Post on: 30 Апрель, 2015

### NHAI/PFC vs SBI bonds; Art of Stock Picking

1) NHAI bonds are all over the internet. For the uninitiated, NHAI is issuing bonds at 8.3% coupon rate (Face value: Rs.1000/-) and the best part of it is that they are tax free. As in, these bonds are not like the infrastructure bonds where only your investment (to the extent of Rs.20000/-) is tax deductible, but the interest received on these bonds is taxed. However, in NHAI’s case, the interest is tax free.

For a better brief on NHAI bonds (and PFC bonds which have been announced just 2 days earlier, but have a similar structure to NHAI bonds), read here and here .

These bonds are rated AAA and technically govt. backed (which indicates that the chances of default are close to zero; although after seeing Europe, nobody would trust govt. anymore)

Compare these bonds with SBI bonds issued in Feb/March 2011. These bonds were offered a 9.75% coupon rate (Face value: Rs. 10000/-). However, the interest arising out of these bonds are taxable (as in added to your income, and will be taxed at your marginal rate). More details here

The point of this post is that there is a logical opportunity to make money by buying NHAI bonds and selling SBI bonds (more fancy language – we need to go long NHAI bonds and short SBI bonds). The reasoning is as follows:

Let’s take the case of the 10 yr bond in both NHAI and SBI case.

If you look over at SBI bonds (series N3. which is the 10 year retail bond issue), it is quoting at a price of Rs. 10,705/-. If I had bought these bonds when they were issued (that is, my buying price would be Rs. 10k), my interest per year would be Rs. 975. Consider if my marginal rate is 30%, the real return on these bonds would be 6.83% ((975*.7)/10k). If I buy these bonds at the current rate, my yield would further drop to 6.38%. (I ignored the call option effect here, but including that, the effect would still be very marginal, maybe about 10-15 basis points).

Compare that with the NHAI issue. If I invest in NHAI bonds right now (i.e. at its face value of Rs.1000/-), I will get Rs.83/- every year, translating to a tax free yield of 8.3% (i.e. the coupon rate).

Why would anyone in their right minds invest in SBI bonds which will return them only 6.83% while NHAI bonds will give them 8.3% (NHAI bonds are govt. backed, mind you. Technically, they are more safe than SBI bonds although in reality both carry almost the same risk-free status).

Therefore, my guess is that the markets would recognize this pretty quickly and correct NHAI and SBI bond prices in such a way that the yield on either of the bonds will be very similar. If we hold the assumption that SBI bonds would not get sold (because of lack of liquidity or some such), then NHAI bonds have to rise to Rs.1200/- to equalize the yields. Alternatively, since NHAI bonds will be oversubscribed and hence may quote at a premium of say 5%-7%, SBI bonds can be sold to such a level that the yield on SBI bond is close to the yield on NHAI bonds, which implies a price of Rs. 850-875 for the SBI bond.

Hence, there is a trade here – going long on NHAI bonds and going short on SBI bonds will generate a return of about 10-15% in a short period of time, if not more.

So, why am I writing this and not executing the trade? Well, going long on NHAI bonds is easy (you can subscribe, today!), but going short on SBI bonds is close to impossible (for one, there is no active bond market in India and two, there is no active CDS market on SBI bonds). Therefore, this is a trade which seems very logical, but close to impossible to execute it (unless you have connections and can find some way to short SBI bonds).

2) If you have not read ‘The Art of Stock Picking’ by Charlier Munger, please drop everything else and read it right now. I came across this by happenstance only a few days ago and was kicking myself to have missed out on this gem of a talk by Munger. Reading this once gave me an insight into how to look for a Page, a Titan, a TTK, a Astral and so on and so forth. Must read, bookmark, print out and all that.

Some of the gems include (must read in full for impact though) -

Well, the first rule is that youve got to have multiple models because if you just have one or two that youre using, the nature of human psychology is such that youll torture reality so that it fits your models, or at least youll think it does.

First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things which by and large are useful, but which often malfunction.

If people tell you what you really dont want to hear whats unpleasant theres an almost automatic reaction of antipathy. You have to train yourself out of it. It isnt foredestined that you have to be this way. But you will tend to be this way if you dont think about it.

If its a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money thats been made by the shareholders of airlines since Kitty Hawk, is now a negative figure ‑ a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Thats such an obvious concept ‑ that there are all kinds of wonderful new  inventions that give you nothing as owners except the opportunity to spend a lot more money in a business thats still going to be lousy. The money still wont come to you. All of the advantages from great improvements are going to flow through to the customers.

n, there are huge advantages for the early birds.And when youre an early bird,

theres a model that I call surfing ‑ when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows.But people get long runs when theyre right on the edge of the wave ‑ whether its Microsoft or Intel or all kinds of

people, including National Cash Register in the early days.

So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you dont, youre going to lose. And thats as close to certain as any prediction that you can make. You have to figure out where youve got an edge. And youve got to play within your own circle of competence.

And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they dont. Its just that simple.

The way to win is to work, work, work, work and hope to have a few insights.

In the stock market, some railroad thats beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So its just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasnt so clear anymore what was going to work best for a buyer choosing between the stocks. So its a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.

In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct. Thats the equivalent in investment management to the custom of binding the feet of Chinese women. Its the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it.

Its so damned elementary that even bright people are going to have limited,

really valuable insights in a very competitive world when theyre fighting against other very bright, hardworking people.

Over the long term, its hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, youre not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, youll end up with a fine result.

So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.

However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager.

Within the growth stock model, theres a sub-position: There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices and yet they havent done it. So they have huge untapped pricing power that theyre not using. That is the ultimate no-brainer.

I think a select few a small percentage of the investment managers can deliver value added. But I dont think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up if you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.

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