A number of newspapers recently reported that in the past few days, nationalised commercial banks and financial institutions have been actively buying in the stock market in order to 'bring normalcy' to the market. I guess the definition of normalcy is price appreciation every week in the magnitude of 2.0 to 3.0 per cent for an annual return of over 100 per cent. Otherwise, in a market that has a price to earning (PE) ratio of over 30, how does the fall of stock prices by a mere 15 per cent in total can be construed anything but normal? Even after recent corrections, the PE ratio is over 25. Putting in perspective, if investors depend only on earnings of the invested companies for return of their capital (let alone any return on capital), they would have to wait for long 25 years. No other comparable stock markets have a PE ratio over 20. In the past 10 years, even Bangladesh stock market traded at a long-term average PE of 20. If such is the case, why a market that is overvalued by at least 25 per cent needs state support? When correction in the market is overdue and is actually a healthy development, why the state is pouring good money into a flawed system, and to whose benefit?
What bothers me most is the mode of the intervention. The news reports state that the Investment Corporation of Bangladesh (ICB) received Tk 2.0 billion 'financial assistance' from the central bank to intervene in the market. ICB used this money, along with its own funds as well as funds from its mutual fund portfolios to purchase stocks whose prices were falling. I guess the same is true for other state-owned banks and financial institutions, as well as some private financial institutions. The whole process is wrong, offensive, foul and reckless in a number of ways. First, this is a clear transfer of state funds to speculators without any accountability. Bangladesh capital market is nowhere near to being an important contributor to national growth that it would have to be propped up by transferring public wealth to rowdy speculators. Second, there seems to be no accountability or policy direction by the government for ICB or others as to what securities should be purchased with this 'financial assistance'. It means these parastatals can use this fund to purchase any stock they wish to please any group of investors they want. Third, ICB is reported to have used cash from their mutual fund portfolios to purchase stocks whose prices were falling. The assets and the cash in the mutual fund portfolios do not belong to the ICB, to the Ministry of Finance or to the government. They belong to the mutual fund investors. What right does the ICB have to use their money and hurt their interests while implementing government policy decisions? This is a gross violation of investors' constitutional rights to own assets without government meddling. Finally, what is a normal state of the market where such intervention stops, at a PE ratio of 100? By a process called "reversion to mean," the market shall and must come down to a realistic level, no matter the size of the intervention. In this case, normalcy may mean a historical PE ratio of 20 or lower. By postponing the day of reckoning, what does the government achieve?
It is understandable that a political government would not want another stock market crash on its watch, and it would do everything to avoid such embarrassment. However, such embarrassment could be nipped in the bud many months ago. The whole affair started with banks' excessive venture in the stock market. As soon as the market PE surpassed the historical average, the central bank should have slowly limited banks' exposure. Instead, platitude substituted for sound policies.
When the horse left the barn, the central bank has been forced to take (or withdraw) measures, which are ignominious to the prestige of the institution. Instead of banks having to adjust by January 15 their loans diverted from industrial accounts to stock market, they now have unlimited time. A time-tested safeguard such as single borrower exposure limit has been relaxed. Finally, it is reported that the central bank has been asking banks not to sell their shares in a depressed market. Since when is it the job of the central bank to maintain the level of stock prices? Sooner or later the market would adjust downward and the banks would be left with losses from these investments. Is a weaker banking system more desirable than a weaker stock market? It appears that the discipline achieved through the Banking System Reform of the last decade could be lost while trying to defend a weak capital market.
The knee-jerk, reactive policymaking that is the hallmark of the Securities and Exchange Commission (SEC) seems to have spread upwind. I would also put the blame squarely on the media that unnecessarily magnified the stock market and its subsequent fall. Robert Shiller in his book "Irrational Exuberance" attributes excessive media coverage of the stock market as one of the causes for speculative bubbles. That surely was the case in our market. The recent market correction should have been ignored and viewed as what it was - a necessary lesson for foolhardy speculators. Instead, we are wasting valuable time, resources and political capital to remedy a make-believe crisis.
Saturday, May 7, 2011
The Market Finally Crumbles
The rot started many months ago, the market finally crumbled Sunday. Between Sunday and Monday, the Bangladesh stock market lost more than 15%. For a small economy such as Bangladesh, a loss of wealth of almost US$ 7.5 billion, even on paper, is remarkable. Given the fact that many small investors flocked into the market lured by easy profit, the ripple effects would be wide-spread.
In 2010 alone, the market appeciated by 100%. In the three years (2007-2010), the average return was over 50%. The market appreciated so fast lately that the inactivity during the first part of the decade was overshadowed by the performance of the last three years, resulting in an average annual return of over 30% during this decade. Despite the current corrections, the magnitude of the return is still stupendous. In other words, nothing to feel sorry about the last two days' loss. After all in a market-based Lassiez Faire economy, nobody has the right to determine how others invest on their free own will.
However, last two years has brought in clueless investors in the market. These are investors with limited capital, limited knowledge and limited risk-taking capacity. Most diverted their funds from essential or productive activities. Most left their day jobs to ponder in the market. In other words, these people had no business partaking in this risky game. We shall keep hearing about the plight of the retired government officials, days together in the future.
In other places, this writer has tried to explain how the speculative bubble started in the first place. It was a confluence of factors, including lack of investment opportunities in the real sector, excessive supply of money and proliferation of trading facilities. Finally, banks' reckless participation in the market exacerbated the situation. What is pathetic is the role or lack thereof of the central bank. In keeping exchange rates fixed and favourable to exporters, it increased money supply without any care for inflation or asset price bubbles. What is more irresponsible is to let banks leave their traditional business and frolic freely in the stock market. Only in the last six months did the central bank notice that something was amiss. Only in the last three months did it actively enforce the rules limiting stock market participation by banks. The last central bank governor was too timid to enforce these rules against the veiled threat by the key functionaries or players in the market, the current one proved too populist to do the same timely. Would anyone care to comment why margin lending is regulated by the Securities and Exchange Commission (SEC) and not by the central bank?
We think the point is not missed by the current government that the stock market crash of 1996 was considered one of the failures of the then government, which precipitated its fall. We would expect them, rightly, to look for the sources of this crash. We would ask them to look at the right places, and not target phantoms such as "speculators" or "rumor mongers". Rather look for the SEC officials that changed rules (especially on margin rules) every few minutes either not knowing what to do or knowing too well how inside information works. Also, it is worth knowing what SEC officials, in connivance with the culprits of the last crash, were involved in overpricing initial public offerings (IPOs), especially mutual funds. Also why and who randomly changed rules regarding mutual funds trading to protect their own investments but misguided the rest of the market. It is easy to find out, with available trade records of the DSE, who bought in one name and sold in another name, thus manipulating the price of certain stocks. Look for names that were or are already discussed is the market, and determine what factors contributed their meteoric rise (5000%), despite those being crappy businesses.
In order to achieve double digit growth, we needed to raise our savings/investment rates by at least 10% of the gross domestic product (GDP), from 25% to 35%. Capital markets could be a very good source for that. It appears as in everything else, we killed the golden goose.
In 2010 alone, the market appeciated by 100%. In the three years (2007-2010), the average return was over 50%. The market appreciated so fast lately that the inactivity during the first part of the decade was overshadowed by the performance of the last three years, resulting in an average annual return of over 30% during this decade. Despite the current corrections, the magnitude of the return is still stupendous. In other words, nothing to feel sorry about the last two days' loss. After all in a market-based Lassiez Faire economy, nobody has the right to determine how others invest on their free own will.
However, last two years has brought in clueless investors in the market. These are investors with limited capital, limited knowledge and limited risk-taking capacity. Most diverted their funds from essential or productive activities. Most left their day jobs to ponder in the market. In other words, these people had no business partaking in this risky game. We shall keep hearing about the plight of the retired government officials, days together in the future.
In other places, this writer has tried to explain how the speculative bubble started in the first place. It was a confluence of factors, including lack of investment opportunities in the real sector, excessive supply of money and proliferation of trading facilities. Finally, banks' reckless participation in the market exacerbated the situation. What is pathetic is the role or lack thereof of the central bank. In keeping exchange rates fixed and favourable to exporters, it increased money supply without any care for inflation or asset price bubbles. What is more irresponsible is to let banks leave their traditional business and frolic freely in the stock market. Only in the last six months did the central bank notice that something was amiss. Only in the last three months did it actively enforce the rules limiting stock market participation by banks. The last central bank governor was too timid to enforce these rules against the veiled threat by the key functionaries or players in the market, the current one proved too populist to do the same timely. Would anyone care to comment why margin lending is regulated by the Securities and Exchange Commission (SEC) and not by the central bank?
We think the point is not missed by the current government that the stock market crash of 1996 was considered one of the failures of the then government, which precipitated its fall. We would expect them, rightly, to look for the sources of this crash. We would ask them to look at the right places, and not target phantoms such as "speculators" or "rumor mongers". Rather look for the SEC officials that changed rules (especially on margin rules) every few minutes either not knowing what to do or knowing too well how inside information works. Also, it is worth knowing what SEC officials, in connivance with the culprits of the last crash, were involved in overpricing initial public offerings (IPOs), especially mutual funds. Also why and who randomly changed rules regarding mutual funds trading to protect their own investments but misguided the rest of the market. It is easy to find out, with available trade records of the DSE, who bought in one name and sold in another name, thus manipulating the price of certain stocks. Look for names that were or are already discussed is the market, and determine what factors contributed their meteoric rise (5000%), despite those being crappy businesses.
In order to achieve double digit growth, we needed to raise our savings/investment rates by at least 10% of the gross domestic product (GDP), from 25% to 35%. Capital markets could be a very good source for that. It appears as in everything else, we killed the golden goose.
Capital market outlook
LOOKING over some numbers of the Bangladesh capital market, it would be an understatement to say that the price performance in the last few years has been remarkable. According to the numbers published by the Dhaka Stock Exchange (DSE), the market has generated annual price return of 30 per cent in the last 10 years. Putting that in perspective, it is about two and half times the return generated by banks' fixed deposits. The annual return in the last three years is 52 per cent (since 2007). Year to date (YTD) return in 2010 is 94 per cent, and there is still a month and half to go. We usually become doubly sad if an elderly relative dies at 99; it appears that the Dhaka market would not leave us in any such regrets. The annual return should comfortably exceed 100 per cent.
Some people are skeptical about the performance calculations made by the DSE, and rightly so. If correctly calculated, a market-cap weighted index for the last 10 years tells of a more astounding performance. Annualised returns have been 37 per cent in the last 10 years, 60 per cent in the last three years and 92 per cent in YTD 2010. It is not a coincidence that the performance measure for 2010 matched DSE's. Only this year did they figure out how to calculate correctly a market-weighted index. However, index values in previous years were not revised. So what the DSE puts forward as an index value is a meaningless number, calculated differently at different times. It implies as if the DSE portrays a bird that has the legs of a stork, the body of a hen and the wings of a turkey.
Nevertheless, whatever measure we use, the market performance has been significant. Although market participants would like to claim genius for such great a performance, there have been a few extraneous contributing factors. First, the economy is flush with excess cash. Money supply in the last five years has grown by an average of 20 per cent, whereas the nominal GDP has grown by 14 per cent. The difference has appeared in the economy as excess cash. In order to keep the exchange rate stable to facilitate export, Bangladesh Bank made a number of large foreign exchange purchases from the open market. In the last fiscal alone, the purchase was for an amount of over $2.0 billion. Secondly, because of lack of power, gas and other infrastructure, investment in the real sector has stalled. Usually the net savings of a country equals net investment. Because of structural inefficiencies in Bangladesh, there has always been a gap between savings rate and investment rate and this year it has gone up to 5 per cent. Both banks and businesses have invested their excess cash in the capital markets. Although this has improved their short-term profitability, their core business has shown little growth or improvement. An excess supply of cash combined with lack of real investment opportunity has caused to move enormous amounts of funds into the capital markets, moving the only 260 odd stocks in the market to stratospheric levels.
The secondary effect of this has only perpetuated the trend. Hugely lucrative return in the market has given rise to the number of capital market intermediaries and has drawn in new investors and additional funds. These new investors have bought at higher prices, pushing the market even higher. A measure of the proliferation is the number of Beneficiary Ownership (BO) accounts, which has grown from about 350,000 in 2005 to 3.5 million in 2010. That is a 10 times increase in five years, or a 60 per cent growth each year. Capital market has finally arrived at far flung district towns. The word in the market is that many new investors are small businesspeople, who have committed their business capital to trading shares. We cannot imagine the scary scenario whereby a major correction impacts the market; the impact on these small investors would be horrendous.
Is such a correction imminent? Are we looking at a hard or a soft landing? Two of the three trends that contributed to the capital market growth are abating. First, with increasing inflation, the Central bank has very little incentive to increase money supply. Second, appreciation of the Taka would not be such a bad thing on the balance, if a stronger Taka buys more food grain. This is especially true when purchasing grain from neighboring India whose currency has steadily appreciated against the US dollar. Third, with a downward trend in net migration, remittance flow may weaken and further remove the need for monetising foreign currency reserve. Fourth, bank deposit rates are improving, making them a more competitive (and safer) alternative to capital markets. Fifth, real investment is picking up despite the agonizing delay in gas and power supply.
All these developments point to a correction in the capital market. This potential is further augmented by the fact that the government seems determined to offload a huge quantity of public company shares. If the government really follows through on its promises, i.e. selling of further shares of listed companies and listing other public companies, the market would experience a large supply of new shares amid a declining money supply. This further supports the potential of a correction in the market. What the government failed to do by managing demands (margin loan reduction) could well be achieved by a supply side intervention. It seems likely that the market would return to normalcy by substitution of funds from old to new shares, not by a drastic fall of confidence or by panic withdrawal of funds by investors. Even if it is preceded by a price correction, that would be a healthy development for the market.
A saving grace for the market is the improvement in earning by well-managed companies. Among all stocks in the market, a select group of large, most liquid, well managed (using some subjective criteria) companies grew their earning by an average of 20 per cent in the last five years. If this trend continues for the entire market, the current P/E ratio of 27.0x should come down to 22.0x in 2011 and 18.0x in 2012. The effect is more dramatic for our select group of stocks; for them the P/E would come down to 15.0x in 2011, provided that the current price levels do not change further. However, to take comfort in such a scenario, we have to be confident about the quality of reported earnings.
If there is a major correction despite such positive developments, what are the consequences? The fickle nature of public sentiment does not always follow logic. No one knows when fear takes over greed, and when it does, the platitudes by the powerful do not mean much. In course of a major correction, would the government intervene for the sake of public sentiments, or would it let the market decide? Would the banks, especially the state-owned banks, be forced to purchase stocks, or would they be allowed to reduce exposure to minimise losses? If banks are indeed forced to make large purchases in the stock market when prices are falling, what does it do to the soundness of the banking system? Would the margin ratio be suddenly made wide open as a means to supply liquidity? We ask what lessons have been learned since 1996 to develop a playbook for a share market crisis.
Rather than an amazing price performance, a much more important need is a fluidity of the market where entrepreneurs can easily raise funds for productive business enterprises.
As we increasingly look at the capital market for financing projects of national importance, it is important that the depth and the breadth of the market improve and confidence in the market is maintained. It is our expectation that we shall make progress toward that goal in 2011. Such a market needs policy stability, not reactive decisions every few days. Ensuring that genuine entrepreneurs look at the market as a source of capital is more important than ensuring the moral hazard of incidental investors who foolhardily buy at high prices.
Some people are skeptical about the performance calculations made by the DSE, and rightly so. If correctly calculated, a market-cap weighted index for the last 10 years tells of a more astounding performance. Annualised returns have been 37 per cent in the last 10 years, 60 per cent in the last three years and 92 per cent in YTD 2010. It is not a coincidence that the performance measure for 2010 matched DSE's. Only this year did they figure out how to calculate correctly a market-weighted index. However, index values in previous years were not revised. So what the DSE puts forward as an index value is a meaningless number, calculated differently at different times. It implies as if the DSE portrays a bird that has the legs of a stork, the body of a hen and the wings of a turkey.
Nevertheless, whatever measure we use, the market performance has been significant. Although market participants would like to claim genius for such great a performance, there have been a few extraneous contributing factors. First, the economy is flush with excess cash. Money supply in the last five years has grown by an average of 20 per cent, whereas the nominal GDP has grown by 14 per cent. The difference has appeared in the economy as excess cash. In order to keep the exchange rate stable to facilitate export, Bangladesh Bank made a number of large foreign exchange purchases from the open market. In the last fiscal alone, the purchase was for an amount of over $2.0 billion. Secondly, because of lack of power, gas and other infrastructure, investment in the real sector has stalled. Usually the net savings of a country equals net investment. Because of structural inefficiencies in Bangladesh, there has always been a gap between savings rate and investment rate and this year it has gone up to 5 per cent. Both banks and businesses have invested their excess cash in the capital markets. Although this has improved their short-term profitability, their core business has shown little growth or improvement. An excess supply of cash combined with lack of real investment opportunity has caused to move enormous amounts of funds into the capital markets, moving the only 260 odd stocks in the market to stratospheric levels.
The secondary effect of this has only perpetuated the trend. Hugely lucrative return in the market has given rise to the number of capital market intermediaries and has drawn in new investors and additional funds. These new investors have bought at higher prices, pushing the market even higher. A measure of the proliferation is the number of Beneficiary Ownership (BO) accounts, which has grown from about 350,000 in 2005 to 3.5 million in 2010. That is a 10 times increase in five years, or a 60 per cent growth each year. Capital market has finally arrived at far flung district towns. The word in the market is that many new investors are small businesspeople, who have committed their business capital to trading shares. We cannot imagine the scary scenario whereby a major correction impacts the market; the impact on these small investors would be horrendous.
Is such a correction imminent? Are we looking at a hard or a soft landing? Two of the three trends that contributed to the capital market growth are abating. First, with increasing inflation, the Central bank has very little incentive to increase money supply. Second, appreciation of the Taka would not be such a bad thing on the balance, if a stronger Taka buys more food grain. This is especially true when purchasing grain from neighboring India whose currency has steadily appreciated against the US dollar. Third, with a downward trend in net migration, remittance flow may weaken and further remove the need for monetising foreign currency reserve. Fourth, bank deposit rates are improving, making them a more competitive (and safer) alternative to capital markets. Fifth, real investment is picking up despite the agonizing delay in gas and power supply.
All these developments point to a correction in the capital market. This potential is further augmented by the fact that the government seems determined to offload a huge quantity of public company shares. If the government really follows through on its promises, i.e. selling of further shares of listed companies and listing other public companies, the market would experience a large supply of new shares amid a declining money supply. This further supports the potential of a correction in the market. What the government failed to do by managing demands (margin loan reduction) could well be achieved by a supply side intervention. It seems likely that the market would return to normalcy by substitution of funds from old to new shares, not by a drastic fall of confidence or by panic withdrawal of funds by investors. Even if it is preceded by a price correction, that would be a healthy development for the market.
A saving grace for the market is the improvement in earning by well-managed companies. Among all stocks in the market, a select group of large, most liquid, well managed (using some subjective criteria) companies grew their earning by an average of 20 per cent in the last five years. If this trend continues for the entire market, the current P/E ratio of 27.0x should come down to 22.0x in 2011 and 18.0x in 2012. The effect is more dramatic for our select group of stocks; for them the P/E would come down to 15.0x in 2011, provided that the current price levels do not change further. However, to take comfort in such a scenario, we have to be confident about the quality of reported earnings.
If there is a major correction despite such positive developments, what are the consequences? The fickle nature of public sentiment does not always follow logic. No one knows when fear takes over greed, and when it does, the platitudes by the powerful do not mean much. In course of a major correction, would the government intervene for the sake of public sentiments, or would it let the market decide? Would the banks, especially the state-owned banks, be forced to purchase stocks, or would they be allowed to reduce exposure to minimise losses? If banks are indeed forced to make large purchases in the stock market when prices are falling, what does it do to the soundness of the banking system? Would the margin ratio be suddenly made wide open as a means to supply liquidity? We ask what lessons have been learned since 1996 to develop a playbook for a share market crisis.
Rather than an amazing price performance, a much more important need is a fluidity of the market where entrepreneurs can easily raise funds for productive business enterprises.
As we increasingly look at the capital market for financing projects of national importance, it is important that the depth and the breadth of the market improve and confidence in the market is maintained. It is our expectation that we shall make progress toward that goal in 2011. Such a market needs policy stability, not reactive decisions every few days. Ensuring that genuine entrepreneurs look at the market as a source of capital is more important than ensuring the moral hazard of incidental investors who foolhardily buy at high prices.
Of Mutual Funds Activism
THE mutual funds industry in Bangladesh is at its infancy. If the mutual fund complex is allowed to develop efficiently and naturally, it improves national rate of savings, helps to mobilize investable funds, acts as an efficient conduit to raise capital and functions as a social safety net. Given the importance of an efficient mutual funds industry, it is important for early participants to remain extra fair and cautious. This is especially true in our country, where misperceptions rule in the mutual funds market. Some outcomes of misperception are overvaluation, excessive trading and perceived irregularities related to pre-IPO placement. A fair amount of activism is necessary by early participants to educate the market. The most pressing objective should be achieving transparency and discipline in the investment process of mutual funds.
While the activism is there, the mission seems to be misdirected. The Financial Express of July 25 reported that representatives of three Asset Management Companies (AMC) out of nine licensed AMCs recently met with the Chairman of the Securities and Exchange Commission (SEC). In that meeting they offered recommendations about the mutual funds industry, which included lifting of margin restrictions, relaxation of limits on pre-IPO placement and reduction of the lock-in period for pre-IPO placements. These recommendations hardly address the real problem of the industry, which is lack of transparency. Liberal use of margins would leverage fund units, which are comprised of stocks that are already overvalued because of over-leverage. Relaxation of placement cap and reduction in lock in period would encourage the business of pre-IPO placement, which seems to have become the main business of some AMCs. This would also encourage excessive trading, which beats the purpose of holding mutual funds. If implemented, these measures would surely benefit asset managers, brokers and beneficiaries of pre-IPO placements. No wonder that some asset managers are resorting to trade-union like behavior in lobbying the regulator. However, if implemented, these measures would continue to perpetuate the problems in the industry. The suggestion that a real fund manager can add value to his portfolio by any means other than stock selection seem appalling to genuine fund managers. Life support such as margin loans or shorter lock-in can prop up the portfolio value for a short-time, but the day of reckoning eventually arrives. Most times it affects small investors who are left with empty bags.
To ensure a steady growth of the industry, we must also ensure transparency in the industry. The first step would be to adopt a universal fund accounting policy. That would ensure that funds own the securities they claim to own, and trade allocation among various accounts is done fairly. Second, funds must announce their holding and their trades at the end of each quarter, along with their net asset value. Third and most important, there has to be an adequate supply of new securities in the market for mutual funds to choose from. Otherwise, funds and retail investors alike would continue chasing the same stocks, ultimately creating unsustainable and bubble-like price levels.
While the activism is there, the mission seems to be misdirected. The Financial Express of July 25 reported that representatives of three Asset Management Companies (AMC) out of nine licensed AMCs recently met with the Chairman of the Securities and Exchange Commission (SEC). In that meeting they offered recommendations about the mutual funds industry, which included lifting of margin restrictions, relaxation of limits on pre-IPO placement and reduction of the lock-in period for pre-IPO placements. These recommendations hardly address the real problem of the industry, which is lack of transparency. Liberal use of margins would leverage fund units, which are comprised of stocks that are already overvalued because of over-leverage. Relaxation of placement cap and reduction in lock in period would encourage the business of pre-IPO placement, which seems to have become the main business of some AMCs. This would also encourage excessive trading, which beats the purpose of holding mutual funds. If implemented, these measures would surely benefit asset managers, brokers and beneficiaries of pre-IPO placements. No wonder that some asset managers are resorting to trade-union like behavior in lobbying the regulator. However, if implemented, these measures would continue to perpetuate the problems in the industry. The suggestion that a real fund manager can add value to his portfolio by any means other than stock selection seem appalling to genuine fund managers. Life support such as margin loans or shorter lock-in can prop up the portfolio value for a short-time, but the day of reckoning eventually arrives. Most times it affects small investors who are left with empty bags.
To ensure a steady growth of the industry, we must also ensure transparency in the industry. The first step would be to adopt a universal fund accounting policy. That would ensure that funds own the securities they claim to own, and trade allocation among various accounts is done fairly. Second, funds must announce their holding and their trades at the end of each quarter, along with their net asset value. Third and most important, there has to be an adequate supply of new securities in the market for mutual funds to choose from. Otherwise, funds and retail investors alike would continue chasing the same stocks, ultimately creating unsustainable and bubble-like price levels.
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