Concept: Ring-Fence

#23

I came across this concept when working on a supply chain problem, where one of the requirements was to 'ring-fence the inventory so no other businesses can access it.' Turns out, it has a connotation in finance too.

What?

• A virtual barrier segregating a portion of an individual's or company's financial assets from all else
• Usually done to reserve money for some reason, reduce taxes on the individual or company, or to protect the assets from losses incurred by other activities
• Can also be used as a method for mitigating liquidation risk or to improve a corporate credit rating

Example

Moving a portion of assets offshore to reduce an investor's net worth

History

When Warren Hastings took charge as the Governor-General (1772-1785) at a critical period of British rule when the British were to encounter the powerful combination of the Marathas, Mysore and Hyderabad, he introduced a ring-fence policy, aimed at creating buffer zones to defend the East India Company's frontiers

Related

Ring-fencing in banking - a new regulation requiring the largest UK banks to separate their core retail banking services from their investment banking and international banking activities

Concept: Golden Parachute

#22

What?

• Contracts in the form of substantial benefits given to key executives who have been laid off after a takeover
• Form of poison pill 

Concept

• Used as a type of anti-takeover measure
• Named so because their aim is to provide a soft landing for employees at higher levels who have lost their jobs
• Benefits may include cash bonus, insurance, stock option, severance pay, pension package
• Compensation is usually thrice the annual basic salary of top executives

Disadvantages

• Controversial practice 
• Lucrative for short-lived CEOs and low-performance executives, who get paid large sums for less or poor work
• The target company becomes less attractive when the Golden Parachute cost is a lot higher for the acquiring company

Examples

• Dell Inc.'s merger with EMC Corporation compensated EMC's CEO with $27 million
• CEO Meg Whitman of HP may receive over $9 million if there is a change of control at the company and more than $51 million if she is terminated
• If in May 2016, the federal court had not blocked the merger, Staples Inc. and Office Depot Inc's merger would have resulted in Office Depot's CEO collecting $39 million

Similar Terms

• Golden Handshake
• A contract clause wherein the employer provides a significant severance package to the employees who have lost their jobs
• Golden Coffin
• A death benefit package awarded to the heirs of high-ranking executives who pass away during employment
• Silver Parachute
• Special compensation for specific employees when their position becomes redundant in the company 

Concept: Poison Pill

#20

What?

• Counter to Greenmail
• Defense strategy used by a target firm to prevent a hostile takeover by another company via diluting its shares

Concept

• Poison pill: something that's difficult to swallow or accept
• Allows existing shareholders to purchase additional shares at a discount and thus diluting the ownership interest of the hostile party
• This process raises the acquisition costs thereby deterring takeover attempts

Origin

• Devised by Wachtell, Lipton, Rosen, and Katz (legal firm in NY)
• Been around since the 1980s 
• Spies used to carry poison pills to avoid being questioned by their enemies when captured

Types

• Flip-in, flip-over (among others)
• Flip-in is more commonly followed

Flip-in Strategy

• Allows shareholders (except for the acquirer) to purchase additional shares at a discount before the takeover is finalized
• Though purchasing additional shares provides shareholders with instantaneous profits, the practice dilutes the shares already purchased by the acquiring company
• Provisions of flip-in usually in the company's bylaws or charter itself

Flip-over Strategy

• Allows stockholders of the target company to purchase the shares of the acquiring company at a deeply discounted price if the hostile takeover attempt is successful
• A target company shareholder may dilute equity by buying the stock of its acquirer at a two-for-one rate
• The acquirer may thus avoid the acquisition in the case it perceives a dilution of shares after the acquisition

Examples

• 2012: Netflix (NFLX) announced a shareholder rights plan after investor Carl Icahn acquired a 10% stake
• Any new acquisition of 10% or more, any Netflix merger, sales, or transfer of more than 50% of assets would enable existing shareholders to purchase two shares for the price of one
• Icahn criticized this move as "an example of poor corporate governance"
• Netflix shares soared to $304 by July 2011
• The poison pill would allow the stock to reach a price of $350 per share
• July 2018: Papa John’s (PZZA) adopted a poison pill to prevent ousted founder John Schnatter (30% stakeholder) from acquiring the company
• The company enforced a Limited Duration Stockholders Rights plan aka the wolf-pack provision, which doubled the share price for those who tried to buy a large stake (31% or more for Schnatter and 15% for others) without the board's approval
• It thus deterred Schnatter from a hostile takeover

Disadvantages

• Stock values become so diluted that even shareholders need to purchase new shares just to keep even
• Institutional investors are discouraged from buying into corporations that have aggressive defenses
• Ineffective managers can stay in place through poison pills, else VCs might buy the firm and improve its value with better managing staff

Example

• In 2008, Microsoft offered Yahoo! shareholders $31 per share at a 62% premium
• They pulled out after Yahoo! launched a poison pill
• Yahoo's share price took a nosedive leading its Head Jerry Pinto to step down

Concept: Greenmail

#19

What?

• Blackmail + Greenbacks (US Dollars)
• Refers to when a raiding company holding a large chunk of stock forces the target company to buy it back at a premium to avoid a hostile takeover
• The target company is coerced into making a greenmail payment as a defensive measure to stop the takeover bid
• Aka bon voyage bonus

Concept

• A rise in corporate mergers during the 1980s led to the inception of greenmail
• Corporate raiders would initiate takeover bids with no intention of seeing it through
• Critics see greenmail as a predatory practice much like extortion
• Some instead see it as a free-market solution to shareholder conflicts

Examples

• James Goldsmith earned more than $90 million from the Goodyear Tire and Rubber Company in the 1980s (see notes for the full story)
• Occidental Petroleum paid $194 million greenmail to David Murdock in 1984
• David Murdock owned a 5% stake in the company and was a member of its board of directors after the company acquired IBP, Inc.
• Murdock owned 19% of IBP as well
• Disputes between Murdock and the CEO Armand Hammer led to a greenmail payment to Murdock of $40 per share
• Share price in the market was only $28.75
• Wall Street, the 1987 film, portrays greenmail tactics
• Fellow corporate raider Sir Larry Wildman refers to Gordon Gekko as "a two-bit pirate and a greenmailer"

Measures put in place

• Federal and state regulations act as deterrents
• Internal Revenue Service (IRS) introduced an excise tax of 50% on greenmail profits in 1987
• Companies introduced defence mechanisms such as poison pills to prevent investors from making hostile takeover bids
• Anti-greenmail provision (a special clause in a firm's corporate charter) prevents the board of directors from approving greenmail payments

Notes

What happened with James Goldsmith:

Sir James Goldsmith was a notorious corporate raider in the 1980s, minting millions via his orchestration of 2 high-profile greenmail campaigns. One was against St. Regis Paper Company from which he earned $51 million. The other venture that earned him $93 million in only 2 months was the Goodyear Tire and Rubber Company.

When Goldsmith acquired 8.6% stake in St. Regis and threatened a takeover, the company was coerced into repurchasing the shares bought at $35.50 by Goldsmith at a hefty premium of $52 per share. After suffering this loss in 1984, St. Regis fell prey to Rupert Murdoch, after which they sought refuge in Champion International,. agreeing to a takeover at $1.84 billion. Murdoch too received remuneration when he sold his 5.6% stake in St. Regis to the Champion.

In October 1986, Goldsmith purchased 11.5% stake in Goodyear at $42 per share while simultaneously planning a takeover of the company. He filed the takeover with the Securities and Exchange Commission (SEC), after which he proposed to sell off all assets of the company except its tire business. Facing obvious resistance from the Goodyear executives, Goldsmith then offered to resell his shares at $49.50 each. Goodyear lost $2.9billion in this transaction by buying back 40 million shares at $50 each. Unfortunately, Goodyear's stock price plunged to $42 after the buyback.

Analysis of Franklin Templeton's Closure

 #17

Overview

• Franklin Templeton Mutual Fund closed 6 of its debt schemes in India:
• Franklin India Low Duration Fund (62.8% of assets invested in bonds rated below A+, 45.76% rated AA)
• Ultra Short Bond Fund (82.8% in AA rated, 23.9% in A rated)
• Short Term Income Plan (58.6% in AA rated, 57.5% in A rated)
• Credit Risk Fund (60% AA rated, 49.6% in A rated)
• Dynamic Accrual Fund (52.7% in AA rated, 44% in A rated)
• Income Opportunities Fund (63.97% in AA rated, 41% in A rated)

Reasons

• Illiquidity in bond markets
• Severe redemption pressure
• SEBI's opening of a window for AMCs to borrow to meet redemptions

Cause

COVID-19

What happened?

• The above 6 schemes of Franklin Templeton Mutual Fund (FTMF) took aggressive credit calls in their portfolios in the recent past
• Despite getting higher returns by taking on these high risks, the debt funds and a few liquid funds (safest of the lot) experienced tremendous volatility
• In the last 18 months due to COVID, worried investors withdrew money and exacerbated the problem

Which led to

• Shrinking of the portfolios
• Funds left with a higher proportion of less liquid (riskier) investments
• FTMF having to keep borrowing money to pay off the redemptions but reached the borrowing limit as per regulations

Outcome

Investors unable to:

• Withdraw or transfer their existing investments
• Start any SIP in those schemes
• Make fresh investments

Let's talk numbers

Debt funds:

• Outflow: Rs 1.94 lakh crore (March 2020)
• Inflow: Rs 43,431.55 crore into liquid schemes, corporate bond funds, banking and PSU funds, overnight funds, and gilt funds (April 2020)

Category-wise outflows:

• Medium duration funds: Rs 6,363.53 crore
• Short duration funds: Rs 2,309.05 crore
• Money market funds: Rs 1,210.35 crore
• Low duration funds: Rs 6,841.07 crore
• Ultra-short duration funds: Rs 3,419.32 crore

Credit risk funds:

• Outflow: Rs 19,238.98 crore (April 2020)
• Inflow: Rs 6,279.23 crore (March 2020)

What all did FT try before winding up?

Borrow

• FTMF AMC borrowed continuously to fund redemption requirements
• But were unable to repay the borrowings by selling bonds
• Will lead to gross asset-liability mismatch in the long run

Restrict redemptions

• Current terms for restrictions under the regulatory framework:
• Maximum suspension period of 10 working days limited to once in a 90-day cycle
• AMC needs to honour redemptions up to Rs 2 lakh per day per investor
• The above terms made this approach infeasible

Elongate redemption payments

• Redemptions pay-outs were being made on a T+1 basis with a maximum of 10 working days
• This approach too was unviable because it would only handle the short-term liquidity issues and not the sustained impact of the crisis

Distress Sale

• In a distress sale, the AMC would have to sell the securities at a discount to meet redemption requests
• If so, investors staying invested would have borne significant losses

Winding up was the only forced choice for FTMF.

So, when will the investors get their money?

Once:

• The macroeconomic situation improves
• Cash-flow pains will be relieved
• FTMF makes good on their debts
• Investors are allowed to withdraw their investments
• FT does an orderly sale of their investments in order to return the money to investors
• FTMF communicates an exit strategy for their schemes

Bright side

Debt fund redemptions slowed after RBI announced a Rs 50,000 crore credit support for MFs

FT can attempt to retrieve the value invested in those schemes either by selling the underlying assets (e.g. corporate bonds), or wait for them to reach maturity, when those companies will have to pay back what is owed to them.

Barbell strategy

#14

What?

• Formed when a trader invests in long- and short-duration bonds, but not in intermediate-duration bonds
• Focuses on the maturities of the securities in the portfolio by ensuring the maturity dates are either very close or at a distant date

Philosophy

• The best way to strike balance between risk and reward by investing in both extremes of high risk vs no risk assets while avoiding middle-of-the-road choices
• Be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative

When?

• Useful when interest rates are rising
• More frequently applied to bond portfolios

How?

• When short term maturities are rolled over they receive a higher interest rate, raising the value
• If an investor's money is tied up in a long-term high-quality bond, he or she won't be able to put that money in a higher-yielding bond if one becomes available in the meantime

Benefits

• Allows for a quick turnover of a significant amount of the assets in the portfolio at one time
• Reduces interest rate risk since short-term bonds can be reinvested
• Includes long-term bonds, which usually deliver higher yields than short-term bonds
• Offers diversification between short-term and long-term maturities
• Can be customized to hold a mix of equities and bonds

Limitations

• Long-term bonds held till maturity tie up funds and limit cash flow
• Inflation risk exists if prices are rising at a faster pace than the yield of the portfolio
• Mixing equities and bonds can increase market risk and volatility

Etymology

Investment strategy looks like a barbell with bonds heavily weighted at both ends of the maturity timeline

Example

Portfolio created with: 

• Speculative stocks (high risk): initial public offerings (IPOs)
• Blue-chip stocks (less risky): unprotected against ups and downs of the economy
• Bonds (safer)
• Bank certificates of deposit aka CDs (safest)

Asset allocation based on types of investors:

• Risk-loving:
• 40% in speculative stocks
• 40% in blue-chip stocks
• 20% in bonds
• Risk-averse:
• 80% in bonds
• 20% in blue-chip stocks

Related

• Contrast: bullet strategy
• Involves investing only in intermediate-term bonds
• This approach allowed Nassim Taleb, an essayist and mathematician to thrive during the 2008 economic recession while his fellow Wall Streeters floundered

Article: SIPs and rupee cost averaging

#11

Concepts

Rupee cost averaging

• Approach wherein you invest a fixed amount of money at regular intervals
• Ensures that you buy more shares of an investment when prices are low and less when they are high
• You avoid the manual, complex task of researching the best time to invest
• Averages out the costs of your units 
• Lessens the results of short-term market fluctuation on your investments

SIP

• Systematic Investment Plan
• Facility offered by mutual funds to investors
• Helps you invest in a disciplined manner
• You invest a fixed amount of money at pre-defined intervals in the selected mutual fund scheme
• Amount can be as low as Rs. 500
• Intervals can be weekly, monthly, quarterly, semi-annually, or annually 
• Investor need not worry about market dynamics or timing
• Stands to benefit in the long-term due to average costing and power of compounding

Gist

• SIPs help you lower your investment cost and hence maximize returns
• When you invest through SIPs, you automatically experience the benefit of rupee cost averaging
• When you invest, you accumulate units at various prices called net asset value aka NAV
• You get more units when the market is down and the fund's NAV is lower and vice-versa

Why it works

Markets are volatile, hence it makes sense to spread your investments over a period of time to benefit from the lows that frequently occur

How it works

• Say you invest Rs 10,000 in a fund at each of these NAVs: Rs 100, 150, 200, 250, and 300
• Number of units accumulated (amount/NAV): 100, 66.66, 50, 40, and 33.33
• Total amount invested = Rs 50,000
• Total units = 289.99
• Average NAV = Rs 172.41 (This amount is less than three of the five NAVs at which you bought the fund!)

Conclusion

• SIPs: psychological tool of discipline
• By nature, investors are tempted to invest more when the market is racing and stop investing altogether when it is falling, which hurts returns
• SIPs automate the entire investment process and delink sentiment from investing
• Via SIPs, you benefit from rupee cost averaging to get a good return

Article: How to buy the right health cover?

#10

Let's look at the types of plans commonly offered. What they do and don't cover should help you determine which one is suitable.

Individual Health Plans aka  'mediclaim' policies

Covers:

• Hospital treatment expenses provided the treatment is on an in-patient basis and lasts for at least 24 hour
• Expenses include hospital bed and room, nursing, surgeon's fees, consultant doctor's fees, blood transfusions, oxygen and operation theatre charges

Does not cover:

• Pre-existing diseases or complications arising from them for the first four years of the policy
• Specific conditions that may not be covered for a certain initial period

There is generally an enhancement for every year during which no claim is made.

Family Floating Policies

The sum insured can be used for the treatment of any or all members of the family and not a single person. Rather than buying an R2 lakh health cover for each member of the family of four by spending for a total cover of R8 lakh, if you buy a Family Policy for R8 lakh, each person covered under it can avail benefits up to R8 lakh as opposed to R2 lakh in the earlier instance.

• Comes at a lower premium than individual policies would have done
• Can be bought by an individual who becomes the proposer along with spouse, including dependent children up to 25 years or even unmarried, divorced, widowed daughter and dependent parent

Critical Illness Plan

• Not a substitute for the basic individual or family policy
• Designed to be added as an addition to the former (The fact that these have to be bought separately is a major flaw in the way health insurance is sold in India)
• Provides financial assistance if the insured develops a serious ailment, such as cancer, or has a stroke
• Each cover has a list of ailments, usually 9-12 of them
• Can get it in the form of a rider attached to a life insurance cover, or as a standalone policy from either a life insurer or a non-life insurer
• If critical illness occurs, it pays the entire sum insured and terminates and can happen only once for any particular illness
• To get the payout, the insured has to survive for 30 successive days after the diagnosis
• No claim can be made during the first 90 days of the inception of the policy

Medical Cover From Life Insurance Companies

Life insurance companies, too, have started offering health plans. Most of these are, however, defined benefit plans - the pre-specified amount which is the sum insured is paid as compensation, irrespective of the actual amount of expenses incurred. Also, these are long-term, having a fixed premium for, say, three, five, or even 10 years. 

If you opt for a good combination of basic mediclaim, family policy and a critical illness plan, then these are not needed.

Article: How ELSS scores over other tax saving avenues

#7

Fact

Under Indian tax laws, savers have a complete range of tax-saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits (FDs), National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others

Question

Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

Answer

There is a confusion of goals between saving tax and making investments.

Equity Options

There are two options other than ELSS that give equity-linked returns - Unit-Linked Insurance Plans (ULIPs) and the National Pension System (NPS)

ULIPs

Longer lock-in period of 5 years, coupled with high costs and poor transparency.

Traps:

1. Mix of investment + insurance 
2. Savers don't have clear cost-vs-benefit understanding of either 
3. Both transparency and liquidity relinquished
4. Terminating the policy early affects returns adversely (instead of 5-year lock-in, it becomes a 10-15-year commitment)

ULIPs aren't suitable for investment due to:

1. High costs
2. Difficulty in evaluation
3. Lack of transparency
4. Low liquidity

NPS

Retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age.

ELSS

3-year lock-in period

Short-term vs long-term: 

1. Equity investment carry higher risk over the short-term. 
2. However, for investment periods of five years or more, the risk on equity investments is considerably lower. 
3. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation.

The best way of investing in an ELSS is through monthly SIPs (Systematic Investment Plan) throughout the year. SIPs also give the dual advantage of avoiding any last-minute rush.

 

At the beginning of every year, estimate the amount you have leftover from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP. 

Simple.

 

Introduction

#1

Welcome to a world of Money, Money, Money!

This blog contains posts on various topics related to finance, such as the following:

1. Accounting basics
2. Derivatives
3. Econometrics
4. Economics basics
5. Good books to explore
6. Famous folks in finance
7. Miscellaneous concepts
8. Scandals
9. Security analysis
10. Valuation

In this blog, I do not plan to talk about theories and concepts in a verbose manner.

What I'd rather attempt is to achieve a fun-filled way to approach the world of finance, a 'finance made easy' concept, if you will.

If you find the topics and the approach I've chosen interesting, you might retain some of them for a long time, and that's all I hope for.

If you do wish to read further on some of the topics, Investopedia is a great site, to begin with.

Cheers!