Friday, March 12, 2010

Valuation Models

A private equity player of my acquaintance once confessed that he had a basic rule of thumb about investments: double estimated expenses and halve projected future profits!

There are more systematic methods of valuation. Some valuation methods are themselves optimistic, others conservative. The multiples assigned to the valuation may also be conservative or optimistic. For example, the price to book value (PBV) ratio is a conservative valuation method. The underlying assumption: in bankruptcy, the investor will receive some portion of the original investment back. A cut-off PBV of 1 or less would be a conservative multiple.

But in an emerging market such as India with its high growth rates, a more optimistic PBV multiple can be assigned. In fact, if one examines average index PBV since 1991, the PBV has never dropped below 1.5.

A dividend yield-based valuation method is also conservative. It assumes no capital appreciation and treats the original investment like debt. Again, a high or low cut-off yield could be set depending on the risk-appetite.

Earnings growth-based valuations such as the PEG (Price-earnings to projected Earnings Growth) ratio are optimistic. A PEG valuation implies that a reliable projection of forward earnings and forward earnings growth is possible. A PEG multiple of less than 1 is conservative but the valuation method itself is optimistic.

Another, more conservative valuation method using earnings, is comparing earnings yield with the yield from a risk-free instrument. If the earnings yield is higher than the risk-free yield, the stock is worth investment. Again, conservative investors will keep greater margins of safety.

In a bull market, people give maximum weight to PEG ratios. In bear markets, more conservative methods come to the fore. At the peak of a business cycle, businesses will tend to be optimistically valued at high multiples. At the bottom, the same businesses will be available at low multiples.

In fact, historically, peaks and troughs in the same economy tend to be associated with similar levels of valuation. In India, bear market bottoms tend to be associated with conservative average multiples. Usually the Nifty will be available at an earnings yield that is higher than the 364-day T-Bill yield. The PEG will be well below 1. The Price-book-value ratio will be down to less than 2.5 and the Nifty's dividend yield will be over 2 per cent.

At the top of a bull market on the other hand, these multiples are all optimistic. The PEG will be 1 or higher. The earnings yield will be below the T-Bill yield. The PBV will be higher than 4 and the dividend yield will be below 1 per cent. Usually the PEG ratio is the last to go into the red zone by rising above 1. This is because the PEG is subjective and growth estimates tend to be optimistic during bull markets. There are minor variations but these average multiples have held good through the cycles of the last 15 years. This means that a conservative value-investor can buy when the multiples are in the bear-market range. And, it is time to sell when the multiples are in the range of a bull-market top.

Since January 2006, most of the valuation multiples have been high. However until late 2007, the PEG was below 1. It was only in early 2008 that the PEG rose beyond 1 and gave the final sell signal. By then, the market had already peaked.

The crash in October has pulled all the valuation multiples back close to the levels that would be expected at a bear market bottom. Right now, at a Nifty level of 2900, the PBV is at 2.42, while the dividend yield is 1.96 per cent and the PE ratio is 12.57, with an earnings yield of 7.9 per cent in comparison to the T-Bill yield of 7.4 per cent.

At the 2550 levels that prevailed for a while in late October, these multiples were even more attractive. The PEG ratio incidentally is close to 1. While the current PE ratios have dropped, so have the forward earnings growth estimates for 2008-09. But given the turmoil, there could be further EPS downgrades.

Is it worth buying into this market? Yes, it looks that way. Certainly systematic accumulation at these prices should work over the long-term.

This column appeared in the November 2008 Issue of Wealth Insight.


Wednesday, March 10, 2010

Ask your wealth manager for money back.

A few months ago, I said I wanted to be a mutual fund agent because it was a great life. I change my mind – I want to be a wealth manager instead. Mutual fund agents are limited to earning commissions on just mutual funds, and thanks to SEBI, those are now in the realm of sane amounts. Wealth managers on the other hand, have whole suite of commission eating opportunities – real estate funds, private equity funds, structured products, and if nothing else, the erstwhile ULIP, which was created for everyone except the end customer to make money. It really is a phenomenal life. You don’t really need to make any investment decision and if the client does lose money, you can conveniently blame the fund manager, because you never handled the money in the first place. You appear smart and sophisticated because you can apparently do “asset allocation” and “risk management”, people trust you because they think you know how to evaluate products, when in reality, you are pushing high commission products down people’s throats.

Do you know what the highest selling products in the wealth management market have been?
ULIPS, for one, because distributors are earning as much as 50% of the premium in commissions, entirely upfront. Private equity funds are another market favourite. They can lock-in capital for 3 years, and pay the distributor a hefty 3-4% commission upfront. Why make 1% in trail on an equity mutual fund, when you can sell a client a more exotic product that pays you four times the fees, all upfront?

Even worse, individual investors don’t realize the curse of commissions, because there are no entry loads and wealth managers claim to be product neutral. The reality is murkier. Because a fund house has to pay a distributor commission, he has to charge you higher fees, so there is enough for everyone to eat. The reason equity funds in the US charge 0.75% to 1% while Indian funds charge 2% is not because Indian funds are adding twice the value – it’s because in India, a fund manager has to feed the distributor to survive. The total fee an equity mutual fund manager earns is around 2%, typically paid every quarter. Of this, even after the change in SEBI regulation, the fund house has to pay as much as 1.5% of the fee as commission to the distributor, most of it upfront. The fund manager, at the end, is left with a meagre 0.5%. Moreover, the fund manager is paying the distributor before he earns most of his fees, only to have the distributor convince the client to buy another fund in six months. Besides the atrocious principle that a distributor is earning more than the individual managing the money, the practice is driving fund managers bankrupt. No wonder most AMCs in India are unprofitable. Worse, it’s killing innovation in the investment market because a fund house’s only incentive is to create long lock-in products that can pay the highest commission – think ELSS or tax-saver schemes.

There is a solution to the problem, a drastic one, but one that investors should think about. Wealth manager should be happy with the advisory fees they are charging, and if they aren’t charging advisory fees, they should start charging them. They should then tell the customer exactly what commission they are earning from each product they are selling, and REFUND the whole commission back to the client. A client will see the commission wealth managers earn and the incentives they actually have, and a wealth manager will truly be product neutral. The customer will pay less investment management fees because he doesn’t have to bear the cost of the distributor, and will pay the wealth manager an advisory fee he deserves. The net results – clients will pay for the services they need and investment professionals for the value they actually add, not the bargaining power they have as middlemen. If a client doesn’t need advice they won’t pay for it, and if a wealth manager cannot give advice, he won’t get paid for it. Simple.

End clients are the only ones who can clean the asset management system of the corruption of commissions, ultimately for their own benefit. Maybe then I won’t see clients who have had wealth managers invest them in 95 different mutual funds (and this is not an exaggeration) or 70-year old retirees who have been sold private equity funds by their investment advisor. Maybe then, we will see a growth in what is right now a very small breed of wealth managers who refuse all commissions and are happy just giving advice. And maybe then, the fund managers of the world will design great investment products, rather than great commission generators.

The next time you talk to your wealth manager, tell him to show you a statement of exactly what commissions he has earned. There is enough competition in this market that you, the end client, can get with the question. And if your wealth manager doesn’t agree, find a wealth manager who will, because they exist. Pay the right fees and do all of us a favour – go, ask for cash back.