Remembering some of India's primordial legacies

I was reading an article in The New York Times on how nepotism is big in India. There is no question that that is the case, be it in the business world or elsewhere. In a country where little separates management and ownership, frat-boys (read offspring of owners) are often groomed to run corporations when shareholders wouldn’t want them to be associated with deploying and managing their capital. We live in a country that promotes and protects legacy and questioning the “obvious” almost always attracts wrath of those who are beneficiaries of the system that ensconces them. That is also one of the reasons why inefficiencies linger on for long in such economies.

In mid-2011, Jairam Ramesh, India’s Union Environment Minister, made a statement that was perfectly corroborated by facts, but was nonetheless targeted by fanatics who remain closed to constructive criticism – “Faculty at some of India’s better known academic institutions are nowhere competitive at a global level”. Anyone who has attended a half-decent business school outside India can take one look at the credentials of most teachers at top Indian institutions and come to the same conclusion as Jairam, possibly not even being generous enough to compare them globally. Senior professors at most decent global b-schools average more than a few published journal articles vs. under one per prof at India’s supposedly #1 school and the few that have been written are all focused on India-specific experiences. For whatever reason, Jairam’s fair observation riled a lot of people who are made to believe that graduating from some of these institutions is the best thing that can happen to those who are fortunate enough to attend them.

India’s education and administrative system is deeply entrenched in entitlement and entitlement in India either comes from pedigree (family, connections etc.) or is invariably a function of nerdability. Consider this – One is given the mandate to build a local economy within a certain municipal area and he/she is required to build an administrative team. Would anyone with IQ higher than that of an owl look for such people by screening them as follows – Who can solve complex equations quickly, or who best knows India’s pre-independence history, or who can articulately recite words of philosophical scholars ?. Unfortunately, we look out for the nerdiest people and hope (we are actually confident) that they would be able to administer such an area better than someone who is smart, resourceful and has passion to administer it. That’s how we fill key positions within our administrative services and that’s how we select candidates who will be linked with those professors whose ability is lamented by the likes of Jairam. Unquestionably, sermons from such teachers when coupled with nerdability of their students would create India’s best leaders. You dare not doubt that. That these institutions are even perched at the top of India’s academic landscape is only a reflection of how poor their competition is. Also, the nerd we selected for that administrative role will likely retire without creating any legacy of his own. It’s ironical that the system that put him/her there has created its own legacy that India finds hard to wrestle with.

Performance Update - Winding down funds invested in US

With my Indian managed accounts platform about to be launched, it will be increasingly hard to actively manage holdings in the US. As a result, holdings within the US have been significantly reduced and there is no near term desire of actively managing a US focused book of securities. As of the end of the first week of May, book was up 5.5% YTD and 46% since inception (July 2008). That compares with 3.7% and 12% for Dow Jones AllHedge Index over the same period (see Exhibits 1 and 2). Save for the big cash position while the book was being winded down, I could have expected to be up in double digits YTD. Except for Tata Motors [NYSE: TTM], every security in the book (remaining or liquidated YTD) had done at least as well as the market or better, with the long book up about twice as much as S&P 500 this year. Overall, hedge funds have lagged the bounce back in small caps to ensure that they fritter the entire 11 points advantage over Russell 2000 (and then some) from 2008.

For now, I don’t plan to publish any investment opinion on this blog.

Exhibit 1 - Cumulative Performance through May 2011



Exhibit 2 - Monthly Performance Summary



Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

2Q10 Performance

2Q10 was understandably brutal – We are set to face tough direct stimulus (tax credits and exemptions, extended unemployment benefits, incentives etc.) comparisons over the next 12 months, European situation remains uncertain, and US employment situation is significantly worse than most expected.

About half of equity holdings ended up in 2Q10, with VSNT being the only name underperforming the broader market. Overall, more than 90% of all holdings outpaced S&P 500 in 2Q, with net exposure remaining largely unchanged versus the previous quarter. Contravest finished 2Q10 up just under 2%, versus sharp double digit declines in S&P 500 and Russell 2000. Contravest is now up 7%+ YTD, comfortably ahead of the broader market and most peers. In under 2 years since inception, Contravest has outperformed S&P 500, Russell 2000, CS Tremont Allhedge* and Barclays Global Bond Aggregate by 50, 47, 33 and 28 pps respectively.

Note: CST AllHedge performance for 06/10 is not available yet.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

1Q10 Performance

Contravest finished 1Q10 up 5.5%, 50 bps ahead of S&P 500. Including dividends, S&P 500’s performance was about in line with the portfolio. Net exposure increased during the quarter, with portfolio beta averaging around 0.55, ahead of the sub 0.40 average in 2009. Since inception in mid-2008, Contravest is up 30%, outperforming S&P 500, Russell 2000, CS Tremont AllHedge, and Barclays Global Bond Aggregate by 37, 35, 31, and 25 pps respectively.

Small cap stocks have rebounded so strongly that they have all but made up for the relative underperformance vs. hedge funds in 2008. Most hedge funds failed to safeguard their 2008 outperformance margin while equities resurged. Fund of funds continued to underperform, trailing S&P 500 by 4+ pps. One can’t help but wonder if poor due-diligence can turn out to be so costly that capital moves to fund of funds to further allocate to active managers – If you just take the number of hedge funds caught in fraud last year and imagine a hyperbolic seasoning curve to identify cumulative frauds, I’ll be surprised if materially more than 3% of all existing hedge fund managers will be caught in fraud over the next 5 years (Is that large enough to warrant investment in a vehicle that underperforms in almost anything other than a bearish market. Since 2002, the only point when fund of funds cumulative returns caught up with the broader market was at the end of 2008). Further, despite the “due-diligence”, it is well documented that FoFs were the biggest losers in the largest reported fraud. I am sure there are some FoF managers that add value but it is likely a small minority.

Exhibit - Cumulative performance through 03/31/10

Note: CST AllHedge performance for 03/10 is not available yet.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

The quest for cash-rich potential targets yields a catch

With market providing ample opportunities, screening for M&A candidates wasn’t the most attractive strategy to pursue last year. Investors were looking for more than the “puny 30%-40%” acquisition premiums. Now, with massive output gaps across the world straining recovery prospects, 2010 will likely shape up as the year of consolidations, with strategic acquirers overwhelmingly taking the cake, in my view, at the expense of financial sponsors (and “puny 30%-40%” potential premiums appear much more attractive). It is as likely that consolidation focus will remain in the US and EU, where output gaps are the widest, ample liquidity is available (cash now accounts for about a fifth of S&P 500 assets), valuations most attractive, and credit markets relatively thawed.

Why financial sponsors will continue to sit on dry powder. Cash availability by itself doesn’t position financial sponsors (those focusing on non mid-market deals) strongly enough to put their capital to work. Lack of exit issues and higher equity contributions (“Tribune” transactions are passé) are among the key challenges to non-strategic buyouts.

CDO-backed deals (vs. those not backed by CDO structures) typically allowed LBOs to garner about 10% more contribution in transactions from banks, high yield bonds, and mezzanine debt. Such deals therefore had more wiggle room. Revolver drawdowns were frequently not required at outset, allowing sponsors more flexibility to re-raise. Loss of that appetite, coupled with requirement of higher equity cushions and already stretched existing investments, has effectively taken a lot of “free lunches” off the table. Financial sponsors are essentially being forced to increasingly restructure businesses without the luxury of wringing synergies through combining newly acquired businesses with over-burdened existing investments. Upside assumptions have been scaled back sharply. In anything other than very low-levered businesses, financial sponsors are much worse positioned against strategic buyers than they were in recent years – In 2009, strategic buyers accounted for almost 77% of middle-market deal activity vs. 69% in 2007. However, selective opportunities, particularly in the mid-market, will be actively pursued by financial sponsors. It is worth noting that a host of new players have recently entered the mid-market financing arena, with regional banks getting more active after CIT’s filing last year.

Here are a few businesses that may be in a position to get acquired without unduly stretching strategic buyers (see Exhibit 1). While there are quite a few ways to do this exercise, I am leaning towards businesses with strong cash positions in industries that have room to consolidate. Obviously, excess capacity can also turn out to be a significant distraction to consolidation if the industry happens to be over-fragmented – Why would you acquire capacity if you already have enough of it and new addition doesn’t benefit your pricing power ?. My current priority is to allocate an undisclosed % of capital to potential near-term targets. Some of these may not fit my usual idea of attractiveness but at this point I am comfortable with including potential targets that might otherwise not be on my radar, as long as their takeout proposition is compelling. Given the focus on “near-term” events, most of these positions will be liquidated if expected events take more than a year to occur, assuming nothing else changes. Since this strategy focuses on acquisition targets, the intention is to keep the focus limited to names with significant float and where trade isn’t crowded. I’ll summarize the following two situations – Forest Labs (NYSE: FRX; $29.48) and Versant Corp. (Nasdaq: VSNT; $15.12).

Exhibit 1 - Cash-rich potential targets

Sources: Company filings, Bloomberg
* QXM's shares o/s includes about 6 mil new shares (including restricted stock) issued post 3Q earnings, following exercise of some converts.
** includes short-term investments

FRX – trap of a kind. Usually, when I see too much pessimism, my eyes twinkle. That said, I am cognizant of the fact that in majority of cases valuations are reflective of something concerning. FRX is no different, except that it’s probably a bigger value trap than I normally see. At least there is something that makes it interesting. If cheap is all you ask for, blindfold yourself and start throwing darts on a board full of S&P 500 stocks. Odds are that you’ll hit something where current earnings power is significantly below what you saw a few years back. Some, such as FRX, are unlikely to regain that earnings power anytime soon.

I agree that FRX has a huge cash stash but the core business isn’t as cheap as it looks. The argument that shrinkage from patent expirations is “more than priced in” is bogus. For a business that will likely lose about 2/3rd of its existing sales between 2010E and 2015E, FRX is certainly not a valuation outlier (see Exhibit 2a and Exhibit 2b).
Exhibit 2a - Est. revenue loss from patent expirations

Exhibit 2b - Core PE vs. est. revenue loss


Source: Internal estimates, GPA, SEC filings, Bloomberg
Notes: Est. revenue loss was calculated as following - Price is expected to get cut in half, with unit share getting halved within 5 years of expirations; The statistically significant trend line in Exhibit 2b suggests one significant outlier – NVS; Core PE is adjusted for net cash position - Net cash is subtracted from market cap and after-tax interest income on this position is excluded from earnings.

Even if one builds in a 75% chance that each Phase III drug will launch at the expected time and ramps up to its expected goal even faster than expected (full achievement within 3 years vs. 5), their expected contribution in 2015E will still end up being no more than ½ of sales lost from Lexapro and Namenda going off-patent. Further, the whole idea revolving around cash being used to acquire new licenses, which in turn will offset revenue loss, isn’t very compelling either. Come to think of it, FRX’ current Phase III pipeline cost the company close to a billion dollars in just up-front payments (including $480 mil that the company paid for Cerexa, which came with Ceftaroline and two other early stage drugs, in 2006). Add in contingent payouts and you’ll come close to FRX’s current cash holdings. Also, the entire pipeline was acquired/licensed in Phase II or later, with launches expected 5-7 years after the deal. Even then, at its estimated prime, the current pipeline will likely not match Lexapro’s current contribution (Never mind Namenda). Effectively, FRX’ current cash is more of a “replacement” lever than a “growth” lever, if that. FRX in all likelihood will be a significantly smaller business by 2015E. For those that wish to look that far, it might be worthwhile looking at valuations on C2014E estimates, which suggest that FRX is the priciest drug name in town, not the cheapest. The fact that I estimate an incremental 30%+ loss in revenues in C2015E (from earlier patent expirations) doesn’t even need to be factored here. This is one of the biggest value traps I’ve seen in recent times.

VSNT – Potential mid-market buyout candidate. Object oriented technology can certainly not be categorized as a growth business. Given legacy issues with relational databases, ramp-up is very slow and sales cycles can easily extend beyond a year - A company like VSNT typically adds 1-2 clients a quarter, with billings starting way below that at existing clients. However, VSNT is truly a cash engine, averaging 30%+ FCF margins. Further, given the niche VSNT operates in, acquisition opportunities are few and far in between, further bloating an already bloated cash balance.

The next identifiable opportunity area for object databases is in MMOGs – VSNT’s object database has been used in developing a few MMOGs. Still, object databases haven’t been as successful as expected while competing with relational database usage within MMOGs. One shouldn’t get too excited about this opportunity yet.

While this is clearly a sitting takeover duck, the problem is integrating this business and its difficult to make a strong case about anyone truly interested in building a large ODBMS platform. The two leading vendors are Versant and Objectivity (privately held). Progress Software (Nasdaq: PRGS; $28.23) competes in this space through its Objectstore platform, which hasn’t been its focus area. Also, ObjectStore is likely no more than a mid-single digit contributor to PRGS’ sales, and PRGS is, in my view, more likely to entertain bids by a buyer than to expand its ODBMS capabilities by acquiring an Object Management business. I could be wrong on PRGS’ strategy, but it doesn’t hurt my eventual thesis here.

Interest from relational database vendors isn’t straightforward either – Incorporation of object oriented features in RDBMS, and high switching costs provide ample safety from direct competition and therefore put a dampener on traditional DB vendors aggressively pursuing ODBMS investments.

VSNT isn’t a type of business I’ll typically buy. There is, at best, an outside chance that a strategic buyer might step in. However, it’s significantly more attractive to a financial sponsor than to a strategic buyer. I’ll bet you that it isn’t every day that you find a business, where despite paying a 40% premium, contributing 60% in equity to the deal, and doing little to squeeze out material synergies, one ends up with IRR in the mid-20s (see Exhibit 3). With no street coverage, such candidates may be out of the radar for now but it’ll likely get attention if it stays here too long.

Exhibit 3 - Est. buyout summary for VSNT


Source: Internal estimates, Company filings, Bloomberg

On the radar – QXM, TSRA. I have certainly passed on QXM (too little float, deteriorating pricing power and limited transparency). TSRA remains on the radar but that trade is too crowded, for now.

Qiao Xing (NYSE QXM; $2.49) faces variety of challenges in its end market but market is effectively pricing the company where cash is being offered just to acquire it (underlying business comes for free). The typical problem with such situations is float, with deal largely dependent on a handful of holders and many of these guys often under-estimate the severity of challenges and won’t sell unless they absolutely have to. The biggest issue at QXM, just as with many other Chinese handset makers, is cut-throat price competition and continued pressure from “fakes”. “Fakes” (also known as Shanzhai) possibly account for more than a fifth of all phones assembled in China, and may be one out of every three sold in the domestic market. Given immense fragmentation, continued cuts by larger vendors, and struggling end demand, handset component providers have also been unwilling participants in the ongoing price competition for handsets in China, which will likely continue in the foreseeable future. But that aside, QXM’s performance has been abysmal – In the two years ending 3Q09, shipments dropped by almost two-thirds. Over the same period, Chinese domestic handsets market grew by more than 20%. Thanks to a new launch of VEVA phones in 2H08 (sounds disturbingly similar to VIVA, which is an HTC brand), QXM was able to temporarily stabilize its ASP. Then came VAVE (Shanzhai’s answer to VEVA) and QXM’s strategy got derailed again. Since 2H08, management had been stressing its strategy to focus on the “high-end” VEVA phones. With VEVA shipments coming under pressure recently, QXM was forced back into launching lower-priced versions. That however, didn’t help in stemming a continued drop in shipments, which sequentially declined 40% in 3Q09.

Attractive handset businesses sell into markets that protect them from illegal competition, and have the culture and know-how of constantly re-inventing themselves. QXM has neither. QXM’s only true attractiveness is from the viewpoint of someone acquiring facilities and using them to export shipments, effectively yielding the CECT brand redundant. Trying to compete in the domestic Chinese market is an exercise in futility – Market is unwilling to pay a premium for differentiated technology (assuming that wireless infrastructure can support it). Further, return on innovation is paltry as handsets are quickly dismantled and fakes quickly eat away at price and unit share. Regulatory intermediation is therefore required to make it attractive to sell into the domestic market. Whether bold decisions that will hurt a $5 bil+ industry will actually be taken is another debate.

This isn’t the first time that an Asian handset business is effectively being given away. Blow-ups such as BenQ’s acquisition of Siemens’ handsets business or TCL’s acquisition of Alcatel’s are prime examples of such situations. Further, two of the chief reasons behind devices’ acquisitions are technology and brand. It’s hard to argue that QXM fits either way. One way to think of QXM’s situation is as following – If price drag continues at current rate for another year, investors’ implied premium on offer* (assuming an acquirer coughs up 40% premium to buy QXM) can be eaten away within 2 years of owning this business, assuming no incremental deterioration in pricing after the first year of ownership. While QXM is certainly cheap (any upside comes for free), a potential acquirer will have its work cut out for it. Admittedly, this one can go either way. It looks cheaper than what it may look like after a year of ownership by a potential buyer. I am not comfortable in such symmetric situations.

*Cash that the market will pay the acquirer to acquire.

Disclosure – Author has a long position in VSNT.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Cumulative Performance [through Dec 2009]

Contravest finished the year up 18%, in line with broader hedge fund indices, following a 5% gain in 2008. This came on the back of conservative portfolio construction and no use of leverage, with portfolio’s beta averaging under 0.4 in 2009. As at the end of December 2009, Contravest was up 23% since inception in 2H08. That compares with -12%, -13%, -3%, and +5% for S&P 500, Russell 2000, CST AllHedge, and Barclays Global Bond Aggregate respectively, over the same period.

Exhibit - Cumulative performance through 12/31/09

Note: CST AllHedge performance for 12/09 is not available

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

All that glitters.......

Think of an event - Usain Boltesque inflation, gold reserves dry up before we leave this planet, dollar’s quick demise, central banks enter into a “happy ending” wedlock with the shining asset, and a concomitant denouncement of the most used method of transacting – paper. Throw in Sweden winning next year’s soccer world cup in the list (Who cares if it hasn’t qualified). With gold trading where it is, one better come up with some sort of a story, which is better than all of the above, and do so quickly.

The finite supply gobbledygook is useless when pricing gold over any realistic timeframe. The finite supply argument just doesn’t hold for a physically non-depreciable asset like gold. Gold’s actual usage (ex-investment) is down by almost a fifth since early 90s. The stock of available gold meanwhile has consistently grown over this period (see Exhibit 1a and 1b). Even assuming that non-investment usage decline stabilizes in the foreseen future, availability will likely continue to outstrip usage, independent of new discoveries or lack thereof. Rapidly dwindling supply just isn’t one of the factors that can support gold’s current price.

Exhibit 1a – Global per capita stock of gold


Exhibit 1b – Per-capita non-investment usage of gold vs. Per-capita stock

Source: Internal Analysis & Estimates; World Gold Council

The father of all decouplings in play. Over the last four decades, gold has comfortably outstripped inflation and currencies of dollar’s biggest trade partners. Over this period, gold is up more than a whopping 17x, well ahead of 5.1x and 1.5x increase in price levels and dollar’s chief trade currencies respectively (see Exhibit 2). Even M2 growth hasn’t kept pace with gold – M2 is up slightly over 10x since the early 70s, including a 5% increase over the last twelve months, comfortably underperforming gold.

Exhibit 2 – Gold vs. CPI and USD’s TWER

Source: WGC; Federal Reserve; BLS

It isn’t a “Chindia consumer” effect either. India and Greater China account for just under 40% of global gold demand, about where they were in the early 90s. For all the hype, India’s per-capita consumer gold consumption hasn’t kept pace with underlying economic growth. Realty and stocks are the new flavors. To put things in perspective, RBI’s recent purchase of 200 tonnes from IMF doesn’t even offset the loss of India’s consumer gold demand this decade.

So, what is gold discounting ?

Demise of the dollar ?. Besides death, few things in the world could be certain. The gradual decline in the dollar is as close as it gets. At some point it'll pass it's global reserve currency baton to another liquid currency, just as it acquired it at the turn of the 19th century from the sterling. The perennial rise in the US trade deficit only necessitates the global need to diversify into new currencies, which is exactly what central banks have been doing this decade. But it’s clearly more than priced in an asset that is up by more than 17x since early 70s, while currencies of US’ largest trading partners have appreciated barely 50% against the greenback over the same period.

…..or perhaps an unprecedented sovereign default ?. Both Greece and Ireland are ticking sovereign debt time bombs (see Exhibit 3). What is surprising however is the magnitude of the after effect that is apparently being priced into gold. It appears that the gold bugs might be working on the hypothesis that central banks will dump Euros in the event of a sovereign EU default and aggressively buy gold - Since most of gold stock is tied in jewelry and central banks hold just about half as much in gold as they do in Euros, Gold has no way to move but up. In my opinion, given underlying liquidity and re-investment challenges, dollar will likely be the prime beneficiary of any weakness in the Euro arising from a prominent EU default, neutralizing the impact from the advertised “rush” into gold, which will nonetheless occur to some extent.

Exhibit 3 – Euro-denominated sovereign debt within euro-transacting economies

Source: IMF; Fitch Ratings

……or maybe a new-found wedlock with central banks. The simplest argument in gold's favor is the growing chorus among certain big emerging market central banks to accelerate their ongoing diversification process. In that context, it's worth noting that emerging market central banks often rush into gold during sluggish growth periods before slowing their purchases down in recovery years. Further, while their aggressive buying may have previously supported strong appreciation in gold, their investment record is suspect, at best - Gold price virtually stagnated for more than a decade following 1988, which incidentally was the biggest year for gold purchases by central banks in almost three decades (see Exhibit 4).

Exhibit 4 – Net central bank gold purchases vs. gold price

Source: GFMS

At these giddying levels, one can’t be blamed for trying to factor in anything and everything to justify the price of gold. Potential payoff in an extreme case however, is unlikely to nearly compensate you for the price you are paying up front. By now, gold bugs are used to such profound levels of malarkey that I suspect that events can unfold in a way that can justify the asset's glittering price tag.

Appendix - Valuation snapshot for global gold miners

Source: Bloomberg; Company Reports



DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.