The Trouble With India

Crumbling roads, jammed airports, and power blackouts could hobble growth

When foreigners say Bangalore is India's version of Silicon Valley, the high-tech office park called Electronics City is what they're often thinking of. But however much Californians might hate traffic-clogged Route 101, the main drag though the Valley, it has nothing on Hosur Road. This potholed, four-lane stretch of gritty pavement—the primary access to Electronics City—is pure chaos. Cars, trucks, buses, motorcycles, taxis, rickshaws, cows, donkeys, and dogs jostle for every inch of the roadway as horns blare and brakes squeal. Drivers run red lights and jam their vehicles into any available space, paying no mind to pedestrians clustered desperately on median strips like shipwrecked sailors.

Pass through the six-foot-high concrete walls into Electronics City, though, and the loudest sounds you hear are the chirping of birds and the whirr of electric carts that whisk visitors from one steel-and-glass building to the next. Young men and women stroll the manicured pathways that wend their way through the leafy 80-acre spread or coast quietly on bicycles along the smooth asphalt roads.

With virtually no mass transit in Bangalore, Indian technology firm Infosys Technologies Ltd. spends $5 million a year on buses, minivans, and taxis to transport its 18,000 employees to and from Electronics City. And traffic jams mean workers can spend upwards of four hours commuting each day. "India has underinvested in infrastructure for 60 years, and we're behind what we need by 10 to 12 years," says T.V. Mohandas Pai, director of human resources for Infosys.

India's high-tech services industry has set the country's economic flywheel spinning. Growth is running at 9%-plus this year. The likes of Wal-Mart (WMT ), Vodafone (VOD ), and Citigroup (C ) are placing multibillion-dollar bets on the country, lured by its 300 million-strong middle class. In spite of a recent drop, the Bombay stock exchange's benchmark Sensex index is still up more than 40% since June. Real estate has shot through the roof, with some prices doubling in the past year.

But this economic boom is being built on the shakiest of foundations. Highways, modern bridges, world-class airports, reliable power, and clean water are in desperately short supply. And what's already there is literally crumbling under the weight of progress. In December, a bridge in eastern India collapsed, killing 34 passengers in a train rumbling underneath. Economic losses from congestion and poor roads alone are as high as $6 billion a year, says Gajendra Haldea, an adviser to the federal Planning Commission.

For all its importance, the tech services sector employs just 1.6 million people, and it doesn't rely on good roads and bridges to get its work done. India needs manufacturing to boom if it is to boost exports and create jobs for the 10 million young people who enter the workforce each year. Suddenly, good infrastructure matters a lot more. Yet industry is hobbled by overcrowded highways where speeds average just 20 miles per hour. Some ports rely on armies of laborers to unload cargo from trucks and lug it onto ships. Across the state of Maharashtra, major cities lose power one day a week to relieve pressure on the grid. In Pune, a city of 4.5 million, it's lights out every Thursday—forcing factories to maintain expensive backup generators. Government officials were shocked last year when Intel Corp. (INTC ) chose Vietnam over India as the site for a new chip assembly plant. Although Intel declined to comment, industry insiders say the reason was largely the lack of reliable power and water in India.

Add up this litany of woes and you understand why India's exports total less than 1% of global trade, compared with 7% for China. Says Infosys Chairman N.R. Narayana Murthy: "If our infrastructure gets delayed, our economic development, job creation, and foreign investment get delayed. Our economic agenda gets delayed—if not derailed."

The infrastructure deficit is so critical that it could prevent India from achieving the prosperity that finally seems to be within its grasp. Without reliable power and water and a modern transportation network, the chasm between India's moneyed elite and its 800 million poor will continue to widen, potentially destabilizing the country. Jagdish N. Bhagwati, a professor at Columbia University, figures gross domestic product growth would run two percentage points higher if the country had decent roads, railways, and power. "We're bursting at the seams," says Kamal Nath, India's Commerce & Industry Minister. Without better infrastructure, "we can't continue with the growth rates we have had."

The problems are even contributing to overheating in the economy. Inflation spiked in the first week of February to a two-year high of 6.7%, due in part to bottlenecks caused by the country's lousy transport network. Up to 40% of farm produce is lost because it rots in the fields or spoils en route to consumers, which contributes to rising prices for staples such as lentils and onions.

India today is about where China was a decade ago. Back then, China's economy was shifting into overdrive, but its roads and power grid weren't up to the task. So Beijing launched a massive upgrade initiative, building more than 25,000 miles of expressways that now crisscross the country and are as good as the best roads in the U.S. or Europe. India, by contrast, has just 3,700 miles of such highways. It's no wonder that when foreign companies weigh putting new plants in China vs. India to produce global exports, China more often wins out.

China's lead in infrastructure is likely to grow, too. Beijing plows about 9% of its GDP into public works, compared with New Delhi's 4%. And because of its authoritarian government, China gets faster results. "If you have to build a road in China, just a handful of people need to make a decision," says Daniel Vasella, chief executive of pharmaceutical giant Novartis (NVS ). "If you want to build a road in India, it'll take 10 years of discussion before you get a decision."

Blame it partly on India's revolving-door democracy. Political parties typically hold power for just one five-year term before disgruntled voters, swayed by populist promises from the opposition, kick them out of office. In elections last year in the state of Tamil Nadu, for instance, a new government was voted in after it pledged to give free color TVs to poor families. "In a sanely organized society you can get a lot done. Not here," says Jayaprakash Narayan, head of Lok Satta, or People Power, a national reform party.

Then there's "leakage"—India's euphemism for rampant corruption. Nearly all sectors of officialdom are riddled with graft, from neighborhood cops to district bureaucrats to state ministers. Indian truckers pay about $5 billion a year in bribes, according to the watchdog group Transparency International. Corruption delays infrastructure projects and raises costs for those that move ahead.

Fortunately, after decades of underinvestment and political inertia, India's political leadership has awakened to the magnitude of the infrastructure crisis. A handful of major projects have been completed; others are moving forward. Work on the Golden Quadrilateral—a $12 billion initiative spanning more than 3,000 miles of four- and six-lane expressways connecting Mumbai, Delhi, Kolkata, and Chennai—is due to be completed this year. The first phase of a new subway in New Delhi finished in late 2005 on budget and ahead of schedule. And new airports are under construction in Bangalore and Hyderabad, with more planned elsewhere. "We have to improve the quality of our infrastructure," Prime Minister Manmohan Singh told a gathering of tech industry leaders in Mumbai on Feb. 9. "It's a priority of our government."

Singh, in fact, is promising a Marshall Plan-scale effort. The government estimates public and private organizations will chip in $330 billion to $500 billion over the next five years for highways, power generation, ports, and airports. In addition, leading conglomerates have pledged to overhaul the retailing sector. That will require infrastructure upgrades along the entire food distribution chain, from farm fields to store shelves.

Envisioning a brand-new India is the easy part; paying for it is another matter. By necessity, since the country's public debt stands at 82% of GDP, the 11th-worst ranking in the world, much of the money for these new projects will have to come from private sources. Yet India captured only $8 billion in foreign direct investment last year, compared with China's $63 billion. "Having grandiose plans isn't enough," says Yale University economics professor T.N. Srinivasan.

Just about every foreign company operating in India has a horror story of the hardships of doing business there. Nokia Corp. (NOK ) saw thousands of its cellular phones ruined last October when a shipment from its factory in Chennai was soaked by rain because there was no room to warehouse the crates of handsets at the local airport. Japan's Maruti Suzuki says trucking its cars 900 miles from its factory in Gurgaon to the port in Mumbai can take up to 10 days. That's partly due to delays at the three state borders along the way, where drivers are stalled as officials check their papers. But it's also because big rigs are barred from India's congested cities during the day, when they might bring dense traffic to a standstill. Once at the port, the Japanese company's autos can wait weeks for the next outbound ship because there's not enough dock space for cargo carriers to load and unload.

India's summer monsoons wreak havoc, too. Even relatively light rains can choke sewers, flood streets, and paralyze a city, while downpours are devastating. Two years ago, Florida-based contract manufacturer Jabil Circuit Inc. saw shipments of computers and networking gear from its plant near Mumbai delayed for five days after an epic storm. "In our business, five days is a really long time," says William D. Muir Jr., who oversees Jabil's Asian operations.

Companies often have no choice but to make the best of a bad situation. Cisco Systems Inc. (CSCO ), the American networking equipment giant, has had a research and development office in India since 1999 and already has 2,000 engineers in the country. To supply the country's fast-growing telecommunications industry, Cisco decided last year to try its hand at making some parts locally. In December it contracted with another company to build Internet phones in the southeastern city of Chennai. Although Cisco says the quality of the workmanship is up to snuff, it has to fly parts in because the ports are so slow—and getting them to the factory right when they're needed is proving nettlesome. "We believe in manufacturing in India, but we don't believe in logistics in India—yet," says Wim Elfrink, Cisco's chief globalization officer. Elfrink adds that unless the Chennai operation demonstrates it can run as efficiently as Cisco setups elsewhere, it won't go into full production as planned this summer.

Even the world's largest maker of infrastructure equipment is constrained by India's feeble underpinnings. General Electric Co. (GE ) last year sold $1.2 billion worth of gear such as power generators and locomotives in India, more than double what it billed in 2005. To meet that surging demand, it is scrambling to find a location where it can manufacture locomotives in partnership with India Railways. But when GE dispatched three employees to survey a potential site the railway favored in the northern state of Bihar, the trio returned discouraged. It took five hours to drive the 50 miles from the airport to the site, and when they got there they found...nothing. "No roads, no power, no schools, no water, no hospitals, no housing," says Pratyush Kumar, president of GE Infrastructure in India. "We'd have to create everything from scratch," including many miles of railroad tracks to get the locomotives out to the main lines.

But there is a silver lining for GE and other international giants: India's infrastructure deficit could yield huge opportunities. American executives who traveled to India last November on the largest U.S. trade mission ever were tantalized by the possibilities. Jennifer Thompson, director of international planning at Oshkosh Truck Corp. (OSK ), viewed construction projects where swarms of workers carried wet concrete in buckets to be poured. That told her there's great potential in India for selling Oshkosh's mixer trucks. "There are infrastructure challenges, but we see a lot of opportunities to help them meet those challenges," she says.

That explains why so many multinationals are flocking to India. Take hotel construction: In a country with only 25,000 tourist-class hotel rooms (compared with more than 140,000 in Las Vegas alone), companies including Hilton (HLT ), Wyndham (WYN ), and Ramada have plans for 75,000 rooms on their drawing boards. Or consider telecom. Because of deregulation and ferocious demand, India boasts the fastest growth in cell-phone service anywhere, with companies adding some 6 million new customers a month. No wonder Britain's Vodafone Group PLC (VOD ) just ponied up $11 billion for a controlling interest in Hutchison Essar, India's No. 4 mobile carrier. U.S. private equity outfits also want in on the action. On Feb. 15, Blackstone Group and Citigroup announced they are teaming up with the Indian government and the Infrastructure Development Finance Corp. to set up a $5 billion fund for infrastructure investments in India.

But while the laws of supply and demand would argue that India's infrastructure gap can be filled, that logic ignores the corrosive effect of the country's politics. To gain the favor of voters, Indian politicians have long subsidized electricity and water for farmers, a policy that has discouraged private investment in those areas. That's what wrecked the now-infamous Dabhol Power plant. In the late 1990s, Enron, GE, and Bechtel spent a total of $2.8 billion building a huge complex near Mumbai capable of producing more than 2,000 megawatts of electricity. But a government power authority set prices so low that it was uneconomical for Dabhol to operate, and the whole deal fell apart. (The plant, taken over by an Indian organization, now runs only fitfully.) A 2001 law was supposed to create a framework to support private investment in power generation. But according to American construction company executives, it's not working well. "Everybody knows what needs to be done, but they have great difficulty doing it," says one of the Americans. "If the party in opposition offers subsidized power, the party in power has to give subsidized power to get reelected."

Politicians who refuse to play the game pay a steep price. N. Chandrababu Naidu, the former chief minister of the state of Andhra Pradesh, transformed the state capital of Hyderabad from a backwater into a high-tech destination by building new roads, widening others, and aggressively carving out land for factories and office parks. Google (GOOG ), IBM (IBM ), Microsoft (MSFT ), and Motorola (MOT ) have all built R&D facilities there.

His reward? Voters tossed him out of office two years ago. During his decade in power, Naidu didn't do enough for rural areas, and his challenger promised to channel state funds into irrigation projects and electricity subsidies. "Naidu thought economics were more important than politics. He was wrong," says V.S. Rao, director of the Birla Institute of Technology & Science in Hyderabad. Naidu, 56, is plotting a comeback in elections two years hence. This time, he's preaching a new gospel. "You can't just target growth," says a chastened Naidu. "You have to create policies that make the wealth trickle down to the common man."

But even when politicians say they're beefing up infrastructure, it rarely helps the poorest Indians. Agriculture is stagnant in part because of a lack of the most rudimentary of roads to get to and from fields. N. Tarupthurai, for instance, scratches out a living from a five-acre plot in Jinnuru, a village in northeastern Andhra Pradesh. But his fields are more than a mile from the nearest paved road, so each day the 40-year-old Tarupthurai must carry his tools, seeds, fertilizer, and crops down a dirt path on his back or on his bicycle. "I have asked for a road, and the government says it's under consideration," says the mustachioed, curly-haired farmer. Then he shrugs.

One reason little practical help makes it from the seats of power to India's impoverished villages is that so much money gets siphoned off along the way. With corrupt officials skimming at every step, many public works projects either go over budget or are never completed. "You figure that 25% of the cost goes to corruption," says Verghese Jacob, head of the Byrraju Foundation, which promotes rural development. "And then they do such a bad job that the road falls apart in one year and has to be patched over again," Jacob says as he jostles along in a car on a potholed byway outside Hyderabad.

None of the solutions to India's infrastructure challenges are simple, but business leaders, some enlightened government officials, and even ordinary citizens are chipping in to make things better. The most potent weapon India's reformers have against corruption is transparency. Last October a new right-to-information law went into effect requiring both central and state governments to divulge information about contracts, hiring, and expenditures to any citizen who requests it. The country is also putting to work its vaunted technology prowess to police the government. Officials in 200 districts are using software from Tata Consultancy Services Ltd. to help monitor a government program that offers every rural household a guarantee of 100 days of work per year. Most of this labor goes into public works. To minimize "leakage," the TCS software tracks every expenditure—and makes all of the information available real-time on a Web site accessible to anyone.

Sometimes frustrated Indians take matters into their own hands. Tired of spending four-plus hours a day in traffic, Aruna Newton last fall helped organize something of a women's crusade to speed up infrastructure improvements. Nearly 15,000 volunteers now monitor key road projects and meet with state officials to press for action. They even enlisted the state chief minister's mother, who helped get his attention. "It's about the collective power of the people," says Newton, a 40-year-old vice-president for Infosys. "I just wish building a road was as easy as writing a software program."

Increasingly, companies trying to expand in India have the government as a willing partner rather than a roadblock. The state of Andhra Pradesh rolled out the red carpet last year for MAS Holdings Ltd. of Sri Lanka, South Asia's largest garment manufacturer. It promised subsidized electricity, new access roads, and even a deepwater port if the company would place a huge industrial park on the southern coast. Now MAS Holdings plans to build a cluster of factories that will eventually employ 30,000 production workers. And it chose India over China. "The government support was absolutely vital," says John Chiramel, India director for MAS Holdings. "If we can work together, there's no stopping growth in this country."

A key to getting massive projects off the drawing boards is forming public-private partnerships where the government and companies share costs, risks, and rewards. In 2005, India passed a groundbreaking law permitting officials to tap such partnerships for infrastructure initiatives. Developers ante up most of the money, collect tolls or other usage fees, and eventually hand the facilities back to the government.

The first project to take advantage of the new law is the $430 million international airport scheduled to open next year in Bangalore. The facility is designed to handle 11.5 million passengers per year—nearly double the capacity of the overburdened existing airport. It will be owned by a private company, which will turn it over to the Karnataka state government after 60 years. Global engineering and equipment giant Siemens (SI ) is helping to build the facility, and Switzerland's Unique Ltd. will manage it. These companies are also equity investors. The state had to contribute just 18% of the cost. Without such an arrangement, Karnataka wouldn't be getting a new airport.

A lot of India's hopes rest on the airport deal's success. If it proves the viability of public-private partnerships, more such ventures could come pouring in. A visit to the site instills confidence. Project manager Sivaramakrishnan S. Iyer is a crusty veteran of mammoth infrastructure ventures throughout South Asia and the Mideast. Wearing a scuffed hardhat, with a two-day growth of white stubble on his face, he surveys the site from a 2.5-mile-long bed of crushed granite that will be the runway. Work goes on seven days a week, 18 hours a day. Iyer is intent on wrapping up on schedule in April, 2008. "We have the will to do it, and it will be done," he says.

Will the airport open on time? That's not within Iyer's control. Two government authorities are responsible for building the road that leads to the airport, and they're locked in a dispute over how to do it. Work hasn't started.

And so it goes in India. Unless the nation shakes off its legacy of bureaucracy, politics, and corruption, its ability to build adequate infrastructure will remain in doubt. So will its economic destiny.

Business Today - The Bubble in Real Estate

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Bear Hug

When the Chinese dragon sneezes, and when economists in America start using the word recession, it's inevitable that most of the world markets that matter will catch a cold. Yet, if you compare the Sensex's performance with the world's leading indices over the past fortnight, it would appear that the Indian markets have been battered the most. For instance, between February 19 and March 5, the Sensex lost 14 per cent; the Shanghai Composite shed 7 per cent in this period, and the Dow was down 5 per cent, till March 2 (see Battered and Bruised). That's because for Indian investors, these global cues served as a well-timed alert to trigger off a sell spree in a market that was hovering in the overvalued zone. On 2008 forward earnings, the Sensex on an earnings per share of Rs 840 was trading at a price-earnings multiple (p-e) of 18 times.

Perhaps the biggest trigger for the global bearish phase is the appreciation of the yen-and if Indian markets got hit badly it's also courtesy their new-found appetite for Japanese portfolio investment. According to estimates, Japanese investors would have pumped in roughly $1.3-1.5 billion (Rs 5,720-6,600 crore) into domestic stocks in the past 15-18 months. "Investors squaring off their trades due to the strengthening of yen has been the reason for the fall in equities across markets," says Rushabh Sheth, Managing Director, Karma Capital. "The Indian market is no more isolated and any global event will have an impact on our market," he adds for good measure. Indeed, a host of big global investors resorted to squaring off yen carry-trade (borrowing in yen and investing in other currencies, mainly the dollar) in the past fortnight. This is because the till-recently weakening yen has suddenly strengthened versus the dollar. In India, foreign institutional investors (FIIs) in four sessions till March 1 were net sellers to the tune of $0.7 billion in the cash segment and $0.27 billion in index futures. "Apart from the impact of collateral damage, tightening of the rates in Europe, news of Chinese regulators tightening their grip over companies on issue of price rigging, tightening of rates in the mortgage market in the us and announcement of ex-chief of Federal Reserve, Alan Greenspan, of a possible recession in the us have led to jitters among global investors," says Nilesh Shah, President, Kotak Asset Management Company. Adds Rajesh Boghani, Retail Dealer, Parag Parikh Financial Advisory: "The market has broken its support level of 12,800 and the next resistance level is 10,880-11,000. And given the current market environment touching those levels looks possible." "Due to short-term concerns (rising interest rates and inflation), post-correction, I see the Sensex consolidating more in 'U' manner than in a 'V' manner like before. It will take at least six months for the Sensex to touch a new high; by the year-end it will hit 15,000," says Shah.

The ongoing correction may have coincided with the Finance Minister's Union Budgetary proposals, but P. Chidambaram might have just been a victim of bad timing (the Chinese crash took place a day before the announcement of Budget 2007). The good news, though, is that most traders feel that the India story is still intact. "Being among the fastest growing economy and markets, it is not possible for global investors not to be invested in the Indian market," says Boghani. This time around, however, the turnaround might just take a wee bit longer-around six months is the consensus on Dalal Street.

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Primary Bloodbath
Crackdown on a recently-listed stock makes IPO investors panic.

Even as the broader markets slipped into a free-fall last fortnight, the stocks of recently-listed initial public offerings (IPOs) got hammered to pulp. Of the 69 companies that IPOed between April 2006 and February 2007, nearly 60 per cent of them were trading below offer price. The trigger for this rough treatment was an interim order by the Securities Exchange Board of India (SEBI), banning promoters of recently-listed construction company Atlanta from the markets. The regulator's concerns had to do with unfair trading practices. According to the order, SEBI has prima facie evidence that the promoters and its close entities have indulged in price-rigging and have also misused the funds garnered through IPO. Atlanta lost a little over a fourth of its market cap since the order; other IPO stocks weren't spared, with a few of them plunging by 30 per cent between 21 and 28 February (the Sensex lost 8.8 per cent in that period). Merchant bankers point out that the fear is that SEBI may be in the process of investigating some more recently-listed companies. SEBI officials aver that the surveillance department is on the job.

Money Column

Remember, nine months ago when the market suddenly collapsed when it seemed to be smoothly sailing over the 12,000 mark. That caught most investors unawares. It bounced soon after, again catching investors by surprise. Yet the volatility saw a certain class of funds provide good returns for their unit holders. Since then, the price movements continue unabated. The market has lost 1,245 points in the last two weeks since February 9. The swinging market often leads to huge differences in the spot and futures markets. And here's where arbitrage funds step in. They make the best use of the markets (MIS)pricing mechanisms to generate returns for you.

Last year, many fund houses launched derivative or arbitrage funds, and most outperformed their benchmarks by considerable margins. As arbitrage funds seek to capitalise on price differences between cash and derivatives, they managed to leverage on the bullish trends of the market. It provides fund managers with large enough spreads to make successful arbitrage gains.

But arbitrage funds, unlike an equity product, aren't too risky. They essentially aim to protect your capital by locking on to risk-free strategies that take advantage of the price differences. They aim to lock in the gains and realise them when futures contracts expire. An arbitrage fund is more like a fixed income fund. Says Delhi-based Mukesh Gupta, MD, Wealthcare Securities: "Derivative funds don't take naked exposures to equity. Returns from these instruments are predictable, and more tax efficient. Corporates and high net worth individuals usually opt for these funds."

As a result, these funds are best suited for investors who generally park their money in fixed deposits or bonds. "These funds have primarily been working well with those investors who have been parking their money in fixed deposits or bonds, and are tailored to increase the investor's base in a conservative market," says Nilesh Shah, Chief Investment Officer (CIO), Prudential ICICI Asset Management Company.

Arbitrage funds as a category have generated superior returns as compared to a host of offerings within the debt mutual funds industry, but with varying amounts of volatility. In view of the volatility of this product, this category should bode well for investors with a minimum time horizon of at least six months. "Rising interest rates have made returns from income funds unpredictable and sometimes negative. Liquid fund returns are not adequate. Moreover, returns from these instruments are not tax efficient," says Gupta.

Arbitrage Secrets

Essentially, arbitrage funds buy a stock in the cash market and sell its futures simultaneously to lock in the price difference. This is also called the arbitrage spread. This spread is realised irrespective of the stock's price at expiry. There's a simple way in which it works. Say 'A' stock trades in the cash (spot) market and the futures market. Since the underlying stock is the same, the only factor accounting for different prices for spot and futures is the interest rate, which is also called the cost of carry. If equal but opposite positions are taken in the spot and futures markets, there is no equity exposure, because it cancels out. But one can earn the cost of carry (equal to the interest).

Here's how it works with specific stocks. On March 31, 2005, Punjab National Bank (PNB) was selling in the cash market at Rs 398.4046 and on the same date, futures (delivery April 28) were selling at Rs 403.2024. By buying PNB in the cash market for Rs 398.4046 and selling PNB futures for Rs 403.2024, one pockets the difference in price of Rs 4.7978. Hence, the profit from the transaction works out to 15.16 per cent per annum.

Fund houses such as UTI, which manage a Rs 300 crore-plus spreadFund, contend that the equity scenario may well remain robust over the long term, leading to extended spreads. Arbitrage funds have a mix of equity and equity-related securities and debt instruments in their portfolios and have been actively chasing these opportunities. It's not always that the markets will have big spreads because arbitrageurs are quick to cash in. But on days of extreme price movements, there's some chance that the arbitraging spreads could be higher, leading to higher yields for the funds.

Their performance will, in future, generally depend on two factors. Firstly, how much spreads a fund can lock-in courtesy of high volatility in the market, and secondly, how high are the yields on low credit risk, short-term debt instruments. Most fund managers are also of the view that arbitrage funds have come of age and there will be more of them in the future. "Till now, mf firms have been providing general products like large-cap equity funds, income funds and hybrid funds, and now that that space is almost saturated, they are looking at specialised catering to varying risk appetite across investor classes," says Shah. More specialised products like thematic funds, derivative funds, structured products and alternate asset class funds will be the order of the day, says Shah.

Among the usual debt funds, derivative funds generated superior returns as compared to a host of offerings within the debt mutual funds industry, but with varying amounts of volatility. But due to the short-term vagaries of the market, this category should bode well for investors with a minimum time horizon of at least six months. Investors looking for a shorter period face the risk of lower returns as compared to a debt fund, because of the arbitrage opportunities. Not all fund houses are enthused by these products because their returns are lower. "These funds generally have low returns ranging between 5 and 9 per cent," asserts Mumbai-based consultant Gaurav Mashruwala. "These have been popular with people who feel that these are new products and have something assured to offer, but over a period time, they could lose appetite," he adds.

But going by the way the market's moving, more funds are coming out with arbitrage funds. Benchmark Asset Management has filed a draft offer document for a 100 per cent equity arbitrage fund. Since June 2006, 100 per cent arbitrage funds have been allowed. Earlier, funds could invest only a part of their corpus in arbitrages. Because of their strategy of locking-in to returns, these funds may make better returns than a liquid fund. However, entry is restricted to certain days in most derivative funds. Fund inflows and outflows have to coincide with the expiration of futures contract or the strategy of the fund. Some funds allow redemptions only after the settlement of derivative contracts.

Options Galore

There are about half-a-dozen funds that make up the category at the moment. These funds, mf circles believe, generally have the scope of outdoing the average short-term options, including liquid funds, because of their strategy. Prudential ICICI Blended Plan A is among the first derivative schemes that enjoys tax treatment of an equity scheme. The minimum and maximum exposure the scheme intends to have to equities and derivatives is 65 and 80 per cent, respectively. The fund manager seeks to capture the spread which is higher than the returns being generated by the debt portfolio. Apart from that, ICICI Pru Blended Plan B caters to international clients. It's a conservative fund offering lower allocation to equity and equity-related instruments.

UTI spread Fund is the latest entrant in the derivative segments. As per the offer document, the scheme strives to maintain varying asset allocation depending upon the market movement. The scheme can have an exposure of up to 90 per cent in equities when there's high opportunity. But Benchmark Derivative Fund, which is India's first derivative fund, is open for subscription only on the last day of the month due to expiry of contracts. Fund managers try to find arbitrages that maximise the gains.

JM Equity and Derivative Fund is a retail savvy derivative fund due to its low investment amount. The scheme has high exit loads to ensure that the investors stay for a longer period of time. From the same fund house, the JM Arbitrage scheme enjoys the tax treatment that equity funds are offered. The scheme maintains an exposure of 65 per cent to equities with a maximum cap of 80 per cent. Kotak Cash Plus offers flexibility of liquidity for the investor. He can enter and exit on any working day. This scheme usually rolls over its position to generate higher returns.

Check out the strategy of the arbitrage fund before signing on the dotted line. If you are looking for pure arbitrage strategies, then go for a fund that has a higher exposure to equity arbitrages. Arbitrage funds are meant for risk-averse investors who want equity exposure. Essentially, arbitrage funds are for investors who seek "debt-plus" returns with low risk.

The straight Advantage
There are endowment plans and there's Jeevan Saral with a flexible life cover plan. Is it for you?
Nitya Varadarajan

If you aren't happy with the rigidity of traditional term plans because there's no return on your investment or aren't comfortable with the uncertainty of the payback in a unit linked plan where returns are highly dependent on the market, endowment schemes could turn out to be what you are looking for. Endowment plans have two advantages: insurance and savings.

In vanilla endowment plans, a policy holder pays regularly during the term of the policy. But if the policy holder dies during the policy term, the nominee gets the death benefit, including the sum assured and the accumulated bonus. If the policy holder survives, he gets the survival benefit and all the bonuses. But there's another plan that allows for partial surrender without penalties and yet keeps much of your benefits intact. In fact, Life Insurance Corporation's Jeevan Saral is not dependent on one's age or term of the policy, unlike many other endowment plans.

For a monthly premium of just Rs 100, one gets a life cover worth Rs 25,000. Additionally, the cover increases every year by the amount of yearly premium you pay, so in many ways it's like an increasing cover benefit plan. Besides, LIC's Jeevan Saral offers your premium back if five annual premiums have been paid, excluding the first year premium.

As this is a flexible plan, opt for the maximum term, which is till the age of 70 or a term of 35 years. Jeevan Saral is a 'for profit' plan, you cannot surrender the policy for 10 years-the minimum lock-in period, if you want to receive loyalty additions, which are paid out after 10 years. But you can surrender 'a portion' of the policy any time. Loyalty additions are payable even if death occurs. However, under this policy, the premium and risk cover reduces after each 'withdrawal'.

Jeevan Saral comes closer to a term plan with premium payback. Says Rahul Aggarwal, CEO, Optima Risk and Management Services, "This is a plan that could suit all sections of society, particularly those whose incomes are uncertain.'' According to Aggarwal, the plan has a very low premium for the cover offered. "The plan has been designed in such a manner to prevent lapses, so it ensures some cover till maturity. That is why it is finding many takers,'' he says.

Returns for the policy are not that great, but decent enough (see The Maturity Benefits). "Jeevan Saral does not offer annual bonuses because of the plan's innate withdrawal flexibility which would make annual computations difficult,'' says Ramakrishnan, a retired actuary from LIC. "But loyalty additions in Jeevan Saral are equivalent to terminal bonuses of other policies and would not be lower than those,'' he says. But for a premium of Rs 100 a month without the hassle of a health check-up, Jeevan Saral fills a gap for individuals looking for lower life covers, with the added benefit of returns.

The Saral Edge
Against other insurance plans, Jeevan Saral stands apart.

Jeevan Saral
PREMIUM COST: Highly affordable
EASY ENTRY: @ Rs 1,200/ year
FLEXIBILITY: Allows for partial surrenders, its key USP
RETURNS: Below average compared to Post Office and other financial instruments
SCORE ON SIMPLICITY: Agent not required
RISK COVER OR RETURN? Risk primarily, but there are rewards

Pure Term Insurance
PREMIUM COST: Highly affordable
EASY ENTRY: Starts at Rs 3,000/ year, depending on company
FLEXIBILITY: Rigid
RETURNS: No returns. Some term plans offer a premium back; but no bonuses
SCORE ON SIMPLICITY: Agent's help is needed
RISK COVER OR RETURN? Risk only

Traditional Endowment Insurance
PREMIUM COST: Expensive
EASY ENTRY: Starts at Rs 5,000/ year, depending on company
FLEXIBILITY: Rigid
RETURNS: Returns better than Jeevan Saral, but poor compared to other financial instruments
SCORE ON SIMPLICITY: Agent's help is needed
RISK COVER OR RETURN? Greater emphasis on return

Unit Linked Plans
PREMIUM COST: Expensive
EASY ENTRY: Starts at Rs 5,000/ year, depending on company
FLEXIBILITY: Allows for withdrawal from fund
RETURNS: Depends entirely on fund mix; risk cover is guaranteed only in a Capital Guarantee ULIP plan
SCORE ON SIMPLICITY: Agent's help is needed
RISK COVER OR RETURN? Emphasis only on return

THE FINER POINTS

Irrespective of entry age and the term of the policy, the premium is Rs 1,200 for a cover of Rs 25,000 and in multiples thereof

Opting for a maximum term up to age 70 or a term of 35 years is best as the policy allows for partial surrender with full maturity benefits and loyalty benefits till the surrender period

Unlike a ULIP plan offering similar flexibility, you can compute the exact money you will receive at any time and add to it loyalty additions of a conservative minimum of 6 per cent, though this could be more

The amount by which the annual premium can be reduced has to be a multiple of Rs 600 and should not be less than Rs 1,200

After a partial surrender, the sum assured payable on death reduces and term and accident rider benefits get correspondingly reduced

Super Saver
Embarking on your savings plan early enough will earn you a lot more than you can imagine.
Clifford Alvares

If you embark on a savings strategy and stick to it for long enough, there's a guaranteed chance that you will make money, loads of it, over time. Anyone who saves money knows that it adds up to a tidy sum. But run the numbers for yourself and you will be startled by the results. Assume you are 25, and that you will retire at 65. If you save Rs 5,000 a month for 40 years that grows at 10 per cent per annum (calculated monthly), it balloons to over Rs 3.46 crore.

But if you start, say, just five years later at the age of 30 and save the same amount for 35 years, your corpus adds up to a little Rs 1.89 crore. That's a loss of more than Rs 1.56 crore in five years. For most people, that could spell the difference between a cosy retirement and a struggled one. There are many benefits of starting a savings plan early. The power of compounding ensures that you make your money grow the fastest during the later years.

The Options

Most financial planners are advising the young investors to start immediately on a savings plan. "Even if you start five years late, the kind of impact it has on your financial corpus of the future is enormous," says Amar Pandit, Chartered Financial Planner (CFP), My Financial Advisor, a financial planning firm, adding, "The sooner you start, the better it is for you." Not only that, one must also make sure that savings instruments that one chooses has a compounding element built into it. Instruments such as the public provident fund (PPF), stocks and mutual funds (MFs) enjoy the benefits of compounding, whereas other vehicles such as insurance don't.

Financial planners like Pandit recommend a pay yourself first concept for today's youth. "Youngsters focus far too much on spending," he says, adding, "but if they focus on paying themselves rather than others, they will gain a lot. If you cannot control your spending, make sure you pay yourself first." Among the easiest ways to start on a savings plan immediately is to open an automatic debit account facility where a periodic constant amount gets socked away every month. One must do this at the beginning of the month just as you get your paycheck. You can temporarily park your funds in an open-end mutual fund or floater fund till you find the right equity fund to invest for the long-term. Once you've begun, start a systematic investment plan (SIP) with the fund for the long haul.

The Plan

Additionally, financial planners recommend that you start with saving at least 25 per cent of your gross salary if you are on the younger side so that you can have a sizeable corpus in a short period of time. Higher savings are the building blocks of creating wealth and take a staggered approach to investing as against saving all at one go.

Thirty-somethings who have nothing in their bank account may have to start with a much higher savings budget of around 30-35 per cent annually. That's because of the loss of time and because compounding works harder in the later years. And those in their 40s who previously ignored savings have to allocate close to 40 per cent to catch up with retirement. Consider this, a 30-year-old targeting savings, say Rs 12,000 for 30 years, accumulates a little over Rs 1.97 crore at the age of 60. But anyone who starts five years later has to up the yearly outflow to over Rs 20,000 to reach close to the same corpus. That means an investor, who neglects saving earlier, puts an additional burden on his savings allocations in the latter years.

But even if you aren't able to up your savings ante, it's better that you start with modest sums rather than not start at all. Says Pandit: "Even if you postpone your savings for a year, it makes a lot of difference in the long run." You don't need to start on an aggressive savings plan. Increase your savings rate modestly by starting from, say, 10 per cent of your income in the first year to 12 per cent the next year and 15 per cent and so on. Even that will go a long way in making the most of your cost of savings.

Financial planners say that to begin to save, you must start identifying and reach realistic goals. In other words, you must set a target of the corpus you want to achieve at the end of 30 years, and then break it down into smaller targets of five or 10 years. Over the longer haul, step up your targets and keep scaling up the savings plan. Says Pandit: "Set a savings target and an asset allocation plan and compare it periodically to see where you stand." If you are falling behind your targets, then make adjustments in your lifestyle to update your plan. That's the only way to "keep up with the Joneses".

Destination Caribbean

A sporting carnival draws its own kind of tourists. But the ICC Cricket World Cup 2007 is a one of its kind tourism attraction. It is not very often that one gets a chance to go to the West Indies. After all, it is the first time that the World Cup is going to be held in the Caribbean, the land of beautiful beaches. Besides, the next World Cups of 2011, 2015 and 2019-to be held in the subcontinent, Australia, New Zealand and England, respectively-have been decided and it could be a while before you get an excuse to savour the Caribbean experience.

For most people, the Caribbean is not the most accessible of places which explains why families in India prefer options like a holiday in Europe or the United States. Of course, Asia and Australia are large attractions. There are some issues like flight connectivity in the West Indies which has prevented most Indians from taking a holiday to that part of the world. With an attraction like the World Cup, there appears to be more than one reason to get your bags together and head to that part of the world. So, what deals beckon the traveller?

Shyam Kartikeya, Business Head, SOTC Sport Abroad, says the objective has been to give something more exciting and different to the tourist. "Our target has been the high net-worth individuals (HNIS) like CEOs, MDs and the large corporates. The West Indies, the way we see it, can be a family destination," he says. SOTC, last week, reduced the cost on some of its twin-sharing packages by Rs 1 lakh. For sometime now, the West Indies has had a paucity of hotels and the current World Cup has resulted in hotel tariffs quite literally hitting the roof. One would be lucky to get a hotel room for $500 (Rs 22,000) per night which in most cases comes with a pretty steep rider-you will have to check in for at least seven nights.

Help has come from players like SOTC who are offering tourists the option of getting on to a cruise within the Caribbean. The cruise will take you to the destinations depending on which package you have opted for. This is what the tourist does-fly into the Caribbean after a stopover in London. In the Caribbean, the first landing destination is Bridgetown in Barbados. Here is where you get on to the cruise.

"The West Indies is far away and there have been concerns about the quality and availability of accommodation. The West Indies has been positioned as a resort and our packages are on land," says Gautam Sharma, Head (Marketing & Financial Services), Thomas Cook India Limited (TCIL). His company offers tourists the option of staying in resorts located in places like Antigua and Barbados, which means you get to watch matches being played there. You could choose a package which, for instance, could be for seven nights, in Antigua which will include all meals, a 24-hour snack service and unlimited land and water sports at the resort -all this is apart from the cricket, of course.

Most people in the travel and tourism industry agree that this is a one-time opportunity for tourists to enjoy the World Cup and also the destination. "For those who think it is expensive, we say there is the excitement of watching cricket. The West Indies can be a family destination with a lot of things to do," says Kartikeya. Sharma states that TCIL has over 200 corporate clients. "Our focus is on the corporate segment interested in cricket," he adds.

For an individual who loves to travel, West Indies, perhaps, seems to be a destination that's considered largely inaccessible. If there is an option of a cruise or a resort or a hotel, it's certainly worth a look. And, what's more, the West Indies bears a great deal of similarity to places like Goa. Yes, the whole trip has very few deals, but this is really a one-time opportunity. So, if sun and sand and cricket beckon you, start packing your bags. The Caribbean carnival is about to start.

The Caribbean Experience
Thomas Cook's packages:

Challenge with Down Under

Seven nights accommodation at Antigua's Sandals resort
All meals, 24-hour snacks and unlimited premium drinks
Tickets for two Super 8 India games at Antigua

Package

Double delux room Rs 1.60 lakh
Prices per person (twin sharing basis)

Cricket Lover's Delight

Seven nights accommodation at the Almond Beach Village Resort, Barbados
Economy class air ticket on Virgin Atlantic
All meals, 24-hour snacks and liquor
Tickets for two Super 8 India games at Barbados

Package

Double superior deluxe garden/pool view room Rs 3.10 lakh
Prices per person (twin sharing basis)

The Grand Finale

Eight nights accommodation at Bougainvillea Resort, Barbados
Economy class air ticket on Virgin Atlantic
Bed and breakfast included
Tickets for semi-final in Lucia and final in Barbados

Package

Double standard room Rs 3.10 lakh
Prices per person (twin sharing basis)

Cruise with Cricket
SOTC's packages:

Encounter in Barbados

12 cruise nights aboard Carnival "Destiny" cruise ship visiting Barbados and Grenada
Choice of meals on board
Tickets for three Super 8 India games at Barbados

Package

Ship's interior cabin Rs 2.88 lakh
Ocean view cabin Rs 3.37 lakh
Cabin with balcony Rs 3.89 lakh
Suite with balcony Rs 4.78 lakh
Prices per person (twin sharing basis)

Final Mission

Eight Cruise nights aboard Carnival "Destiny" cruise ship visiting St Lucia for the semi-final and Barbados for the final
Choice of meals on board
Tickets for the St Lucia semi-final and the Barbados final

Package

Interior cabin Rs 3.88 lakh
Ocean view cabin Rs 4 lakh
Ocean view cabin with balcony Rs 4.40 lakh
Suite with balcony Rs 5.30 lakh

Down Under Action in Antigua

Seven hotel nights at a luxury resort
Buffet meals with your stay
Tickets for two Super 8 India games at Antigua

Package

Prices per person (twin sharing basis) Rs 2.50 lakh
Assumption: India makes it to the Super 8 level, and plays at the specified venues

Market pull tests religious sentiment

In May 2006, when the Sensex, Bombay Stock Exchange’s benchmark index, first crossed 12,000, a Muslim investor approached Ashraf Mohamedy, managing director of Idafa Investments, with a question.

The investor wanted to know whether it was halal—or permissible—under Islam to invest in the stock of Mid-Day Multimedia Ltd, a publishing company that runs a popular afternoon paper here and, like a lot of papers these days in India, features photographs of scantily clad women.

Mohamedy, who heads Idafa, one of two Indian Shariah—or Islamic-law compliant—brokerages in India, responded by immediately striking the publisher off his list of companies in which a Muslim can invest without running afoul of his religious principles. Mohamedy’s logic: the photographs were harmful to the readers of the tabloid. “Anything harmful to anybody is un-Islamic,” he says.

Fast-forward to today. The Sensex has risen to 13,049 points after a roller-coaster ride that saw it cross 14,000 points last month, even though Mid-Day Multimedia’s shares have actually dropped from Rs72 to about Rs37 since May.

But even as Islamic investment and banking services are gaining ground in many parts of the world, Indian Muslims, bereft of most Shariah-compliant offerings, are finding themselves torn between the urge to invest in a booming stock market—up a whopping 47% in 2006—and strict religious edicts that bar them from earning income based on either speculation or through interest-generating products.

“Even educated Muslims are not sure if they can invest in the stock market,” says Farid Batawala, a Mumbai-based trader. “Most of them still hoard wealth and hide stacks of money in their pillows and mattresses.”

Outside India, over 300 institutions spread across West Asia, Europe, Asia and America now offer Shariah-compliant banking and financial services with assets valued at $500 billion, according to an FTSE Global market report released in March 2006. HSBC Amanah, the global Islamic banking division of HSBC Group, alone has 110 million customers for its Shariah-compliant banking in 77 countries. The products are widely marketed and accessible to Muslim investors. But in India, home to 150 million Muslims, there are just two brokerages—Idafa and Parsoli Corporation Ltd, with a combined customer base of just around 2,000 clients—that currently offer formal Shariah-compliant investment services.

“We did explore the demand for Amanah in the Indian context and met the Reserve Bank of India in this regard but currently the regulatory environment for banking in India does not permit us to launch Amanah,” says Nicholas Winsor, head of personal finance at HSBC India, even as he notes that the “Muslim wealth is substantial in India.”

HSBC isn’t alone in not being able to cater to this potentially lucrative segment. Deutsche Bank, ABN Amro, UBS and Citigroup also offer Islamic financial products and services globally but not in India.

Earlier this week, the government said in Parliament that there was no plan to set up an Islamic bank in India, throwing water on some media reports that Prime Minister Manmohan Singh had appointed a committee to explore the idea.

On Saturday, Parsoli is organizing what it bills as the first “Islamic Investment Opportunities” conference in Mumbai to discuss Shariah-compliant opportunities, complete with a separate enclosure for women and arrangements, during the day-long conference, for Zohar prayers.

But, notwithstanding the nascent efforts by Idafa and Parsoli, the paucity of opportunities isn’t any better in equities than it is with banking and mutual funds.

Consider Faisal Ahmed, a Bangalore-based incense manufacturer. He has been playing in the market for about three years, dealing with both losses in day trading and his father’s angst over doing something haram, or forbidden by Islam. Ahmed says he has met dozens of religious experts seeking advice on investments in the stock market. Each time he meets an expert, he has had to explain that owning shares was not necessarily a speculative activity as it involved owning a piece of the company. “They know about the Koran and I know about the market but it was difficult to make a meeting ground of the two,” says the 35-year-old.

Ahmed, who is always collecting religious advice on investing, would have benefited greatly from India’s first seminar last month on Islamic investing, where 1,100 fellow investors—most of them Muslims—discussed the pros and cons of playing the stock market. The conference was organized by Zafar Sareshwala, managing director of Parsoli, the Ahmedabad-based brokerage firm which also launched an Islamic financial portal at the event.

Parsoli has been around for 15 years and is a publicly-traded entity. Sareshwala says his Shariah-compliant stock index has mirrored the rapid rise of the Sensex. His apparent success, even if with a very small client base, has attracted attention, especially overseas. Germany’s Baader Wertpapierhandelsbank AG, the largest securities trading firm in Germany and owner of Baader Bank, recently took a 30% stake in Parsoli. While Indian Muslims may not be beating a path to his doorstep, India’s sizzling stock market is fuelling Sareshwala’s plans to launch a fund, along with Baader Bank for West Asian investors interested in Shariah-compliant firms in India.

Sareshwala has tried to build investor confidence by teaming up with religious scholars such as Mufti Abdul Qayoom, who is also an investor in the stock market. “Traditionally, Muslims did not enter the market because they equated it with gambling,” says Qayoom. “But now they see that there are opportunities to make money in a halal way.”

Indeed, more Muslims seem to be starting to dip their toes in the market if Idafa’s numbers are any indicator. Mohamedy says that of his investor base of about 1,000, some 350 have come on board just in the past year.

With its three television sets tuned to financial channels, Idafa’s office in a dilapidated building in Crawford Market has the trappings of a regular brokerage, though the excitement is definitely muted—in part because day trading, where money is made off intra-day volatility, is forbidden under Shariah. Still, Mohamedy says his clients’ average annual returns this past year has been between 30% and 40%.

Mohamedy updates his list of Shariah-compliant stocks at regular intervals. At the moment, the list includes roughly 15% of the listed stocks on Indian bourses—780 of 4,600. He meticulously avoids stocks of hotels, liquor companies, banks, tobacco firms, pesticides and genetically modified crop companies. He also avoids companies involved in gaming and manufacturing products such as asbestos because of their environmental impact. Islamic practices also do not allow investing in companies whose debt is more than a third of their market capitalization and receivables are less than 5%.

To be sure, not every Muslim investor is always Shariah-compliant. One of Mohamedy’s clients is Roshan Naik, the 75-year-old mother of Indian television’s most famous Muslim preacher, Zaquib Naik. Naik, who has been investing in the market for more than three decades, says she did invest in hotel and other non-halal stocks in her early days though she has since pruned her portfolio to Shariah-compliant stocks in deference to her preacher son. And she is a devout Muslim when it comes to not having a bank savings account or even an insurance policy.

While Islamic tenets were meant to discourage profiting from speculation and gambling, applying them to modern times can sometimes be problematic. Insurance, for instance, is an area where a dearth of Islamic offerings is particularly noticeable.

“I really feel that I should be insured,” says Tariq Qureshi, a Mumbai-based trader, who exports meat, garments and machinery. But when it comes to shares, he is definitely taking the high road. “There are many stocks we want to buy,” he says. “But we also have to think of the world after.”

Inverted reasoning and its consequences

In a classic, “ An Investor’s Anthology”, there is a brilliant piece by George Selden written in 1912.

“It is hard for the average man to oppose what appears to be the general drift of public opinion. In the stock market this is perhaps harder than elsewhere; for we all realize that the prices of stocks must, in the long run, be controlled by public opinion. The point we fail to remember is that public opinion in a speculative market is measured in dollars, not in population. One man controlling one million dollars has double the weight of five hundred men with one thousand dollars each. Dollars are the horsepower of the markets—the mere number of men does not signify.

This is why the great body of opinion appears to be bullish at the top and bearish at the bottom. The multitude of small traders must be, as a plain necessity, long when prices are at the top, and short or out of the market at the bottom. The very fact that they are long at the top shows that they have been supplied with stocks from some source.

Again, the man with one million dollars is a silent individual. The time when it was necessary for him to talk is past—his money now does the talking. But the one thousand men who have one thousand dollars each are conversational, fluent, verbose to the last degree.

It will be observed that the above course of reasoning leads up to the conclusion that most of those who talk about the market are more likely to be wrong than right, at least so far as speculative fluctuations are concerned. This is not complimentary to the “moulders of public opinion,” but most seasoned newspaper reader will agree that it is true. The daily press reflects, in a general way, the thoughts of the multitude, and in the stock market the multitude is necessarily, as a logical deduction from the facts of the case, likely to be bullish at high prices and bearish at low.

It has often been remarked that the average man is an optimist regarding his own enterprises and a pessimist regarding those of others. Certainly this is true of the professional trader in stocks. As a result of the reasoning outlined above, he come habitually to expect that nearly every one else will be wrong, but is, as a rule, confident that his own analysis of the situation will prove correct. He values the opinion of a few persons who he believes to be generally successful; but aside from these few, the greater the number of the bullish opinions he hears, the more doubtful he becomes about the wisdom of following the bull side.

This apparent contrariness of the market, although easily understood when its causes are analyzed, breeds in professional traders a peculiar sort of skepticism—leads them always to distrust the obvious and to apply a kind of inverted reasoning to almost all stock market problems. Often, in the minds of traders who are not naturally logical, this inverted reasoning assumes the most erratic and grotesque forms, and it accounts for many apparently absurd fluctuations in prices which are commonly charged to manipulation.

For example, a trader starts with this assumption: The market has had a good advance; all the small traders are bullish; somebody must have sold them stock which they are carrying; hence the big capitalists are probably sold out or short and ready for a reaction or perhaps for a bear market. Then if a strong item of bullish news comes out—one, let us say, that really makes an important change in the situation—he says, “Ah, so this is what they have been bulling the market on! It has been discounted by the previous rise.” Or he may say, “They are putting out this bull news to sell stocks on.” He proceeds to sell out any long stocks he may have or perhaps to sell short.

His reasoning may be correct or it may not; but at any rate his selling and that of others who reason in a similar way is likely to produce at least a temporary decline on the announcement of the good news. This decline looks absurd to the outsider and he falls back on the old explanation “All manipulation.”

The same principle is often carried further. You will find professional traders reasoning that favorable figures on the steel industry, for example, have been concocted to enable insiders to sell their steel; or that gloomy reports are put in circulation to facilitate accumulation. Hence they may act in direct opposition to the news and carry the market with them, for the time at least.

The less the trader knows about the fundamentals of the financial situation the more likely he is to be led astray in conclusions of this character. If he has confidence in the general strength of conditions, he may be ready to accept as genuine and natural a piece of news which he would otherwise receive with cynical skepticism and use as a basis for short sales. If he knows that fundamental conditions are unsound, he will not be so likely to interpret bad news as issued to assist in accumulation of stocks.

The same reasoning is applied to large purchases through brokers known to be associated with capitalists. In fact, in this case we often hear a double inversion, as it were. Such buying may impress the observer in three ways:

1. The “rank outsider” takes it a face value, as bullish.
2. A more experienced trader may say, “If they really wished to get the stocks they would not buy through their own brokers, but would endeavor to conceal their buying by scattering it among other houses.”
3. A still more suspicious professional may turn another mental somersault and say, “They are buying through their own brokers so as to throw us off the scent and make us think someone else is using their brokers as a blind.” By this double somersault such a trader arrives at the same conclusion as the outsider.

The reasoning of traders becomes even more complicated when large buying or selling is done openly by a big professional who is know to trade in and out for small profits. If he buys 50,000 shares, other traders are quite willing to sell to him and their opinion of the market is little influenced, simply because they know he may sell 50,000 the next day or even the next hour. For this reason great capitalists sometimes buy or sell through such big professional traders in order to execute their orders easily and without arousing suspicion. Hence the play of subtle intellects around big trading of this kind often becomes very elaborate.

It is to be noticed that this inverted reasoning is useful chiefly at the top or bottom of a movement, when distribution or accumulation is taking place on a large scale. A market which repeatedly refuses to respond to good news after a considerable advance is likely to be “full of stocks.” Likewise a market which will not go down on bad news is usually “bare of stock.”

Between the extremes will be found long stretches in which capitalists have very little cause to conceal their position. Having accumulated their lines as low as possible, they are then willing to be known as the leaders of the upward movement and have every reason to be perfectly open in their buying. This condition continues until they are ready to sell. Likewise, having sold as much as they desire, they have no reason to conceal their position further, even though a subsequent decline may run for months or a year.

It is during a long upward movement that the “lamb” makes money, because he accepts facts as facts, while the professional trader is often found fighting the advance and losing heavily because of the overdevelopment of cynicism and suspicion.

The successful trader eventually learns when to invert his natural mental processes and when to leave them in their usual position. Often he develops a sort of instinct which could scarcely be reduced to cold print. But in the hands of the tyro this form of reasoning is exceedingly dangerous, because it permits of putting an alternate construction on any event. Bull news either (1) is significant of a rising trend of prices, or (2) indicates that “they” are trying to make a market to sell on. Bad news may indicate either a genuinely bearish situation or a desire to accumulate stocks at low prices.

The inexperienced operator is therefore left very much at sea. He is playing with the professional’s edged tools and is likely to cut himself. Of what use is it for him to try to apply his reason to stock market conditions when every event may be doubly interpreted?

Indeed, it is doubtful if the professional’s distrust of the obvious is of must benefit to him in the long run. Most of us have met those deplorable mental wrecks, often found among the “chairwarmers” in brokers’ offices, whose thinking machinery seems to have become permanently demoralized as result of continued acrobatics. They are always seeking an “ulterior motive” is everything. They credit—or debit—Morgan and Rockefeller with the smallest and meanest trickery and ascribe to them the most awful duplicity in matters which those “high financiers” would not stoop to notice. The continual reversal of the mental engine sometimes deranges its mechanism.

Probably no better general rule can be laid down than the brief one, “Stick to common sense.” Maintain a balanced, receptive mind and avoid abstruse deductions. A few further suggestions may, however, be offered:

If you already have a position in the market, do not attempt to bolster up your failing faith by resorting to intellectual subtleties in the interpretation of obvious facts. If you are long or short of the market, you are not an unprejudiced judge, and you will be greatly tempted to put such an interpretation upon current events as will coincide with your preconceived opinion. It is hardly too much to say that this is the greatest obstacle to success. The least you can do is to avoid inverted reasoning in support of your own position.

After a prolonged advance, do not call inverted reasoning to your aid in order to prove that prices are going still higher; likewise after a big break do not let your bearish deductions become too complicated. Be suspicious of bull news at high prices, and of bear news at low prices.

Bear in mind that an item of news usually causes but one considerable movement of prices. If the movement takes place before the news comes out, as a result of rumors and expectations, then it is not likely to be repeated after the announcement is made; but if the movement of prices has not preceded, then the news contributes to the general strength or weakness of the situation and a movement of prices may follow.

CONFUSING THE PRESENT WITH

THE FUTURE-DISCOUNTING

It is axiomatic that inexperienced traders and investors, and indeed a majority of the more experienced as well, are continually trying to speculate on past events. Suppose, for example, railroad earnings as published are showing constant large increases in net. The novice reasons, “Increased earnings mean increased amounts applicable to the payment of dividends. Prices should rise. I will buy.”

Not at all. He should say, “Prices have risen to the extent represented by these increased earnings, unless this effect has been counterbalanced by other considerations. Now what next?”

It is a sort of automatic assumption of the human mind that present conditions will continue, and our whole scheme of life is necessarily based to a great degree on this assumption. When the price of wheat is high farmers increase their acreage because wheat-growing pays better; when it is low they plant less. I remember talking with a potato-raiser the above custom. When potatoes were low he had planted liberally; when high he had cut down his acreage—because he reasoned that other farmers would do just the opposite.

The average man is not blessed—or cursed, however you may look at it—with an analytical mind. We see “as through a glass darkly.” Our ideas are always enveloped in a haze and our reasoning powers work in a rut from which we find it painful if not impossible to escape. Many of our emotions and some of our acts are merely automatic responses to external stimuli. Wonderful as is the development of the human brain, it originated as an enlarged ganglion, and its first response is still practically that of the ganglion.

A simple illustration of this is found in the enmity we all feel toward the alarm clock which arouses us in the morning. We have carefully set and wound that alarm and if it failed to go off it would perhaps put us to serious inconvenience; yet we reward the faithful clock with anathemas.

When a subway train is delayed nine-tenths of the people waiting on the platform are anxiously craning their necks to see if it is coming, while many persons on it who are in danger of missing an engagement are holding themselves tense, apparently in the effort to help the train along. As a rule we apply more well-meant, but to a great extent ineffective, energy, physical or nervous, to the accomplishment of an object, than to analysis or calculation.

When it comes to so complicated a matter as the price of stocks, our haziness increases in proportion to the difficulty of the subject and out ignorance of it. From reading, observation and conversation we imbibe a miscellaneous assortment of ideas from which we conclude that the situation is bullish or bearish. The very form of the expression “the situation is bullish”—not “the situation will soon become bullish”—shows the extent to which we allow the present to obscure the future in the formation of our judgment.

Catch any trader and pin him down to it and he will readily admit that the logical moment for the highest prices is when the news after it comes out—if not at the moment, at any rate “on a reaction.”

Most coming events cast their shadows before, and it is on this that intelligent speculation must be based. The movement of prices in anticipation of such an event is called “discounting,” and this process of discounting is worthy of a little careful examination.

The first point to be borne in mind is that some events cannot be discounted, even by the supposed omniscience of the great banking interests—which is, in point of fact, more than half imaginary. The San Francisco earthquake is the standard example of an event which could not be foreseen and therefore could not be discounted; but an event does not have to be purely an “act of God” to be undiscountable. There can be no question that our great bankers have been as much in the dark in regard to some recent Supreme Court decisions as the smallest “piker” in the customer’s room of an odd-lot brokerage house.

If the effect of an event does not make itself felt before the event takes place, it must come after. In all discussion of discounting we must bear this fact in mind in order that our subject may not run away with us.

On the other hand, an event may sometimes be over-discounted. If the dividend rate on a stock is to be raised from four to five per cent, earnest bulls, with an eye to their own commitments, may spread rumors of six or seven per cent, so that the actual declaration of five per cent may be received as disappointing and cause a decline.

Generally speaking, every event which is under the control of capitalists associated with the property, or any financial condition which is subject to the management of combined banking interests, is likely to be pretty thoroughly discounted before it occurs. There is rarely any lack of capital to take advantage of a sure thing, even though it may be known in advance to only a few persons.

The extent to which future business conditions are known to “insiders” is, however, usually overestimated. So much depends, especially in America, upon the size of the crops, the temper of the people, and the policies adopted by leading politicians, that the future of business becomes a very complicated problem. No power can drive the American people. Any control over their action had to be exercised by cajolery or by devious and circuitous methods.

Moreover, public opinion is becoming more volatile and changeable year to year, owing to the quicker spread of information and the rapid multiplication of the reading public. One can easily imagine that some of our older financiers must be saying to themselves. “If I only had my present capital in 1870, or else had the conditions of 1870 to work on today!”

A fair idea of when the discounting process will be completed may usually be formed by studying conditions from every angle. The great question is, when will the buying or selling become most general and urgent? In 1970, for example, the safest and best time to buy the sound dividend-paying stocks was on the Monday following the bank statement with showed the greatest decrease in reserves. The market opened down several points under pressure of liquidation, and many standard issues never sold so low afterward. The simple explanation was that conditions had become so bad that they could not get any worse without utter ruin, which all parties must and did unite to prevent.

Likewise in the Presidential campaign of 1900, the lowest prices were made on Bryan’s nomination. Investors said at once, “He can’t be elected.” Therefore his nomination was the worst that could happen—the point of time where the political news became most intensely bearish. As the campaign developed his defeat became more and more certain, and prices continued to rise in accordance with the general economic and financial conditions of the period.

It is not the discounting of an event thus known in advance to capitalists that presents the greatest difficulties, but cases where considerable uncertainty exists, so that even the clearest mind and the most accurate information can result only in a balancing of probabilities, with the scale perhaps inclined to a greater or less degree in one direction or the other.

In some cases the uncertainty which precedes such an event is more depressing than the worst that can happen afterward. An example is a Supreme Court decision upon a previously undetermined public policy which has kept business men so much in the dark that they feared to go ahead with any important plans. This was the case at the time of the Northern Securities decision in 1904. “Big business” could easily enough adjust itself to either result. It was the uncertainty that was bearish. Hence the decision was practically discounted in advance, no matter what it might prove to be.

This was not true to the same extent of the Standard Oil and American Tobacco decisions of 1911, because those decisions were an earnest of more trouble to come. The decisions were greeted by a temporary spurt of activity, based on the theory that the removal of uncertainty was the important thing; but a sensational decline started soon after and was not checked until the announcement that the Government would prosecute the United States Steel Corporation. This was deemed the worst that could happen for some time to come, and was followed by a considerable advance.

More commonly, when an event is uncertain the market estimates the chances with considerable nicety. Each trader backs his own opinion, strongly if he feels confident, moderately if he still has a few doubts which he cannot down. The result of these opposing views may be stationary prices, or a market fluctuating nervously within a narrow range, or a movement in either direction, greater or smaller in proportion to the more or less emphatic preponderance of the buying or selling.

Of course it must always be remembered that it is dollars that count, not eh number of buyers or sellers. A few great capitalists having advance information which they regard as accurate may more than counterbalance thousands of small traders who hold an opposite opinion. In fact, this is the condition very frequently seen.

Even the operations of an individual investor usually have an effect on prices pretty accurately adjusted to his opinions. When be believes prices are low and everything favors an upward movement, he will strain his resources in order to accumulate as heavy a load of securities as he can carry. After a fair advance, if he sees the development of some factor which might cause a decline—though he doesn’t really believe it will—he thinks it wise to lighten his load somewhat and make sure of some of his accumulated profits. Later when he feels that prices are “high enough,” he is a liberal seller; and if some danger appears while the level of quoted values continues high, he “cleans house,” to be ready for whatever may come. Then if what he considers an unwarranted speculation carries prices still higher, he is very likely to sell a few hundred shares short by way of occupying his capital and his mind.

It is, however, the variation of opinion among different men that has the largest influence in making the market responsive to changing conditions. A development which causes one trader to lighten his line of stocks may be regarded as harmless or even beneficial by another, so that he maintains his position or perhaps buys more. Out of a worldwide mixture of varying ideas, personalities and information emerges the average level of prices—the true index number of investment conditions.

The necessary result of the above line of reasoning is that not only probabilities but even rather remote possibilities are reflected in the market. Hardly any event can happen of sufficient importance to attract general attention which some other process of reasoning cannot construe our old friend of the news columns to the effect that “the necessary a large volume of business,” may influence some red-blooded optimist to buy 100 Union, but the grouchy pessimist who has eaten too many doughnuts for breakfast will accept the statement as an evidence of the scarcity of real bull news and will likely enough sell 100 Union short on the strength of it.

It is overextended speculator who causes most of the fluctuations that look absurd to the sober observer. It does not take much to make a man buy when he is short of stocks “up to his neck.” A bit of news which he would regard as insignificant at any other time will then assume an exaggerated importance in his eyes. His fears increase in geometrical proportion to the size of his line of stocks. Likewise the overloaded bull may begin to “throw his stocks” on some absurd story of a war between Honduras and Roumania [sic], without even stopping to look up the geographical location of the countries involved.

Fluctuations based on absurdities are always relatively small. They are due to an exaggerated fear of what “the other fellow” may do. Personally, you do not fear a war between Honduras and Roumania; but may not the rumor be seized upon by the bears as an excuse for a raid? And you have too many stocks to be comfortable if such a break should occur. Moreover, even if the bears do not raid the market, will there not be a considerable number of persons who, like yourself, will fear such a raid, and will therefore lighten their load of stocks, thus causing some decline?

The professional trader, following this line of reasoning to the limit, eventually comes to base all his operations for short turns in the market not on the facts but on what he believes that facts will cause others to do—or more accurately, perhaps, on what he sees that the news is causing others to do; for such a trader is likely to keep his fingers constantly on the pulse of buying and selling as it throbs on the floor of the Exchange or as recorded on the tape.

The non-professional, however, will do well not to let his mind stray too far into the unknown territory of what others may do. Like the “They” theory of values, it is dangerous ground in that it leads toward the abdication of common sense; and after all, other may not prove to be such fools as we think they are. While the market is likely to discount even a possibility, the chances are very much against out being able to discount the possibility profitably.

In this matter of discounting, as in connection with most other stock market phenomena, the most useful hint that can be given is to avoid all efforts to reduce the movement of prices of rules, measures, or similarities and to analyze each case by itself. Historical parallels are likely to be misleading. Every situation is new, though usually composed of familiar elements. Each element must be weighed by itself and the probable result of the combination estimated. In most cases the problem is by no means impossible, but the student must learn to look into the future and to consider the present only as a guide to the future. Extreme prices will come at the time when the news is most emphatic and most widely disseminated. When the point is passed the question must always be, “What next?””