The RandomChalice Price

A few days back on CNBC Europe I saw some UBS analyst talking about who is going to win the Euro 2008, no it was not a fun banter; this man had actually constructed a mathematical model!!! to predict this………no wonder UBS is doing so terribly, I really don’t know what value this analyst community actually add……..

Let’s talk about the value of a stock. Frankly there is nothing called a ‘right value’ or a ‘fair value’ of the stock and all these valuation methods of DCF/FCFE etc though may sound very logical but are nothing more than B School lab rats, think about it…………If I ask you about the fair value of the apple in the market, ofcourse you can theoretically calculate it by constructing some exotic utility function and projecting some inflation figures but your answer would be as good or as bad as mine if I wake up early morning and in my half asleep stage just take a guess. So what really matters is ‘Relative Value’

Keeping this thing in mind how should I take a call of investing in a stock, Let’s take the example of ICICI bank, currently ICICI Bank is trading around 800 rupees however at the time of writing this article it was trading around 950 rupees. Now for argument sake let’s assume its earnings growth remains linear at 25% (though I have my reservations over the fact that this bank would be able to keep up with this earnings growth). The reasons:

A banks growth is dependent primarily on its financial capital and human capital. The return on financial capital is going to be very mediocre due to the state of capital markets and the bank itself is scaling down on its employee intake. So with both aspects of growth faltering the earnings momentum of this bank is surely going to take a hit.

The price (P) of any stock is composed of two components:

- Linear price (Lp)
- RandomChalice price (RCp)


═> RCp = P - Lp

When I invest my money in the stock I expect it to grow faster than the money in fixed deposit. Now the PE of ICICI bank in case of the market price of 950 is around 26. Now if I put my money in FD, I can get my principal back in about 8 years. At 20% growth rate any stock

═> P/E = ((1+g)n – 1)/g

So in case of ICICI bank n ≈ 10 yrs

So much longer, at n = 8 years my P/E = 16.5, this implies that this bank warrants a reduction of 36.5% in price, which implies its linear price if approximately equal to around 600 rupees. Any excess price above this is what I call the ‘RandomChalice price’. This is the price we pay for positive surprises in the stock or in other words it’s the price of unknown (this can be due to anything: structural change in business, new invention/discovery, oil find, acquisition, increase in earnings or any other unimaginable thing on the planet or in the universe). At 36.5% this price is too high for this relatively mature stock when many other stocks are available in the market with a very low randomchalice price.

I have taken the benchmark as the return from FD, however the returns from stock should certainly be greater than that of an FD due to the higher risk associated with them (ofcourse a number given to this risk can always be subjected to argument). This is just an example to show how exorbitantly high the price of ICICI bank is.

So essentially after adjusting for the risk any price over and above the linear price is the randomchalice price, if this price is negative then either the stock is too undervalued or the associated risk associated with the stock is too high and you need to adjust your risk adjusted return. This is how one should really judge a stock by its randomchalice price because this what ultimately leads to real wealth creation and through some predictable mathematical model……..


And O! yes by the way that UBS analyst had predict Germany to be beaten by Switzerland in the quarter final, unfortunately Switzerland is out in the very first round so much for the mathematical model……………

Oil touches an Intraday high of $139/bbl

Oil shot an intraday high of 139 yesterday. I was watching an interesting debate yesterday on CNBC Europe wherein one of the guests termed this phenomenon as a transfer of wealth. I am afraid this is a very myopic view towards international trade. Wealth is not just measured in monetary terms. In realty oil is an asset for the oil producing country. So we are essentially purchasing this asset and giving out cash in return. Here is how the transfer takes place:


Now the key here is that what really country I and E does after this transfer. For the importer nation oil purchased at $139/bbl should yield more value than the price paid for it and if that is the case it is not really a transfer of wealth, wealth is still created in country I though some may argue that the pace of wealth creation can certainly slowdown, but again my answer to this argument would again be – ‘it depends’.

Since the oil price spike has been fairly quick and sharp the economies of the oil exporting nations are still not mature enough to absorb such sudden inflows (remember the funds flow problem in India during October – December 2007) so they are then forced to invest abroad and hence ultimately a large part of money ends up coming back into the Importer country (provided its assets are attractive enough for investment), so if the oil utilization is prudent enough any slowdown in growth due to the oil price hike should be compensated with the capital inflows, ofcourse if import oil and just burn it without any productive outcome then it will always yield you into a problem. Let me also add that subsidies also contribute to the inefficiencies in the oil utilization, however the Indian subsidy bill especially on petrol is just a farce as thanks to the taxes on petrol we end up paying much more than warranted.

So here is summary of the article:

- The rise in oil prices does not really lead to a transfer of wealth.
- Any possible slowdown in the importer country is avoided due to the capital inflows from the oil exporting nations.
- However for this to happen the attractiveness of its assets has to be proportional to the possible slowdown as a result of oil price hike.
- This is only possible if the utilization of oil is prudent, subsidies hamper this process in a big way.

The Economic Growth of Nations

Sorry for delaying my articles all this time.....I have been consistently writing articles on my notebook during my flights, just never got the time to post them on the blog....I will try to be more organised now going forward....So going forward I will post 3 articles that I have written, I which I would post today relates to the another small step in decoding the economic growth mystery, next would be talking about a critical concept on investment fundamentals and in the third article I would continue with options trading.....I would delay the China topic for sometime ( I hope I don't have to write that article prospectivelly...), so here goes the article for today.........

Sitting on my flight to New York, I can't help but think how far has India grown (well atleast some part of the population). People essentially become rich because of wealth effect. However it does not mean that the 'income effect' is insignificant. Infact it is the rise in the income level that ends up driving the wealth effect.

15 years back a plane ticket to US was twice more expensive than what it is today around Rs 120000, however back then a good salary for an Indian used to be around 5000 pm, 15 years down the road this has multiplied 12 folds while the expenses on such items in relative terms have come down significantly. This phenomena is visible in every field. Let's take the e.g. of a Maruti 800, I remember we buying this car some 20 years back for around 52000 rupees, today this car costs around 2,00,000. A rise of just about 4 folds and compare this to the rise in paychecks.........So things are becoming cheaper relatively....Therefore the fundamental key to invest in such growth economies is to invest in areas werein in the pattern is as follows:

(1-∆price(relative))*∆growth(product) > ∆ income growth of the topmost percentile of people. The funda for such an investment decision is as follows….

Due to a high base the change in price (which is going to be negative as discussed above) is going to be lower, the change in growth is going to be higher due to a lower base ( as still a very low number of people are consuming the goods), stock/sector following this pattern would certainly outperform.

Just saying that a product or service would grow in the country is not enough because its price would inevitably depriciate vis-a-vis the income levels. So keeping this equation in mind I would say that the best investment in any gowth economy is real estate (ofcourse the flip side to this is the fact that in a slowing economy the worst sector is also real estate)

The 'price' is always a barrier to ownership. The price has to be higher preferrably much higher compared to than the current than the current income levels of the topmost percentile population. This leaves a wide scope for the prices to come down and also gives a lot of time for the prices to come down, also the service has to be prefferably more of a necessity (if not now then atleast in few years from now) this would ensure a very high growth rate.

So whenever a company says that it is moving to the villages because it sees growth there, consider that the growth story of the company is over ---- ' Get out of that stock'..........

As I discussed above that to me price is nothing but a barrier to ownership which can be really due to some tigh regulations, so any sector where such regulations are released also provide enticing opportunities for investment.....

My plane is about to land at the JFK airport but before I end this article consider this, the real estate prices in this country (atleast in the NCR area) have grown 100 times in the last 20 years!!! ofcourse there has been a currency depreciation, even if we take this account an Indian has gained over a New Yorker and now even this currency trend is changing so the gap between an Indian and an American is narrowing faster than ever before. Ofcourse keeping this thing in mind we should not forget that almost 60% of our population lives on agriculture and we desist when wheat, rice gain in prices so think about this that while some part of India is ceratinly becoming richer it is these people who are becoming poorer everyday, so keep up the economic growth momentum of this country it is imperative that we reduce the gap between these two halves of India by moving people away from agriculture or improving prodcutivity or else it is a disaster waiting to happen, time to see New York, catch you soon................

The Swiss and American Growth Story

The last week was extremely busy so writing after a big pause. I would be leaving for New York on Sunday so before I do that let me elaborate the points on the reasons of growth in Switzerland (some points of the analysis holds for many European countries) and briefly discuss growth of US. I know I am unable to discuss about options trading and China story, probably my next article would be about them if something more interesting doesn't strike me. So here we go.........

Two countries that gained tremendously in the watershed event of WWII were US and Switzerland


America gained tremendously as result of influx of great minds from Europe, no amount of physical capital can match the influx of high influx of human capital, its simply invaluable (almost like a call option with limited downside and unlimited upside) , no one can tell the value of the idea or business venture started by some crazy nerd today whereas in case of pysical capital we know the number printed on the note!! So these great minds from Europe (particularly Jews) entered the US shores and made America , powerful and also changed the face of the planet. Einstein discovered general relativity, Goldman started an organisation that later came to be known as Goldman Sachs.


Back during the period of WWII, Switzerland chose to remain neutral in the global conflict. Unlike US it mainly gained from the influx of physical capital. Wealthy Jews and others kept their money in Swiss banks. Large part of money was never claimed as their owners lost their lives during the war. Now once you have large sums of money it has to go somewhere (to business and assets) and this leads to wealth multiplication over time. This is what has given rise to UBS, Credit Suisse. Don't fool yourself in believing that they are big because there are a lot of smart people in these organisations (smartness has no correlation with money making and oh! yes UBS just recently devalred losses worth USD 12 billion... smart people). Anyways a few such organisation can change the face the nation that has a population of not more than a millionWith almost 50% of them in active workforce these two organisations employ a very large chunk of population. Also with banks with such lare capital around it propels other internal businesses as well e.g. ABB. So with just a handful of entrepreneurs and large amount of wealth created this nation is a rich nation even though people don't work!!!, shops open at 9 a.m and close at 6 p.m, some restaurants open for not more than 3 hrs!!! well let them carry on this way other nations would surely catch up.

One more important point in development of Switzerland and many other European countries is culture. Well before jumping up and down just read..... I walk out of the airport and call for a taxi, two drivers come up one is an Indian driver and another one is an american, whom would I hire.... well the Indian driver....why? because I feel comfortable thats all, nothing against any country or race...its just a human fallacy. In a similar fashion these European countries have benefited from the influx of investment from global giants (mainly from US and UK) over other economies in aisa, simply because of this reason. All countries in south asia is still poor and so there is no surplus capital to invest. Atleast the countries in Asia Pacific, Taiwan and China have benefited from a rich Japan. So the next time you pick a taxi think about this point.........

The European View

Been very busy the day I stepped in Zurich and so ofcourse have been unable to write any new articles. I will continue the articles specifically on options trading and China once I return back to India. Anyways this article is a bit of digression but one important insight that I have gained from my visit.

I expected Zurich (financial capital of Switzerland) to be a very modern city, however it turned out to be just another town, totally shocking. The buildings are old, well maybe because Switzerland was a neutral country during WWII and so unlike most of Europe the city survived with its legacy. Anyways two important things that I observed here are:

- People are not very rich in the west, ofcourse Indians would find the place expensive but thats purely due to purchasing power parity ( which anyways would vanish in the next 30 years) though the people are not very poor unlike in India. So the GINI index (level of disparity) is smaller here compared to India. What is the reason behind this I am yet not sure. The government taxation and social security system might be one answer but certainly there must be some more important reason to ponder over.

- Also one thing to think over is how such a small country with negligible natural resources became developed. Well the answer to this question is relatively easier. One reason is that the surrounding countries were richer so it automatically boosts the economy of your country as labour and trade arbitrage processes are quicker and this transfers and creates wealth in that country (switzerland in this case). The second reason is that during the WWII many of rich jews and other people kept their money in the swiss banks ( this is what made UBS and Credit Suisse) and most of that money was never claimed as their owners lost their lives during the war. This money in turn got channeled into the Swiss economy and created the growth momentum..............

Decoding the relation between Money Supply, Inflation and Growth

The cutting of interest rates by the Fed has raised the inflation and inflation expectation of people. This has prevented other Central Banks particularly that of the Euro zone, Bank of England and the RBI to resist in cutting of interest rates. While I have given my views on this topic in the previous article, over here I am going to discuss one fundamental dilemma in economics that of money supply on Inflation and growth. Are they truly antagonistic and if not in what scenario.

Assume a small slow growing economy Torts from tortoise having just 3 players A B C each having 1 kg of wheat. Let’s put a monetary cost to their produce at Rs. 10/- . In such a scenario the economy would remain stagnant and the growth of the economy is going to be 0%. Now seeing this perilous scenario an angel descends on their world with the name ‘The Party Pooper Bank of Torts’ – PPBT. The bank says that it is prepared to lend Rs. 5/- to anyone for 1 year but wants Rs. 5.5/- in return. A is the entrepreneurial type of guy. He comes forward and takes the offer. Now at the end of year one the following 3 scenarios can occur:

First of all in all the 3 cases let’s convert their wheat stock to Rs. 10/- per kg unless otherwise mentioned. A toils his land and produces rice. Now he can sell his rice at any price between Rs. 0-10, let’s take 2 cutoffs of 5.5 or less and more than 5.5, in the scenario where A is able to sell his rice at more than Rs 5.5, he is able to make a profit on his venture. Let’s say A is able to sell his rice at Rs. 10 so the GDP grows at 33.33%.

Let me add that this scenario also answers one of the basic questions in economics: ‘Why do economies grow’. This economy grew because of 3 factors:

Capital (Money from PPBT)
Land (Asset which is natural resource in this case)
Labour (The effort put in by A)
Entrepreneurial spirit (As shown by A)

A would have equivalent of Rs 20/- , B would have equivalent of Rs. 10/- and C would have equivalent of Rs. 10/-. Now A can buy some of the goods from C at Rs 10 or more. If A knows that B has just Rs 10 with him then he would buy the goods at Rs lets say at 10.05, so the inflation in the economy stands at 0.5%. However in a normal scenario there is ‘information asymmetry’ in the market and so A may jack up the price to as high as Rs 14.5/- for the product of C causing inflation to shoot up to 45% !!!. So its important to understand that the culprit here is not the monetary policy but information asymmetry.

In the next scenario wherein A gets Rs 5.5 or less A makes no profit however the economy still grows at 18.33%, any surplus liquidity is absorbed and so inflation menace doesn’t raises its head. Well this looks like the perfect scenario which has no excesses, the only problem is that if this scenario continues for long it will generate 2 problems. A would loose any interest in investing in the venture and also A would have no surplus capital of his own to invest.
In the last scenario A takes the 10 rupees and jacks up the price of the product of C to Rs 20. This causes the inflation to rise at 100% and GDP growth is 0%. Later on in order to repay the loan when A tries to sell back the product whose value is supposedly Rs 20/- but only C has the capacity to buy, however there is no reason for C to buy back the product he sold a little earlier (Velocity of money comes into picture) the value of the product crashes. This might lead to cutback in supply leading to negative GDP growth.

One question that can come to mind is why on earth would A behave in such a manner. The reason can be mainly two fold:

- The inflation is very high and so he feels that he needs money just to consume
- The inflation expectation is very high and he wants to buy products today expecting a rise in prices in the future

So it’s important to understand that printing money in itself is not inflationary. Inflation happens because there exists an information asymmetry and high inflation expectation. Printing more money in such scenario could be disastrous.

In countries like Zimbabwe which is suffering from hyperinflation is clear case in this regard. The supply crunch led to inflation and higher expected inflation, to top it all the government printed more money thus creating hyperinflation and causing the nation to go in a tailspin.

I conclude this article with two points that must be amply clear while taking the decision of printing more money and thus making sure that this money results to higher growth rather than inflation:

- Information Assymetry should be minimal
- Extra money to be used in capital assets and not in consumption.

If inflation expectations are high then the money supply would go into consumption instead of creating assets and hence leading to further inflation at the cost of growth (as players would first be concerned with consuming goods to survive and then think about creating capital assets). …………………..

Options Trading - The Trading Ways

The beauty of options trading is the whole array of trades that are made possible by options with varying risk profiles. One more thing I would like to add here is that unless specified I would be refering to equity options. Ofcourse after sometime I would be moving towards options on other asset classes as well. Using options one can get into the directional trades on equity prices, perform volatility trades, trade on skewness and kurtosis. I would be covering each of these class of trades, this would including various trading strategies and arbitrage trades for some. Each trade would include the risk and returns possible. Right now derivatives products are limited in Indian equity markets and those that are available have limited volumes specially in stock puts. However unless you are a very big player the lack of volumes should not bother you. However new products are being introduced now in our markets. This include long term options and the volatility index to come very soon, so things are going to specially become quite interesting.

So I would start with directional trade on equity prices using options the next I write on this topic...............