Monday, September 30, 2013

Concentration: the case for putting all your eggs in one basket

This article was first published in the Financial Times, FTfm, on September 30, 2013; Co-Author: Khemchand H. Sakaldeepi

Is diversification the best way to invest in the market today? Not really. The portfolios of major investors worldwide make the case for another, often-ignored, strategy: concentration. Business schools need to refrain from pushing the merits of diversification without highlighting the efficacy of concentration.

“Do not put all your eggs in one basket. Diversify.” In 1952, investment aspirants received this clarion call fromHarry Markowitz, a US economist and Nobel laureate.Peter Lynch, the famous US businessman and stock investor, “never saw a stock he didn’t like” and was a great proponent of portfolio diversification. While managing the Magellan fund, at the peak of his career, Mr Lynch’s portfolio had more than 1,000 stocks. To date, portfolio diversification remains the most important lesson taught to students of investment and risk management. The concept is a common thread in the investment approach of most fund managers and investors.

However, if we look at the portfolios of the rich and famous, they are, surprisingly, mostly concentrated. Several great investors, spread across geographies, have very concentrated portfolios. Warren Buffett, George Soros, Rakesh Jhunjhunwala and many others are renowned proponents of portfolio concentration. To Mr. Buffett, over-diversification presented a “low-hazard, low-return” situation and thus he dismissed it. A concentrated portfolio pivots on the absolute conviction of the investor in his or her stocks and his or her risk appetite.

A diversified portfolio, on the other hand, works well if the investor is optimistic about the stock, but wary of the associated risk. Investors like the first billion-dollar Indian investor, Mr. Jhunjhunwala, walk a fine line between the two.

John Maynard Keynes, the influential British economist, was another staunch supporter of concentration. “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes,” he once said.

Mr. Buffett, echoing Benjamin Graham, the father of “value” investing, says he does not just buy an insignificant thing that bounces by a small percentage every day on the stock market. He buys part of a real business and thinks like the owner of a business would.

Mr. Buffett says: “Wide diversification is only required when investors do not understand what they are doing.” Bruce Berkowitz, founder of Fairholme Capital and a leading “value” proponent, adds that just a handful of significant positions are enough to do unbelievably well in a lifetime.

In 2012, the results of a study from the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, University of Technology Sydney, showed that if skilled fund managers invested in concentrated portfolios, they would improve their performance markedly as compared with the portfolios that they would build under the compulsion to diversify. Despite mitigating stock-specific risks, the method of diversification cannot fortify the portfolio against market risks.

Advocates of concentration also opine that building or creating wealth with a diversified portfolio is difficult, unless the entire market is experiencing a bull phase and all the stocks in the portfolio are performing well. Even then, you may not get the full advantage of a multi-bagger as your investment in that particular stock would be just a fraction of your entire portfolio. The anti-diversification camp proposes that to generate wealth some concentration is required, provided people know how to assess their risk appetites and simultaneously pick winning stocks.

Fund managers today are caught in a catch-22 situation. Is wealth generated first by diversification and then maintained through concentration or vice versa? Knowing that concentration has been the mantra for success for most investment gurus, is it savvy to jump on the “diversification bandwagon” by adhering to popular belief? Awareness of such dilemmas and seeking clarity on them is essential for future managers.

It is, thus, time for business schools to introduce concentration as an important strategy in wealth creation, management and enhancement. Special attention needs to be given to this in business pedagogy, as the training of financial advisers and finance students will remain incomplete if it is restricted to the hallowed realm of diversification as the only plausible investment strategy.

Thursday, September 12, 2013

Duvvuri Subbarao: Green Horn that Locked Horns

This article was first published in the business section of on September 11, 2013; Co-Author: Puran Singh

"May you live in interesting times. I can hardly complain on that count. I had come into the Reserve Bank five years ago as the 'Great Recession' was setting in, and I am finishing now as the 'Great Exit' is taking shape, with not a week of respite from the crisis over the five years."

- Duvvuri Subbarao on his term as the Governor of RBI
He began his tenure on September 5th, 2008 as the 22nd Governor of the Reserve Bank of India (RBI). Within days, the roller coaster ride began. Global financial crisis set in and the newly appointed RBI governor, Duvvuri Subbarao, geared up for toughest of the times RBI had seen.

India had limited exposure to international markets in the year 2008. As a result of which impact of global financial crisis was not as severe. However, a comfortable rupee position and foreign exchange liquidity had to be maintained along with economic growth.
Under his leadership, RBI kept the domestic markets, to a large extent, alienated from the international meltdown to avoid liquidity or solvency cascades. Apart from conventional steps for liquidity infusion such as reduction in rates, he took unconventional steps such as rupee-dollar swap facility for Indian banks, refinancing window for Non-Banking Financial Companies and facilitating refinancing of the credit to small industries. Through these measures, liquidity to the tune of $75 billion or approximately 7 percent of GDP of the country was induced in the economy post November 2008.

Everyone agreed that the country had fared relatively better during the global financial meltdown. Subbarao's original term of three years was extended for another two years by Government of India in September 2011. Most bankers and economists supported the move as any change in apex bank’s policies may not have been the best for the economy at that point of time.
The year 2012 brought more challenges for the Governor. Increased liquidity in the economy had led to a period of high inflation starting from 2009-10 that eventually became a hot potato. In February 2012, RBI decided to increase the bank rate from 6% to 9.5% for the first time in nine years (there had been no change in the bank rate since April 2003) calling it a technical adjustment.

The bank rate was decreased to 9% in April 2012 to support the growth push that the economy needed. But seeing the ineffective efforts of government to rein in the deficit and high inflation, Subbarao decided to hold the bank rate unchanged from then on despite pressure from the Center to lower it further. He had to make a tough choice between reining inflation and supporting growth through fiscal policies that the government had in mind. For lack of belief in the government’s plans, Subbarao took a stand in favor of the common man and refused to further cut the rates much to the disappointment of Mr. Chidambaram who publically expressed his anguish over it.
Listed among ‘India’s 50 Most Powerful People 2009’ by Bloomberg Businessweek, Subbarao stood against the wide calls to cut interest rates by the industry and the government. He stuck to his belief that inflation hurts the common man and hence curbing it was more important even if it meant sacrificing part of the growth.

Subbarao made efforts to make RBI a body that was ‘communicative, honest, open minded and accountable’ rather a black box which was a mystery for people. He had the opinion that people should know what RBI does. He aimed to demystify RBI and make it a role model for central banks globally.
In this direction, RBI designed financial literacy programs and pushed the states to introduce financial education curriculum at school and college levels to help enable the people to demand services from banking system.

In similar direction, he pressed on IT enabled banking, promoting financial awareness, and starting financial inclusion drives. In February 2013, in its new guidelines for banking licenses, RBI mandated that the aspirants, in their business plan, include ways to achieve financial inclusion.
He was criticized for not maintaining high forex reserves when rupee was appreciating during 2009-10. Also, his tenure was worded as the worst by a RBI governor by Arvind Panagariya, Professor of Economics at Columbia University. During the last few months of his tenure, he was blamed for falling rupee. Despite all criticisms he stuck to his guns and defended his decisions. While the government blamed RBI’s tight monetary policy and non-cooperative policy behavior for deteriorating economic situation, RBI governor convincingly reallocated the blame to loose fiscal policies of the government and policy paralysis.

A Green Horn five years back, he retired locking horns with the bosses. On September 4th, 2013, as he handed over charge to Raghuram Govind Rajan as the 23rd Governor of the RBI, he may not have been the favorite of the finance minister of India, Mr. Palaniappan Chidambaram, but had certainly raised RBI's stature as an autonomous body. He charted an independent path from the government, refused to succumb to the pressure from the Center.

Wednesday, September 11, 2013

Punishing India’s love of gold will not yield result

This article was first published in the Financial Times, Beyond Brics, on September 10, 2013; Co-Author: Puran Singh

"Getting married this year would be very costly for me. With gold prices at all-time high, jewellery shopping will literally wipe out all my savings. My parents will insist that I buy at least 50g of gold jewellery for my future wife. It does not make sense  right now at such high prices", says a friend who is planning to postpone his marriage to his fiancĂ©.

India's finance minister P Chidambaram has blamed the $86bn (4.5 per cent of GDP) current account deficit on India's "passion for gold", and has introduced various measures to curb demand. There are several reasons why such steps are unlikely to succeed. 

At the start of 2013 import duty on gold was increased from 4 to 6 per cent. At the same time, the duty on raw gold was doubled to 5 per cent. In February, gold deposit rules were relaxed by the Reserve Bank of India (RBI). In March, the RBI started monitoring gold coin sales by banks. In May, the RBI restricted consignment-based gold imports by banks. In June, import duty on gold was hiked to 8 per cent. In July, RBI tied gold import quantity to total imports. 

But, the demand for Gold did not budge downwards. Having failed to curb demand, a hike in import duty was announced in August for the third time. The import duty currently stands at 10 per cent.

The bad news for the RBI and Chidambaram is that 2013 is scheduled to have 31 extra wedding days in India, because according to the lunar calendar only 117 days will be lost to Chaturmas (considered inauspicious) compared to 148 days in 2012.

If it can, the Government of India should come out with an incentive for couples planning to get married to not do so this year. About half of gold jewellery shopping in India happens during weddings.

India produces a negligible 2.3 tonnes of gold a year and consumes almost 1,000 tonnes a year. No points for guessing where the balance comes from. Increase in gold demand in any year has to be met by importing more, and given the importance of gold in Indian marriages, any reduction or postponement in gold demand is not a reasonable assumption.

Apart from weddings, festivals are the second most important occasion for the Indians to buy gold jewellery. Just under a quarter of the demand for gold jewellery is bought during festivals in India, according to a survey by AlphaWise and Morgan Stanley Research in 2012, compared to 43 per cent for weddings.

Diwali, the most important festival for Hindus is in early November and people buy gold on Dhanteras to please Goddess Laxmi (the Goddess of wealth). Our presumption is, given the sentiment attached to buying gold and the returns it has offered post 2008, people will not mind buying gold even at soaring prices. 

In history, wars have been fought over the ownership of gold. Now the battles take place in the form of derivatives, exchange traded funds, and mutual funds. Gold is still much sought after, but more so for its financial than aesthetic value. The government of India and RBI are fighting another war against its own people. 

People are wondering why the RBI and the government would try to curb gold imports to solve a problem that is created due to government overspending and policy paralysis. Why would a government which is not able to protect its citizens from inflation prevent them from buying gold, which is considered a hedge against inflation?

Gold gives a common backdrop to an India which is otherwise diverse in religion, faith and culture. Embedded in the Indian psyche as symbol of prosperity and wealth, owning gold is akin to the American dream of owning a home. 

Hence, the curbs on gold may not yield the desired result. But it will succeed in building up further anger against the ruling government.

Tuesday, September 10, 2013

A bit on the virtual currency

This article was first published in the Hindu Businessline, Investment World, September 07, 2013; Co-Author: Khemchand H Sakaldeepi, CFI, ISB
The first time I heard of a currency issued by an institution, apart from the Government or the Central Bank of a nation, was way back in 2002. A relative, devotee of Maharishi Mahesh Yogi, told us about “Raam”. Raam is a currency in circulation in Holland and parts of United States, issued by the Stichting Maharishi Global Financing Research (SMDFR), a charitable foundation based in Holland. Two questions came to my mind: First, who guarantees the payment to the bearer? Second, if many more institutions start to issue currencies, wouldn't it lead to a lot of chaos?

Similar, and more, questions were raised in our minds when we heard of Bitcoin for the first time.
In 2008 Satoshi Nakamoto (a pseudonym for the person or group of people who designed the original Bitcoin protocol) posted a paper describing a cryptocurrency protocol. He created an open source client and issued the first Bitcoins in 2009 that are encrypted so that it cannot be misused or reused. This is just like a wallet (free to create) on your desktop and you can use a currency that does not belong to any country or any region or any organisation, for transactions. Instead of a central bank mining the currency, the mining of Bitcoin is done by users all across the network. There are inbuilt checks in the open source algorithm which prevents any conflicting transactions or prevents people from paying the same bitcoin to two different people.

Bitcoin can also be bought using regular currencies such as dollars, or pounds or euros. Currently, one bitcoin can be bought for approximately $107. One can payout in bits (as in computers). Free email, free calls (skype/viber), now free transfer of money! It’s an absolutely logical evolution. However, my original questions remain. Is the currency backed by some organisation/ bank /or government? No. It has value because there is demand for it. If tomorrow there is no demand, its value will be worthless. Is there a possibility of that happening? Yes and No. Regulators are seriously concerned in the US and other countries and they are watching the currency and allied activities closely. They may take extreme steps and ban the use of Bitcoin. Thailand recently banned trading in Bitcoin.
On the other hand, there is a growing community of users who are in favour of digital currency.

Will it lead to chaos? The value of the currency is definitely very volatile. It is first of its kind. There may be more digital currencies which would crop up in the future. It may lead to chaos, even network security breaches. Adopting good practices by users may be the key.
“All over the world people are trading hundreds of thousands of dollars worth of Bitcoin every day with no middle man and no credit card companies. It’s a startup currency which has never happened before” says Organizations like Amazon, Barnes & Noble, iTunes and many more accept bitcoins for transactions. The virtual currency is also very popular in China, as popular as in US and the UK, reported Rob Minto in Beyondbrics, Financial Times (July 9, 2013).

All this sounds cool but how big is it? It has definitely made some headlines recently. Cameron and Tyler Winklevoss, twins known for battling Mark Zuckerberg over ownership of Facebook Inc, have filed for an initial public offering of a Bitcoin ETF designed to allow investors to track the performance of the digital currency bitcoin. It will be just like an index that represents the bitcoins. The response to the proposal is, however, lukewarm at best.
The fear of criminal activity, money laundering, high volatility, no regulation, bubble, are all rife. So are the whole generation of users who swear by the currency and consider it an economic revolution. We are not clear about the implications of virtual currency yet. Though it is definitely challenges the way we conceive money. The question to ask is whether money as we know it is undergoing a tremendous change.