An Overview of Financial Markets - II

(Recap: In part I, the motivation for the series had been laid out. In part II, we had discussed a bit about stock markets, what are their objectives, why liquidity is important etc. The previous article had been concluded with the point that to understand stock markets (which is the secondary market) better, it is important to understand the primary market. In this part we look at the primary markets.

Acknowledgments are also due here to Shyam Sundar (Peter to IITM guys :)) as some of the ideas came in our conversation.)

III

Primary Markets

As a definition, we can use the wikipedia definition that primary markets is that part of the capital markets that deals with the issuance of new securities. Hence, the term primary. It is like this is where there instruments originate, then they are traded on the secondary markets.

But what are these instruments? The common term for them is securities. Again, the term is self-explanatory. A security has a commercial value and you can use it in a commercial transaction as a security of some kind.

But why do these securities originate? Who originates them? Why do they come into existence?

For that consider the following scenario. You have a business idea, say, something related to setting up a website for something. You do some estimation and find that 40 lakhs is needed to get the project off the ground. You may have savings of 10 lakhs and can maybe borrow 10 lakhs from family and friends. So what has to be done for the 20 lakhs?

You can approach a bank. But a bank may not like the risk they are seeing. Like most dotcom financial projections, your projections promise the moon and sky, if you reach a certain critical traffic. And honestly, that is a big "if". Even if a bank were to fund it, it would require something as collateral and you may not have that.

Another alternative would be to approach an investor who has the stomach to take the kind of risk you are looking at. But before that, you need to write a business plan. Too much hype is made of business plans mainly due to the proliferation of business plan competitions. A B-plan (I hate that term!) is simply a checklist of items to make sure you have thought things through. Therefore, any business owner needs to think about:

• What is it exactly he/she is selling
• How to get the information across to the public that they exist - there is an art in this. The look and feel of the communication exercise matters as much to the public's perception as is the actual look and feel. Ok, not as much, because even the best marketer can't sell a bad product, but between two almost equal products, marketing can make a huge difference.
  
• How much money would be needed to finance the funding – how long would funding be required, when can the venture be expected to break even
• Operational issues – what sort of office do you want, where should your office be, how many people to hire, where to get them etc.
  

It is just an organized way of thinking about a business. At the starting time, only a few things would be clear, the rest of the picture emerges as you go along. But atleast, when you have a plan, you know what you know and what you don’t know!

Therefore, before going and meeting the investor you draw up financial projections. According to your projections, subject to certain assumptions, you don’t make money for the first two years but after that you really start raking it in. After the initial two years, you expect to make upwards of 2 crores a year say.

The investor looks at the plan and he likes it. He likes your business model and the idea but he is not sure if you have the maturity to execute it. Imagine the following conversation:

Investor (I): I like the business model. In fact, I think you are being conservative. This business can really grow exponentially once we take the hit for the first two years.

Entrepreneur (E): (Smiling) That’s encouraging…

I: But, I have my doubts on how you would implement it. I think you need to come back to me with some more details on the team. Fine, how much money are you looking at?

E: I have 20 lakhs, I estimate I need 30 more to get the process started.

I: Hmm… I really like your business. Subject to a better team, I am interested in taking equity stake. I could give you 30 lakhs for majority stake in your company.

E: How much?

I: I would own around 60% since I am giving that much money. But don’t worry I will be a dormant partner. Think about this. The other option is that I give you money in return for an interest payment. The interest payment can really screw you, this way I swim and sink with you.

E:(To himself) I am not comfortable with that at all. What if he is not dormant? What if he gets edgy after one year?

(To the investor) What happens if I borrow for an interest payment?

I: Hmmm… In that case, I am ready to invest 30 for 5 years at an annual rate of 20%.

E:(To himself) Wait… that means I need to pay you 6 lakhs a year as interest! And in the final year I have to return the principal and interest at 36! That is nonsense! This guy is sitting on his ass, doing nothing and I have to pay 6 a year in interest!

(To the investor) This is too high. In the first two years, I am anyway making a loss, this just adds to it.

I: (Persuasively) Look, I think you can reduce the operating costs. The interest payment would not pinch so much and…

E: If it is 20%, then you must give me a two year interest holiday? I can pay the corresponding interest at a later date…

I: You are not getting my side of the deal. If I charge 20% and say the company goes bankrupt in 2 years, I atleast get back 12 lakhs…

E: if the company goes bankrupt, you will get a claim on whatever I get by selling the assets of my company like the servers and stuff…

I: Haha… how much will that be! If I give you a 2 year holiday, I could earn much more by just putting my money in a fixed deposit. That is why I offered equity stake as an option. Think about these things and get back to me.

E: My problem with equity stake is this. You are a nice guy, I like you. Suppose, for some reason, you sell the stake to someone and exit and that person does not work with me, what happens.

I: If you have a problem with majority stake, we can work on a combination of debt and equity. Think about it.

E: Ok, I will do that. Thanks for your time.

I: Thanks for yours!
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This is a stylized example. An example is an isolation of reality, isolated by the author with an intention in mind. Please do not think this to be how actual negotiations get conducted. I don’t know how they happen, maybe it is like this, maybe it is not.

But the example brings out points I would like to illustrate.

• The entrepreneur needs money and the investor, unhappy with returns from other sources, is looking to increase his/her returns. It is basically an opportunistic union and while it would be great to have a human touch in the process, the priorities of each party are clear. The entrepreneur does what is best for his baby, the investor does what is best for himself or his shareholders. Having said that, if either one gets over smart, both tend to lose.

• There were two structures discussed here. One was an equity investment and the other was a debt investment. If the business goes according to plan and it really works out, the equity investment makes more money. How? Say, the investor took a 50% stake and the company grew to having profits of 2 crores. This 2 crores is the earnings for the shareholders in the company. Therefore, the investor gets 1 crore, the entrepreneur and his family gets the rest. However, there are two options. The shareholders can take back the money i.e the 2 crores, but in that case, the company will not have any cash reserves to begin the year. Or they could reinvest it back into the company to make more money (hopefully) the next year.

In the debt structure, the investor gets 20% in good times. But in the bad times he gets the first claim on the proceeds from the liquidation. At the time of bankruptcy, the equity holder gets whatever is remaining after the creditors have been paid off. That makes sense, if the equity holder could have the first claim in good times and bad, then even when the going gets slightly tough, he may be tempted to run the company into the ground! Therefore, the debt structure is a less risky structure; both the loss and gains are capped. The equity structure is riskier. The moral from this is that in a good deal, the reward must be commensurate with the risk taken.

In the above example, the entrepreneur was a small guy and the investor was also a relatively small guy. It need not be. A big company like Reliance can approach investors for money for a new plant they are putting up. A bigger company could approach investors for funding for a takeover. These investors could be a bank, could be a private equity fund, could be a hedge fund etc. The actual structure of the deal would depend on the risk appetite of the investor and their commitments to their shareholders.

This "structure" that we spoke about is essentially a contract. That piece of paper now has some value, hence it becomes a security. Depending on the nature of the contract, this can either be made into a mass product and sold to everyone. Or you can make specialized, newer contracts from this and sell it to specific institutions. Either way, these agreements, if they have a value, can be traded. Where would they be traded? In the secondary markets.In the next part, we would take a closer look and begin to look at how to apply these ideas to real world situations.

An Overview of Financial Markets

(This is part I and II of an n part series on financial markets as I understand them. n part because even I don't know how many would be required. Not to fear, I will not leave it half baked, I have written parts III and IV and will put it up based on the response to this.)

I

In the recent past, there has been much focus on the functioning of capital markets. This set of blog articles is aimed at the layman who may be bewildered by the sudden assault of finance-related jargons everywhere. Turn on any TV channel and there are gurus and pundits each giving their own views sprinkled with newer and newer jargon. Now, in addition to TARP, there is TALF, TGLP yada yada and it gets too much for regular market watchers also. Funnily, two highly respected people, sometime from the same organization, hold different views on the same issue! And sometimes the confusion gets pretty serious, for instance, when President Obama recently blamed a set of “speculators” for their intransigent attitude that led to Chrysler filing for bankruptcy.

Just at the end of February, everyone had given up on the stock markets. Publishers were paying advances on books that were going to address the death of Capitalism. Now, a lot of the major indices have rallied 25-30% from the lows and suddenly, the world seems sunnier. And Economists are talking of U,V, W shaped recoveries?

What the hell is all this? Why do we need a stock market? What are these financial institutions? Who is the “Market” that everyone is talking about? On what basis is stock trading done? If it is indeed blind speculation, why doesn’t the government shut it down? If it is shut down will the world end as these guys claim? Is financial innovation good at all? If you look at the daily turnover of BSE and NSE, it has been varying between 80,000 crores and 1,00,000 crores. It may come as a surprise that around 70% of that is in the Futures and Options Segment of the NSE. If indeed financial innovation is bad, how has it withstood the test of time and in fact gained in importance?

As stated earlier, this is meant for the layman. However, I am still a student and just because I use the word layman it does not imply I am an expert. I have tried to keep it as accurate as possible but please feel free to point any flaws or confusions in the presentation.

Also, at first shot, I would not advise the reader to apply whatever has been written here to the real world. Some of the ideas will be “idealized” forms. We will see later how to apply it.

II

The Stock Markets

When I was in school, I used to think that the stock market was an entity run by the Government of India. This misconception arose due to the fact that the stock market position was telecast daily on the news. I figured if it is coming on a daily basis it must be something important to everyone and the Government usually controlled these institutions.

Of course, I later realized that it is a private entity and the stock market number quoted was that of the Bombay Stock Exchange. There were many stock exchanges once, almost all state capitals had one, but most went out of business. Interestingly, since the BSE and NSE are for-profit organizations, they could issue shares and get listed on their own exchanges! Now when people refer to stock market they could be referring to either the Bombay Stock Exchange or the National Stock Exchange in Delhi.

(Actually, I need more clarity on how the index numbers are calculated. I have heard that NSE is based on market capitalisation. So is the Nifty a weighted average of the market caps of the 50 companies? Fundaes needed please)

The stock exchange acts as a marketplace. What do exchange owners want? They want people to trade on it and they make their money by taking a part of the transaction fees. The transaction fee is very small in percentage terms but very profitable overall. As mentioned earlier, say, the overall turnover of NSE is 60,000-70,000 crores on an average per day. 0.01% of that translates to 6 crores a day. With 250 trading days on an average, we are talking of upwards of thousand crores a year of turnover.

For the exchanges, success begets more success. If there were two exchanges, similar in terms of what you can trade, one with 1000 players and another with 100,000 players, the second exchange is likely to have more “liquidity”. What does that mean? If you go to money.rediff.com, and look up the quotes for individual stocks, you will see various bits of information given about that stock. You will find information like Day’s High/Low or Year’s High/Low. In addition you would see something called Volume. That gives an indication of how easy it is to get into that stock or get out of it.

For example, according to some analysis, you may think a particular stock is a good investment. But for the past 6 months if it has traded only say 1000 shares a day and you want to buy 500 shares, then you could have a trouble exiting the position. When there are more buyers and sellers, the probability of getting the price you want gets higher. This attracts more people into that exchange which in turn increases the probability of getting the desired price and so on.

However, if the 1000 player exchange offered more innovative services and charged a higher fee, there may even be an “oomph” factor associated with it!

Exchanges take on significant operational headaches. With technology, it is not that apparent today. My father said it used to take more than a month in the 80s and 90s to get hold of the shares you bought. Errors were common and people made arrangements to counteract those problems which in turn created other problems. :P Today delivery happens at T+2 i.e you get hold of the shares you two days after you bought. In addition there are facilities like “Buy Today Sell Today”, “Buy Today Sell Tomorrow”. While these facilities increase the liquidity, they also require clear definitions of who is legally liable for what.

“All this is fine. But the basic question has not been answered. On 28^th April 2009, the BSE went down by 350 points and on 29^th April it went up by 400 points. The stock markets seem like a casino or a con game. What is going on?”

The stock markets are secondary markets. To understand the existence of stock markets it is important to understand primary markets.

“Hey, this is the problem with finance types. Everyone speaks very well but no one seems to give a one line answer. Is it a con game or not?”

Hmm… If I could, I would. The financial system that has evolved is not an Act of God. It is the result of evolution, conventions and practices. And sometimes the logic goes a bit backward and forward, wish I could help it!

On Managerial Challenges

The recent events at Satyam have been quite shocking, starting from the Maytas announcement to today's startling confession. The letter itself is a must read. It has been well crafted and one almost feels sympathy for Ramalingam Raju. I suppose the ensuing events will be avidly watched. However, the events set me on another line of thinking. The musings below are related to the incident but are in no way my views on Satyam as a company.

I use the word "He" for the manager. I understand it is completely inappropriate given the times, but I am used to writing like that, so Mea Culpa.

I have an agenda for writing this. Up till now, being a student, it was easy to blame the world, pour scorn on authority, blame it on the old people. Now, that I am about to pass out (and possibly never return to student life) I experience the occasional bout of nostalgia. As a graduate of two premier institutions, I suppose I have been trained for those very authority positions that I once happily poured scorn on. Those fancy degrees carry some responsibility, no two ways about that. Being a student is in a way... seductive. Crib without responsibilities, sleep whenever you want, eat whatever you like, dress however you like. Is it worth leaving all this! Should not be tough to kill time as a grad student somewhere else, I suppose. Then I remember exams and CGPA and the cloud clears. Let me at 'em :P

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The Problem of Yes-Men

There is the recurring phenomenon of perfectly good top managements bungling up in a large scale that smacks of stupidity. This is obviously perplexing. The worrying thing is if it can happen to people who thought themselves to be smart, could it also happen to us? (:)) Often people rationalize that by saying that it happened to that company maybe because their performance appraisal mechanisms were not good to begin with. Possibly the HR systems were flawed. But it won't happen to us. Possible. That is the first point of check.

However, I would contend that even companies that had perfectly good HR processes are prone to fall into this trap, despite the best intentions. Note the Italics. I am not saying that all companies are doomed. I am just saying that the effects of management are felt in a very subtle and nuanced manner and it is easy to see the effect but very tough to trace the causes.

Note that I am talking about senior executives - upper management and the top layer of middle management maybe. (NOT about freshers :)) As people start moving up the corporate ladder, I argue that it is very easy for them to get stuck in clubs, cloistered circles, groups. Remember that though senior executives have lots of people indirectly reporting to them, ("under them") they repeatedly talk only to a few executives for critical decision making inputs.

Given two equally good subordinates, senior executives will be more likely to pick those with whom they have a good working relationship. And this is where the problem and subjectivity comes. Why does the senior manager pick the subordinate with whom he has a better relationship? Is he irrational/evil/dishonest? Not necessarily. Given that both candidates have similar calibre, working with someone with whom you have a good chemistry can really zoom productivity. It is extremely expedient. For example, in IIM, after a point, group formation falls into a steady state and when teams have to form in 2nd year, usually there is a core group of 3/4 that always sticks together. Even if the output is not mindblowing atleast you would have had fun working this group, so you stick to it. It is a perfectly sensible thing to do.

Of course, the basis of the excellent working chemistry can be random. It could be linguistic similarity (that old complaint in every IIT fest coord selection ;)), similarity in outlook, similarity in movie tastes, anything! Of course, it could also just be sucking up and the manager could be dumb not to see that, but remember we are talking of "good managers".

Hence, these perfectly rational managers have a predisposition to taking people with similar viewpoints. I argue that this phenomenon to make things more efficient also leads to biased information flow. How does that happen?

To understand this, one must always bear in mind this axiom: "Human Beings Respond To Incentives"!

A lot of situations in life are inherently ambiguous, maddeningly ambiguous. When you look at the data in one way, you can say one thing. When you look at it in another way, you can say the completely opposite thing! I am sure people who have worked in any sort of data crunching exercise would testify to this. But say, you had to take a stand. How would you respond?

In the real world, often the subordinate has an estimation of the boss. (Even the geekiest of them) Given that you are faced with the unenviable task of coming up with a recommendation in an ambiguous situation and have to recommend something. You have twisted and turned data every which way, but it refuses to throw insights. Deadline is nearing. What do you do, sport?

You have two options. Most probably, you know your boss' bias. Most probably, you have an estimation of what his decision would be like. If you give a recommendation that drastically differs from his view and he takes it and it goes kaput, then the penalty is likely to be high. If it goes well, then the reward is also likely to be high.

On the other hand, if you concur with him, if it goes wrong, he is not likely to blame you too much. (Because he was thinking that anyway) And if it goes right, he is likely to be happy for seconding his "intuition".

If you are a risk averse rational individual what do you do?

Most probably you would recommend what you think that your boss was thinking, but you may add a rider here or there for the contrary view. (:D)

What?! Aren't you being dishonest? Shouldn't you fight for your cause, you worm! But the beauty is, the situation is so ambiguous even you do not know what cause you are fighting. It is better to do the safe thing. Once this becomes a habit, your boss' world view starts becoming your own because that is the "tie-breaker" you use to resolve data ambiguities. Soon, an information filter steps in.

(Stupid example, but one that illustrates the point. Imagine, you were at a Roulette table and your boss forced you to pick a number for him. You know that he is predisposed to 10 say. The sensible thing would be to just say that. Similarly, lots of decisions in life can be akin to taking the blind guess, even after all the analysis.)

Remember, all these people were perfectly sincere, perfectly rational people. What is the solution? I don't know. Maybe there is some HBR article which looks into it in detail. My solution to everything is just to be aware that this could be a problem and factor that into practice. That is all. There are no magic solutions. When you see some things are consistently not adding up, just break out of your routine for the heck of it. Talk to people who may have previously annoyed you, just for the heck of it.

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Why is integrity so tough?

When I was in school, I used to get bewildered when certain personalities were praised as men of impeccable honesty, integrity and character. I used to wonder what was so great in that. After all, they were just honest. As a kid, being honest is not really a big thing. And even dishonesty is mostly mischief. (Note that I have used the words "mostly mischief". Kids can be more sophisticated in their emotions than adults give them credit for) So I never understood what was the big deal in being honest. Now, of course, we understand that honesty is the basis of the social contract that society must revolve on.

But that is the problem! It is naive to think that crime does not pay. The truth is... it does, it must, otherwise why will so many intelligent people do these things. (Madoff was NASDAQ chairman!) The truth is there are lots of dishonest people who are doing quite well. Every reader can name a few. This raises a few questions.

Are all these dishonest people the product of some genetic orientation?
Laughable. But there are lots of well educated people who harbour these views and let them out only when drunk or in amenable company.

Are kids born in a certain type of environment prone to more dishonesty than others?
Possible, very possible. HOWEVER, the determinant of that environment is not wealth. There could be suitable logical arguments to state that people from a poorer environment are prone to be more dishonest. I would qualify that and state that "Perhaps people from a poorer environment may have compelling reasons to be more dishonest than the average, but the maginitude of the dishonesty is rarely large." Perhaps the dishonesty is to get a few 100 rupees but it is rarely more harmful than that. Then what could that factor be? I don't know.

The seeds of one man's dishonesty are almost always sowed by the succesful act of dishonesty of another man. And in the case of corporates, one act of dishonesty by a competitor is enough to justify it amongst managers and make some other dishonest act acceptable. In this case, all the other IT companies appear to have carried themselves well, so this idea may not hold. From the point of view of incentives however, this would be a logical proposition.

Extending this idea, one may well speculate that the idea to fudge the balance sheet would not have occurred to the promoter on his own. The person who would have advised Raju may have told him that he has done this kind of thing earlier. Or there may be stories of other companies which must have done this and gotten away. That could have tempted Ramalingam Raju. Of course, I may just be wrong, in which case he was just foolhardy.

But the point that I am trying to make is that despite all the Panchatantra tales and Bibles, there is something that draws humans to commit crimes, every time thinking that they can beat the odds. What gives them that feeling? That feeling will repeatedly arise only if there are odds to begin with. That is, if people were sure to be punished then they would not play the odds. However, due to physical limitations every crime cannot possibly be punished with utmost fairness. Hence when there is atleast one instance when a breach of law is not punished immediately, some individuals are emboldened to play the odds.

Of course, I am not advocating crime. The humiliation that is caused to people around you is just not worth it. I am merely speculating on the processes that lead to these behaviours.

I think this much is obvious. Most people would immediately walk out from a company that was indulging in dishonest things. But that is the beauty. No company will ask you to do something that is blatantly illegal. Similar to the data problem, the ethical dilemma may arise because looking at the problem from one way, it will be right and looking at it from another way it will be wrong. HOWEVER, unlike the data problem, if there is an ethical confusion, invariably there is something fishy about it. There is rarely an ethical ambiguity.

But let us address a common justification. Say the macro environment is itself corruption ridden and organizations justify unethical acts on the basis of that. While no one may do illegal things, people may even take pride in going the extra step to "help the company in operational matters". Imagine the dilemma of a high integrity individual who quits whenever he encounters unethical practices. Quitting the first two jobs on grounds of integrity may be okay. But after that it does not look good on the resume. By the third or fourth job the individual is left with no option to turn a blind eye. How does one resolve it?

Ideally, it is good to work for a ruthlessly scrupulous organization. By that argument, it may appear that there may be a handful of companies that we believe to be scrupulously honest. Then are the rest of the high integrity individuals left with no option but to become teachers and rant and rave against the immoral world from the safe confines of academia? Of course, one can also become an entrepreneur and create a high ethics institution.

I must admit I have no real solutions. I must resort to a traditional recommendation that there is no such thing as moral ambiguity. If confronted with such situations and if one cannot walk away from the company, the nest best course of action would be to design a creative and ethical work around. If that also does not work, I suppose the best thing would be to distance oneself from it. Of course, there will be professional consequences, but over time (hopefully) one will make back these losses in form of a premium for a name that inspires trust.

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A Note on the TATA NEN Hottest Startup Contest

I stumbled upon the TATA NEN Hottest Startup contest yesterday. The site can be accessed at http://hotteststartups.in. The site features a slide show on the 30 finalists, 5 of whom get declared as the hottest startups in India. I spent some time going through the websites of the finalists and I found the array of ideas and business models extremely stimulating.

A word here. It is one thing having an idea, it is another making it work. "Making it work" involves pricing it right, selling it in packages the customer wants, having flexibility to adjust to demand, managing operations, managing short term and long funding etc. Essentially, the same idea can be operationalised in different ways. One way to break down the operational aspects of a company are in terms of the 4Ps. (Product, Price, Promotion, Place) One can take an idea as old as the hills and play around with this mix and come up with an entirely new offering. Therefore, you could have a lorry business, but maybe if you came up with an innovative pricing scheme, and if pricing was very important to clients in this business (which is the case), then just that innovation could make your company different. You can take this one step further and become a company that comes up with pricing solutions for the lorry industry. (Of course, the demand would have to be large enough and all that) This is on the marketing side. On the finance side, for a startup, if your idea does not generate cash quickly, the pressure is that much more. Getting all these elements right ensures success. Frankly, it is not as complex as it sounds. One must always remember this. The MBA program is 100 years old, Corporate Finance in the modern form is 50-60 years old. Business on the other hand is thousands of years old. Hence, all these fancy terms constitute a checklist of stuff that the entrepreneur needs to be wary about. A more organized form of this "checklist" is the business plan.

Enough talk. Let us get into some ideas that I thought were worth sharing. (Please note that the list is very very subjective. These views are shaped purely by the personal experiences of one individual and in no way a reflection on the other startups)

There is a startup called Wyn Brands whose business model is based on managing the supply chain for fresh vegetables for customers like McDonald's, Domino's, Pizza Hut etc. Till now, I assumed that this would be an in-house function. Apparently, these firms outsource vegetable procurement (maybe even cutting of vegetables) to vendors! Who knew! But once you are aware that this opportunity exists, it makes perfect sense. If I ran a big restaurant and my vegetable demands are well understood (which is usually the case), why not leave the headache to someone else and just focus on quality check. I like this because the idea is simple and the value is clear. The problem is that it is easily replicable and risk of margin pressures in the future (due to competition). But that is ok. I am sure something can be figured out in time. What matters is that someone has got this to work. The company started in 2003 has a turnover in the range of 1-5 crores. Again, it would be interesting to see the net profit margin, but I still quite like the idea.

Another interesting startup is FieldTurf Tarkett. This company offers artificial grass for landscaping, indoor sports flooring, synthetic tracks etc. I would have expected that designers/architects would have normally been responsible to find a subcontractor for this kind of thing. In the case of sports flooring, I suspect that one would have had to contact foreign vendors. Currently, there is a lot of interest in non-cricket sports in India and I think these guys have come in at the right time. Of course, there is always the question of pricing and profits. But the reason I am highlighting this idea is that just by looking around us and asking how did this get here, we could get thousands of ideas. All of us walk into beautifully designed offices day in and day out. Some of us admire them, but we just assume that the builder would have taken care of it. But even the builder would have to contact so many vendors to achieve that goal. Just breaking down those elements and researching about them could be a starting point to ideate for the budding entrepreneur. For example, maybe, specialized energy management solutions for buildings are a big business segment. Observe and ask!

One totally whacky idea on first encounter, but kind of obvious on reflection is Sacred Moments. The company offers designer pooja kits! Outwardly, all of us like to pretend we are oh-so-rational, but face it, all human beings need something to hold on to. One would expect that this business is not only recession proof but one that thrives in recessions! I am sure these Bhakti Packs are sold for a few hundred rupees, but I doubt if it would cost much to put one of these things together. The biggest costs should be packaging and transportation costs. I would expect it to be a high margin business. Since I am currently not a pooja doing type, I don't see the value of this product for me. It would be interesting to see how this evolves. But I still like the entrepreneurial thinking! :) This is to highlight that you don't need to have high funda to the max ideas to become a "succesful" entrepreneur. If your objective is to earn a steady and comfortable income by working a few hours, then such "low funda" ideas could give you more bang for the buck.

In the Indian business environment, legal services and logistics are two huge huge gaps. Remember both of these are essential for the smooth functioning of companies in the macro operating environment. In the field of legal services, the startup featured here is TakeOverCode.com. Imagine, there is a fresh faced kid right out of school who wants to start something. The biggest stumbling block or the "fear factor", in my opinion, is the labyrinthine legal system that one may have to confront. I guess most people would go to their family lawyers. What if you never had a family lawyer? Then you would go by referral. Normally, lawyers do not advertise. (Someone told me that they are not allowed to advertise) This kind of a site, while clearly not advertising, serves just as that. By presenting some oft needed resources on the net, the company must be able to strike up quite a few clients.

Coming to logistics, we have Chennai based Ennovasys. Ennovasys' company profile says that "..[It] is a software company providing real-time asset visibility across supply chain." This is a really cool idea. Imagine you were a trucking company owner and could monitor your assets on real time basis. For the right price, I would buy it.

A related idea is Rasilant Technologies which offers tracking services based on RFID. However, their product offering is quite interesting. They offer inventory management systems, smart card solutions for campuses and clubs as well as secure access systems. There is nothing new about the business model but the reason I have featured it is because they have claimed in their profile that "Rasilant tackles Security concerns and improves organization processes through RFID automation and has a turnover of INR 1 Billion in three years." If this number is true, damn, who knew!

This post has gone for too long. The full list of finalists can be found here. In the IT services sector I liked DeskAway. I did not understand the exact value proposition of some of the other ones, but some of them have really high turnovers.

I will conclude shortly. There are two business models that I found to be very innovative but not sure about the take off for these ideas. One is librarywala.com. This startup uses the internet to revive that beautiful tradition of lending libraries. You choose a Price plan and the books get delivered to you! They claim that there are no late charges! Even with all that, I don't see myself signing up for such a service. But again, I would be very interested to observe this startup.

The other one is Mumbai based Ecomove solutions. While the argument that increasing pollution would see people switching to alternative modes like bicycles is well taken, unless the government makes special facilities for cyclists I don't see the idea taking off. Again, I could be wrong. It is not for nothing that these startups made it to the top 30 from over 500 nominess.

There are many more exciting startups here. Happy ideating!

Book Reco

I guess this is not the time when people would be going behind books on Derivatives, but I recently came across a nice book. It is called "Option Volatility and Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg. The Amazon Link can be found here.

The most popular book used on Indian campuses is "Options, Futures and Other Derivatives" by John C Hull. It is cheaper and much easier to obtain. It is my personal opinion, but I found Hull verbose and difficult to read.

The basic difference is, Hull gets into the mathematics, whereas Sheldon Natenberg is more of a "How Things Work" kind of book. Sheldon Natenberg was an Options trader while John Hull comes from an academic background. Both books are excellent in their own ways but the difference lies in the language and the mode of presentation.

Hence, if you are looking for a starter book that is mathematically less intimiditating or if you have read Hull and found it a bit above your head, I would strongly recommend Sheldon Natenberg.

Another book that has been strongly recommended to me (from the point of view of practise) is "Dynamic Hedging: Managing Vanilla and Exotic Options" by Nicholas Nassim Taleb.

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'Tis the time for alternate views

Given the current turmoil, one chances upon more articles questioning the integrity of the markets. In my view, the question is not so much as to whether markets work, but more of whether we must accept the boom and bust behaviour that has been characteristic of markets. While all of us enjoyed the highs of the boom, the current "bust" (which would be an understatement) has left most people questioning whether that was all worth it. (In fact, whether it was all there to begin with in the first place)

One such work which questions market fundamentalism is "The Alchemy of Finance" by George Soros. He delves a bit into philosophy, raising fundamental questions of how the human mind learns and understands. He uses that to build his "Theory of Reflexivity" making some important observations in the process. Frankly, I have found the book very difficult to read. I have been truly laboring through the pages. In fact, if it was not written by Soros, I would have discarded after one sitting. This blog is purely meant to highlight the existence of the theory. I shall not attempt to explain the theory as I am not sure I even understand it.

It may also be noted that the Theory of Reflexivity has not been taken very seriously in Academia. But, there are some intuitively appealing points for the practitioner. Again, if you have never been truly convinced or impressed by the Efficient Markets Hypothesis, this could be an alternative viewpoint to consider.

A Proposal for a Market for Trading Bunks

The inspiration for this idea is a certain course whose classes are quite drab. Much to my chagrin I realized that I had unknowingly exhausted my quota of bunks and am doomed to attend all the classes henceforth. The distant reader has no idea of the torture that yours truly undergoes! The torture is not so much the class itself, rather the fact that I had chosen this course as an elective i.e out of my own volition and hence have no one else to blame.

Then it occurred to me that certain individuals do not bunk classes at all or, at any rate never use, nor even intend to use up their full quota. Let us call these people who have the bunking quota to be “possessors of bunks”. Therefore, (the logical mind thinks), on the one hand we have people who need bunks and on the other hand we have those that are not particularly enthusiastic about the said bunks.

Eureka! There is a market here! Before we get into the details, there is an assumption here. The assumption is that the penalty for not meeting attendance requirements is hefty and it is strictly enforced. If it is not strictly enforced or the bunk penalty is not significant, there is no need for a market. Just suck up to whomsoever it may concern when you are in trouble!

The question begs to be asked and I shall ask it “Why do some individuals not bunk?” For us to build a market there must be an economic motivation underlying bunking/non-bunking which gives value to it in the first place. That economic value is value of time. If I think I would be better off sleeping that attending class then there is an incentive to bunk. This is important from the non-bunkers’ side. There are two species of non-bunkers.

There are some who derive a moralistic pleasure out of non-bunking i.e for these folks “non-bunking” is a way of creating a moral pedestal, a way of telling the world, “I am more perfect than you because I don’t bunk, you depraved turd.” Sadly, there is no cure known for moralists and these people shall grow on to becoming social activists, cause fighters, prohibitionists and other generally undesirable elements of society. In fact, my belief is that, as much harm is done by people who set out to do “good”, as those who set out to do “bad”. For who decides what is good and bad? If he who doth bad, doth not think it is good from his viewpoint, he would not do it, would he?

The second class of bunkers would be my target audience. These people go to class with a none-to-sure emotion. Years of being sincere makes them feel that missing class, would somehow do them harm, but basically they are kids who would like to have a good time in life. They just have a voice in their heads which keeps on chiming “After all, there is a chance that something significant could be done in class…” Correction, all of us have that voice, just that some of us have stopped listening to it a long time ago. However even they know that some classes are just a drag. More fundamentally, they have nothing better to do with their times. Nothing better to do with their time. Therefore, if these possessors of bunks could be compensated with something for their time, then there is a chance they would bunk.

Out of this crucial insight flows the market for bunking. As a first step, let us assume that only bunks can be traded for a particular subject. Therefore, is we have some course, say Creative Financial Accounting 101 and 60 people take it, then the bunks are traded only within these 60. We develop a software system where each guy in the class offers his bunks for sale or bids for bunks.

A system would look like this:


Since it is only one course, the same guy cannot buy and sell bunks. However, there is one issue here. What if someone sells bunks without having enough of them? Why would he/she do that? In an educational setting, you know everyone usually. But what if it is a huge campus? And what if the market for bunks is irrational and over-pricing it? Then maybe someone would profit by selling bogus bunks.

This is where the assumption fits in. If the penalty is strictly enforced, then the seller of bogus bunks does not have the incentive to sell it, because he/she is putting his degree in jeopardy.

But anyway, just to prevent any irrational behaviour, we can have an additional field for available bunks so that people boycott bogus bunk sellers.

But this kind of a system is really not very optimal. In our example, Middleton may not like Creative Financial Accounting but he may like the course “How to make Common Sense Sound Sophisticated” while Middleshwar may prefer the latter to the former. In this case, they end up taking these courses, and because of our first requirement, their pool of bunks is restricted to their respective classmates. To solve the problem, we relax the requirement of bunks being traded only within a section. Therefore, if an individual takes 5 courses and he/she is allowed 5 bunks per course, then that individual has 25 bunks to trade.

One thorny issue remains. What if Middleton takes Creative Financial Accounting as well as “How to Make Common Sense Sound Sophisticated” (HTMCS3) and the former course has marks for attendance while the latter does not. Can that individual transfer bunks to himself free of cost or should he pay the market rate for HTMCS3 bunks? Till now we have also implicitly assumed that there is no agency like an exchange.

Again, going back to what we have said, the 25 bunks is Middleton’s property. Therefore, he/she should be allowed to transfer it free of charge. But as such I am not in favour of it.
The better system would be to insist that Middleton pay the going rate for HTMCS3 bunks.

Voila! Again we apply the power of Adam Smith’s invisible hand to setup a most satisfactory system for allocating one’s time. Sigh, if only someone would implement it.

Parachute AfterShower: An Analysis of the Branding Strategy

(This is a post for another site I will be blogging for regularly. (That is the stated intention!) This site called brandbhai.com has been started by some of us ad mad guys and we review ads and branding strategies of many of the products we see around us. Fundamentally, good marketing achieves it ends in a very subtle manner. brandbhai.com (atleast for me) is an attempt to better understand those processes.)

Oh boy! Times are changing! Gone are the days when the only ads for men’s personal care were those to do with Shaving products. I loved those ads, where the guy with the smooth shave and the rugged looks would look arrogantly in the direction of a female and she would come running to caress his cheeks. Ah! So corny, yet so cool... how I waited for facial hair, so that I too could shave it off with that arrogant style!

Now you have a plethora of ads on men’s products. One of the cooler ads that struck me was the Yuvraj-Sreesanth ad for Parachute Aftershower, Parachute’s new offering. It is a styling cream for men and I quite liked the ad.

As the ad progressed, a thought struck me. Where does Parachute AfterShower fit in for Parachute? This kind of a strategy would be called a Line Extension for Parachute in the Hair Care segment because it is a new brand under the hair care segment aimed at a different segment. The packaging and the ad itself clearly indicate the target segment. The ad shows two young men in an upmarket gym bantering away in a colloquial yet stylish manner. It can be inferred that this product offering is targeted at the high disposable income urban male. In that sense, it is a more high end brand compared to Parachute’s most popular mass coconut oil brand. It is also important to observe that they have taken great pains to indicate allegiance to the mother brand Parachute, cleverly working it into the conversation. However, the basic pack I think comes in around Rs. 30 for a 50 gm. tube. I have a Brylcreem 60 gm. tube which cost me Rs. 60.

This is an interesting point isn’t it? The offering is seems high end but the price is not! Therefore, they appear to have positioned themselves as a High Style/Rs brand. This way they can also target a larger segment.

While I give ParachuteAfteshower 100 marks on the Yuvraj-Sreesanth ad, I give them much lesser on their branding strategy. Let us now put ourselves in the shoes of the marketers and see how it plays out. Clearly, there is a huge opportunity for a company like Marico to come up with an offering for the rapidly expanding market of styling cream for men. From a theoretical viewpoint, there are three branding strategies that can be followed for a product introduction:

• A new stand alone brand

• Sub-branding: The new product brand is combined with a more powerful existing brand (Eg: Gillette Mach3, Gillette is the parent brand but mach3 is the specific brand of the razor. When you go to the shop you ask for Mach3, so it has some value on its own, BUT that value is derived from Gillette.)

• A type of branding where it goes as “Brand X brought to you by Brand Y”.

A new stand alone brand is too costly and does not make sense for Marico given they have Parachute in their stable. They have opted for a sub-branding strategy by choosing Parachute AfterShower. I personally do not agree with this. Let me elaborate.

When I think of Parachute, I think of the following brand associations:

• The Indian Woman

• Value for Money

• Care (the girl who tends to her long, lustrous hair lovingly)

• Purity – the coconut oil is a fantastic product

• Last but definitely the most important: Coconut Oil!

Why would I think that? Just have a look at the two ads below. One is a Tamil ad featuring my favourite Tamil actress Asin. The other is an ad featuring Dia Mirza in Parachute Advanced’s “1 Hour Champi” campaign. Both are fresh and contemporary. And nail the message into the viewer’s mind. Simple, effective ads.

However, given the brand associations they evoke, having Parachute sub-brand a product that is in some way a substitute or competition for coconut oil, doesn’t work for me!! It may be one of the Great Indian Brands that is there in every household, but you can’t sell anything under the name!

I strongly believe that they should have gone for Strategy 3. It should have been branded as “AfterShower by Parachute”. This works completely differently. The message now is: Buy AfterShower because it solves your hair problem and oh by the way, it is brought to you by the same people who have been solving your hair problems till now.

In fact, if the branders had thought about strategy 3, they would not have given a lame name like AfterShower. Can anyone tell me how that name reminds you of a styling cream? AfterShower brings to my mind an image of some think like an aftershave, a piece of toiletry.

Therefore, from a branding point of view, I just cannot get their sub-branding strategy. Let us contrast this with Brylcreem. Brylcreem was always top of my mind for hair cream. Their name clearly indicates that their some sort of a cream and they targeted the urban male much earlier than lots of products. Using this they can afford to price their products at a premium to the market and consumers may pay the premium ,inferring a higher quality.

Final Verdict: In all probability, the product will do very well because of its competitive price. But I doubt if they can ever capture the top spot in this market because of the faulty branding strategy.

On the Disconnect between Education and Practice

I have been reading Seth Godin’s “Small is the new big and 183 other riffs, rants and remarkable ideas”. (Seth Godin is a prolific blogger and his blog can be found here) The book itself is a collection of his blogs over an eight year period and they provide great food for thought. As the author states upfront, the book aims to provide that “... small prod or a friendly whack”.

A detour. I actually didn’t intend to read this book. I wanted to find his other book “Permission Marketing” in the library. The library database showed the book to be available but I couldn’t find it. This is SUCH a pain. It happened in IITM and it happens here and you cannot really blame anyone for it. I really think an advanced real time book tracking system could serve the purpose. A kind of a system where every book's physical location can be detected using the RFID maybe? Anyway, I took the book by the same author that I could find.

Each of these articles, small nuggets, so to speak, is quite provocative. Some of the articles brilliantly articulated passing thoughts I have had, but did not follow up. I know this sounds a bit... vague. Let me elaborate. One of the recurring problems I face when writing on the big bad world is the trap on making sweeping generalizations. I really have too little experience. Therefore, I am hesitant to make many assertions without data. But lots of things in this world cannot be captured by data. At best, we can derive measures of these, but if you go too much into the mathematics, you would spend all your time on the technique, missing out on the essence. Therefore, it is often reassuring to blog about these things under the borrowed umbrella of a guru or authority.

The "friendly whack" that I liked has to do with this article on Competence. (Would encourage you to go through it) The author defines what we call competence as the ability to solve problems in a predictable and reliable manner. By hiring/working with competent people you know what you will get and that provides security. However, the same desire to be competent, reliable and right can render the very same people ineffective in the highly fluid environment that business today is currently slipping into. (Remember all those “What are your strength and weaknesses?” questions and you write “Perfectionism is my strength blah blah ... But the same perfectionism is my enemy blah blah... This is exactly like that!)

It is fascinating to speculate on the psychological process at play here. By definition, disruptive thinking is that which upsets existing thinking by (i) Identifying changing market assumptions (ii) Tweaking existing ones (iii) Proving them wrong. However, when the idea first floats around, the typical response of the competent is to be plagued by doubts of “Was I wrong all along?” or "I could not have been wrong all along!" Now, clearly a person who has been deemed competent by society could not have been wrong all along. Therefore, in their minds this disruptive thinking is some fancy piece of jugglery and they oppose it. Before you cluck your tongue and condemn people for their short-sighted behaviour we must realize that this phenomenon is as old as the hills. Our grandfathers thought they were cooler than their fathers and our fathers would have thought the same and I am sure we think the same. We just have a phrase for it viz. ‘disruptive thinking’ but it has been there for generations. To me, this is a complex problem in organizational behaviour simply because it is so subtle and most of the times you cannot even prove that market assumptions are changing/wrong.

When there is a development that is changing the industry, it will rarely announce itself. (The Nano is a ready exception that comes to the mind) Also, organizations will always prefer hiring competent people as their output is more reliable. And we saw earlier, there is simply too much cost of being wrong for competent people.

If competent people are a problem in the face of disruptive thinking, then what is the way out? Hire incompetent people? This is where one must understand the term incompetent as defined by the author. Seth Godin defines incompetence here to mean people “... who have the option to be competent but choose to be different.” Incompetence does NOT mean incapable. He further argues that Bob Dylan would be an incompetent musician by his definition simply because his output is unreliable. “From year to year, from concert to concert, there’s just no way to be sure that he’ll deliver exactly what you’re expecting”.

This is a very crucial assertion that one has to bear in mind. The problem is that educational systems reward competence, while rarely recognizing incompetence, and sometimes being harsh on it. I am sure all of us have taken the easy way out in many things simply because there is no reward for being different in normal coursework. The system rewards you to read the professor’s notes and look at old papers and try to work out the psychology of the examiner. Then you pass out with a seal that says you are more competent than the guy in the next seat. This system also creates a value system that perpetuates itself. Let us look into that in detail.

In the title I have used the phrase “Increasing” because the more you think and read about real life problems and real life successes, you are struck by the irrelevance of much of what you learn. Most of that which is taught is highly idealized, involves learning some content and getting it right after practice. However, we seem to be moving to a fast environment in which you may not have time to get stuff right by practice. By the time a technology has been perfected, it could become obsolete. This kind of training emphasizes the importance of hard work. However, I believe that we will soon move to another era when hard work will no longer be a differentiating factor. Nowadays people are willing to work hard if you dangle the right carrots. You can work for 12 hours, big deal; I can find thousand others in India who will work longer and so on and so forth. In the face of disruptive thinking, all the hard work and all the competence are of little use. I believe that working hard for its sake because you get a kick out of boasting about it, can hamper your creativity. To quote Seth, “Give me five serially incompetent nine-to-five executives with a focus on velocity, and I can change the world – over and over again.”

You can accuse me of crying wolf. Do I think the current situation in India is that disruptive? No way. Do I have a personal interest in saying this? Absolutely. I don’t like this mindless completion and in fact, hope that Seth Godin’s quote on the 9-5 company is true. To be fair, this blog borrows from a blog that is entirely derived on American experience. However, my personal bet/belief is that within a couple of decades the Indian context will get there. So what is the way out? You don’t have to do anything actually. Since educational systems do not explicitly appear to reward such thinking, the only option is for the individuals to realize that such a thing exists. A warning: One must also not take this as an excuse for failure. It reflects my own belief that in the real world, the best attitude is: Once you have achieved a certain standard, the best thing is to do something that you enjoy/have fun and in the process you may win some and lose some, but that is okay. I think one can call it the “Richard Branson Approach to Management”. :)

On Entrepreneurship

I was doing some vetti surfing and stumbled on to Forbes.com. The website is filled with slideshows featuring rankings of all kinds and ranking are always a good way to spend time! One talked about the ten biggest disruptors in the last ten years written by the Guru of Disruptive Thinking, Clayton Christenson. Another interesting feature was on the “Most Popular Virtual Worlds”. One of the more interesting slide shows featured the hottest billionaire heiresses! Smokin', is all I say!!!! (Trivia: Did you know that Julia Louis-Dreyfus who plays 'Plain Jane' Elaine on Seinfeld is a billionaire heiress?)

Then I stumbled on to Forbes’ ranking of the 10 best small companies in US. Interestingly, lots of these companies were based on offbeat "techie” ideas. Frankly, a lot of the business ideas left me with the feeling "This is big?!!" (Rolls eyes) This set me thinking on entrepreneurship.

After almost six months into Management education, I get this nagging thought that all business decisions reduce to a random gamble whatever you do. To elaborate, say you are facing a business decision of some significance. Now, how much ever analysis you do, qualitative or quantitative or both, you will come to a situation where you will be confronted with a probability distribution of outcomes. At this stage, the decision maker is left with no choice but to choose one of the alternatives randomly. It is literally no better than gambling on a throw of dice.

Given this belief, how does one factor in entrepreneurship? To put it differently, the above argument seems to imply that entrepreneurs are pledging their lives on a random gamble? That cannot be right. For example, 7 of the top 10 richest individuals are self made men who built their fortunes in their own lifetime. That couldn’t have come by making random choices! However, in this case, the successful entrepreneurs may have tackled the uncertainty in their environment by simply controlling and manipulating it. That is one way of working around the problem. But in this blog, I am interested in that stage when the entrepreneur is actually gauging whether to stake his future and go on his own.

The mentality at this stage is very different from the mindset of writing a business plan. Business plans require believable projections and models with convincing assumptions. These formal approaches just lend a measure of discipline to your efforts and in my opinion, all the sophisticated business analytics in the world helps to better approximate the probability distribution confronting the decision maker. However, when one actually sits down and contemplates the costs of becoming an entrepreneur, then the probabilistic nature of the decision making process hits you on the face.

How does this impact decision making? Given that there is an element of probability in any significant decision, I believe that the second most important determinant of entrepreneurial success, besides the idea itself, is the ability of the entrepreneur to muster up liquidity.

Therefore, it is more important to have money to fund your mistakes, if they may occur, rather than being perfectly “right” in your business decisions. This is because, beyond a point, being “right” in business is outside your control. Here, I have assumed the individual would have done all the analysis possible.

This point is rarely ever mentioned. In today’s context, I guess one can take it as a given that if you have a good idea, you will get funding. However, in times of trouble, access to funding will become difficult and that is why I have used the word liquidity.

Extending this idea, we arrive at the following conclusions. If you are a first generation entrepreneur, besides just having an idea, you need to think deeply on how to get access to cash, especially in times of trouble.

This in turn, is a function of Institutional and Social norms. The attitude of financial institutions towards an entrepreneur is reflected in institutional norms. For example, in pre-liberalized India, financial institutions took a rather suffocating view of debt and we found that entrepreneurship suffered. However, even in those times, there were entrepreneurs. How did they manage? Most of these entrepreneurs could be classified into two types: Those who inherited money or those who belonged to certain communities. This is not a perfectly exclusive classification and there are overlaps between these two. The community ties helped to muster liquidity in times of trouble and I suspect that such social norms, when they do exist, are more effective than institutional norms. (Of course, I have ignored the presence of small time money lenders and unorganized financial sector in India because I don’t know anything about it. However, I am sure it can be added as one more factor in our analysis when the information is obtained.)

I admit, that at first glance, this appears to be a rather defeatist assertion. How many of the big guys thought of all this? Weren’t they driven by passion? But when I listen to all the hoopla on “that one great idea”, I become cautious and skeptical. There are thousands of ideas and there are even greater numbers of failed entrepreneurs. I would think the factor that separates the men from the boys is the ability to access liquidity.

Therefore, can people without an advantage in this respect not become entrepreneurs? Not at all!

• You can make your money in ventures that require low capital first, and once you reach a critical size, you will have all the money to gamble to scale up.

• To reach that critical size, it would help to start with an idea, where the profit is high and source of uncertainty is low. How does one do that? I don’t know… maybe an idea that alters the environment itself!

(P.S: Happy New Year!
My New Year Resolution: Blog more regularly!)