The role of exchange rates in gold prices

You don’t think about currency exchange rates when you are buying gold because the two are generally not talked about together, and most people buying jewelery would perhaps be surprised to hear that the exchange rate has any bearing on gold prices at all.

However since India, and much of the rest of the world imports most of their gold for which they have to pay in a foreign currency, the price of gold domestically is impacted by the exchange rate much like the price of oil.

A good way to visualize this is to see how gold prices moved in 2012 priced in different currencies.  (Data from GoldPrice)

 

Gold price movement in 2012
Gold price movement in 2012

Part of this price difference is exchange rate, and part of it is domestic demand and supply, but I think it is really hard, if not impossible to distinguish which is which.

I think the relationship between USD INR and gold prices is going to be talked about a lot in the next few years because the Rupee has become a floating currency and it will continue to move a lot and gold is becoming more of a financial asset than anything else and that will mean that the demand also depends on people’s appetite of gold as a financial asset instead of just jewelry.

Where would you invest if you had only three options?

A friend of mine asked for some good investment ideas, but he put the condition that I give him just three options. He didn’t want an information overload and certainly didn’t want to deal with any more jargon than he had to.

With that in mind, these are the three things I told him to buy and I thought it would make an interesting post here too, so here goes.

Tax Free Bonds

For people in the 30% tax bracket – tax free bonds are an attractive debt option because many of these have interest rates of close to 8% and if you don’t have to pay tax on that then that becomes a very good post tax yield.

I’m not putting a number to the after tax yield because that is open to debate and if you haven’t seen the post on the comparison between SBI fixed deposits and tax free bonds, then that will be a useful read.

Fixed Maturity Plans

FMPs are more tax efficient than fixed deposits and these can also be used as part of your fixed income portfolio to enhance your returns, especially if you are in the higher tax brackets.

These will be shorter term than the tax free bonds, and will only be available for investment during their NFO period as they are close ended funds.

ELSS Funds

Anyone reading this blog for any length of time will know that I’m biased towards equities and there is no way that I can talk about investments without talking about equities. However, for someone who has never been in equities, it is important to understand the volatility and the lack of guarantee that comes along with it.

I told my friend that the 80C part of his investments can go in a ELSS fund and that’s a good way to get started in equities.

Are three options enough?

He wanted three and I gave him three keeping in mind his high tax bracket and an inclination to keep things simple, but I honestly don’t think three options are enough.

I’m fairly sure he’s not going to take this advice and I find it hard to see how anyone else can implement this plan either especially if you are reading this blog and know the many many other investing options available.

That being said, if you could invest in just three things – what would those be?

Ted Talk: Joshua Foer Feats of Memory Anyone Can Do

I reviewed the Classic Guide to Improving Your Memory in July last year, and while I had no doubt that the techniques in the book work I never got in the habit of using them and had all but forgotten about the it until a few days ago.

Then I chanced upon this Ted Talk by Joshua Foer who talks about the same thing and I read parts of the book again.

After that, I decided to start applying the techniques again, and for some reason, the things that I found hard to do last time were easier this time, and I’ve been using the techniques again for about a couple of weeks now.

There were two things that I did differently this time – the first one was to start with easy things.

I felt that one of the hardest things taught in the book was memorizing long numbers like 4685678901234512 and that’s where I started last time. This approach didn’t work in my favor because it was a bit discouraging to fail at remembering 16 digit numbers, and turned me away from other things as well.

This time I just started with simple numbers that I thought I’d need to remember like the level where I parked, or how many species of penguins are there in the world and other such smaller numbers.

The second big change I did was to go by the book. Last time I improvised on a few techniques and made tweaks that I thought would be easier for me to follow. But that didn’t work so well because there were shortcomings in my tweaks that weren’t apparent to me when I made them. This time I decided to go by the book and follow the techniques exactly as they had described them, and that worked better than last time.

Finally, I think watching the Ted Talk helped immensely because it is a live demonstration of how to use the technique and the story is told in a wonderful manner. The talk is 20 minutes long and I’m sure you will find that your 20 minutes were well invested.

What is Balance of Payments (BoP)?

Balance of Payments (BoP) is an account of the international transactions of a country, and shows how the country is faring in trade, attracting capital from abroad, and the effect of that on its foreign exchange reserves.

The budget website has a BoP document and that contains the components of the BoP and understanding the components is a very good way to understand what BoP is.

When talking about the BoP – you will usually hear reference to the current account and the capital account and along with the change in forex reserves these form the most important parts of the reserves. They have mentioned errors and omissions as the fourth part, and I’ve included it for accuracy but if you think about it, that’s not really a head on its own.

Before we go any further, let’s look at this chart that has the hierarchy of these components and then look at each component one by one.

 

What is Balance of Payments
What is Balance of Payments

Current Account

The current account shows you the trade position of the country. It shows you the merchandise imports and exports, and then the invisibles part of it is also trade but it’s that part of trade where there is no physical good exported or imported.

In India’s case, the transfers and grants part of the invisibles is quite big relative to other countries because of the large Indian diaspora.

As far as I know India has always run a current account deficit which means that it has always imported more than it has exported. This is something I’ve touched upon several times earlier and if you want to read more about this you can read the posts on what India imports and exports.

The rest of this is fairly self explanatory so I’ll move to the capital account now.

Capital Account

Where current account shows you trade, capital account can be thought of as the investments part of the international transactions.

This is further broken out into equity and debt investment and the FII money and FDI money is part of the equity investments while the external commercial borrowings, money deposited in banks by NRIs and trade credits are debt investments.

Till recent years, India’s current account deficit was being financed by a capital account surplus which meant that foreigners were buying more assets in India or lending more capital to India than India was doing to the rest of the world, and as a result the foreign exchanges reserves were steadily growing. However, the trend has reversed lately, and even the capital flows have been negative.

Change in forex reserves

The difference between the current account and the capital account is reflected in the change in the forex reserves.

For example, in 2010 – 11 – India’s current account deficit was $45.9 billion but the capital account surplus was $62.0 billion and this resulted in increase in foreign exchange reserves of $13.1 billion. This doesn’t exactly total up due to the effect of errors and omissions.

Conclusion

India’s forex reserves had dwindled to lows of $5.1 billion in 1991 and as a result India had to borrow from the IMF by pledging its entire stock of gold. The IMF simply didn’t lend money against the gold, but India had to physically move all its gold to IMF locations and people talk about Air India planes full of India’s gold.

Though that happened more than two decades ago, it is always fresh in memory for most people and that’s why as soon as the foreign reserves start going down you start reading articles that talk about a BoP crisis or a repeat of 1991.

At over $290 billion, India’s position is far better than it was in 1991 but if you look at the example of any of our neighboring Asian tigers, or even the western countries when they were growing, all of them have grown by relying on exports and running trade surpluses, and that’s what India’s goal should also be.

This post is from the Suggest a Topic page.

 

You don’t need to buy a children’s plan to invest for your children

I feel that investing is a lot more about emotions than it is about numbers, and it becomes even more emotionally charged when you think about investing for your children.

I regularly get emails about investing for children and there are two common things about all such emails.

The first one is the use of the word “best”. I’ve never seen someone write in to ask about a “good investment” for their children. It has to be the best investment, how can it be anything else?

The second thing I notice about these emails is that they generally refer to a children’s plan or a product that has the word “children” in it.

I think there is a general perception that plans or products that have the word “children” in them are significantly different from other plans, and only these plans should be used when you’re thinking about making investments for your children.

I don’t think there is that much difference though, and I’m fairly certain that if I made a table with the features of 5 plans and didn’t disclose which ones were children plans and which ones were other ones – it would be quite hard even for financial advisers to tell one from the other.

At their core, all plans or products invest in a few asset classes, give some insurance cover and have a certain time frame for maturity.

Instead of being swayed by the adjective of the plan you need to look at the components of the plan.

It’s a great idea to invest for your children and an even better one to start early, but you don’t really need to rely on any children’s plan for that. You can make that plan yourself with a little common sense and the right research.

Everyone knows what the big expenses are going to be – schooling, higher education, perhaps studies abroad and wedding, and if you start planning early and allocate money specifically for a purpose and invest in an asset accordingly you can build a good base for it.

For example, a Rs. 1,011 SIP yields Rs. 10 lakhs in 20 years if the money grows at 12%. You can put this relatively small amount away every month in a balanced fund with the idea that this will be used for higher education, and since you’re not going to need it for a very long time period you can ignore the volatility of the market and keep accumulating the funds. Similarly you can start with goals and work backwards to find a product that suits your need for any other goal that comes to mind.

Plan first, and then buy the product that suits that plan, let the dog wag the tail, don’t let the tail wag the dog.

The Rs. 7.50 Petrol Price Hike and India’s Vicious Cycle

The big news today is the massive Rs. 7.50 petrol price hike and with this, petrol prices have crossed Rs. 73.00 per liter in all the metros with Bangalore being the worst at over Rs. 81.00.

Theoretically, oil market companies have hiked the prices and not the government since petrol prices are “deregulated”  but no one even pretends this is true.

In a press release issued today, IOC says that the industry has lost Rs. 4,651 crores since the last price change in December because domestic conditions (read state elections) didn’t allow any price hikes after that.

Currently, the under – recovery on petrol is Rs. 6.28 / liter which is down from Rs. 7.17 / liter in the May 12 fortnight, and 8.04/liter in April 12 2nd fortnight.

The press release also says that the current hike is not enough and there needs to be another hike of Rs. 1.50 for the rest of the year to make up for the losses that have already taken place.

The under recovery on diesel, kerosene and LPG is expected to be Rs. 1,86,000 crores in this year, and the last time the price on these was increased in July 2o11. The under recovery on diesel is Rs. 13.64 per litre and the diesel subsidy was Rs. 81,192 crores last year.

It’s hard to see why diesel prices weren’t increased first, and perhaps that’s only because they will be increased in the days to come.

There will also be a lot of political drama in the next few days where other parties will ask the government to roll back prices and will try to extract as much mileage from this unpopular decision as possible, but it is highly unlikely that anyone will touch upon the subject of how the heck do you pay for all this?

Goa’s CM recently brought out the state budget and reduced petrol prices there but he did increase taxes on a host of things to pay for it, and that’s the reality that everyone needs to acknowledge.

Unfortunately, today we’re having discussions about issues in isolation where we talk about the INR depreciating, or fiscal deficit increasing, inflation increasing or petrol price hikes but not talking enough about the inter linkages between these things. Petrol price doesn’t exist in isolation and nor does the Rupee exchange rate, these things need to be looked at holistically.

For example, the government will badly miss the deficit target for last year and one of the reasons for that is they couldn’t raise enough money through PSU disinvestments last year.

They rushed through ONGC FPO and when that had a luke warm response, LIC picked up a stake in it on which it is sitting at a loss right now.

Then recently Moody’s downgraded LIC because they said the credit worthiness of LIC is highly correlated with the government’s credit strength and this downgrade reflects badly on both of these entities.

The downgrade affects how much money flows in India by way of FII investments and that’s bound to worsen by this which in turns affects the Rupee exchange rate and contributes to its depreciation.

This in turn makes oil pricier and the hole in oil marketing companies’ pockets become larger who then have to pass over the price to the customer which causes inflation and so on and so forth.

It’s as if India’s economy has fallen into a vicious cycle and the feedback loop worsens the whole situation.

The silver lining, if there is any at all, is that the feedback loop works the other way round too, and India has been through much worse in the past and been able to get through it.

The government (this or the next) can still turn things around and focus on real issues instead of wasting time looking at issues in isolation and trying to “fix” one problem that only ends up making another worse.

Factors to keep in mind while deciding whether to invest in a company fixed deposit or not

Last week I wrote about the two big ideas that you should keep in mind while investing in corporate bonds, and this week I’m going to build on that post and write about some factors that will help you build a negative list of companies that you should avoid buying fixed deposits in.

My assumption here is that you want a lot of safety for your bonds, and a part of your portfolio is already invested in equities which exposes you to risk of capital loss, and that’s why you want to play it really safe when investing in bonds or NCDs of a corporate.

Avoid loss making companies

You will see that the difference between the interest rate of a NCD of a well established large, profitable company and a smaller loss making company is hardly 2 or 3 percentage points, and normally for most retail investors who aren’t going to invest a lot in any NCD – this difference will not translate to much in absolute terms. Keeping in mind the small gain and increased risk, I think it doesn’t make much sense to invest in NCDs of companies that are loss making and not very stable.

Avoid companies where promoters have pledged stock

NSE has data on companies where the promoters have pledged stock to raise money and to me this is usually a big red flag because raising money by pledging stock has got to be one of the very last options for any promoter as it can potentially lead to them losing control on their company especially in the ever volatile Indian markets.

Avoid companies where the auditors have mentioned irregularity

The annual report has a section for the auditor’s report where they give comments. Most of the time you won’t find anything of interest here but in some circumstances, the auditors will give comments mentioning some irregularity which is a red flag because who knows what else is going on?

Avoid over-leveraged companies

This is a relative term because a company like Muthoot has to borrow a lot in order to carry out its business while a company that’s not as capital intensive will not need to borrow so much money in the first place. You can look at the debt equity ratios of similar companies to figure out whether the company is over leveraged or not and usually articles about NCD issues touch upon this point and help get a sense of where the company stands with respect to its peers in the debt it has already taken.

Avoid companies with low credit ratings

Every company is required by law to get a rating for its credit issue when it offers new debt. You can read the rating report as well as what it signifies and stay away from companies that aren’t ranked stable or safe for their debt.

Outside of this, there are plenty of articles online that give you a good idea on what’s going on with a company and you should search and browse through a lot of them before deciding to put your money anywhere.

I think it is better to be conservative and stick to the very best issuers as far as NCDs are concerned because usually the few extra percentage points you get by way of interest won’t make up if even one in ten of your NCDs go bust in your investing life-time.

What is the difference between basic and diluted EPS?

The P/E multiple or the Price / Earning ratio is probably cited more than any other when it comes to financial numbers.

The EPS (Earnings Per Share) is one of two inputs of the P/E ratio and companies have to report two types of EPS numbers – Basic EPS and Diluted EPS.

Basic EPS is calculated by taking the total net profit and dividing it by the total number of ordinary shares that are outstanding for the company.

If the total number of shares were increased then the profit per shareholder would reduce and that’s primarily what happens in the case of diluted EPS.

Diluted EPS is calculated by assuming that everyone who has an instrument that can be converted into an equity share converts it into an equity share and so the total number of outstanding shares of the company increase, thereby reducing the EPS.

Stock options are one example of these kind of instruments, preferred stock is another, and in the case of many Indian companies – FCCBs (Foreign Currency Convertible Bonds) feature prominently among instruments that can dilute the earnings. Subject to certain terms, all these instruments can be converted to ordinary shares by the instrument holders and if they did that then the profit available to each shareholder will be reduced and earnings will be diluted.

Now just because an instrument can be converted into a share doesn’t mean that it will be converted and that will be true in a lot of cases where the dilution occurs due to preferred stock or FCCBs.

The other aspect of this is that when you convert such instruments to ordinary shares the company is relieved of the obligations that arise due to them. So, if FCCBs were converted to shares then the company no longer needs to pay any interest on them and if the preference shares were to be converted to ordinary shares then they won’t have to pay dividends on that any longer, so that will actually increase the profit available to shareholders and that’s why the net profit that’s used to calculated the Basic EPS and Diluted EPS is different.

Although not exactly diluted EPS, one thing that comes to mind while talking about this subject is when companies do an IPO – they often sell promoter stock and issue new shares as well.

The EPS and PE ratios that are normally reported in the papers and present in the prospectus are the ones that are calculated before the new shares are issued. But that is a bit inaccurate because as soon as the IPO hits the market, the new shares will be issued and the earnings will be diluted to that extent. I have an extensive post on that with the specific example of Power Grid FPO and that will make a good further subject and also give some context on how the dilution actually works with some concrete numbers.

As always, questions and comments welcome!

This post is from the Suggest a Topic page.

Rupee slide is a symptom, not a problem

As the Rupee hits new all time lows against the Dollar, it is natural to look for ways to arrest this slide and look for solutions to this problem.

The problem however is the not the Rupee slide itself – the fall in the Rupee is the symptom of underlying problems and you have to look at those problems to find solutions.

You can take short term measures to stop the fall but if they are not backed by long term efforts to correct the underlying problems, nothing will change and we will have to deal with the same situation 8 or 12 months down the line.

RBI allowing banks to set their own interest rates on NRE deposits and making these NRE deposits tax free is a good example of a short term measure. That would have surely helped bring in foreign exchange at the time, but since January, the Rupee has already lost 9% against the Dollar so whatever gains an NRI will make on the interest have already been nullified by the loss in the value of Rupee, and any similar measure is not going to be as attractive a second time.

While such short term measures are essential at the time of volatile downturns, past experience has shown that they aren’t enough to reverse the trend over a longer duration.

The exchange rate depends on the demand and supply of INR and foreign currencies, and that relationship is shown in the current account and capital account of the country.

Simply put, the current account is the account that shows the imports and exports of goods and services and the capital account is the account that shows the money invested by foreigners in India, and money invested by Indians outside the country.

As far as I know, India has never had a trade surplus, which means it has never exported more than it imported and the deficit that occurs as a result of this has been met by investments by foreigners in the form of FDI and FII inflows in India. But recently, even those have slowed down putting pressure on the currency.

A simple fish – bone diagram will help explain this better.

Rupee Slide
Rupee Slide

Current Account Deficit

The current account deficit as measured by the difference between exports and imports of goods and services has never looked in worse shape. The trade deficit last fiscal was $184.9bn, and this is as high as 9.9% of GDP.

On the import side, higher oil prices, and gold imports are causing a lot more outflow than previous years and as I wrote in January, these two alone contributed to 43% of Indian imports.

Exports have been slowing down too and in fact March of 2012 actually saw a drop in exports from a comparable period a year ago, something that hadn’t happened for more than two years.

Capital Account Deficit

On the capital account, FDI has been in the news for all the wrong reasons. Even historically, India has attracted lower FDI when compared with other emerging countries and the lack of reforms and the inability to make any progress on issues like FDI in multi-brand retail means that India has been below its potential in attracting FDI from the world.

FII investments have dried up due to the global flight to safety because of the resurfacing Euro concerns, but even before that, after the GAAR announcement in the budget, the FII volume had reduced quite a bit in the Indian market.

Investments also depend on the general economic environment and that hasn’t been good in the past few years leading to an environment which doesn’t inspire confidence in investors (both global and domestic) to put money in the market.

If you look at these factors, some of them are within India’s control and some aren’t – India can’t do anything to influence oil prices, or do anything about the Euro problems but it can certainly take steps to simplify labor laws, get clearances fast, build infrastructure to get foreign investments and other such things. These things need to be done anyway to help improve the standard of living of the people in the country, the volatile Rupee fall just gives a sense of urgency to carry them out.

Facebook, Grexit and Investing Wisdom

The big news today is that Facebook barely traded above its listing price and had it not been for the bankers behind the issue, the stock would have surely ended the day in discount. This probably doesn’t bode well for the future but then with the market you never know.

There were a number of articles about Facebook’s valuation the whole week and most people expressed skepticism about the valuation, however none of them come even remotely close to the excellent valuation done by professor Aswath Damadoran.

All this excitement took all the attention away from the other big thing that’s on everyone’s mind these days – Grexit.

Hemant has a good article on what you need to think about when you start your own business.

Deepak Shenoy laments the recent moves to curb freedom as evidenced in a court order to ban Vimeo and the new set of  IT Rules announced by Kapil Sibal this week.

Harvard Business Review on building your personal user interface. 

Finally, the best thing I’ve read in a long time – pearls of wisdom from Paul Kedrosky on Facebook in particular, and investing in general.