Archive for June, 2007

Revisiting CARITAS

It may still be vivid in many investors’ minds the game of the century, ‘Caritas’, the Ponzi* scheme of the early 1990s in Romania. It was owned by Ioan Stoica and attracted over 400,000 investors who gambled over 1 billion dollars because it promised to repay 8 times the amount invested. Although Caritas lasted for just over 3 years it finally went bankrupt on August 1994 with debt of over 450 million dollars. Nobody knows why this company was allowed to gamble with people’s savings and where the money went but this is another topic all together.

What we are witnessing today in Romanian stock exchanges is a reminiscence of the 1990s Caritas. There are several layers of investing in Romania that would make the best financiers on Wall Street feel stupid. Most companies who are using the spot exchange as a platform for their company’s financial development are small and may have difficulties running to banks for financing, therefore they use the local spot exchange disintermediation facilities.

So how does this process work? Well let’s use Armax, Dafora and Albalact for example. They all raise the capitalization by issuing millions of shares to existing shareholders for an under market valuation at nominal value rather than real value. This not only allows existing shareholders in these companies to subscribe freely or large discounts to par value but it also allows a free run up to the price by overcrowding the buyers who in same case see it as free money. It is to everyone’s dismay that Biofarm one of the darlings of BVB following a 25% dilution with no real change in the fundamentals return a 12.50% overnight gain. We have many other examples with some other BVB Majors.

One interesting fact is nobody is really worried about the consequences of this dilution. Was it necessary to raise a couple million euros for capital expenditures to completely obliterate the capital structure of those companies? We believe not. Someone at the other end of the stick will pay the price when all is set and done. Financial responsibility comes with a price. There is no free lunch. Or is there one?

Well it seems that there is free lunch, since executives form Armax, Dofora, Flamingo and others walk away with millions. How is this possible we are asking ourselves? In case of Albalact a 230% dilution resulted in more than double capital appreciation since the shares closed up at same level when the dilution occurred. Let’s look at ARAX, the company issued stocks at 0.10 lei (Nominal Value) worth 5.6 million lei in February. The existing shares were diluted 2.25/1. However the stock quadrupled since the news was announced. Although initially with a stake of over 50%, the executives were content to sell for lei 2.50/share since they got back under the dilution at lei 0.10 an astronomical 2500% return in only few months on new shares issued and still maintain majority ownership.

There is no problem with locking profits and making money, but it raises a red flag, about how long will the party last. There are some factors that can not be overlooked. First what happens when the companies will not deliver on their promises? These companies are priced from a fundamental perspective beyond perfection and any reasonable valuation model. And more dilution is on the way. How do we explain Impact’s 1 billion share outstandings, which beg for a DCF analysis to justify the valuation?

Is there a correlation between the number of shares and market capitalization of a company? It is certainly not supposed to but everything is possible in the current Caritas mania that grips the Romanian markets today. Who gets the carrot and who gets the stick? Sophisticated investors will be the first ones to decide when to bail out and small investors will be caught holding the short end of the stick.

One eloquent example is (EXC) Kandia. Although the stock ran up to 3.90 Ron/share last week when the big news came out with Cadbury Schweppes buying the Romanian company at 2.90 Ron/share, what followed along with a fear of delisting from the stock exchange was a clobbering 25% price to 2.80 Ron/share in just 2 transaction sessions.

There is no reason why one should buy a stock at 60% premium from what an insider sells. An insider sold 13% stake in Prospectiuni S A Bucuresti at 240.47, but the stock went up to 385.00. This is an anomaly and although we might assume that this creates “liquidity”, it brings no real fundamental value to a company. If anything it should raise red flags of the exit strategy.

There is an implied assumption that Pension Funds will invest in existing companies listed in Romanian stock exchange and will sustain valuations. Well that may or may not be true. The pension funds will not throw the pensioner’s money into highly risky companies, unless this option is fundamentally sound. Also, there is the management issue. Pension funds do not invest in companies whose founders and management are bailing out. Large caps conservative well run and highly liquid stocks are the ones which will benefit the most from the fund’s money.

One can avoid capital loss in case we see a repeat of a Caritas like situation. The risk management strategy might consider the following. First: Everyone should take part of this “Free Lunch” bonanza while it lasts, but emphasis on an Exit strategy should be clear. Second: Look up for Insider trading and buying. This is a good indicator and it should give you reasonable expectations or at least raise flags to investigate further. Third: Remember everyone is buying stock to make money, but there are many reasons why someone sells or reduces. Fourth: Don’t pay more than what insiders sell for. Fifth: Learn about the management of the company. Sixth: Look up at fundamental and technical indicators. Seventh: Know about the business environment (operation, competition, regulation etc.). Eighth: Listen to your broker but remember the brokers are making money on your trades. Ninth: Consult a financial advisor if necessary.

A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns (“profits”) to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business, named after Charles Ponzi.

Horatiu Tocan


Sentimental Rupee

INR touched our anticipated level near 40. This is what we said on December 4, 2006, “The currency is headed down to 43 and lower, despite what the RBI does, despite macroeconomic conditions, despite the seasoned trader”. When we hit 43, we carried the other rupee update on Apr 2 saying, “The long term trend remains near 40 vs. the dollar”. Well it was not that long, as in barely two months INR managed to touch 40.14, missing 40 by a whisker.

And where do we go from here? We can have many answers to this question. We can try interpreting the story and the correlation of the Rupee and Sensex, or the talk about the wave of capital flows, or the drivers behind the Indian economic story, which never tires and knows no cyclicality. Not to forget, we can try comprehending the Reserve Bank endeavors to curb volatility in the local currency, which saw a free fall of 15% in less than a year. Other reasons might lie in the forex reserve leveling at new highs etc.

Some might even look out of the box. What is the rupee strengthening against? It’s the Dollar. So if the Dollar Index continues to weaken, INR will strengthen against its counterpart. So maybe, the stories should be pegged around Dow and not the Sensex. So as you see, there can be more reasons, innocuous and silly.

For us at Orpheus, it’s not over yet. And markets like Keynes said can remain irrational longer then you can remain solvent. So just because 40 seems a good psychological level, good enough for a pause, is not the reason the INR might pause. The psychological or wave impulse down seems incomplete. We will be surprised if any bounce back on INR crosses the 42 levels. We see this as a coiling continuing action. The main trend still seems down to near 38 or lower. Above 42 we review.


Credit Bonanza! Is it?

Emerging Market Series, Eastern Europe, Romania

So it finally happened. The BNR (Central Bank of Romania) decided to drop the minimum requirement barrier and allow the banks to decide based on their credit system evaluation what the population’s level of debt should be. Additionally, the banks will determine what will be the minimum down payment for their new and existing customers. The BNR would like to see a qualifying ratio of 35%. That means the monthly principle and interest payment cannot exceed 35% of the median family monthly income.

Already, we see that Primary Banks are “breaching” this level with 30% for BRD and low or no initial down payment. So what does this all mean to the average family of Romania? Based on several “Specialized” real estate agencies - don’t hold your breath - the housing market is only heating up. Only in Bucharest alone according to several brokers there are over 750,000 new habitants coming into the market. Is this so? Last time we checked the population of Romania was diminishing with many participants leaving the labor and looking overseas for better “paid” work. This is not to mention that many if not all these who are working abroad have any access to local bank for credits since they can’t provide income qualification. Or maybe the banks will just issue credit to just about everyone? Have they not learned from their counterparts overseas?

It is hard to believe that the credit markets around the globe are tightening up after the collapse in the Sub-prime landing. So where are all these people coming from? Probably many are swapping the apartments and they probably are not even affected by the new rate system. Or is just because all agencies post similar ads, we have an “artificial” price? Probably a combination of both.

So now we are asking. Will the credit bonanza announced catapult the real estate prices through the stratosphere? Hard to believe considering that there is no correlation between the average income levels and the real estate prices. Only yesterday the INS reported the April monthly average income level of 308 Euros, a 1.7% increase over March level. This includes the Easter bonus etc. So what does this mean for a family of 2 working people with an average of 620 Euros? Assuming no down payment, for a 6% APR (Annual Percentage Rate) to be extremely conservative, a 30 year fix mortgage loan will qualify the family in the best case scenario for a 103,410 Euro mortgage. A 70% debt ratio to income will allow the same family a mortgage of only 72,387 Euros. No PMI* (Private Mortgage Insurance) is included on the first 20% down payment that the bank will ask for, nor do we speculate on the standard of living that an average family will have when all their incomes will be locked in the mortgage payments.

It is possible that many “qualified buyers” will go into debt for speculative reasons only resulting in temporary price appreciation. If this is the case how will they afford the payments? Maybe they will rent out units. It means rents have to go up to 600 Euros/month to justify those prices… hard to believe.

It is likely the CPI (Consumer Price Index), which the BNR is trying to keep under 5% will skyrocket. After all there is plenty of “free money” which will have an exponential effect on the multiplier, especially if this money will be used for discretionary spending.

So who are the winners and who are the losers? Banks evidently are going to take huge risks by allowing consumers to take large debts. Insurances will charge premium on naked mortgages that either banks will pass to buyers thereby resulting in larger mortgage payments, or simply will absorb. The most recent American Housing Bubble followed by the Sub prime Lending should raise a red flag. Winners are major material and construction companies who will take the lion’s share with an already overheated housing sector ready to accelerate. This may raise subsequently the price of commodities and natural resources. Ultimately the labor cost will have to rise to keep up with demand.

Did the BNR open a Pandora Box by eliminating any restrictions on credit? This is a question that will be answered soon. One way or another market will find equilibrium. In a perfect scenario, the overheated house prices will come down to match the existing affordability level, This is sustainable if supply of housing keeps up with demand and if banks recognize and prevent the potential of a crisis that lays within their hands. Or maybe the Romanian government should introduce an index of affordability such as US-NAR (National Association of Realtors)*.

The affordability index measures whether or not a typical family could qualify for a mortgage loan on a typical home. A typical home is defined as the national median-priced, existing single-family home as calculated by NAR. The typical family is defined as one earning the median family income. The prevailing mortgage interest rate is the effective rate on loans closed on existing homes from the Federal Housing Finance Board These components are used to determine if the median income family can qualify for a mortgage on a typical home.

Interpreting the indices, a value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. An index above 100 signifies that family earning the median income has more than enough income to qualify for a mortgage loan on a median-priced home, assuming a 20% down payment. For example, a composite HAI of 120.0 means a family earning the median family income has 120% of the income necessary to qualify for a conventional loan covering 80% of a median-priced existing single-family home. An increase in the HAI, then, shows that this family is more able to afford the median priced home. The calculation assumes a down payment of 20% of the home price and it assumes a qualifying ratio of 25%.That means the monthly principle and interest payment cannot exceed 25% of the median family monthly income. In addition to providing a composite index, the monthly report breaks the index down by fixed-rate mortgages and adjustable-rate mortgages. It’s also broken down by region.

How is it used? The index helps analysts understand consumer’s ability to purchase a home. The monthly index tends to receive the most attention because of its timeliness. It’s also valued because it breaks the index down by mortgage type and geographical region.

Why use it?

First, falling mortgage rates can actually improve affordability when the overall economy is growing below its potential. Mortgage rates are closely tied to the yield of the 10-year Treasury note, which is tied to expectations of inflation and economic growth. If inflation or economic growth expectations or both are subdued, the yield of the 10-year Treasury note usually falls, thereby bringing mortgage rates down to more affordable levels. Yet, inflation typically has a greater affect on the movement of the yield of the 10-year Treasury note and mortgage rates.

Example, if the economy is expanding at a solid pace, supported by robust productivity growth, inflation would likely be contained. This could keep the yield of the 10-year Treasury note subdued and mortgage rates relatively affordable.

Second, home prices are also affected by the health of the economy. If the economy is strong, it likely means home prices are rising. But is this necessarily a bad situation? It probably isn’t for consumers in general because family incomes could also be rising, thereby improving home affordability from that perspective. Furthermore, it clearly isn’t negative for established homeowners because they build greater equity and that provides a source for consumer spending.

However, rising home prices clearly hurt affordability for first-time buyers. Consequently, analysts use the affordability index for first-time buyers in conjunction with various other reports to gauge how the impact from rising home prices is affecting overall economy growth. In conclusion, the credit bonanza, might only heat up the already inflated real estate bubble.

Horatiu Tocan

* Lenders mortgage insurance (LMI), also known as private mortgage insurance (PMI), is insurance payable to a lender that may be required when taking out a mortgage loan. It is an insurance in the case that the mortgagor is not able to repay the loan, and the lender is not able to recover its costs after foreclosing the loan and selling the mortgaged property. The annual cost of PMI varies between 0.19% and 0.9% of the total loan value, depending on the loan term, loan type and proportion of the total home value that is financed.