Technical Analysis - a misunderstood topic by fundamental analysts

Technical Analysis is a much less understood subject by fundamental analysts. It is considered more of voodoo than being an art based on science of patterns and trends. Lets try and dispell some of the myths so technical analysis is treated more of a friend by most of the fundamental analyst community.

Technical analysis gives you a view to how other market participants have reacted to the stock in the past. This is an important data to understand and interpret as humans tend to react the same way in times of greed and fear and hence likely to repeat such behavior. In essence, a technical analyst believes that patterns repeat themselves and hence tries to find patterns in the stocks previous prices and volume charts and extrapolate the same in hte future. The basic tenet behind technical analysis is that human behavior is repeated whether it be greed or fear. Hence the knowledge of market behavior participants in the past gives you another data point to consider ascertaining the stocks future performance. Technical analyst is based on human behavior be it greed or fear and people tend to react in the same manner no matter what security or what time frame and hence the concept of symmetries and patterns.

There is a saying in the Indian market “bhaw bhagwan hain” meaning price is god. Prices by themselves convey a lot as is taught to us in basic economics. Technical analysts take it to the next level by looking at open, close, high and lows of a security in one day, one week or one month. By looking at patterns they can tell whether bears or bulls rule the market.
As is with fundamental analysis, it is more of an art than an exact science. For a fundamental analyst a P/E of 10 can mean overvalued as well as undervalued depending on where the market, the sector and the company has traded historically and his future expectations. Similarly for a technical analyst it is the subtle art of deciphering patterns and symmetries can make all the difference whether a particular stock is overvalued or undervalued.

The basic advantage that a fundamental analyst gets is to get a sense of the entry and exit levels of the stock.

A word of caution - Technical analysis does not work on illiquid stocks as in such stocks it is not the behavior of the masses but that of a select few that have more often than not insider information. Hence, technical analyst is most useful on liquid stocks.

Time for capital market participants to look at emerging markets more closely?

For the last 30 years, growth in financial assets was primarily driven by rapid increase in equities and private debt securities in countries such as United States, Japan and Europe. The world’s financial assets – including equities, private and public debt, and bank deposits rose from $11 trillion to $194 trillion, becoming four times the size of GDP.

The United States has the dominant share of the global financial markets with $50 trillion(385% of GDP) of assets. The eurozone is second, with nearly $40 trillion (314% of GDP). Japan ranks third with $26 trillion(533% of GDP) and the U.K. market has less than $8 trillion(325% of GDP) of financial assets. Asian financial markets remain fragmented and have very different characteristics. Japan has a huge government-debt market, whereas China holds 75% of its more than $12 trillion(270% of GDP) in financial assets as bank deposits. India's financial system is tiny, with only $2 trillion( 160% of GDP) in assets -- possibly ranking as the global dark horse in the decade to come.

However, after the 2008 downturn, the drivers of future growth have likely shifted. There is a growing consensus that going forward, growth in financial assets would be led by emerging markets such as China and India. There are primarily two reasons cited for this – one, the fundamentals support it; second, there is enough room for them to grow.

Equities have been the fastest growing asset class in mature markets since 1990, as corporate earnings and price earnings ratio increased. But now, earnings growth has slowed and valuations fallen. In developed markets, GDP growth is likely to more modest due to aging population and mounting government debt- little reason to believe that corporate earnings would grow, if at all from domestic growth. On the other hand, emerging economies will likely grow much faster on the back of better demographics and high savings rate. India alone would have 270mm net increase in working age population (almost the size of the US) and middle class would nearly quadruple from 22 mm to 90mm. Subsequently, consumer spending would increase by four times to $1.2 trillion by 2025. Secondly, these countries lack basic infrastructure and hence massive amounts of financing will be required to build them. India alone would need about $1.2 trillion capital investment to build its roads, metros and cities.

Thirdly, the growth of the equities will also be driven as more state owned enterprises are privatized and as existing companies expand. It is commonly believed that only about a fraction of the companies are listed in emerging markets, while about 70% of the companies’ trade on the exchanges in the US. Similarly the corporate bond markets and other private debt securities would grow with significant legal and financial reforms.

The third big factor contributing to the growth of financial assets would be bank deposits. Currently 2.8 bn people in emerging countries are unbanked. For instance in India, more than 50% of the household savings are pooled into hard assets such as housing and gold. Bank deposits would grow significantly as more of the unbanked are brought into the mainstream financial system. As more and more people open savings accounts and household savings grows, deposits would grow.

More importantly, if we compare the size of financial assets in terms of GDP, more commonly known as financial depth, most emerging markets are tiny compared to the US and other mature markets. The total value of all emerging market financial assets is equal to just 165 percent of GDP – just 145 percent if we exclude China – well below the 403 percent financial depth of mature economies. Clearly there is a lot of room for the assets of these economies to grow.

Clearly, all these factors combined would lead to substantial growth of financial assets in the emerging markets in the next twenty years; their relative share in the global capital markets would only gain further prominence. It is simply too glaring to be ignored any longer.

IMF raises India's target GDP growth to 9.5%, is it sustainable?

The IMF revised India's target GDP rate to 9.5% with many brokerage houses following suit. It also reported that growth would be largely consumption led . Clearly this is great news, where growth in US and China seems to be losing steam. But is the "largely consumption" led growth sustainable? Lets break down the numbers -
GDP growth has three components -
1. Due to Investment growth
2. Consumer spend
3. Net exports
In the case of US, where lot of core investment has already been made, the growth is largely consumption led. China is largerly export oriented economy and hence most of its growth is derived from exports and investments.
India differs from the two -
India has net negative exports and hence growth in India would be largely investment and consumption led. Also, since it is still a developing economy, investment growth forms a major component of GDP growth. Now, lets look at the two numbers broken down -
1. Investment - The investment to GDP growth is 34% which is quite good. However, this might largely be projects getting completed rather than new projects being started.
2. Consumption - In an economy such as India, where organized retail forms 4-5%, it is hard to track consumption growth. Consumption is tracked through quarterly GDP estimates - household expenditure. Secondly, we can use IIP data as a proxy. We break IIP data into consumer durables and consumer non-durables. Consumer goods data is very healthy at 6-7%, but if you further break it down - consumer durables is 20% and consumer non-durables is 2%. My index of sustainable consumer growth is non-durables growth. The reason being - consumer durable growth is driven by interest rates (one buys an automobile, as they feel interest rates might go up). Consumer non-durables is lifestyle augmentation - once you start consuming these, you can't really roll them back - they are not one-off purchases.

To maintain an 8-8.5% growth, we need consumption to grow at 6%. If you look at the historical pattern - it tends to lag and is more robust. Household consumption is also more stable than investment spending. When things go down, households preserve their consumption expenditure until their incomes start getting strained. On the way up, household expenditure does not go up all of a sudden, it gradually does. In the 2000 cycle, investment hit rock bottom in 2000, then gradually recovered by 2002, however consumption response to income growth came in late 2004 and gradually picked up in 2005.

Is it going to be the morning after?

In a span of 15 months, i have seen a black Monday(Sensex down 1000 pts) and a golden monday (sensex up 2200 pts, upper circuit hit, mkts closed for the rest of the day). Indeed markets have very short memories. On March 9th anything and everything was getting sold. On May 18th anything and everything was getting bought.
What would explain this irrational exuburance ?? The markets seem to think that the UPA govt will change the face of India. To some degree they would, but the market has conveniently forgotten about the budget deficit and that the current government was in power for the last 5 years as well. A 7-10% surge was warranted, but the kind of franctic buying - $1bn of FII investment with PE of 15.4x (above the long term average of 14.5x) . FII's can very easily pull out money as they put money in, so for a retail investor it would be key to look at fundamentals, rather than sentiment. Surely, it seems the momentum is huge - it remains to be seen how long this rally will last

Venture Capital Industry in India and Bay Area - a few points of comparision

A lot has been written about venture capital in India and US, and here is my take on it from the perspective who has lived in the bay area for 9 years, went through the dot-com bust and helped sell a company , worked at one of the internet darlings only to be working at the best investment bank of the world.

The industry in India and Bay Area is vastly different

1. Stages of investing - Bay Area as you can imagine is the incubator of all technologies and the venture capital ecosystem is mature and setup with firms specializing at each stage of the company starting from seed stage investing to late stage firms. However, in India most venture capital firms have morphed into late stage growth capital private equity shops. My personal take on this is that over a period of time they would see a dearth of deals as the venture funding required at the seed stage or early stage of investing is missing.
   
2. Succesful exits - Most venture capital firms have not witnessed the kind of exits that they have seen in the valley - the likes of Google, Yahoo!, Electronic Arts. It is going to take some time for venture backed companies in India to see such exits.
   
3. Environment of innovation - I see a lot of development, especially in the IT hubs of Bangalore and to some extent in Mumbai where the young folks are leaving their cushy jobs to become first generation enterpueners. Also a lot of venture capital firms are visiting universities, colleges and having enterpuenership meets to create budding enterpueners. Such efforts need to be appreciated, however, it is still in a nascent stage and would take some time to develop.
   
4. Business Models - I think this point bears a lot of thought. There is a lot of difference of how the early stage companies are set-up. India is still trying to solve basic logistical problems like bus ticket inventory (bus travels is an unorganized sector with most operators having 2-3 buses with little incentive to bring inventory online) or yellow pages where the carpenter in the neighborhood is listed on the web. So, most business models that get funding are either models that have been successful in the US and are being replicated in India.
   

Trends in BPO/KPO industry in India

From the hey days of IT outsourcing which put India on the world map in 2000-2001, this is a successful and tested model. This model has contributed almost 3-4% of India's GDP in the past.

The Indian IT-ITeS sector (including hardware) grew by 33 per cent in FY 2008 to reach US$ 64 billion in aggregate revenue. Of this, the ITeS/BPO sector contributed US$ 12.5 billion as against US$ 9.5 billion in FY 2007, an increase of 31 per cent.

The Indian ITeS-BPO exports grew significantly from US$ 8.4 billion in FY 2007 to US$ 10.9 billion in FY 2008 while the revenues of domestic BPO grew to US$ 1.6 billion in FY 2008 from US$ 1.1 billion in FY 2007. The sector provided direct employment to 700,000 in FY 2008 up from 553,000 in FY 2007.

This business model is based on labor arbitrage and works on two conditions being fulfilled- one, wage disparity between different countries and secondly, tasks that can be performed off line using a predetermined set of instructions. My personal take on this is that wage discrepancy will exist in India so long as India keeps churning young eager high caliber talent from its numerous engineering and management schools ready to work for less than $500 a month. According to economists, India would have the largest population in the world in the age group of 20-50 by 2035.
The two new trends in outsourcing are legal process outsourcing and with the demise of banking system in the US - banking and research KPO. However from my experience working at a services company, for the long term success of such models - the model down the line needs to maintain Service level agreements (read Quality) as well as provide value addition to the process/task ( read move to being a product company in addition to a purely services company or be able to provide on the ground research/intelligence not available to the foreign outsourcer). Some of the emerging financial services companies are Amba Research (Helion Ventures), Copal Partners, Evalueserve, UnitedLex (Helion Ventures), Pangea3 (Sequoia Capital), Mindcrest (Ganesh Natarajan), and JuriMatrix (Jerry Rao) to name a few.

How do Venture Capitalist value your startup

There are generally two ways VC's do their Voodoo !!

1. Early Stage start-up - This is more of an art and less of a science. To calculate the exact value of a business is tough, since a lot of assumptions used can change over time starting with from the definition of the market the startup is going after. However, the general method used is - start with the market size, estimate as to how much of the market share this startup can potentially capture and then multiply these two with the profit margins. This would generally give you an idea of the value of the startup. But as you can imagine there are a lot of variables and most numbers are best a gestimate firstly because there are no published authoritative reports on how big the market size is or would be and secondly, over time how would the competitive landscape change - meaning, how much market share and the startups' profit margins might be. Hence, frequently you would find a lot of Venture capital firms focusing on the sectors they know best(so the assumptions/variables have been tested and verified against) and investing money with people they trust (so they are reducing at least one variable/risk - the management's ability to deliver.

2. Late stage start-up with some cash flows - Again, you would use the same methodology as you would with early stage start-ups, the only difference is the variables/assumptions are more grounded in reality. Firstly because the company has been in operation for a while so you can judge from past performance as to market share and profit margins. Secondly, hopefully you are in a sector which seems attractive to other enterpueners and you see competition - you a benchmark to compare your startup both in terms of precedent deals that other VC's have done as well as market share and profit margin numbers to compare.