by Santosh Nair
Every bull run needs a poster boy or Big Bull to look up to; that is something typical of the Indian stock market. This time the market found its hero in Rakesh Jhunjhunwala. A skilled trader, but an even better value investor, Jhunjhunwala suffered sizeable losses during the technology rally of 2000. He invested heavily in the shares of public sector firms and other old-economy companies. Simultaneously, he short-sold most of the junk technology stocks being rigged by Ketan.
The stocks Rakesh bought fell, despite the companies being fundamentally sound and even paying good dividends in many cases. And the price of the junk shares that he short-sold kept rising in value, forcing him to buy back those shares at a loss. In short, both his investing and trading calls were going wrong.
When the tech bubble finally burst, he recouped some of the trading losses by again shorting the same set of market-fancied stocks that had caused him grief in the past. But the bear market that followed shrank the value of his long-term portfolio considerably. More trouble followed, as his trades were also probed by the regulator for alleged bear hammering, post the Budget in February 2001.
But Rakesh’s patience and his penchant for quality stocks began yielding fruit as the market recovered. Value investing was back in fashion, and Rakesh was the embodiment of it. His stakes in companies like Titan Industries, CRISIL, Matrix Laboratories, Geometric Software and Hawkins Cookers had appreciated significantly since the time he had started buying them. A feature on him in the October edition of Outlook magazine pegged the value of his 1 per cent-plus stakes in twenty-one companies at Rs 114 crore.
Of course, the market had grown too big over the last few years for any one individual to dictate the trend. When Ketan’s stars were rising, the market was still shallow in terms of trading volumes and quality of stocks. FII activity was mostly concentrated in the top 20-25 stocks. Thanks to dematerialization of shares, the tech boom and the US listing of some Indian companies, more foreign investors were eager to invest in India where there was now a wider range of superior companies to choose from. Rakesh would go on to have a huge following in the market over the next few years. And while he would never evoke the mass frenzy for a stock that a Harshad or Ketan could at their prime, his investment style endured, despite a fair share of bad bets.
Soon he began to be referred to as ‘India’s Warren Buffet’ by the media, a comparison he always resented. Rakesh credited Buffet with having far more wealth and wisdom than him, and in the same breath also maintained that he (Rakesh) was not anybody’s clone.
Hounded by regulators, his mentor and close friend Radhakishan Damani took a break from the stock market to set up a supermarket chain under the brand name of D-Mart.
Year 2004 began on a cheery note for the bulls, with the Sensex closing above 6,000 for the first time ever. The success of the Maruti issue encouraged the government to arrange more stake sales through initial and follow-on public offerings. The largest of them was ONGC’s follow-on offering in March, which fetched the government around Rs 10,500 crore.
A clerical error at the share registrar’s end resulted in HNIs being allotted more shares than they were entitled to. The investors were surprised to see the extra shares when they checked their demat accounts, and many of them immediately sold off their entire lot, hoping to profit from the error.
But pocketing the money was not as easy as they thought it would be. SEBI and the finance ministry swung into action and forced them to return the shares. Being regular traders and well versed with the allotment process, the HNIs could not pretend ignorance.
As the market continued to climb, retail investors slowly began to test the waters, and brokerages cautiously began adding staff. But the market had one big shock coming in May, which led many to think that the boom was as good as over.
The BJP-led NDA coalition decided to call for elections in April, a good six months ahead of schedule, convinced that the public mood was in its favour. But the move backfired, with the Congress and its allies winning more seats than the NDA coalition. The results came as a dampener for the market, which was rooting for a BJP win as the party was perceived to be pro-business and pro-market. Still, the bulls took it in their stride. But their resilience would be severely tested over the next couple of days.
To block the BJP from forming the government, the Left parties offered to back the Congress-led UPA, but without being part of its government. A day after it promised support, leaders of the Left parties began demanding that the government scrap the divestment policy initiated by the NDA government. That made the market nervous, and it showed its displeasure with a 330-point drop in the Sensex on Friday, the day after the election results were announced.
Matters did not end there, and worse was to follow on Monday. CPI leader A. B. Bardhan tactlessly remarked, ‘Bhaad mein jaaye Sensex,’ in response to a television reporter’s query on the Left parties’ stand on divestment. That comment sent the Sensex and Nifty crashing 10 per cent, to the lower end of the intra-day circuit filter. Under the rules, trading was frozen for fifteen minutes. But when trading resumed, there was no let-up in selling. Both the indices fell 5 per cent more and the market had to be closed again. The Sensex was now down 840 points over its previous close and the Nifty down around 290 points.
The last I had seen such a ferocious selling spree was when the Harshad Mehta securities scam had been exposed in 1992. But this was the first time that trading had to be suspended midway through a session because of such a rapid decline in share prices. Angry brokers and investors spilled on to the street facing the stock exchange building and shouted slogans denouncing the Congress, SEBI and Sonia Gandhi. Their rage was only natural, as the steep fall had almost entirely snatched away nearly all their profits painstakingly earned in the last few months.
Trading resumed again for the day a couple of hours later. Congress leaders tried to pacify the rattled market participants by promising to stay on the path of reforms. Simultaneously, LIC and other government-backed institutions stepped in to steady the market with their purchases. The nosedive had triggered margin calls at many broking firms, and most clients were not in a position to arrange additional funds at short notice.
The build-up to disaster had begun the previous week, when the Sensex and Nifty fell around 10 per cent each over the week. In particular, Friday’s 330-point fall in the Sensex had many bulls on the ropes. The stock exchanges imposed ad hoc margins on some large brokers with significant positions in shares that were most vulnerable to a further fall. Trading terminals of many brokers who had been unable to meet margin obligations on Friday had been disabled.
Their finances already wearing thin, many traders had little option but to liquidate their long positions to meet the demand for additional margins. The exchanges would later deny that they had imposed ad hoc margins, but I knew of brokers who had got faxed instructions to collect higher margins from clients in certain stocks.
As soon the market opened on Monday, a deluge of sell orders hit the trading screens as many traders liquidated their long positions, unable to pay the additional margins. A SEBI probe would reveal exactly a year later that the maximum damage was caused by sell orders from UBS Securities Asia.
The Swiss broking firm dumped shares worth Rs 188 crore within minutes of the market-opening. SEBI found that the broking firm had short positions of a cumulative Rs 726 crore in Nifty index futures and some stock futures. When share prices fell sharply, the index and stock futures too moved lower in tandem. The investigation showed that UBS made a loss of around Rs 17 crore on its cash market sales, but gained around Rs 59 crore on its futures positions. On the face of it, UBS stood to gain if prices fell sharply.
UBS initially told SEBI that it had sold the shares in its proprietary account. Later, it changed its version, saying it had sold the shares and futures on behalf of clients who had exposure to India via participatory notes.
Participatory notes – P-notes or PNs – were derivative instruments issued by SEBI-registered
FIIs. The buyers of these instruments were overseas investors who were either ineligible or chose not to register with SEBI. Often, the supposed buyer of the P-note was merely a front for another investor, and that investor too was often a front for still somebody else. And the chain was so long the ultimate beneficiary was well shielded from the regulator’s gaze. The Joint Parliamentary Committee probing the 2001 securities scam had found plenty of instances of wide misuse of PNs during the technology boom of 1999-2000.
Promoters found PNs a convenient tool to launder black money and to prop up their share prices. The peculiar structure of PNs made it difficult for SEBI to trace the true owner; more so if he/they/it happened to be domiciled in a tax haven where banks could refuse to disclose the identity of their customers, citing confidentiality laws.
SEBI asked UBS to disclose the identities of the beneficiaries of the PN accounts. UBS stonewalled SEBI, saying its clients were refusing to cooperate. Under the rules, FIIs were required to be aware of the identity of their PN clients and provide their details to the regulator when asked for them. UBS’s inability or reluctance to disclose the names only strengthened the suspicion many had about PNs – that they were mostly a conduit for round-tripping and money laundering.
The SEBI order indicting UBS highlighted the misuse of PNs but could not prove that UBS had deliberately sold shares in the cash market to profit from its derivatives trades. And the punishment for UBS? A one-year ban on issuing PNs for a year. UBS promptly appealed against the order to the Securities Appellate Tribunal, and in less than two months, won the appeal.
SEBI moved the Supreme Court, but in January 2009 the matter was settled through a consent order. UBS paid a penalty of Rs 50 lakh to SEBI without admitting or denying the charges against it.
The UPA government’s maiden Budget had a pleasant surprise for stock market investors. The 10 per cent long-term capital gains tax was abolished and the tax on short-term capital gains was reduced to 10 per cent from the income tax rate applicable earlier. For those in the 33 per cent income tax bracket, the short-term capital gains tax had more than halved. And investors did not have to pay tax on any shares held for more than a year.
‘All in the name of encouraging retail investors,’ GB smirked, when he heard the announcement. ‘Actually it is the promoters who will benefit the most since they are the ones who trade more often.’
To make up for the revenues lost by way of the new capital gains tax rates, Chidambaram introduced a 0.15 per cent Securities Transaction Tax (STT) on all stock market trades. A key reason for its imposition was the notoriety of stock market players for evading capital gains tax by showing fictitious losses. Also, since this tax was to be collected by the stock exchanges at the time of the trade, players would not be able to escape it. For the government, STT was both an efficient as well as low-cost source of tax.
But the STT sparked a furore among day traders who played for spreads as low as 5 to 10 paise. Unlike capital gains tax, STT had to be paid whether or not the trader made profits from his trades. Capital market players, with support from the stock exchanges, made presentations to the finance ministry, arguing that trading volumes would dry up if day traders stayed away because of STT. Day traders – also known as jobbers or arbitrageurs – were an important source of stock market liquidity. An absence of speculators would make stock prices volatile and hurt even genuine investors, they argued.
The government refused to repeal the tax, but agreed to modify the STT rate. For delivery-based transactions – buy and sell – the rate was reduced to 0.075 per cent. For non-delivery-based transactions, the rate was reduced to 0.015 per cent, and for derivatives transactions, the new rate was 0.01 per cent. Traders and investors could also claim a rebate on their tax liability to the extent of STT paid.
The government had to take a huge hit on its tax estimates for that year because of this revision in STT rates. But an illiquid stock market could have cost the government even more.
It was one of those rare occasions when the powers in Delhi had to soften their stance in the face of sustained protests from the broking community.
Before long, the ingenious brokers would exploit a loophole in the STT and help clients lower their tax liability for a cut of the savings they made. The government hit back by scrapping the rebate after a few years.
After a long gap, 2004 turned out to be a busy year for merchant bankers, with 26 companies raising around Rs 12,400 crore through IPs. They included the Rs 5,420 crore IPO of India’s number one software services exporter, Tata Consultancy Services (TCS). The issue drew an enthusiastic response from investors, even as the overall market was recovering from the post-election drubbing in May. The retail portion of the issue was subscribed three times, and the issue fetched 12.5 lakh applications. Overall, the issue was subscribed 7.7 times.
Again, concerns that the TCS IPO would cause a liquidity squeeze in the secondary market turned out to be unfounded. Another Rs 23,000 crore was raised by companies through the year by way of FPOs, preferential issues and rights issues. Despite the massive capital mop-up, the Sensex made a new high by December.
I decided to upgrade my Opel Astra to a Mahindra Scorpio.
22
In the Name of Wealth Creation
It is a standard practice for most promoters to siphon money out of their companies. Their business would be flourishing, but very little of the money would show up in the company’s books. Only a certain portion would be booked in the company’s accounts, while the rest would be diverted to the promoter’s personal accounts.
But, as the bull market began to gather steam, promoters realized that there was more money to be made by showing the full revenues in the company’s books, and maybe even showing more revenues than there actually were. The higher the earnings and earnings growth potential, the more value the market was willing to assign to a stock.
And so began the great game of ‘market capitalization’ and ‘wealth creation’, as many promoters went in for an image makeover, helped by market operators, analysts, fund managers and last, but not least, a friendly media.
Market capitalization is the share price multiplied by the outstanding number of shares (equity base) of a company. A huge equity base does not necessarily lead to a large market capitalization, as a large number of shares floating around would make it hard for the stock price to move up. So the key to higher market capitalization is a fat stock price. The higher their market capitalization (or valuation of the company), the easier it became for companies to raise more funds by selling the least number of shares.
By now I had become very friendly with an analyst I had nicknamed Sherlock because he was forever suspicious of promoters and the numbers companies put out. We regularly met over drinks. During our discussions, he would tell me a thing or two about his profession, and in turn I would tell him a few things about trading.
One evening we had a very long chat, during which he told me about the ways in which promoters manipulated the earnings of their firms. According to him, manipulation was more rampant in mid-cap firms, though large-cap firms too were not always above board.
‘It is like this – all milk is adulterated, only the proportion of water varies,’ Sherlock explained to me.
One way to manipulate numbers was to recognize revenues in the books of accounts ahead of time when there was no certainty that the company would receive the payment. A property developer’s luxury residential project may be fully booked on the very first day of launch, but there could be cancellations or defaults later on. A products firm could reduce its inventory by getting dealers to overstock by offering them favourable credit terms. Companies also booked fictitious sales or showed income from non-core operations (for example, income from investments in shares, bonds, mutual funds) as sales. There were companies that dabbled in their own shares and showed the profits in their earnings. Some companies would not make adequate provisions for doubtful receivables, tax disputes and other liabilities. In the b
anking industry, ‘evergreening’ of loans is a standard procedure to lower provisions for bad loans. The banks issue a fresh loan to the troubled borrower so that he is able to repay his earlier loan with it, thereby technically avoiding a default.
In a rising market, promoters were keen to show off a fat bottom line, real or fake, as it helped them raise equity capital at fancy valuations. But in a bear market, promoters would usually revert to their old trick of siphoning off money from the company’s books. They know that showing good earnings is of little help when the market is down because prospective investors are finicky about the price they are willing to pay.
The most common strategy to pilfer cash from the company’s books was to suppress receipts and inflate expenses. These could relate to a wide range of items, from sales and promotional events, to capital expenditure programmes.
Merely studying the profit and loss statements of companies would tell investors little about the funds that were leaking out. Only those working in the company or in the same industry would know the true picture. In some sectors like liquor, a good deal of sales were done in cash, outside the company’s books, because of the steep difference in sales tax rates across states. Many companies would under-report production to evade central excise duty, sales tax and income tax. Firms also diverted a part of their sales to associate firms in locations where tax rates were lower. Sometimes companies sold a chunk of their goods to dummy entities below their fair price. The dummy entities then sold those products at market price, ensuring the profits from the sale never reached the company’s shareholders. If the company catered to export markets, promoters could take the money out of the country through this route. The company would sell its products to a promoter-controlled entity in Dubai or Singapore at a discounted rate. That entity would then sell the product in the international markets at its true price, and the difference would flow into the bank accounts of the promoters in Switzerland or the Cayman Islands.
