POOR COMPANIES RICH MULTIPLES

Author: Preetam Mittal

               PGDM RM 2011-2013

               Welingkar Institute of Managament

The document is about common mistakes made by investors while analyzing the financial ratios and how companies manipulate their stock prices.

A premium earning multiple is hard to come to a company and even harder to maintain.

In the recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio.

Countless investors - individuals and professionals alike spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for some reasons, they are not in favorable industries or have poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years.

But investors don’t understand this fact and companies take their advantage and modify the P/E ratio by various means – the most common been -inclusions of debt in the capital structure. When companies are financially leveraged then the one with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers.

Exhibit 1

Leverage distorts the P/E ratio (Hypothetical case)

Exhibit1clearly shows that though both the company has same EV value, their P/E ratios have substantially changed due to inclusion of debt. Taking the example of two companies Apache Corp and Anadarko Petroleum, each of these energy firms in the year 2010 had an EV/EBITDA multiple of just over 5 (source: investing answers.com) the average EV/EBITDA multiple in their peer group was just under 7. That seems to indicate APA and APC were relatively undervalued.

But if you looked at Anadarko strictly on a P/E basis, you'd wonder why shares hold any appeal, trading at nearly 30 times of its net income.

Why PEG is better than P/E ratio?

There are more detailed valuation models available in the market which seldom makes the headline. These are generally the cause of concern for the senior executives as they claim that their company has great growth prospects and many investments projects in hand. Actually, they are not necessarily wrong. Even financial theories suggest that companies which have higher growth prospects should have higher earnings ratios and hence better market value.

But the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history - you're purchasing its future cash flows. What matters is what the company is going to do and not what it has done.

So what's the solution?

The solution is to account for the growth rate of the company or expected growth rate if it can be estimated. Thus, it gives birth to a new and better ratio - PEG ratio, the calculation is as follows:

PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings per Share Growth

In fact, if one goes back a decade ago then one may find that Apple's P/E ratio at that time was as high as 297. So, anyone making investment on the basis of P/E ratios would not have considered it a very profitable investment but had you bought shares of the company then, you'd be up over 7,300% today.

But, if someone calculated the PEG ratio it would be something closer to 1. A crude analysis suggests that companies with PEG values between 0 to1 may provide higher returns (the closer to 0 the more undervalued).

Common manipulation techniques used by the management

There is another very common form of manipulation used by companies called the "big bath," and this can cause these stocks to seem undervalued to investors. This happens when the company incurs a big loss to their bottom line. This method involves the company taking the complete loss in one single period, instead of spreading these losses over years. This will cause the earnings per share to drop significantly for the time period involved, due to the large losses posted. The intention of the company is to foster the idea among investors that this charge is a once only deal, and that the stock will rise considerably after the loss has been absorbed. This will cause investors to see the stock as one of the undervalued stocks, or as an attractive investment and thus will cause the demand and price for the stock to jump up.

One must always keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.

These ratios are completely ineffective for cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples and these requires a bit more investigation. Although one would typically think of a firm with a very low trailing P/E as cheap, but that would precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.

In a similar way, when you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. The denominator of the ratio can be easily manipulated by changing the revenue recognition, depreciation and capitalizing cost methods the company have been following.

The company generally projects “pro forma” earnings, which shows the profit the company would have made in case some bad/extraordinary event didn’t happen. Consider the case of the attack on hotel T­­aj few months back. It would have surely affected its current earnings, but long term scenario remaining the same. Using Pro forma in those cases makes absolute sense to get an overall long term picture. But there are companies which excludes preferred stock dividends, taxes paid, bad investments, etc., and shows a very attractive pro forma earnings. Hence in general, it’s always better to forget about the pro forma earnings as more companies have come to misuse it, than guiding the stock holders.

Sometimes, companies may show an attractive figure as per-share earnings, but in the foot note it may take away a major part of it as special charges. In such cases investors usually do not pay attention or are ignorant about these facts but this ultimately affects the total earnings of the company and reduces the per-share earnings. Sometimes the special charges may not be really so special and it may show all its operating expenses and even losses as special charges.

Another common mistake made by investors in calculating the EPS is calculating it based on the number of shares currently available in the market and neglecting the convertible debentures available in the market. Companies generally issue fully convertible debentures in the market which the debenture holder converts into equity share when he/she finds the market lucrative. Here at any condition, one should only take the diluted earnings and also check if the company has any plans to dilute further, as it may take away another piece from your pie.

Why management manipulates financial statements?

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business.

Conclusion

Are these ratios the “be all to end all” for pricing a share of stock for a company? Of course they aren’t. There are a lot of factors that go into pricing shares of stock and so it's important to continually sharpen one's skills and put new tools in the toolbox. It makes sense to go through and calculate different multiples such as EV multiple (EV/EBITDA, EV/EBIT), PEG and Dividend yield ratio etc. for all current holdings and for future investments.

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Yellow Metal, Yellow Fuel causing Economy Blues

Name: Vibhu Gangal

Institute: Symbiosis Centre for Management and Human Resource Development

A significant reason for the recent fall in rupee is attributed to macroeconomic deficiencies of India. The article below analyses the same and tries to establish a relation between the steep fall of rupee and the general tendencies, trends and situations prevailing in India that affect the economy eventually.

The demand equation states that the aggregate demand (and the national income at equilibrium) is an algebraic sum of consumption demand, investment demand, government expenditure and net exports. The moment we say 'demand', it is backed by money and indicates a destination where people roll out the money they possess. If this money is spent to fulfill any of these demands which add up to the national income, it’s a positive sign. The more this happens, the more the country grows economically, the more is the national income, the stronger is the home currency. One scenario, where possession of money with individuals of a nation can harm the economy, is when the money possessed gets expended big time towards imports, which makes net exports and overall national income negative, leaving the investment demand of the nation unquenchable. A similar thing seems to have happened in India. Let’s take a closer look at its causes and implications.

Consider an analogy, where we have a dam constructed with an aim to irrigate fields. It has some water collected in the reservoir. This water flows to the fields through channels. Thus, it’s the channels which ensure that the water in the dam gets utilized for growing crops and not for domestic purposes of farmers' households. Had the channels being broken and had the water been routed to households instead of fields, crops could never have grown due to lack of water and the production of the territory could have taken a severe hit. The water is equivalent to liquid rupee with the Indians, crops to the GDP, and channels to the government regulations and policies. In India, a major part of money (water) is spent in buying volumes of gold by families (household demand). If gold was available in India, the tendency of buying gold would have created better circulation of money and the multiplier effect would have done well to the economy. Unfortunately, out of 902 tones of domestic annual gold demand, India produces only two tones and the rest 900 tones is imported. 

More the demand for gold, more are its imports, more is the payment in dollars, more is the influx of rupee in forex market, more is the outflow of dollars from forex market, more depreciates the rupee,  more expensive becomes any imported item including gold. This self-feeding spiral continues and raises ringing-alarm-bells when it reaches a stage where RBI cannot save the rupee by adhoc workarounds like selling dollars and "trying" (rather struggling) to induce more FII participation.

Indians have imported gold worth $61.5 billion (or around Rs 341,000 crore) in 2011-12, recording a growth of 44.4 per cent during 2011-12. Same is the case with petrol. A consistent surge in demand eventually causes the same vicious circle of events. Together, gold and petrol are the biggest burden on trade deficit and have worsened current account deficit badly, causing the sharp decline in value of rupee vis-a-vis dollar. The trade deficit during 2011-12 was recorded at $184.9 billion than $118.7 billion during 2010-11 mainly on account of large imports of fuel, gold & silver accounting for 44.4 per cent of India’s imports. Reports suggest that gold imports contributed to almost one third of the incremental rise in Current Account Deficit over the 2008-2011 period.

Directly, gold contributes 0.36% to inflation index. Indirectly, it makes all imports including crude oil costlier fuelling input costs for all industries ranging from plastics to automobiles. If the input costs rise, so have to be the prices of finished products. Eventually it’s the inflation which kicks off. The time lags between rise in gold demand, rise in import prices and rise in end product prices make the three events appear disconnected to the general public and as the "safest" option, we end up blaming the government without any knowledge of ground level proceedings. Arithmetically, every dollar reduction in international oil prices translates into a cut in product price by 33 paisa.But every time the rupee depreciates against the US dollar by one rupee,it translates into a requirement to raise prices by 77 paisa.

Another aspect is, with booming inflation, with industrial products being costlier than earlier, why would a buyer in international market prefer buying Indian expensive goods when the same is available at a lower price in other countries? Together, with imports already being discouraged due to sharp depreciation of rupee, this fall in exports due to inflation exacerbates the trade deficit causing further decline in rupee value. It all gets again into the self-feeding loop discussed above.

So, where do we break this infinite-loop of events where every step, every action has a well justified reason behind it? But somewhere, somehow you need to break this to get things in place. Weakeningor breaking one block might give a temporary relief to figures, but in long run, this would cease growth. Instead, if every link in the chain is made to melt down in terms of its prominence, its just a matter of time, the whole chain shall cease to be prominent. What I wish to convey is instead of unplanned adhoc and short-term steps like giving subsidies on fuel prices and making efforts to attract hot money sources, this nation needs to plan for a durable strategy which would 'subtly' and 'indirectly' bring about relatively stiff and lasting changes in the economy. Here’s what I mean to say…

Whenever individuals hold disposable rupee, government should ensure that substantial part of rupee gets either invested into banks, corporate bonds, government securities and the share market or it gets to quench 'domestic' consumption demand of goods and services. Let’s remember in a dam, it’s the channels which ensure the usage of water in desired way and ultimately govern the production. Whenever it’sexpected to have an enhanced liquidity among individuals, it should be THE time for government to make capital investment attractive. This would trigger the multiplier to take effect and eventually translate liquidity into growth. As far as demand for gold is concerned, it can be discouraged by raising customs duty exorbitantly. Buying gold should be made at least half as tough as buying a scooter was in late 1980s... Even if the demand for gold reduces partially, this would mellow down dollar appreciation and prevent further damage.

On the other hand, the consumer which demands gold and oil so excessively needs to understand that if he chooses deliberately to intensify imports, he is fuelling inflation to such an extent that he himself is going to get in trouble. A major reason for S&P indicating to downgrade India in terms of its investment-grade rating was a drought of investment opportunities in India. With Indian businesses borrowing big-time from foreign sources, with other events increasing imports and causing rupee to depreciate, Indian borrowers will now pay more for every dollar borrowed. With every firm borrowing millions of dollars, the rupee loss is going to be phenomenally huge and shall reflect on a cost-cutting approach by companies' management which shall also include a cut in salaries. Eventually, a self-check on surge of gold demand can help prevent a number of significant things.

Recently, after a lot of hue and cry on oil price hike, the government declared a subsidy on petrol price. I say why? As a long term plan, the government should let the petrol price rise so that vehicular usage takes a hit, even though the hit is marginal. Towns, where bikes and cars are favorites for personal transport, should be picked up and transformed into towns with a quality mass public transport, quality in terms of speed, frequency, availability, ambience, approachability, grievance handling mechanisms and any and every aspect which makes mass transport well-preferred and equal in status vis-a-vis individual vehicles. This shall help in fading the rise in demand for crude oil and so shall prevent the rest of the spiral.

One may say that it’s the gold which facilitates loans and so fosters investment. But one misses to note that at the time of repaying the same loan taken against gold, the value of the money repaid plummets so much that the good done by the investment gets offset substantially by severe inflation, the root cause for the good and the bad being the same. One may say that if investment in India is on a backseat, why doesn't the government invest? But one misses to note that it would be dumb on the government's front to do so, as it is already burdened under a budget deficit of 5.19 percent and any further disbursement of money would widen it more. One may say that subsidies on fuel shall be continued for some more years as the inflation is cost-pushed and not demand-driven. But one misses to note that it’s the demand which drives the entire spiral discussed above and it’s the drive of this demand which ultimately coverts into a cost-push inflation. Thus, it’s high time now that the administration of the nation gets into a patient and consistent mission of correcting the fundamentals of economy at a macro-level with an aim to bring about a long-term change.

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Does Weak currency mean Weak Government?

Author: - Ashish Aggarwal

College: - NMIMS, Mumbai (Capital Markets)

Before answering this million dollar question, I would like to give brief introduction about exchange rates and how they are determined.

Exchange rate is defined as value of a country’s currency in terms of another country’s currency. Exchange rates are determined through forces of demand and supply. For example dollar-rupee exchange rates will depend on how the demand-supply forces moves. When the demand for dollars in India rises and supply does not rise correspondingly, each dollar will cost more rupees to buy.

Important point here to be understood is where this demand/supply does come from?

Sources of Demand: -

Most important source of demand is Importers which needs Dollars (foreign exchange) to buy goods and services.

Other very important source of Demand is Companies / Individuals investing abroad.

Other important sources of Demand include companies sending profits back to their home country.

Sources of Supply:-

Again we can say that most important source is Exporters who sell goods and services and earn Dollars (Foreign exchange)

Other very important source of supply is Companies / Individuals investing into Indian markets.

Other important sources of supply include Indian MNCs sending profits back.

We can see that the factors that contribute to the demand for a currency are mirror images of those that add to their supply.

Rapid increase in value of dollar in recent times

We (India) have witnessed a rapid increase in value of Dollars in recent times which mean there is a change in forces of Demand and supply, obviously demand has outgrown supply of dollars.

There are 2 basic factors that have led to the change in this equation. Firstly, FII’s (Foreign Institutional investors) that have been pumping billions and billions of dollars until few months back, have been desperately pulling money out of India and putting it into safer havens like USA and Germany.

Secondly, Trade deficit gap i.e. gap between values of our Imports and values of our exports has widened i.e. exporters are not able to bring in as much dollars as our importers are giving out and hence demand is more than its supply.

What could have efficient government done to solve the problem?

Solving first problem i.e. of getting FII’s to put money into India. This problem has two dimensions to it, they are

First, FII’s have been pulling money out of India because of financial crisis facing them in their home market. So they are looking for safe heavens and right now with Euro zone’s Euro and Japan’s Yen in a mess there is no other safer and stronger asset than US Dollars.

Second FII’s are pulling out their money from Indian markets because of slowing rate of growth of Indian economy.

It will be totally unfair to say that government can solve or handle the first dimension of this problem as it is a global phenomenon and Indian economy still is not big enough to influence world events.

Looking at second dimension, yes image of India has taken a hit due to following recent events like

·         Retrospective amendments

·         Going back on FDI reforms in Retail and aviation sector

·         Various corruption charges against ministers of central government

·         Increasing Fiscal Deficit

Obviously an efficient government would have tackled it and have saved image of Indian economy.

Question to ask here is that if second dimension of problem is taken care than would it stop FIIs from pulling their money back from India.

Answer is NO, because global crisis is a phenomenon much bigger than then few wrong events occurring in Indian economy. Investors would still have ran towards safe havens and India is not even close to be known as safe haven by  any stretch of imagination. This means money (dollars) would still have flown out of India.

To make my argument more convincing I would like to lay stress on fact that India is expected to grow at 6% to 6.5% this year which is better than almost all the countries of the world but still investors are not willing to take risk in current situation and are running toward safe heavens.

Basically the fact is whenever financial crisis happens investors moves towards safe heavens as risk appetite reduces during financial crisis.

Solving second problem i.e. of Trade deficit gap. This problem has come up due to decreasing growth of values of exports as compared to values of import.

Again this problem can be broken up into two first lower growth in exports and second higher growth in value of Imports.

First part i.e. lower growth in values of export is mainly due to lowering demand in Europe and US which can again be attributed to financial crisis in Europe and doubts about growth of US economy.

Second part i.e. higher growth of imports, basically our Imports depends on price on Crude Oil in international markets and not on strength of government in India.

Following two charts will illustrate this fact

Chart 1: Value of Oil Imports of India

 Chart 2: Value of Crude Oil in international market

Source: - International Monetary Fund – 2011 World Economic Outlook

 Let us look at the trend after 2002 because that is when India rapidly industrialized.

During the period 2003 to 2008 there was increase in prices of crude oil from 26$ per barrel to 140$ per barrel similar trend is visible in value of Oil import by India.

Also we can see that slope of both the curves are in coherence.

After 2008 till 2010 we can see Crude prices falling from 140$ per barrel to around 75$ per barrel similar trend is seen in value of Oil import by India

From this we can easily see that value of our oil imports depends heavily on price of crude oil in international market.

Now since 70% of our import bill is Oil imports that mean our imports are heavily dependent on price of crude oil.

Hence above argument proves that Increase in trade deficit in current conditions in case of India is due to global phenomenon and not because of ineffective government.

So far the discussion put forward has been India specific; now let’s talk about various other reasons why we can’t say that weak currency is an indicator of weak government.

Following are some of the reasons:-

·     Many strong countries want weak currency: - Two prominent examples for such countries are Japan and China. This is because it keeps prices of their export lower so that its products and services become attractive for consumers in other countries. This helps them increase production which creates more jobs and also gets foreign currency which ultimately leads to overall growth of economy of the country.

·     Role of Speculations: - In any market, expectations and speculation play an important role. For example, when there is an expectation that the dollar will rise against the rupee, exporters tend to hold back their earnings in the hope of getting a higher rate.

Similarly, importers will try and buy as much as they can today, adding to the current demand and making the dollar rise even more.

All this skews the supply-demand equation even further and thus setting off a vicious cycle.

 Does weak government means weak currency?

Again we need to see how can weak government affect demand supply equations?

Following are some of the adverse effect of weak government: -

Loss of investor’s confidence: - perhaps the most adverse effect of political instability is on investor confidence. There may be certain policies that may not be in the interest of business or government may not be working in larger interest of economy, government may not be strong enough to take unpopular but necessary decision like increase in fares of public transport or increase in fuel prices or reduction in subsidies, All these can lead to lack of investor’s confidence in future growth of country making him pull out his money from the market of that country.

Poor business environment: - Poor business environment means high taxes, unclear tax regime, poor law and order, difficulties in setting up new business, lack of infrastructure like lack of roads and electricity etc all this results in lesser production for domestic companies which results in lesser revenues also it discourages foreign companies to invest in the country leading to lesser inflow of foreign exchange in form of foreign direct investment again adversely affecting demand and supply situation.

Poor Fiscal Management: - Generally it is seen that ineffective government are unable to keep their expenditure under check and there is excess of expenditure over revenues. As such governments have to borrow more and more money which increases their borrowing cost and country with fiscal deficit needs to pay more for each dollar they borrow.

Uncontrolled Inflation: - High inflation may persist in such countries because of supply side problems. High inflation is dangerous for overall health of economy as it may lead to lack of savings and more of spending which further increases inflation, as a result Interest rates are higher in such countries leading to increased cost of borrowing and hampering the growth of business.

All of these may or may not occur simultaneously but all of them are harmful for growth and development of an economy.

Cause	effect on Supply of dollar (Foreign Exchange)	effect on Demand of Dollar(Foreign exchange)	Effect on currency (Weakens or strengthens)
Loss of investor’s confidence	Reduced	No Direct impact	Weakens
Poor business environment	Reduced	No Direct impact	Weakens
Poor Fiscal Management	No Direct impact	Increases	Weakens
Uncontrolled Inflation	Reduced	Increased	Weakens

Above table summarizes ill effects of weak and inefficient government and we can see that weak government does leads to weak currency.

Conclusion

From the above argument it can be concluded that weak currency does not necessarily means weak government, just by looking at state of currency we cannot say much whether the government is weak or not, we need to carefully analyze causes for weakness in the currency to determine whether it is due to some global phenomenon or whether country has intentionally kept its currency weak or whether it is due to weak government.

Vice Versa, i.e. if we have weak government at centre than surely currency of the country is going to be weak.

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All About Commodities Market

By: Shipra Jha , NMIMS , MBA Capital Markets

WHAT ARE COMMODITIES?

Commodities are one of the most volatile asset classes available to investors .They are interchangeable products which, as a consequence, share a common price. Examples for commodities are goods such as grains, livestock, oil, cotton, or even financial products like currencies, bonds, and stock market indices.

ABOUT COMMODITIES MARKET:

The commodities market has emerged during the modern era as an important player in the way people invest and speculate. The two most-watched commodities by far are crude oil and gold: oil because it is the primary form of energy commodities market use to power international transportation and trade ,  and gold because it is viewed by financial markets as a hedge against rising inflation. Daily price swings in commodities of all kinds can be violent and due to the use of leverage, investors can lose more than their initial investment.

PROCESS :

Prices in the commodities market are determined by the motives of the buyers and sellers, who together make up the market.

TYPES OF COMMODITY MARKET :

A commodities market can be a : Cash market or futures market.

 In the case of a cash market, again it could be either a spot or forward market. In case of a spot market, you get immediate physical delivery of a commodity, whereas in the forward market, you tend to get your commodity delivered at a specific date in future. Both spot markets and forward markets are together known as actuals since actual delivery has to be made in either of the types.

A futures contract is a special type of forward contract. They are designed to reduce risks and increase flexibility of forward contracts. The contract, for instance, may specify delivery points and price variations for discrepancies in the quality of the commodity being shipped.

HOW  VULNERABLE ARE COMMODITY PRICES ?

The recent decline in commodity prices attests to the possibility that commodity prices are vulnerable to a deterioration of the global outlook.

HOW BENEFICIAL HAS QE3 BEEN TO COMMODITIES ?

As the Fed embarked on a third round of quantitative easing, risky assets are rallying hard. Commodities were among the biggest gainers of any asset class following the announcement of QE2.Are commodities poised for similar gains this time round?

Conditions in the macro economy are much less supportive, commodity prices are higher and the impact of successive waves of QE is reduced each time. China’s big build is maturing as capacity catches up with demand and that is beginning to backfire through parts of the global commodities supply chain that has fed China for the past decade. Markets are concerned that with business confidence low, growth faltering and export demand poor, weakness in China’s commodity imports will become more pervasive, especially with high inventories overhanging sectors such as copper and steel. With the dollar weakening and the debate over fiat currency debasement now likely to retake centre stage, QE3 is likely to unleash enough physical and futures market buying to bring to an end to gold’s position as one of the weakest commodity markets in 2012 so far. In terms of current market positioning, base metals look likely to benefit most from better sentiment in the short term, as hedge funds look severely underweight, especially in copper.

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Informed Investor – an asset to the company

Author : Charchit Joshi, NMIMS, MBA Capital Markets

In the past few years the relationship between the corporate managers and investors has gone for a beating. Investors lost money in the turbulent markets. Their disinterest in the scribes brought down the stock prices. And this added to the woes of decision makers and top management of the public companies. Many corporate houses started believing that managers should not take care of the capital market. Managers should do their business, do well and investors will follow the success story. They have forgotten that it is a mutually beneficial relationship which if respected in an honest and transparent way can prove to be a win-win situation for both the involved parties.

Giving true and relevant information to the investors is generally a good business. But doing it in a detailed and unambiguous way is rather more important. Providing investors with something more than just quarterly and annual results can help in maintaining this mutually beneficial relationship between the two.

As per the economic theory of information asymmetry – When one party in a transaction knows more than the other, someone suffers – and it is not whom you might think of. If the seller has more information than the buyer, the sellers are the primary losers, as a suspicious buyer can bring down prices or can quit the market altogether (George Akerlof won Nobel Prize for this). No one would buy a car without inspecting it. Same theory applies to share market as well. By providing the necessary information about the company’s plans and estimates in future a manager can avoid falling share prices, weakening demand, high volatility, higher cost of capital, etc. Such practice if followed by a company eliminates suspicion in investor’s mind. It further helps a company to hold an investor with the company’s stocks for longer period of time and to attract new investors to invest in the company.

To make this practice of information sharing, working, companies should know their investors well. They should dig deep to know what investors want from them. According to a misconception, very prevalent amongst the corporate managers today, those who buy and sell stocks are jumpy and myopic in nature. But it is the other way around. Market is usually dominated by the investors who are more concerned about long term investments rather than short term or intraday investments. Though short term news, fluctuates the market. But the impact of long term forecast revisions and financial reports of the companies have much stronger impact on companies’ share prices. Actually investors suffer from what organizational researchers call, limited attention. It is the inability or rather restricted ability of human brain to process and analyze vast information. Hence investors react to the news that captures the headlines of the News Papers. This causes knee jerk reactions, even from the long term investors, who would have never paid much heed to such news ahead of the forecasted financials of the company.

Hence companies should not only provide its investors with the information about the present financials, but also a detailed report of the future projects, estimated financials , possible threats , opportunities, etc. They should highlight the key points of such detailed information. This will not only help investors to be well informed about the main features of the company’s current and future operations but also help company in safeguarding against the knee jerk reactions to the short term news.

As I said earlier the company investor relationship is a two way bond where interacting with the investor does not always mean giving information. The movements in share prices speak a lot. Capital Market’s response after the announcement of financial results reveals the investors’ expectations and faith on the current management. Knee jerk reactions and sudden short sales often signal some serious trouble with operations of the company that needs to be fixed.

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GAAR REPORT – A tax reform or a Shenanigan?

Author : Chakshu Aggarwal,NMIMS

                 
The confusion over the General Anti Avoidance Rule (GAAR) cropped up when on 21^st January, 2012 Supreme Court ruling went in favor of hutch-vodafone deal on grounds that the deal between two companies was incorporated outside India and thus exempted Vodafone from tax of $2.5 billion. This led to series of events which resulted in weakening of investor sentiments and thus goaded the government in July to set up a 4 member panel to look into the concerns of foreign investors in GAAR. 

DEVELOPMENTS IN GAAR TILL JUNE,2012 AND ITS IMPLICATIONS

• The Supreme Court ruling in favor of Vodafone led to introduction of a retrospective clarification to Income Tax act 1961 thus amending the law to tax cross border transactions such as Hutch-Vodafone deal.

• The new provision in Income Tax act stated that any company situated outside India shall be deemed to be situated in India if it derives its value or shares from the assets located in India.

• The provision was disclosed in the Union budget of 2012 by then finance minister Pranab Mukherjee. Post inclusion of this provision it was estimated that it could earn the exchequer Rs 35000-40000 Crores in back dated revenues.

• INCOME TAX department filed a petition in SC in March, 2012 for reversal of its earlier decision on back of the retrospective clarification in Income Tax act.

• The amendment to Income Tax act did not bring any gains to Income Tax department and petition was turned down by Supreme Court.

• The argument given by government for introduction of GAAR in form of change in Income Tax  act was that it will come into action where in particular transaction tax avoidance is one of the motives.

• This led to a lot of uncertainty as foreign investors feared that this provision will bring the past transactions under the purview of Income Tax act that were completed in last five years since 2007 when hutch-vodafone deal happened and will tax them retrospectively

• This took the foreign investors by shock leading to erosion of investor sentiment and Prime minister Manmohan Singh had to reign in by forming a 4 panel committee headed by Dr. Parthasarthi Shome to look into concerns of foreign investors in GAAR.

 NEED FOR GAAR COMMITTEE AND HOW DID THE COMMITTEE GO ABOUT IT

The investor sentiment already dented by policy paralysis, decelerating growth, spiraling inflation and high interest rates was being further impacted adversely by the clouds of retrospective taxation that was hinted upon by the retrospective clarification in Income Tax act and the first GAAR Draft guidelines issued on june 28, 2012. This impact was significant in the erosion of FIIs from Indian capital market as foreign investors saw lots of ambiguity in Indian investment climate. Anticipating the detrimental effect of the draft guidelines, On june 29,2012 PMO came out with a statement that guidelines posted have been put out for receiving feedback and discussion purposes. Furthermore, PMO stated that these guidelines have not been seen by PM and will be finalized after its approval. A day later it was announced that PM has approved the constitution of 4 member committee headed by Dr. Parthasarthi Shome to undertake stakeholder’s feedback and finalize the guidelines. The series of events followed by posting of first Draft guidelines clearly suggested that was a difference of opinion between PMO and finance ministry.

Dr. Parthasarthi Shome had major task at his hands as these final guidelines would determine the fate of FIIs and hence the investor sentiment in the Indian capital market. A roadmap was laid down to go about the task at hand and the main highlights of the roadmap were:

• Record comments from the stakeholders and the general public on the first draft guidelines that have been published on government website and complete this task by end-July 2012

• Rework the guidelines based on this feedback and formulate second draft of guidelines and publish it for comments and consultations by 31^st august 2012

• Undertake consultations on the second draft guidelines

• Finalize the GAAR guidelines based on the consultations and prepare the implementation plan and submit it to government

HIGHLIGHTS OF SECOND DRAFT OF GAAR GUIDELINES SUBMITTED BY GAAR COMMITTEE

• GAAR delayed by 3 years and will be applicable from assessment year 2017-2018
• Approving panel of GAAR will have 5 members including a retired HC judge and two from outside government in contrast to 3 members ( all from government) recommended by first draft
• Abolition of tax on transfer of listed securities for resident as well as non-resident Indians.Prospective positive impact of this provision: Earlier short term capital gain (less than 1 year holding) used to be taxed at 15% and short term business gain used to be taxed at 30% and to prevent the tax foreigners used to invest via Mauritius route which is a tax haven. This move will make the Mauritius route redundant and will facilitate pooling of funds directly in India.
• Limit of Rs 3 crore has been kept for tax benefit exceeding which GAAR will be applied in contrast to the first draft where this limit was not certain
• Investors from Singapore and Mauritius have been spared from GAAR. The rationale given behind this provision is that these places already have limit of tax benefit in their treaties and so GAAR should not be applied as they already have tax avoidance rule
• GAAR will be invoked only when tax benefit is the main purpose in contrast to earlier draft which stated that GAAR to be invoked where tax benefit is one of the main purposes.
• There will be no retrospective taxation on transactions that happened in past

After taking a glance at the guidelines submitted by GAAR committee, provisions look encouraging and one would think that it would do enough to revive investor sentiment. The main motive of government behind setting up of GAAR committee was to clean up the mess created by the earlier finance minister Mr Pranab Mukherjee who introduced the provision of retrospectively taxing the transactions which made the investment environment ambiguous and shocked the foreign investors. The government sees latest GAAR guidelines as tool to placate the volatility in the investor sentiment. The move aimed at discounting the trade and fiscal deficit woes to some extent by revamping the investor sentiment through GAAR report. But it was not to be as share market in turn discounted GAAR and Sensex fell 0.26
% on the day subsequent to publishing the guidelines of GAAR. Market sees policy inaction and want of reforms as more important issues than GAAR . Also, there is lots of skepticism about delaying the GAAR by 3 years and it questions the government’s effort of GAAR as serious tax reform. It is yet to be seen that whether GAAR will prove to be a positive tax reform or just a shenanigan by Government to improve the investment environment which has been worsened by their inaction.

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