10 to Rs. 6 and as a result shareholders may oppose the demerger. If these circumstances arise, entire value created for shareholders and for the company itself by demerger will be at risk. But as of now this demerger looks to be a good deal for both the Future Group and its Shareholders.

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Cover Story Story Cover

SENSEX 2013

Team Niveshak Introduction 2012 was an action-packed year, from big events like the U.S. presidential race, New Chinese Leader Nomination, the London Summer Olympics, to regional conflicts in the Africa and Middle East and, to issues closer to home like Coal Gate Scam, 2G Scam etc. Despite very little going India’s way, the periodic bursts of FII flows, and reform measures announced by the government kept Investor sentiments up and going. Till August, the rally was mainly on account of benign liquidity but post Mr.

Indices

35

30

30

26 22

20

13

15 10

16

6M

12M

3.4

11.4

25.6

Nifty

5855.8

3.4

11.9

27.7

Auto

11304.4

8.8

19.9

39.2

Banking

14150.3

9.1

20.4

56.6

Capital goods

10727.6

-0.4

8.8

35.2

Cons durables

7613.6

10.2

23.2

44.7

FMCG

5920.2

7.9

19.1

47.3

8125

8.6

18.8

39.2

5672.6

-4.3

-1.8

-1.5

10980.3

4.9

2.4

18.8

Oil & gas

8303.6

-3.3

3.6

11.1

Power

1955.8

-3.6

-0.7

9.9

Realty

2067.1

13.2

25.5

52.1

BSE 500

7504.7

4.9

13.1

30.8

BSE midcap

7022.9

6.9

14.9

37.6

7349

5.1

12.7

32.8

IT

Fig 1: World Indices CY12 performance( in %)

Germany

India

Japan

France

US

UK

1

Performance in % 3M

Healthcare

7

Current 19255.1

Sensex

Metal

Brazil

0

7

China

YoY Growth

25

5

Chidambaram’s return to the finance ministry during the same period, the markets revived growth by the Government’s reform drive. From being the worst global performer in 2011, SENSEX turned the corner registering a 26% YoY growth, poised for its biggest annual growth since 2009 as foreign investors poured in a net US$23 billion this year.

Taking a deeper look into the sectorial indices in Figure 1 and Figure 2, we see that the major growth came from the Banking, Realty, FMCG and Consumer durables whereas the IT sector was still found in the

BSE small cap

Fig 2: Major indices CY12 performance

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Fig 3: Sensex Quaterly Chart showing Eight-year cycle phenomenon

entangles of Eurozone crisis registering a negative growth of 1.1%. The basic sectors like Power, Metal and Oil Gas registered a steady growth of 10-20% YoY. With forward looking policy reforms like opening up of FDI in many sectors, formulation of Cabinet Committee on Investments and more such in the pipeline like GAAR and new banking licenses, the markets have entered the New Year with renewed zeal and optimism. In this story, we aim to technically analyze the journey of Sensex so far and come up with buy and sell strategy for this year. A critical analysis and top picks for Banking and Auto sector have also been touched upon.

The 8 year Sensex Cycle Our analysis is guided by a long term structured study of the index in order to determine how we are currently positioned. Interestingly, the Sensex has followed certain patterns of time, cycle and price behaviour since its inception. One such pattern has been the eight year operating cycle since 1984. In the Figure 3, we observe that the year 1984 started with a bull run which lasted for eight years till the peak of 1992. A similar trend was observed in eight year rise and fall cycles from 1992 to 2000 and from 2000 to 2008. While the first two turning points (1992 and 2000) coincided with the Harshad Mehta scam and Ketan Parekh scam respectively, the third one (2008) was encountered in the backdrop of the US Sub-prime Crisis, the 26/11 terrorist attack and Satyam scam .

Based on our observations from Figure 3, we identify the following trends for the eight year cycle phenomenon:

• A correction of over 55% from peak value follows after every eight year top • Each eight year major peak is not preceded by multi fold gains whereas every 16 year peak is led by multi fold and broad based rallies. For instance, the 1992 and 2008 tops were anteceded by 11fold and 7- fold rallies respectively and broad based gains, while the 2000 peak was led alone by a major uptrend in the IT and media stocks.

• The Sensex continues to witness its usual cyclical bear and bull rallies within every large eight year cycle.

• Also, the Sensex has a tendency to top out in the first quarter of every year. In the adjoining monthly chart (refer exhibit 6 make a table) of the Sensex since 2000, we have observed that out of 13 times

Fig 4: Sensex peak pattern in the first quarter of every year

January 2013

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Fibonacci Retracement (price stops going lower) or resistance (price stops going higher). The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction (refer Figure 6). These levels are created by drawing a trend line between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

Fig 5: Performance post 2008 top

the index has made a significant top on 11 occasions in the first quarter of every year. Currently, we are positioned on the upward leg of the first quarter of 2013.

Attempts of Retest “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”- Sir John Templeton The rally before a major eight year cycle top is fraught with extreme market euphoria. Subsequently, this market uptrend is brought to an unexpected standstill and the consequent sharp collapse has a major impact on investors’ sentiments. It is for this very reason that the succeeding pullback efforts to replicate the major eight year cycle tops are subject to reactions. As a matter of interest, the index behaviour so far post the 2008 top has exactly emulated the trend post the 1992 peak and we can safely assume that what transpired post 1992 top has a bearing on what comes post the 2008 uptrend. Since we are still in a consolidation phase post the 2008 top, it becomes extremely important to understand the index behavior within this phase

in the 1992 cycle.

First attempt to re-test in 1994/2010 There was an attempt to retest the high of 1992 (4546) in 1994 as the index marginally bettered the 1992 high by 2% and jumped to 4643 in 1994 before going into a consolidation phase for almost four years. After this retest attempt, the index plummeted and lost 39% towards early 1996. A comparable movement was detected post the 2008 peak wherein the index almost duplicated the 2008 high (21206) in November 2010 (21108) and took a plunge thereafter to register a correction of 28% (15135) by December 2011.

Second attempt to retest in 1997/2013 After a 39% correction towards early 1996, the index once again endeavored to touch the 1994 highs (4643) during August 1997 (4605). However, this attempt failed to take off and the index once again started its journey downhill. By looking at the trends, one might also think that in 2013 there would be a higher peak. But, the first attempt in this case has already been made in 2010. So, in 2013 we don’t expect the index to outdo the 2008

Fig 6: Fibonacci retracement

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A term used in technical analysis that refers to areas of support

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Fig 7: BSE Bankex: Monthly Candlestick Chart

high.

the previous segment.

Time period of alternate peaks and troughs

Verdict for Sensex

If one analyzes the historical movement, the velocity of Sensex is swift in the direction of the primary trend. Whereas the secondary swings (the swing inside the 8 year operating cycle) tend to gulp up more time. Post the 2008 peak, we observe that each major down-leg/ up-leg for the Sensex has lasted around 13-19 months (refer Figure 5).

The first downfall from January 2008 to March 2009 lasted 15 months while the matching rally from March 2009 to November 2010 spent 19 months. The next fall from November 2010 to December 2011 took 13 months, while the current rally from the December 2011 low is already 13 months old while we are still approximately 5% away from completely retracing

Before concluding the long term prognosis of SENSEX movement, it may be noted that our study is primarily governed by ‘History repeats itself’ principle. Currently, the index is fluctuating at a well-established medium term uptrend touching a 24-month high. The recent sentimental boost provided

by Indian Government through the much anticipated reforms, coupled with the successful dodging of Fiscal Cliff by the US, is likely to sustain the journey uphill into 2013. However, the SENSEX approaching the 2010 highs or even surpassing the same by a small margin (2%) in the near future cannot be assumed as the start of the new Bull Run. It can be perceived that, SENSEX is in the midst of a larger consolidation phase post 2008 (peak) and thus it should re-test the previous highs. However, the sustainability of such highs is

APPLICATION OF FIBONACCI RETRACEMENT Taking the 2012 lows (16358) and assuming 2013 high as 21200, the golden Fibonacci ratio of 61.8% of the entire rally from 2012 lows to 2013 highs is placed around 17592 points.

January 2013

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Fig 8: PNB: Monthly Candlestick Chart

uncertain.

Burning question: Whether long term retail investors should get tempted to put their money in the market in anticipation of a new bull run?

Based on the above-mentioned technical analysis, we expect the current upward movement in SENSEX to attempt a re-test of the 2010 high or even exceed the same by a 2% margin (as has been the case in post 1992 scenario) in the early part of 2013 leading to a rally towards 21000/21500 levels. After attaining the previous top in the first quarter of 2013 (second attempt of retest), we expect triggering of a downward trend, which can last for around 12-15 months leading up to the middle of 2014. On the other hand, we also believe the price wise correction towards 17500- 16800 concurring with time wise correction up to middle of 2014 would be the most opportune moment for long term investors to take out the shopping cart and start cherry picking to build a portfolio to ride the next wave up which is expected to last up to 2016, the next potential eight year cycle top.

Banking Sector After the 2008 peak the banking index went down hitting a low of 3600 around March 2009. Post that,

the banking index has performed decently in the last four years. The index showed a sustained upwards movement in 2009-2010 and also crossed the 2008 peak making a new all-time high of 15108 in November 2010. But the correction during 2011 caused a retracement of 50% of the previous upwards rally making the index to fall down to 9263 (around 50% of low-3600 and high-15108 of previous rally). After the pause in 2011 the index has continued to move up throughout 2012 and is now trading at its all-time high. The figure above shows the peaks of 2008, 2011 and 2012, which is the current all-time high. It also shows the lows of March 2009 and early 2012.

The index currently is moving up and is expected to perform well at least in the near future. After this upward move if the index falls, the support for the index should be placed in the range of 11500-12000 based on the following arguments: • While the index was moving up in 2012, trend line resistance breached during September 2012 at around 11400 level. This line is expected to reverse its role as support line in case the index falls.

• The 50% and 61% Fibonacci retracement of the up leg since January 2012 lows (9058) to all-time

Based on the technical analysis, we expect the current upward movement in SENSEX to attempt a re-test of the 2010 high or even exceed the same by a 2% margin

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Fig 8: BSE Auto: Monthly Candlestick Chart

high of 15108 is placed at 12100 and 11400 levels of the previous decline from 1323 to 659. So Punjab National Bank shares are the hot pick currently in respectively. the banking sector. It should be a correct move to Hot Picks buy its shares now and keep it till it reaches the The Figure 8 shows how the share price of Punjab target of INR 990.

National Bank has behaved in the last four years.

After retracing from its 2008 high of 670 to March Auto Sector 2009 low of 266, it showed a steady increase in price for the next 20 months reaching its all-time high price of INR 1323. This sustained growth in price was followed by a corrective phase that lasted till August 2012 when the share price fell up to INR 659. The following phenomenon can be seen in the behavior of the stock price of Punjab National Bank: • The August 2012 low of 660 is the Golden Fibonacci retracement (61.8%) of the 20 month long 2009-2010 rally that started from low of 266 to high of 1323. • The retracement also coincides with the 2008 peak, which has reversed its role from causing resistance to providing support.

Seeing the past behavior it is expected that the share price of PNB will continue its upwards movement, which has already started in August 2012, till the price reach around INR 990 to INR 1050, which are 61.8% and 50% retracement respectively

Very much like the Banking Sector, the automotive sector has also seen a strong upward trend in the last four years, during which the index has jumped almost 5 times from the low of 2128 in December 2008 to a strong 10500 in November 2010. For almost 2 years post this achievement, the index had been in a consolidation phase where it drifted in the range of 10800-7900. More recently, the index has broken out of this range embarking on a positive ride achieving an all-time high of 11868 in the past one year and more importantly the trend looks promising. On the week ended January 18, 2013, BSE Auto Index (Figure 8) stood at an encouraging level of 11298.

The long term analysis of this strongly growing sector indicates that the index is expected to reach a minimum of 12600 (61.8% of the depth of consolidation range of 2900 (10800-7900)) before

Very much like the Banking Sector, the automotive sector has also seen a strong upward trend in the last four years, during which the index has jumped almost 5 times from the low of 2128 in December 2008 to a strong 10500 in November 2010

January 2013

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Fig 9: Ashok Leyland: Monthly Candlestick Chart

it encounters any significant resistance. Also, the monthly long term Moving Average Convergence Divergence (MACD) which has been above the trigger line for almost 3.5 years now thereby indicating a positive momentum, signals the buy strategy for the sector. MACD is calculated as the difference of the value of the 12 day and the 26 day Exponential Moving Averages.

So, now that the technical analysis suggests a good investment strategy in the automotive sector for the coming year, the obvious question that comes next is which stocks are the best bets in the sector.

Again, we use the technical analysis to arrive at the answer. The analysis which follows gives the following verdict: 1. Ashok Leyland 2. JK Tyre & Industries Ashok Leyland that trades at around Rs.26.5 per share today was not so long ago (read January 2009) trading at only Rs.6 per share. In the subsequent 2 years, it saw almost a 7 fold rally, hitting an alltime high of Rs.39 in November 2011. The next 10 months saw a corrective phase during which the stock hit a double bottom at around Rs.20, which stands at a very important support level of 61.8% of the difference of the multi fold rally (61.8% of 33). The past experiences have suggested positive signals for the shares that start the bullish pattern at the Fibonacci retracement levels. The volumes of shares changing hands in the last 4 months or so are also a very healthy sign for our first pick in the sector. Team Niveshak suggests the target price for Ashok Leyland at around Rs.35.

JK Tyre and Industries which is our second pick in the auto sector, has also witnessed a seven fold rally from March 2009 to April 2010, where it has traded at rock bottom price of Rs.30 to an all-time high of Rs.204. Post this period, JK Tyre entered a corrective phase, retracing almost 80% of the gains it had made in the financial year 2010 by the end of 2011. Since the start of 2012 however, the stock has only known one direction. The volumes of the stock being traded are also significantly higher since the start of 2012. By joining the higher lows since January 2012, the value of the rising trend line is placed around the level of 106. This rounding bottom breakout level is expected to act as a strong support and should be used as a price level to include JK Tyre and Industries in one’s portfolio.

Team Niveshak suggests the target price for the share at Rs. 152.

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Article FinGyaan of the Month Cover Story

UNITED STATE’S FISCAL CLIFF DEAL Niket Kumar Dixit

IIT Madras

Some people believe that the term “Fiscal Cliff” was first used by Goldman Sachs economist, Alec Phillips. Others credit Federal Reserve Chairman Ben Bernanke for taking the phrase mainstream in his remarks in front of Congress.

Still others regard Safir Ahmed, a reporter for the St. Louis Post-Dispatch, who in 1989 wrote a story detailing the state’s education funding and used the term “Fiscal Cliff”, as the one who coined the term.

“Fiscal Cliff” is used to describe the measures of deficit reductions in accordance with the Budget Control Act of 2011 beginning on January 2, 2013. The measures aimed at sharp decline in the budget deficit due to increased taxes and across-the-board spending cuts (known as “sequestrations”). According to the Congressional Budget Office (CBO), by 2022, the budget deficit would fall to $200 billion from its current level of $1.1 trillion with these measures.

The current crisis came to fore with the expiration of Tax Relief Act of 2010 and deficit reduction steps under the Budget Control Act of 2011. The former extended the Bush tax cuts for two years, while the latter was enacted to resolve the public debt ceiling crisis.

Bush Tax Cuts They are referred to a series of temporary income tax relief measures, the Economic Growth and Tax Relief Reconciliation Act of 2001, enacted by President George W. Bush in 2001 and 2003. But as the tax cuts were in place for such a long

January 2013

period, people began to feel them permanent rather than temporary.

The Bush Tax Cuts were fairly extensive and covered a wide range of tax provisions. In general, below are the changes that were scheduled to occur after January 2, 2013 1. The standard deduction for married couples will be lower - no longer double the single filer deduction.

2. The ceiling of the 15% tax bracket will be lower - also no longer double that of single filers.

3. The tax rate on qualified dividends earned by middle and upper-income earners will balloon from 15% to the taxpayer’s ordinary income tax rate; as high as 39.6% for the highest tax bracket.

4. The 10% tax bracket for lower income earners will revert back to the 15% tax bracket.

5. The child tax credit will drop from $1,000 to $500.

6. The Earned Income Credit will be eliminated for lower income taxpayers.

7. The tax rate on long term capital gains earned by middle and upper income taxpayers will rise from 15% to 20%.

8. Ordinary income tax rates will increase.

9. The Alternate Minimum Tax (AMT) will revert to the higher 2001 levels, which have not been adjusted for inflation, meaning that many middle class earners will fall into AMT territory.

10. The Personal Exemption Phase-Out (PEP) and Pease itemized deduction phase-out will be restored, removing the value of some

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Fig 1: Tax rates with the Bush Tax Cuts and without them

As already mentioned, it is expected that the budget deficit would fall to $200 billion in 2022 from its current level of $1.1 trillion. That would all be welcome news, but in order to get there, the nation would face almost certain financial turmoil.

Arguments against Fiscal Cliff The Tax Policy Centre reported that middle-income families would pay an average of $2,000 more in taxes in 2013. Many itemized deductions would be subject to phase-out, and popular tax credits like the earned income credit, child tax credit, and American opportunity credits reduced. The 401(k) and other retirement accounts would be subject to higher taxes.

The marginal tax rate is the tax you pay on each additional dollar of income you earn. As your income rises, the marginal tax rate (better known as your tax bracket) rises. For 2012, the tax brackets were 10%, 25%, 28%, 33% and 35%.

If the deal did not get through, those rates

would have gone up respectively to 15%, 28%, 31%, 36% and 39.6% (shown in the figure 1).

In addition, the Congressional Budget Office (CBO) estimated that 3.4 million or more people would lose their jobs. The October 2012 unemployment rate of 7.9% represents significant improvement over the October 2009 rate of 10%. The Congressional Budget Office (CBO) believes that up to 3.4 million jobs would be lost, post fiscal cliff, due to a slowing economy with layoffs stemming from cuts in the defence budget and other things. This could result in an increasing unemployment rate up to 9.1% or more.

The “Fiscal Cliff” deal The American Taxpayer Relief Act of 2012, also known as Fiscal Cliff deal, was signed into law by the President Obama on January 2, 2013 and eliminated much of the tax side of the fiscal cliff, with the Congressional Budget Office (CBO) projecting an 8.13% increase in revenue and 1.15% increase in spending for FY 2013. The Act resulted in a projected $157 billion decline in the 2013 deficit relative to 2012, rather than the sharp $487 billion decrease projected under the fiscal cliff.

The main features of the fiscal bill that the Congress passed aimed at averting wide tax increases and budget cuts scheduled to take effect with the beginning of this year. The measure would raise taxes by about $600 billion over 10 years compared with tax policies that were due to expire on December 31, 2012. It would also delay for two months across-theboard cuts to the budgets of the Pentagon and numerous domestic agencies. Some of the measures are 1. Income tax rates: Extends decade-old tax cuts on incomes up to $400,000 for individuals, $450,000 for couples. Earnings above those amounts would be taxed at a rate of 39.6%, up from the current 35%. It extends Clinton-era caps on itemized deductions and the phaseout of the personal exemption for individuals making more than $250,000 and couples earning more than $300,000.

2. Estate tax: Estates would be taxed at a top rate of 40%, with the first $5 million in value exempted for individual estates and $10 million for family estates. In 2012, such estates were subject to a top rate of 35%.

3. Capital gains, dividends: Taxes on capital gains and dividend income exceeding $400,000 for individuals and $450,000 for families would

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FinGyaan Cover Story

exemptions and deductions (like charitable contributions) from high income earners.

11. The Lifetime Estate Tax Exemption and Lifetime Generation Skipping Tax (GST) will revert from $5.12M to $1 million exclusion.

Arguments in favour of Fiscal Cliff The cliff itself would prove to be a positive step in long-term. Macroeconomists argue that the United States has to fight its budget deficits at some point. The “Fiscal Cliff” would be harsh, but right step in that direction. The short-term impact could be severe, but the long –term gains like lower budget deficits, lower debts, better investor sentiment and better growth prospects would be worth the short-term gains (? Or losses).

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increase from 15% to 20%.

4. Alternative minimum tax: Permanently addresses the alternative minimum tax and indexes it for inflation to prevent nearly 30 million middle- and upper-middle income taxpayers from being hit with higher tax bills averaging almost $3,000. The tax was originally designed to ensure that the wealthy did not avoid owing taxes by using loopholes.

5. Other tax changes: Extends for five years Obama-sought expansions of the child tax credit, the earned income tax credit, and an up-to-$2,500 tax credit for college tuition. Also extends for one year accelerated “bonus” depreciation of business investments in new property and equipment, a tax credit for research and development costs and a tax credit for renewable energy such as wind-generated electricity.

6. Unemployment benefits: Extends jobless benefits for the long-term unemployed for one year.

7. Cuts in Medicare reimbursements to doctors: Blocks a 27% cut in Medicare payments to doctors for one year. The cut is the product of an obsolete 1997 budget formula.

8. Social Security payroll tax cut: Allows a 2-percentage-point cut in the payroll tax first enacted two years ago to lapse, which restores the payroll tax to 6.2%.

9. Across-the-board cuts: Delays for two months $109 billion worth of across-the-board spending cuts set to start striking the Pentagon and domestic agencies this week. Cost of $24 billion is divided between spending cuts and new revenues from rule changes on converting traditional individual retirement accounts into Roth IRAs. Will “Fiscal Cliff” deal end the economic woes?

Though fiscal cliff deal is a welcome step, but it should not be forgotten that the deal is only addressed with the revenue side (taxes) and has postponed any discussion of spending cuts for another two months. And on a longer-term basis, the cliff deal did little to address the country’s debt load - which currently stands at approximately $16.4 trillion.

Also, the “Fiscal Cliff” is not the only issue nagging the United States and world economy.

In February-March, United States will again hit the “debt ceiling” and Congress will need to negotiate it. The Congress will also renegotiate the sending/appropriations bill for the remainder financial year 2013.

January 2013

FIN-Q Solutions DECEMBER 2012 1. Bretton-Woods System 2. Predator’s Ball 3. John Maynard Keynes 4. Sahara Group 5. Lombard Rate 6. X= Tata Capital Limted, Y= Tata Capital Financial Services Limited 7. FWWB (Friends of women’s World Banking, India) 8. Recent Merger of Penguin and Random House to create arguably the biggest publishing house.

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CAUSES AND THE IMPACT ON THE ECONOMY Deepak P.

IIM Shillong

The Stock Market Crash of 1929, which started market correction. It regained momentum by in the month of October that year, has been the around 8%, to close just 2% down for the day. most catastrophic stock market crash ever in the Even then there was some abnormality which history of the United States. Although the crash made the bankers worried because the volume lasted just for four days, it had a tremendous traded on that day was quite abnormal; almost impact globally. The crash signalled the starting triple the normal volume was traded during the of the Great Depression that affected all the entire trading session. Even though there was a Western industrialized economies. huge buying to prop up the market, it fell again Just to explain in brief about the magnitude on Black Monday 28th October 1929. The stock m a r k e t of crash, the crash ended Dow Jones with a panic Industrial Average fell selling on down to the stock almost 10% m a r k e t of its record on Black high value of Tu e s d a y, 381.2, which 29th October it attained on 1929. Over September 3, 16 million 1929. It was shares were trading at sold just around 41.22 on that day on July 8, alone. Over 1932 which the four was almost at days during the bottom of w h i c h its valuation the stock cycle.

That m a r k e t was the worst crashed, the slump in Fig 1: Fluctuation of the Dow Jones Industrial Index Dow fell by market in terms of around 25%, percentage loss in losing almost the modern U.S. history. It took almost 25 years $30 billion of market capitalization. The people for the same index i.e. Dow jones to actually reach were terrified. This was almost equivalent to the its September 3 high. The details of the crash total cost of World War I. are as follows. The market started to crash from October 24, 1929; the day that later came to be Situation before the crash: Roaring known as the Black Thursday. The stock market 1920’s opened to trade at 305.85, falling approximately The economic condition that existed before the by 10% during day trading, barely, a stock crash was in complete contrast to the one that Š FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Finistory Article of the Month Cover Story

STOCK MARKET CRASH 1929:

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Fig 2: Volume of shares traded during the crash

was after the crash. This could be inferred from the fact that the period before the crash was also called the “Roaring Twenties”. The condition was such that during the 1920’s discoveries and inventions took place in almost every field that later became the foundation of thriving businesses. New business and production methods that were followed resulted in huge profits which they invested back into new businesses resulting in a tremendous increase in the buying power. The share markets showed a tremendous upward trend and reached peaks during the period. Stock market grew by almost 20% every year. The Dow jones Industrial index almost quadrupled during this period. Most of the investment was bought on Margin, i.e. only 10%-20% was required to be put in the market and the rest was borrowed from the brokers. The situation was such that out of every 5 dollars a bank lent, 2 dollars were invested in stock market. The low unemployment rates of around 4%-5% were another evidence of the economic prosperity that existed during the decade. The GNP also skyrocketed from $4700 per household to $5500 per household. The rising GNP also

meant that the workers had enough money to spend, resulting in mass consumption leading to creation of even more jobs and more demand for products.

Some of the factors which contributed to the Economic boom of the early 1920’s include the advancements in science and technology that resulted in the invention of a new material called Bakelite which was used for the manufacturing of radios and telephones. Ford’s assembly line means of production resulted in production of approximately 6 cars per minute, also huge advancements were made in the field of medicine and healthcare. The rules and regulations that imposed high tariffs on imported goods made the imported goods more expensive and hence most of the people bought US made goods which resulted in creation of more jobs in the factories. Confidence was sky high among the people, credit system was more prevalent which also increased the amount of goods purchased; out of every 10 cars bought 6 were bought on credit. It seemed that this economic prosperity would go on forever.

The “Roraring Twenties” saw the Dow Jones Industrial Indes almost quadruple with the stock market growing by almost 20% every year

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The stock market crash marked the beginning of a decade of unemployment, poverty, lack of economic and personal growth, and decrease in other market opportunities. The US economy fell into a complete downturn or rather recession that lasted for almost a decade. At the height of this great depression, GNP was down by almost 40% from its original levels and unemployment rate was above 25% while underemployment was much higher at a rate of 50%. During this economic downturn, millions

of American workers lost their jobs. Industrial and construction workers faced great difficulties during this period. In Ohio, by 1933, more than 40% of factory workers and 67% of construction workers were unemployed. Farmers did not get fair value for their products resulting in farm foreclosures across the United States. Industrial growth was hampered and fell by almost 45%.

Some of the industries that were most severely hit include the construction, shipping, mining and logging industry. The economic condition

The Stock Market crash of 1929 led to a major economic crisis known as the Great Depression

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Finistory Article of the Month Cover Story

Causes of the Crash There were many reasons that led to the stock market crash in 1929.The significant contributor to the crash was the overvaluation of stocks. The stocks were overvalued to a great extent and the P/E ratios were very high. The overconfidence among the citizens riding from the economic boom of the 1920’s influenced them to search for an easy source of money and they invested hugely in the stock market. Another important reason was that of marginal buying. When share prices eventually slumped, investors had to sell their shares to meet margin calls resulting in further decrease in share prices, worsening the problem and leading to the share market crash.

The government also was partly responsible for the crash. Mr Adolph Miller, the then president of the Federal Reserve board, introduced very strict monetary policies. The interest rates on the loans were increased to a great extent making it extremely difficult for the investors. Some other reasons include the proliferation of investment trusts, large number of bank loans which could not be liquidated, and an economic downturn that had begun earlier in this phase. Analysts also opine that frequent comments by the public officials that the stock prices were too high could also be a reason for the crash. For example, the then President of the US, Herbert Hoover, stated publicly that stocks were overvalued and that speculation could have hurt the economy.

Hoover’s statement was indicative of the drastic steps he was willing to take to control the market. These types of statements by an official of such repute made the investors believe that the market would correct itself soon and attain the true value, which could be attributed as one of the reasons for the crash. All the above factors more or less contributed to the most disastrous stock market crash ever that happened in the history of the US economy.

Consequences of the Stock Market crash 1929: The stock market crash of 1929 had a significant impact on the economy. It led to a major economic crisis known as the Great Depression.

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continued to slide and eventually reached its lowest in the winter of 1932-33. Another significant impact of this was that during the recession, approximately 9000 banks had to be closed which resulted in millions of people losing their savings. The economic slump saw the average income of an average American family being reduced by about 40%. Around 3 lakh people were left homeless. Corporate profits slumped by around 10 times during this period. Amount spent on education was very less, causing many schools to operate with very less staff or shut down due to lack of funds. The wages of the workers was significantly reduced.

Due to the bad economic conditions, world trade decreased sharply as each country tried to safeguard their own industries and products by raising tariffs on imports. The depression also resulted in major political changes. In countries such as Germany and Japan, reaction to this current economic downturn brought about the rise of power of militarist governments who followed aggressive foreign policies that eventually resulted in the Second World War. Many Reforms were introduced after the crash.

After a loss of approximately $14 billion, reforms had to be introduced to stabilize the economy.

One of them included setting up of the Securities and Exchange Commission or SEC. The role of this body was to lay down the market rules and punish the offenders in case of any violation.

Another act called the Glass-Stegall Act was also passed. This act was passed to cut the connection that commercial and investment bank had before passing the law. The other reform that was introduced was the setting up of the Federal Deposit Insurance Corporation or FDIC. This was introduced to make sure that each and every individual bank account was insured up to $100000.

But the questions that we face today are: Have we learnt from the past? Have we got in place a system that shields us from the drastic effects that such a crisis can bring about?

I don’t think so. There is still a long way to go before we can say that with certainty. The financial crisis of 2008 was a harsh reminder

of the same. But we can confidently say that we have taken several measures that helped reduce the impact. Measures like BASEL III can really go a long way in solving the problem.

Approximately 9000 banks had to be closed which resulted in millions of people loosing their savings

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Finsight Cover Story

New Banking Licenses: Should RBI bite the bait?

Abhinav Sonal & Gautam Bansal

SRCC Delhi Should Reserve Bank of India (RBI) bite the bait? In order to answer this question, let’s understand bait in RBI’s context. Reserve Bank of India, the central bank of the country, regulates and supervises the financial system, manages exchange rates, issues currency, and is the banker to all banks. The bait being offered in this case is the assurance that the change in Banking Act 1949 will be passed by the House in upcoming budget sessions.

Pranab Mukherjee, the then Finance Minister, promised the issue of new banking licenses in his 2010 Budget Speech. RBI was then asked to draft the guidelines and the conditions to be fulfilled in order to apply for this license. RBI agreed to do the same but put forward a condition, it wanted the Banking Act 1949 to be changed a bit. It proposed the following clauses: 1. A new section 12B should be inserted in the Act which states that any acquisition of 5% or more of the share capital of a bank will require RBI’s approval.

2. The updated Act should empower RBI to supersede the board of directors of a banking company and appoint an administrator during the period of super session.

3. The updated Act should also empower RBI to call for information or inspection of any associate enterprise of a banking company.

For the below mentioned reasons, the Government of India (GoI) is trying to convince the RBI to issue the licenses based on the current Act. The contention of Government of India is that the Act

does state that no acquisition of 5% or more can take place unless there is a ‘prior acknowledgement’ (and not approval) from the RBI. On the issue of super session, the Act says that the promoter or the promoter groups will be permitted to set up a new bank only through a wholly owned non-cooperative holding company which will hold the bank as well as other financial services companies regulated by the RBI and other financial regulators. Government of India also says that Section 36AA and 36AB of the Act already empowers the RBI to replace members of the board or any officer of a banking company and to appoint additional directors.

One cannot deny that the new banks will be good for the economy. Opening of new banks will extend the geographic coverage of banks and improve access to banking services. Though the Indian financial system has made impressive strides in resource mobilization, geographical and functional reach, financial viability, profitability and competitiveness, vast segments of the population, especially the underprivileged sections of the society, have still no access to formal banking services. This will also lead to greater competition, innovation, reduction in cost and improvement in quality of service.

One need not be an economist/analyst to figure that ‘Target 2014’ is the Government’s objective. In a recently held meeting between P. Chidambaram and the heads of the state controlled banks, the finance minister said that he wanted the process of issuing new bank licenses to start without waiting for an amendment of banking rules. Is the Government

Pranab Mukherjee, the then Finance Minister, promised the issue of new banking licenses in his 2010 Budget Speech. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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NIVESHAK

rushing into issuing new bank licenses? If it is true, why is that so? To put things into perspective, it is very evident that the current government is finding it tough to get a foothold as the party of choice for most of the countrymen. It can be debated that the Government of India is approaching ‘the opening of new banks’ as another effort to redeem its failures and scams. RBI probably appreciates and supports the actions being taken by the Ruling Government and all it demands is the safeguard on the functioning of new and existing banks. In short, RBI wants to ensure that the Banks do not start to overlook the public interests to simply be more profitable.

‘Stable India’ is RBI’s objective. Section 22 of Banking Regulation Act 1949 entrusts Reserve Bank of India with the power to issue the licenses to new banks.

But the Act also lists down certain conditions which needs to be satisfied in order to issue the license.

Some of the conditions are “that the affairs of the company are not being, or are not likely to be, conducted in a manner detrimental to the interests of its present or future depositors; that the general character of the proposed management of the company will not be prejudicial to the public interest or the interest of its depositors; etc.”

In order to ensure law and order in the banking industry it makes sense for the RBI to first get the changes made in the Act and ensure that they are allowed to supersede the Board of Directors.

RBI’s conservative approach in the past has paid dividends. During the booming period of the early 21st century, the whole world was optimistic.

Everyone was talking about the Great India Story.

India was growing at a very rapid pace. But RBI was keeping a close tab on the future. While everyone was hoping for more liquidity in the market, RBI took an unexpected channel. It increased the CRR and reduced the liquidity. It abolished Land Loans and prohibited Off-Balance Sheet financing. All this had an adverse impact on the investments and the profitability of the companies. And while the world financial sector collapsed, India averted a major disaster. In retrospect, we all appreciate the strong stand taken by the RBI. India did come out of recession better than a number of other nations and the future of India still looks bright.

Looking forward, one senses caution. India’s growth has been on an 8-year low. Inflation (CPI) has averaged 8% for the same period. Government has been in regular talks with the heads of state controlled banks to infuse more capital into the banks. Well-to-do Public sector banks such as Indian Overseas Bank, Central Bank of India and Bank of Maharashtra are stacking up NPAs in their balance sheets and need major revisions in their budgeted provisions.

Can our economy really afford non-regulated new banks, when half a century old banks are repeatedly failing on their budgets and provisions year-afteryear?

All we want is the Banking System, which is complex and very sensitive in nature, to not get corrupted by the misdoings of the new banks. We have a live case on how Spanish banks have failed their economy miserably because (of unregulated banking system/ loopholes in their banking policies) they could not anticipate the sub-prime/Eurozone failure. Also, we do not want a 2G scam, a Coalgate scam, a Reliance 1992 ADR issue problem, etc. to happen with the Banking industry, the consequences of which can have fatal effects on the economy and the common man. Therefore, RBI ought to take calculative precautionary measures and ensure that its reasonable demands are fulfilled before they issue licenses to new banks.

Section 22 of Banking Regulation Act 1949 entrusts Reserve Bank of India with the power to issue the licenses to new banks

JANUARY 2013

NIVESHAK

Sir, often there are articles in newspapers on actions being taken against companies following Ponzi Schemes. What is a Ponzi scheme?

In a Ponzi scheme, a single person woo the investors by offering a higher profit than what is offered in the market by showing some made up investments. But the truth is that the initial set of investors are paid by their own money or by the money paid by the subsequent investors. This is different from a Pyramid scheme where one person starts it in much the same way as a Ponzi scheme and then “tiers” of investors continue the trend in place of the single person.

How exactly is a Ponzi scheme carried out?

Ponzi Schemes are quite basic but can be very powerful. They are carried out in the following way: 1.Convince a few investors to invest in your scheme 2. Make the promised payment along with the specified rate of return to the investors 3. Banking on the success of the investment, attract more investors, mostly the initial investors 4.Repeat the first 3 steps. Most of the times, the cycle breaks due to lack of new investors.

How is this different from what a Bank does? Even a Bank run has the same effect as a Ponzi scheme. Then why is a Ponzi master mind adjudged as a criminal while a banker is not?

Ponzi Schemes V RAMPRASAD IIM Shillong See, banks and other legitimate financial institutions are supposed to invest the money which they receive from depositors and increase it, thus being able to repay the investors later on. The problem is that most of the funds with the bank are tied into investments. When a bank run occurs, the bank runs out of cash to give to those who want to withdraw their funds. But, that doesn’t mean that the bank has run out of money! That money is there but it is tied into investments that are not liquid. It is just an instance of inefficient cash management. On the other hand, the Ponzi scam master mind supplies the victim with false documentation making it appear as if their investment is still intact and earning a very high rate of return.

Even after so many Ponzi scams being exposed, why are people still becoming a victim to such schemes?

A very good question, the first scheme that was exposed was that of Ponzi in 1920, after whom the scheme is named. Lack of proper research before investing is making people invest in such schemes.Most of the times the people getting ripped off are not ignorant to scams. Informed investor’s often fall apart in the face of offers to “make money fast”. A successful Ponzi scheme requires an investor who thinks he is smarter than he really is and a fraudster who makes him think he’s being given an opportunity which no one else is getting.Another reason is that a Ponzi resurfaces every time in different forms. For every exposed Ponzi scam, there are others who read about the mistakes made and create a different version of that fraud. There were some schemes like the one followed by Charles Ponzi that were “too good to be true”, offering close to 40% profit and at the same time there were other schemes like the one offered by Bernard Madoff that provided a consistent return of 8% every year to make the scheme look lucrative.

Thank you very much sir for the explanation.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month

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FIN-Q 1. He received his doctorate of economics from Harvard University and taught at the Yale School of Management. He is best known for the development of the X in 1970s as well as for his role in developing the model Y which uses a “discrete-time” model of the varying price over time of the underlying financial instrument. Identify the person and X and Y. 2. X is an investment firm founded in New York in 1947 as Franklin Distributors, Inc. It is listed on the NYSE under the ticker BEN. In 1973 the company’s headquarters moved from New York to San Mateo, California. In October 1992, X acquired Y for a reported cost of $913 million, leading to the common name XY. The owner of Y, a mutual fund pioneer, together with his son and Z together owned 70% of the firm. X, Y, Z? 3. Company X acquired Indian operations of Y to broaden its product offerings in Mutual Fund Business this year. Identify X and Y. 4. Identify the third company?

5. Incorporated in 2007, the company has been in existence since 1967. The company recently issued its IPO with the issue price of Rs. 48-50 per equity share. The company has its only manufacturing plant located in Hardwar, Uttarakhand. Name the company.

6. Self-employed people and the business houses which are unincorporated can avail a plan for retirement purposes. This plan provides that the contributions are tax deductible up to 25% of annual income with certain limits. Identify the plan.

7. X was involved in a financial scam which shook the country considering the amount of money he made. X was sentenced to rigorous imprisonment for 13 years. Cure out who is X ?

All entries should be mailed at niveshak.iims@gmail.com by 10th February, 2013 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

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WINNERS Article of the Month

Prize - INR 1000/-

Neeraj Gupta & Anurag Mishra XIME Bangalore

FIN - Q

Prize - INR 500/-

Sankalp Raghuvanashi MDI Gurgaon

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