Value Investing: The Line from Graham to Buffett

This article was first published by the Global Association for Risk Professionals on September 30, 2016;

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003KzExEAK/value-investing-the-line-from-graham-to-buffet

The Oracle of Omaha has not strayed from basic principles but adjusts to changing conditions

The stock of Berkshire Hathaway has historically outperformed S&P500 benchmark. As pointed out in the, Wall Street Journal (http://blogs.wsj.com/moneybeat/2016/05/02/warren-buffetts-epic-rant-against-wall-street/), “From 1965 through the end of last year [2015], Berkshire shares have risen 1,598,284%, compared to the 11,355% return on the S&P 500.”

Warren Buffett, the chairman of Berkshire Hathaway, was a student of Benjamin Graham, the foremost guru of value investing, at Columbia Business School. Buffett is Graham’s most famous disciple and has attracted many to adopt value investing.

“Intrinsic value” and “margin of safety” are the two keys to value investing.

When shares are bought at a price cheaper than what the market values them at, and sold at a higher price later, value is extracted through this transaction.

Sanjay Bakshi, managing partner of Value Quest Capital, a value investor, professor, and ardent fan of Warren Buffett and Charlie Munger, said in an interview, “There are times when the markets are extremely inefficient, and at that time you should take advantage of the market. If ‘Mr. Market’ is buying you out at crazy valuation, give him your shares, and if he is willing to offer his stake very cheap, take it. This fundamental principle of value investing has never been compromised by Buffett or any successful value investor.”

Margin of Safety

Graham’s margin of safety is one principle that has had a profound influence on Buffett. It is the difference between a stock’s market price and its intrinsic value. For example, if the market price is much below intrinsic value, the margin of safety is large enough to protect the investor against future uncertainty and market downturns.

“If you were to distill the secret of sound investment into three words”, Graham wrote in his book The Intelligent Investor, “we venture the motto, margin of safety.”

Firms which trade at a high margin of safety dramatically reduce the risk of a permanent loss of capital.

Sanjay Bakshi offers an explanation: “You need a gap between value and price because value might drop, or your valuation might be wrong. Great businesses get destroyed because of many reasons including technological obsolescence, change in regulations, natural calamity or management hubris. Value investors don’t buy dollars for 95 cents because that leaves little margin of safety. They buy at 50 or 60 cents or even lower. This principle too has not been compromised by any successful value investor.”

‘Great Companies’ and Book Value

While Graham advocated buying stocks that are underpriced relative to their intrinsic value and can earn more than what the market expects – that is, stocks with very high margin of safety or those trading at large discounts – Buffett does not shy away from buying at reasonable prices what he deems a “great company.”

Graham advocated that a defensive investor should look for companies with current ratio of at least 2, long-term debt not more than net working capital, positive earnings for each of the past 10 years, uninterrupted dividends for the past 20 years, 33% increase in earnings per share for the last 10 years using a three-year moving average, price not more than 15 times past three-year-average earnings, etc. Some of these were based on the then prevailing market conditions in the U.S. and can be easily modified to suit the changed conditions, different risk appetites and different countries.

Graham also suggested that conservative investors buy stocks at prices close to their book value per share, and no more than one-third above that figure. However, this criterion alone may not indicate a sound investment, and investors must verify that the company has a sufficiently strong financial position and its stock is selling at a suitable ratio of earnings to price.

Due to the emphasis on book value, which excludes intangibles, the criteria will tend to exclude firms that have considerable assets in the form of goodwill, patents, software, franchises, etc. While Buffett did invest largely in traditional stocks like General Motors and Coca-Cola in the initial days, his portfolio has changed over the years to include the likes of Verisk Analytics and IBM, which have considerable intangibles.

Financial Sector

A common refrain among Graham watchers and followers is to stay away from financial services. These stocks have a very different model, especially when it comes to deposit-taking institutions where the assets are essentially leveraged products and the liabilities can never be truly paid-off, as that would lead to a collapse.

However, according to The Intelligent Investor, “We have no very helpful remarks to offer in this broad area of investment other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments.”

The financial services sector as a whole is very diverse, with numerous banking, brokering and asset financing services coming under the umbrella. Buffett has over the years invested in such companies as American Express, Bank of New York Mellon, Goldman Sachs and Wells Fargo.

Although Buffett has himself said in the past that he is “85% Graham,” it is safe to say that his investment style has evolved over the years and adapted to changing business scenarios. As Bakshi puts it, “Buffett did not change any basic principle of Graham. He just applied them in a different manner.”

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 Sakaldeepi

http://www.ft.com/cms/s/0/d4e511fc-250f-11e3-bcf7-00144feab7de.html#axzz2gLgr9ACE

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 from Harry 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.

Mobilizing Data and Analytics in Malaysia

The interview was first published by the Global Association for Risk Professionals on September 09th 2016

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003KRuSEAW

Insurers turn to predictive and anomaly-detection techniques as fraud losses cut into profitability and cause regulatory concerns.

Mounting motor insurance claims have been a source of worry for general insurers in Malaysia. They suffered a net loss ratio for Motor Act business of 219.6% in 2015, and an above-100% combined ratio for the total motor portfolio. The losses are attributable to high frequency of third-party bodily injuries, rising accident rates and medical costs, as well as fraudulent claims (Source: ISM Insurance Services Malaysia’s Statistical Yearbook.) Industrywide efforts are being made to control the fraudulent claims payout. A fraud detection and prevention system of Insurance Services Malaysia (ISM) is part of the industrywide effort to control payouts of fraudulent claims.

ISM was conceptualized in 1998 by the General Insurance Association of Malaysia (PIAM), initially to establish the Malaysian Insurance Rating Organization. In 2003, MIRO and the MIS department were merged to form the ISM department, and the scope of the project was expanded to include anti-fraud and IT-related services. ISM Berhad was incorporated in 2005 and today provides an infrastructure of databases and analytics that allows members to make informed decisions and support a liberalized pricing environment, build competencies in quantitative underwriting and technical pricing, and increase efficiencies in operations. The shared information and capabilities are accessible online to enhance fraud detection.

Mahendran (Mahen) Samiappan, the chief executive officer of ISM, discusses in this interview with Dr. Nupur Pavan Bang the general insurance industry in Malaysia and efforts by the organization to curtail fraud.

What is the state of the general insurance market in Southeast Asia, and particularly Malaysia?

Motor Insurance is the largest portfolio in the region, followed by property. Health insurance is generally sold as a rider with life insurance policies. So in comparison to the life segment, health is not a very big business for the general insurance market. Health is also sold as unit linked policies by the life insurers.

In terms of technology and distribution, Singapore would be the leader, followed by maybe Malaysia and Thailand. Everyone acknowledges that Malaysia has good regulations due to the active role played by Bank Negara Malaysia as the regulator of this industry. We have averaged a growth rate of 6% to 8% in general insurance consistently. In 2015 the industry experienced much lower growth, 2.7%, and 2016 is expected to have a low growth rate as well.

What are some of the major challenges in Malaysian insurance?

The biggest challenge is pertaining to the motor portfolio. Motor comprises 47% of the total portfolio. It is still under the tariff regime, for both the third party (act or mandatory) as well as the own damage (non-act) cover. The act business endures heavy losses as a result of rising claims-cost bleeding. The current tariff was set out in 1978 and has not been revised since then.

Bank Negara Malaysia has put in place a road map for gradual liberalization of motor insurance tariffs. By July 2017, non-act business will be de-tariffed, and gradually the act business may also see certain adjustments in prices. The flexibility to price is important for the Insurers, but it may lead to price wars, as has been witnessed in some other countries. That may still mean that the portfolio remains loss making.

Is the market ready to price?

The larger players, who have backing from their foreign partners with considerable underwriting and technical know-how, are ready for risk-based pricing. The largest insurer would have about 15% of the market share and, with that kind of data, coupled with their capabilities, can do the pricing.

The smaller companies may not have adequate data, and this is where ISM comes in. ISM was established to support the industry in the de-tariffed environment. So we will definitely play our role and carry out our responsibility to support the industry in this transition. The regulator has also been aggressively going around and assessing the readiness of the insurers.

Does Malaysia face the uninsured-vehicle challenge that some markets do? Uninsured vehicles not only result in loss of premiums for the insurers, they also have huge economic impact on the uninsured vehicle owners and victims of accidents.

Not really. The Road Transport Department and insurance databases are linked. So if a vehicle does not have the mandatory third-party policy, road tax will not be issued by the department. Road tax in Malaysia is annual, and almost all vehicles would have at least the act policy.

For the victims of road accidents, ISM provides a Vehicle Information Exchange service – if the vehicle registration number is captured, the details of the insurer of the vehicle can be obtained.

How is the industry tackling its leakage problems?

It is true that leakages from premiums as well as claims are plaguing the insurers. It is plain fraud. In its road map, the regulator has clearly stated that they want to control and manage fraud. They don’t want the insurers to be lax on claims and then keep adjusting (increasing) the premiums to cover the losses. The focus is on fraud and data quality.

ISM’s Central No Claims Discount (NCD) database is already being used by the insurers to plug leakages at the application stage. Over the years, the NCD database has evolved into a system called Claims & Underwriting Exchange (CUE), which provides alerts to the insurers based on certain business rules. For example when an old vehicle moves from act only policy to a comprehensive policy, it is unusual, and hence an alert is sent to the insurer. These initiatives have helped to some extent.

Can you elaborate on fraud at the application stage?

Fraud at the application stage can be perpetrated by a customer providing a bogus identity or falsifying records like the driving license, use of the vehicle, incorrect claims history, etc. There is a strong linkage between claims fraud and fraud committed at the application stage. Reducing application fraud can significantly decrease the exposure to certain types of claims fraud. Stopping fraud at the application stage saves investigation, claim adjudication, litigation and recovery expenses.

How is the industry planning to deal with such fraud?

ISM is working on a platform with an objective for comprehensive fraud detection and prevention. Using analytics techniques such as predictive modeling, link analysis, anomaly detection and text mining, claims will be scored, and certain claims with high potential of fraud will be highlighted based on business rules and analytics. The insurers can allocate resources to investigate the highlighted claims and thereby make more effective use of available resources.

However, analytics and models are only as good as the data. So a right mix of analytics with prudence, diligence and judgment should be applied by the insurers while processing applications and claims.

The RBI after Rajan

This article was first published by the Global Association for Risk Professionals on August 25, 2016;

https://www.garp.org/#!/risk-intelligence/detail/a1Z40000003K0bjEAC/deloitte-c-level-client-facing-risk-executive

Continuity, but a contrast in style, at India’s central bank

On September 4, 2013, the internationally prominent economist Raghuram Govind Rajan took charge as the 23rd governor of the Reserve Bank of India. He decided in June to depart at the end of his politically tumultuous three-year term, and with the August 20 announcement of his successor, deputy governor Urjit Patel, the book on Rajan is officially closing.

A former International Monetary Fund chief economist and University of Chicago finance professor, Rajan came in with a “rock star” image, a contrast to his predecessor, Duvvuri Subbarao, whose performance was the worst ever by an RBI governor, according to Arvind Panagariya, then professor of economics at Columbia University and now vice chairman of the government think tank NITI Aayog. Subbarao had kept the Indian economy relatively stable during the global crisis period. By the time he entered into the second phase of his tenure, in 2012, the economy was marred by nearly 10% inflation, a depreciating currency and low GDP growth.

Rajan dazzled with degrees from IIT (Indian Institute of Technology), IIM (Indian Institute of Management) and MIT (Massachusetts Institute of Technology) and a reputation for speaking his mind, was widely credited with predicting the 2008 crisis, and key economic indicators seemed to respond immediately to his moves.

Anticipated Criticism

When Rajan addressed the media after assuming office, he said, “Some of the actions I take will not be popular. The governorship of the central bank is not meant to win one votes or Facebook ‘likes.’” He said he sought “to do the right thing, no matter what the criticism, even while looking to learn from the criticism” — words that turned out to be prophetic.

Over the three years that ended September 4, 2016, Rajan did mostly the right things. He brought inflation down, stabilized the rupee, and GDP was going in the right direction. Yet he could not escape criticism.

There was really no end to the tug of war between him and the government over interest rate cuts. The government continually pushed for greater cuts, while Rajan refused until inflation fell within the targeted range. But even when inflation was within the targeted range, Rajan did not cut the rates as much as the government would have liked, citing risks in the global economy, rising crude oil prices and uncertain monsoons.

Rajan was also quite vocal about issues that did not directly come under his purview. That did not sit well with the government, which needed to tread carefully due to Rajan’s positive image amongst industry, the media and general public.

Return to Academia

Subramanian Swamy, a Harvard University PhD in economics and member of the Upper House of the Parliament of India, stepped up as the central banker’s vocal public critic. He was allowed to rant against Rajan for a long time before Prime Minister Narendra Modi made his unhappiness over the entire issue known, subtly, in a television interview. By then, Rajan had already issued a statement saying that he would not be seeking another term and would return to Chicago’s Booth School of Business, from which he was on leave.

There was outrage. There were letters of support for Rajan, speculations about who would succeed him and how he or she would measure up to Rajan in stature, independence and ability to complete policy and regulatory changes in progress.

Modi’s choice of Urjit Patel was seen as a safe one. Patel has a doctorate in economics from Yale University, along with degrees from the University of Oxford and London School of Economics. He has done stints at the International Monetary Fund, World Bank, Brookings Institution, Reliance Industries and Boston Consulting Group, and has been associated with various central and state government task forces and committees.

Patel is known to be the architect of the current monetary policy framework of RBI, which focuses on inflation targeting. He is quieter and lower-profile than Rajan. The consensus is that continuity in policies will be maintained and that the government did well in appointing an “insider” to succeed Rajan.

Share Pledges and Market Reactions

This article was first published by the Global Association for Risk Professionals on August 03, 2016; Co-authors: Ramana Sonti and Ramabhadran S. Thirumalai

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003CLgtEAG/share-pledges-and-market-reactions

How and why prices can move when company founders and insiders pledge shares as collateral

Pledging of shares as loan collateral by company founders, insiders and majority shareholders is legal in a number of countries, including the U.S. and the U.K., although disclosure norms vary from country to country. The U.S., U.K., Australia, and Hong Kong, among others, mandate disclosure of share pledges. Pledging of shares by founder-promoters is very popular in India, where disclosure became mandatory from January 28, 2009.

Background

On January 7, 2009, Mr. B. Ramalinga Raju, the founder-promoter of Satyam Computer Services, a company listed on the Indian bourses as well as the New York Stock Exchange, disclosed to the company’s board that he had raised Rs. 12.30 billion (then equivalent to around $253 million) by pledging Satyam shares to various institutions and had used the money for personal purposes. Satyam’s share price on the Indian bourses dropped by 87% over the subsequent two trading days, and they lost 94% of their value on the NYSE on January 7.

In the aftermath of this revelation, the Securities and Exchange Board of India (SEBI), the Indian regulatory equivalent to the U.S. Securities and Exchange Commission (SEC), appended Regulation 8A to the existing Substantial Acquisition of Shares and Takeovers (SAST) Regulations of 1997. The new regulation mandated disclosure of share pledges to the stock exchanges within seven days, which then had to make this information public within a further seven days. This sequence of events led to the popular perception that share pledges on average conveyed negative information about firm value and prospects.

The What and How of Pledging

In the Indian context, share pledges are collateral for secured fixed-maturity personal loans, with the company's shares acting as collateral. The typical tenor of the loan is between three months and two years. The interest rate is two to three percentage points higher than that of corporate loans.

At the lender's discretion, the loan may be rolled over. The borrower could be the company's founder, a member of the board, an executive, majority shareholder, employee, or even a small shareholder. However, disclosure of share pledges is mandatory only for certain shareholders, which vary by country. In the U.S., U.K., and Australia, mandatory disclosure applies to all directors. In Hong Kong, it applies only to the controlling shareholder. In India, it applies only to the promoters.

Under SEBI regulations, at the time of initial public offering (IPO), companies are mandated to identify a promoter or promoter group, or even another company as a promoter. While SEBI regulations do not formally define who or what is a promoter, it is usually the founder of the company. Promoters are not required to have a majority stake in the company.

Bank Limits

As per banking regulations in India, commercial banks may not provide loans against share pledges. Only non-banking financial companies (NBFCs) are allowed to do so. While NBFCs perform functions similar to those of banks, they cannot accept demand deposits. They are not part of the payment and settlement system and hence cannot issue checks drawn on themselves. Their deposits are not covered by India's Deposit Insurance and Credit Guarantee Corporation Act.

The annual value of the share pledge market in India is estimated to be around Rs. 2 trillion (about $30 billion) as of December 31, 2015, as per the data compiled by Prime Database. The NBFCs usually get shares worth two times the borrowed amount. Borrowers receive a margin call if the value of shares drops to between 1.25 to 1.50 times the borrowed amount. The exact multiple depends on the NBFC’s “comfort level” with the promoter.

It must be noted that in addition to the collateral of pledged shares, the loan to the promoter may also be secured by personal guarantees, pledge of other assets, etc. However, the authors’ discussions with NBFCs reveal that they consider the pledged shares as the primary collateral for the loan, especially since enforcing recourse through personal guarantees and other assets almost surely involves going through the notoriously tardy and overburdened legal process in India.

If the borrower does not respond to the margin call, and the share price continues to decrease, the lender invokes the pledge and becomes the owner of the shares and may recover the borrowed amount by selling the shares on the exchange. If the borrower repays the entire principal and all accrued interest by the loan's maturity date, the pledge is said to be revoked and the borrower continues to own the shares.

Reasons for Pledging

The commonly cited reasons for pledging the shares by promoters are:

1.       To increase personal stake in the company through open market purchases.

2.       To fund other group companies.

3.       To meet the company’s short-term working capital requirements.

4.       To provide a long-term loan to the company.

5.       To finance takeovers by group companies.

6.       To cover personal expenses.

Positive or Negative Signaling

The end use of capital borrowed through share pledges became a hot-button issue in the aftermath of the Satyam transaction. Though practitioners and the popular press note that markets react negatively to share pledge announcements, there is no systematic empirical evidence on the issue. Markets could react either positively or negatively to share pledge announcements.

If the promoter uses the funds to increase her stake in the company, an outside shareholder may view this as a sign of the promoter’s confidence in the future performance of the company, resulting in a positive impact on share prices. A lender’s acceptance of the shares as loan collateral also sends a positive signal to the market.

Another positive interpretation of a share pledge is that the company has a positive net present value (NPV) project on hand, and hence the promoter is willing to pledge shares to raise capital for the project.

In contrast to the above, there are a number of reasons for interpreting a share pledge as a negative signal about the company’s current and future prospects. In falling markets, the lender may be forced to invoke the pledge. To recover the loan, the lender may turn around and sell the shares in the market, putting additional downward pressure on stock prices. This could result in huge losses to existing shareholders. If the market believes that this is the likely outcome of a share pledge, markets will react negatively at the time of share pledges.

Further, when the pledge is invoked, the promoters stand to lose control of the company. This may be detrimental to the future prospects of the company, especially if the promoter has some specialized skill or knowledge that is not easily transferable or replicated.

Another interpretation could be that the company is in a dire cash flow situation, and the promoter is bailing it out by borrowing at a higher interest rate. The market may also interpret the share pledge as the promoter having private information of a large negative signal. The promoter may prefer not to sell her shares for liquidity and price impact reasons. Share pledges are an alternate way of encashing her shareholdings before the bad private information becomes public. In this case, the promoter could be perceived to be pledging shares with no intention of repaying the loan.

Empirical Evidence

Since a share pledge can be interpreted in either way, the authors analyzed a sample of 2,567 share pledge announcements in India, with data collected from the National Stock Exchange of India (NSE) website. All these pledges were after the SEBI disclosure rule of January 2009.

Standard event study methodology with a market model, using the S&P CNX 500 Index as a proxy for the market, is used, along with an estimation window of 220 trading days. We find that the average cumulative abnormal return (CAR) on the date of a share pledge ranges between -0.53% [-1 to +1; 3 day window] and -2.35% [-10 to +10; 21 day window], depending on the width of the event window around the day the promoter pledges shares.

There is a much smaller reaction, between -0.05% and -0.58%, around the day the company reports the share pledge to the exchange. Our conversations with practitioners revealed that there is no restriction on the promoters, the NBFC or any other market participant regarding communication of information about the pledge between the date of pledge and the date of announcement of the pledge by the stock exchange. Our results support this as the market reaction is much larger around the share pledge date than on the announcement date. There is most likely immediate leakage of information, and hence the market reaction is larger around the pledge date rather than announcement date.

Interestingly, though the average CAR is negative, only 56% of all CARs in our sample are negative. Contrary to the popular view, only a small majority of share pledges convey bad news.

Revoking Pledges

The authors also examine market reaction around the revoking of share pledges, that is, when promoters repay the loan and recover their pledged shares from the lender. Regulation 8A of SAST Regulations 1997 mandates the disclosure of the revoking of share pledges, much like with share pledges.

Regardless of the reason for a share pledge, revoking it would demonstrate the promoter’s ability to repay the loan. If the reason for the pledge was personal use, its revoking would signal to the market that the promoter had borrowed money for legitimate personal reasons and has promptly repaid the loan. If the reason was a short- or long-term loan to the company or a working capital requirement, revoking of the pledge would signal the company’s ability to repay promptly, and hence its good financial health.

Thus, revoking of a pledge should send a positive signal about the promoter and the company to the market. From study of a sample of 2,171 pledge revocations from the NSE website, it was found that markets do not react significantly on the day the pledge is revoked. This is puzzling, given the expectation that the market will react positively.

Conclusion

Pledging of shares acts as an important signal to the market. Pledging may be an easy way to raise money quickly, especially when capital market conditions are tight. More and more promoters in India are resorting to share pledges in recent years. The reason behind the pledging of shares must be investigated before investing in companies where the promoters have pledged a significant percentage of their holdings.

Algorithmic Trading: Balancing Pros and Cons

This article was first published by the Global Association for Risk Professionals on June 19, 2016

https://www.garp.org/#!/risk-intelligence/detail/a1Z400000035AAdEAM/algorithmic-trading-balancing-pros-cons

Six years since allowing algo trading, India wrestles with questions familiar across financial markets  

Since first being allowed in 2008, algorithmic trading has grown to account for 40% to 50% of the turnover on the National Stock Exchange (NSE) of India.

Widely regarded as a disruptive technology, and creator of advantages for some that harness it, algo trading was defined by the Securities Exchange Board of India (SEBI) as “any order that is generated using automated execution logic.”

The late Gangadhar Darbha, who was executive director and head of algorithmic trading strategies at Nomura Securities, said, “Algorithmic trade per se is nothing but a reflection of what happens in our brains. Algo trading is the use of electronic platforms for entering trading orders with an algorithm which executes pre-programmed trading instructions whose variables may include timing, price, or quantity of the order, or in many cases initiating the order without human intervention.”

Institutional investors, insurance companies and mutual funds use algorithmic techniques for portfolio rebalancing and risk control amid large order flows on either side. Anonymity and mathematical logic to break large orders into small pieces can counter adverse price moves and manipulation.

Financial firms apply the cutting-edge technology to product development and innovation in such areas as liquidity-seeking, cross-asset and multiple-exchange trading.

While it is difficult to know the strategy or logic being applied by looking at the trade data, it seems unlikely that the algorithms act on fundamental information about companies or the economy. Algo trading takes into account quantitative information regarding trends, reversion to mean, arbitrage, etc.

It is argued that computer-assisted trading improves liquidity in the markets by breaking down large trades into smaller trades, reduces bid-ask spread and lowers risks of adverse selection and trade related price discovery. Terrence Hendershott, Charles M. Jones and Albert J. Menkveld, in “Does Algorithmic Trading Improve Liquidity?” (Journal of Finance, Vol. LXVI, No. 1, February 2011), argue that algo traders are more likely to be providers of liquidity. They also increase the speed and efficiency of trades and reduce costs of trading.

Flash Crashes

There are also purported disadvantages.

There have been many instances of flash crashes on exchanges around the world, in which automated trading has been implicated, whether due to erroneous coding, a systems failure or cascading effects of certain trades. Algo is also often blamed for causing large fluctuations or volatility in the markets.

On October 5, 2012, the CNX Nifty Index of top 50 companies traded on India’s NSE fell nearly 16% within seconds (before rebounding), causing panic amid traders and institutional players, as stop losses were triggered. Similarly, the Bombay Stock Exchange (BSE) had to annul all trades on “muhurat day” in 2011 due to extraordinary volumes. (Muhurat day is a special trading session on Indian bourses to mark to beginning of the new financial year on the Hindu calendar. It coincides with the popular festival of Diwali.)

Algo trading’s effect of improving liquidity has been scrutinized. It is alleged that algo trades focus on a few large stocks, resulting in short-term liquidity improvement only for those stocks. If this also means that trading gets concentrated in fewer stocks, then this is not good for an exchange. And if algo trading magnifies panic, it can have an avalanche effect on prices.

Technology is reducing the cost of trading and attracting large volumes. But that requires exchanges to improve the efficiency and capacity of their data servers, matching engines and bandwidth, which in turn increases infrastructure cost and has to be added back to the brokers transaction cost.

Haves and Have Nots?

Does algorithmic trading "discriminate between rich and influential brokers and common investors/retail investors and create inequality” among constituencies on the BSE and NSE, as has been alleged by the Intermediaries and Investor Welfare Association? Algo traders have a technological advantage over the regular market participants, who are not able to afford such high fixed costs.

The Technical Advisory Committee of the SEBI, it was reported in April, noted that a certain broker benefited from loopholes in the systems architecture of NSE, which were not prevented by the exchange. Larger questions regarding the role of the regulator in coming out with policies on co-location and algorithmic trading are being raised as well. The surveillance systems of the exchanges and regulatory actions against manipulative activities have not kept pace with the improvements in technology and the complexity of algorithms.

Interestingly, rampant accusations that flash orders favor insiders led some lawmakers in the U.S. to urge in 2009 that the practice be banned by the Securities and Exchange Commission. It remains legal. The Indian counterpart, the SEBI, has set an agenda for itself to come out with a discussion paper on high-frequency trading, or algo trading, in the coming three months, which could lead to regulations of those activities.

Perhaps the right way to look at it is as Darbha once said in an interview: “Algorithmic trading is not just a facility, but an aid. While algorithmic trading gives you freedom to trade, it does not replace fundamental research. It only enhances trading efficiency.”

The Indian Economy under Rajan

This article was first published by the Global Association for Risk Professionals on June 09, 2016; was updated on June 20, 2016; Co-author: Anisha Sircar, Flame University, Pune

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000034vGa

Results of the central banker’s first term made a strong case for reappointment to a second

Subramanian Swamy, a Harvard University PhD in economics and a member of the Upper House of the Parliament of India, recently wrote a letter to Prime Minister Narendra Modi. It criticized Dr. Raghuram Rajan, the 23rd governor of the Reserve Bank of India, on many different counts, and urged immediate termination of Rajan’s services, on grounds that the central banker, whose three-year term expires in September, is deliberately trying to “wreck the economy.”

After saying he was open to serving a second term and leaving the decision to the Modi government, Rajan issued a statement June 18 saying he will step down.

Rajan has been generally recognized as one of the most influential and proficient governors of the RBI. He was previously chief economist at the International Monetary Fund, chief economic adviser of India’s Ministry of Finance, and the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. He is credited with predicting, early in 2005, the global financial crisis that hit in 2008. He was regarded as someone with international exposure who could anticipate problems and find distinct solutions.

When Rajan assumed office at the RBI in 2013, the economic climate was characterized by a free-falling rupee, touching nearly 70 against the U.S. dollar, alongside rising deficits, high inflation and overall sluggish growth.

Early on, Rajan announced his “Five Pillars of Reform,” inspired by the three “arrows” of the Japanese Prime Minister, Shinzo Abe. The pillars were an effective monetary policy framework that was transparent, credible, clear, and that could be “understood by the broader public”; banking sector reforms to give anybody the liberty to apply and set up a bank at any time; deepening the Indian markets; providing financial services to rural areas; and the creation of a “simpler, cleaner and less value-reducing” mechanism to address financial distress so that lending was rendered easier, faster and more efficient.

Besides delivering on the promises made at the start of his term, Rajan, along with other key decision makers and other factors, helped in ensuring that India has been the emerging-markets nation to withstand a general economic downturn. Other BRICS countries were considerably weakened in the aftermath of the Chinese slowdown.

Furthermore, facing anticipated Federal Reserve tightening, the rupee remained relatively strong. Last year, when the rupee plummeted to a two-year low, passing the 66/$ mark, and Sensex tumbled after the yuan shock, Rajan assured the world that India was in a far better position to weather the volatility.

Downward Inflation

Monetary policy under Rajan has been regarded as far more clear and systematic than its antecedents. According to the new framework, the challenge was to achieve an inflation target of 6% by 2016 and 4% by 2017; that is on target, with inflation now around 5.4%.

Declining inflation has made India a favorable investment destination and paved the way for continual interest rate cuts. However, containing inflation through interest rates has not gone down well with critics such as Swamy, who has called it “disastrous” to the industry, causing unemployment.

In his May 16 letter to Modi, Swamy voiced objections to the shifting of the inflation target from the wholesale price index (WPI) to consumer price Index (CPI). That the move was recommended by an Expert Committee set up to “Revise and Strengthen the Monetary Policy Framework,” and that the committee was comprised of eminent economists and statisticians from such institutions as the Indian Statistical Institute (New Delhi), Williams College (USA), JPMorgan, Bank of Baroda and Nomura Securities, apart from being represented by the RBI, does not seem to matter to Dr. Swamy.

As explained in the committee report, “CPI inflation excluding food and fuel has remained sticky at an elevated level, averaging above 8% and playing a growing role in determining wage and price behavior in India.”

The report also stated: “Shocks to WPI inflation have no statistically significant impact on inflation expectations, indicating that targeting the WPI would do little to anchor inflation expectations”.

It is also contended that private-sector corporate investing has flatlined after peaking in 2011, that the stressed assets may lead to a decline in investment, and that this is a bottleneck that needs to be dealt with by the RBI. “In the last two years,” Swamy wrote, estimated NPA [non-performing assets] in public-sector banks has doubled.”

Bank Provisions

It needs to be acknowledged that the NPAs have accumulated over several years. But, at least under Rajan, the banks have started to recognize these stressed assets and begun provisioning for them. The first step towards solving a problem is to recognize that there is a problem – and that step seems to have been taken.

It is also argued that despite the success so far with inflation, and interest rates coming down, real borrowing costs remain high. And although it has remained relatively resilient, it is not on a strengthening trajectory, which is a cause for worry as it may engender higher inflation in months to come. The cost of borrowing/lending is determined by the banks, and Rajan has been appealing to the banks to pass on the decrease in interest rates to the customers.

Equity strategist Christopher Wood of CLSA, in one of his “Greed & fear” reports, argued that the biggest risk to India’s bond and currency markets would be to let Rajan’s term expire.

Doyens of Indian industry have come out in support of Rajan, urging a second term at the RBI. These are the same industrialists who have kept up pressure on Rajan to reduce interest rates further. So why would they be so supportive of him? The answer is simple. Rajan has “performed.”

Rajan said on CNBC Awaaz as reported June 8, “The announcement over my tenure will be made between now and September 4 when my term ends.” He acknowledged that his “long-term plan is to get back into academics, to teach and to go for research.

Rajan has now ended the suspense, stating the following in an open letter to RBI colleagues that, in large part, defended his record: “While I was open to seeing these developments through, on due reflection, and after consultation with the government, I want to share with you that I will be returning to academia when my term as governor ends on September 4, 2016. I will, of course, always be available to serve my country when needed.”

The role of TPAs in the Health Insurance Eco System

This interview was first published in IIB Bulletin, Vol. 2, Iss. 4, 2016, pp.11-12

https://iib.gov.in/IIB/Articles/IIB%20Bulletin%20IIRFA2016.pdf

Malti Jaswal, has close to 30 years of experience in the General Insurance industry in India in different capacities; marketing, operations, claims management etc. She has worked with both public sector and multinational insurers. Since 2008, she is working in health insurance field and is an active member of multi‐stakeholder working groups on health insurance in India. She is a regular speaker at health insurance forums and she has published papers relating to Universal Health Care, Third Party Administrators (TPAs) best practices, claims management, and fraud control.  

 

She has also been a member of sub-committees of Ministry of Health on Categorisation of Hospitals and Costing of Care. As a Consultant, she worked on varied projects relating to health insurance training and education, Information Technology (IT), payer-provider exchange platforms, cost control, and fraud control.

 

She has developed a Certification Course on Health insurance for Insurance Institute of India. She is currently working as the Chief Operating Officer of the Health Insurance TPA of India Ltd (HI TPA), a joint venture of the four public sector general insurance companies in India, namely, National Insurance Company Ltd., New India Assurance Company Ltd., Oriental Insurance Company Ltd. and United India Insurance Company Ltd, along with GIC of India.

 

In a conversation with Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, Jaswal talks about the need for HITPA, the important role played by TPAs and fraud in Health Insurance claims.

You have worked extensively in the field of Health Insurance. Can you tell us about the role of TPAs in the Health Insurance Industry in India?

The concept of TPAs came to India around the years 2001-2002. That was the time the Insurance sector was opened up to the private players. The private players, when they started, didn't have in- house capability of running 24*7 claims support functions and wished to focus on core areas to build business. Public sector companies also did not have such capabilities though Mediclaim (generic term for health insurance product of PSUs) is being sold since 1986. Thus outsourcing seemed a natural choice. This gave birth to the concept of TPA in India. The TPAs were licensed by the Insurance Regulatory and Development Authority of India (IRDAI) to ensure that certain minimum requirements were met to set up a TPA. 

There are 30 licensed TPAs in India. So what is the purpose of setting up another TPA- Health Insurance TPA of India (HI TPA), promoted by four public sector general insurance companies?

The growth of business in health insurance has been exponential in India in the last decade with a year-on-year growth of 25%-30%.  To handle the growing business, robust processes, latest systems and technology and trained people are needed. However, the required investment did not happen across the spectrum of TPAs and the TPA industry remains under capitalized even today.   

Most of the large private sector insurance companies, including standalone health insurers, gradually started setting up in-house TPA/claims management facilities to have better control and do not use TPAs in big way anymore. Public sector insurance companies however continue to use the TPAs because of certain peculiarities of 24*7 operations. The terms and conditions of employment contracts of public sector general insurance companies are not generally geared for engaging manpower for round the clock services nor is rest of infrastructure.  In my view perhaps, it is also realized that the demanding nature of 24*7 TPA services required by customers, could be delivered more efficiently and effectively through a non-public sector entity.

Thus it seems to be a considered decision for the four public sector companies to come together, pool capital and create such an entity. This way, adequate capital investment could be made in HI TPA from an IT perspective because robust IT infrastructure and trained manpower are the key requirements for the TPAs to handle complexities of current health insurance products and high volumes. The four companies already enjoy the benefit of scale when bargaining with the hospitals together under Preferred Provider Network (PPN) arrangements.

Would HITPA also provide services to private insurance companies? And would the PSU companies use only HI TPA’s services in the future?

As of now the TPA license given by IRDAI to HI TPA is only for the four public sector companies. We have represented to IRDAI to make the license open to service business of private insurers.

There is absolutely no doubt that PSU companies will continue to use multiple TPAs. There is no intention of moving business completely to HI TPA as voluminous business is being serviced by various TPAs and retaining competition in essential to ensure that all parties deliver value to the customer.  At the same time if there is an entity with adequate capital, trained and skilled resources, robust processes and IT infrastructure, which can in a way, set the benchmarks for the entire TPA industry in India; it will surely bring better practices and impact the market in a positive way.  HI TPA aims to be that entity.  

You mentioned that the concept of TPAs came to India around 2001-2002. Prior to that, the public sector companies were managing the claims in-house. Since many of the private companies are now setting up in-house TPAs and claims processing teams, why can’t even the public sector companies continue the earlier practise of settling the claims in-house?

Claims management is an integral part of any insurance operation world over.  Since inception public sector insurance companies have had high quality technical manpower to do so for all lines of their business. The companies were also managing health insurance claims in-house prior to 2002.

In 1986, retail Mediclaim was launched for the first time in India by the public sector companies. The practice from 1986 to 2000 was that the customer would pay the hospital from her pocket and get the expenses reimbursed later from the insurance company which could take many days/weeks. With the entry of private sector companies in joint venture with large and experienced international insurers, cashless facility was introduced, as one of most customer friendly service.

For cashless facility to work, TPAs were inducted to organize and facilitate the same 24*7*365. TPAs facilitate networking with the hospitals on one hand and cashless/claims processing for the customers on the other.   

So the TPAs only process cashless claims?

A claim is a claim whether on cashless basis or on reimbursement basis.  Cashless is a customer friendly process wherein customer need not pay for treatment and then file claim later.  However customer has every right to seek treatment in any non-network hospital (so long as it meets the criteria) and file for reimbursement claim.  A claim is admissible and payable depending on terms and conditions of the policy, on what risks are covered, to what extent etc. The TPAs process both types of claims, however traditionally (and even today), role of TPA is primarily considered to facilitate cashless and all other services around the same e.g. 24*7 call center, issuance of member id cards, hospital network etc.   

Does the TPA pay the claims?

As per IRDAI guidelines, claims are required to be paid and repudiated by insurers directly to customer/provider.  TPA’s role is to process the claims as per guidelines of the specific insurance company and subject to terms and conditions of the policy.   The TPAs do not carry the risk, nor are involved in selling or underwriting. 

Some accounts put Health Insurance frauds to the tune of 15% of all health insurance claims in India. That is huge and puts a lot of burden on the customers in the form of increased policy premiums. Would HI TPA be instrumental, to some extent, in controlling fraud in health insurance?

As the health insurance industry has grown in India, so has the number of fraud cases and also modus operandi of fraudsters is getting sophisticated.  High growth tends to loosen controls and here in India we do not have Health Regulator. HI TPA aims to fulfil the twin objectives of its creation - enhancing customer experience and bringing in greater efficiency in Health Insurance claims processing.  Efficiency in claims processing would also incorporate better handle on controlling and managing fraud.

Can you elaborate on the ways in which fraud may be controlled?

The main job of TPA is claims processing and managing the hospitals network. TPAs handle the claims process right from the point of intimation to the settlement of the claim. TPAs have good IT systems. Policy data is integrated with their systems. Policyholder and members’ (people covered in the policy in the case of family and group policies) profiles are available with the TPAs as also the details about network hospital. All this information, coupled with the knowledge about medical practices and hospital tariff should make it easy to detect any outlier behaviour or pattern.

For example, let’s say a customer reports a non-emergency claim 1000 kilometres away from home.  It should ring a bell. If it's a non-emergency claim, why would a patient go to a hospital which is so far away from home unless it’s a specialty treatment like cancer.  Another example, if there is a very large reimbursement claim of say Rs400,000 or more, it should raise an alert. Why a customer would chose to pay such a large sum out-of-pocket and not avail the cashless facility made available in so many good tertiary care hospitals in normal circumstances.

During the entire chain of events, from intimation to payment, there are at least 5 or 6 trigger points, which a smart system and skilled manpower should be able to detect. Next step is data analytics in retrospect. Sometimes small value claims can slip through. But if analysed appropriately, those leakages would also become apparent over a period of time and amenable to control.

In India, there is no proper definition of what is a financial/insurance fraud. In the absence of a clear definition, even if a fraud is detected, the companies may choose to not pursue it if the amount is small. Even when a company decides to take legal recourse, the battle is often very long drawn and not worth the effort. As an industry, are there any steps being taken to tackle this lacunae?

It's indeed a big lacunae – there is no definition of insurance fraud under Indian laws nor provisos to deal with the same. There are three angles to fraud management; one is detection, second is recovery, and third is prevention/deterrence and punitive action.  Right now the insurance industry in India is primarily focused on detection and to some extent on recovery.  Not losing the money is the first and foremost priority. Unfortunately, prevention through punitive deterrent action is missing because our legal system and penal codes have not yet caught up with the changes in the financial and insurance domain. The Insurance Act of 1938, in spite of the recent amendments to it, doesn’t carry any active provisions to handle fraud. Punitive action is necessary for effective deterrence.

There have been industry level discussions at the Federation of Indian Chamber of Commerce and Industries and the Confederation of Indian Industries about what can be done to tackle fraud in the absence of legal provisions and health regulator. There have been suggestions to involve the Indian Medical Council to prevent doctors from conniving with the customers and hospitals to exaggerate claims or be a party to the fraud in any way. A few companies have started issuing letters to hospitals and doctors to seek explanation when a certain course of treatment seems unreasonable.   ‘Name & shame’ guidelines have been discussed.  

IRDAI has taken cognizance of growing menace and ways to control the same. IIB is also now directing lot of action to health data collection and analysis, hospital registry has been set up for the first time. Though a small step, data sharing of fraudulent customers and fraudulent hospitals has now started. Hopefully in times to come, we shall see more action on this front.