Saturday, November 22, 2008

Credit default swaps in India

Credit default swaps, a financial intrument which insures creditors against default on loans owed by them is likely to be introduced next year. A credit default swap (CDS) is essentially a financial instrument that allows a bank or a financial institution to insure a loan or a debt investment it has made by paying periodic fees to another institution called a protection seller, which is willing to take the risk.The CDS seller, in turn, guarantees to pay the buyer a pre-determined amount if the company that has borrowed money defaults on repayment.
Worlds largest insurance company was in trouble bcoz of these had sold CDS worth $440 billion on subprime and other securitised financial papers. Once the subprime borrowers started to default on their loans, investors who had invested in these securitised loans found their securities turn wothless and so they turned to CDS seller AIG to recoup their losses. AIG couldnt make good their losses, as every invstor turned up to demand their repayments at the same time.So it defaulted on $14 billion of CDS.

Wednesday, July 9, 2008

Myths about Branding

Often people misconstrue brands as a form of competitive advantage but this is not true. Firstly,What is competitive advantage? it means that it allows an incumbent firm to do what its competitors are not able to do or it deters them from emulating the incumbent firms is an effective barrier to entry.So, basically barriers to entry and competitive advantage are the same thing. Only incumbent competitive advantage has value and not entrant competitive advantage bcoz entrant competitive advantage implies absence of barriers to entry for the incumbent firm. By definition, a successful entrant becomes an incumbent and then is vulnerable to the next entrant and the process continues with the every new entrant replacing the previous incumbent and this implies that are no competitive advantages neither for the incumbent nor for the entrants.
Now lets consider brands which are often mistaken to be a source of competitive advantage. Branding is like any other asset of a company which requires investment in form of marketing and advertising. By branding a firm can only make its presence felt in the market. It is an important asset of the company and cant be taken in a a loose manner but at the same time it doesnt deserve so much hype it gets compared to other assets. Its just an important asset of the company and by itself it will not drive excellent returns for the business. It wouldnt protect a lousy business. A competitive advantage is something which enables a business to earn high return on invested capital and keeps the rival at bay. It enables it to take away a disproportionate share of the market. A high return on invested capital and a disproportionate share of the market is a tell-tale sign of presence of competitive advantages or barriers to entry. Not many branded products show high returns and dominate their markets. they might show high returns in the short-run but not in the lon-run
It is not branding per se which drives the returns of the business but economies of scale with high customer captivity. Most of the branded products are in a market called monopolistic competitive market where in the long-run they dont tend to be highly profitable because there arent any effective barriers to entry. A monopolistic competitive market is defined as the one where there are large no of firms selling similar but differentiate products which means that the products sold by different firms are close but not perfect substitutes of each other
For example : soft-drink market,apparel market and various other brand oriented markets. Theoretically, in the long run in a monopolistic competitive market firms are not highly profitable and their profitablity tend towards zero.
For instance, consider the soft-drink market where there are a number of brands which differ slightly from each other in terms of taste and to some extent in color. In a study of demand for colas which used a simulated shopping experiment to determine how the market share of a Royal crown and Coca-cola changes in response to its price. In other words how elastic is the demand for a brand.

It was found that Royal crown is much less price elastic than coke i.e its demand is not much reponsive to price increases. The study seems to suggest that consumers are more loyal to royal crown and it has more brand loyaly than coke. But even because of higher brand loyalty it is not more profitable than coke. Profits depend on fixed costs and volume, as well as price. Coke will generate more profit beacause it has a much larger of market. Its the economies of scale which enables coke to spend heavily on advertising,marketing and distribution and this practice over a long period of brand reinforces the brand and keeps new brands at bay. Competitive advantages are supposed to protect profits and brand loyalty doesnt pass on that terms. Its the inherent characteristic or nature of the product which makes the customer more loyal to it than brands. people in america are habituated to coke and that is because of the first-mover advantage for the coke and the scale which enables it to sells at such a low price- the price difference between coke and any other brand is few cents and that prevents its consumer from switching to alternate brands just for price difference of a few cents.
Being a first mover in the market is more important thand brands.
At the end of the day brands are just necessary cost of doing business and making a presence in the market , nothing more and nothing less.

Thursday, May 8, 2008

Complexity of the CDOs Demystified

In early April the megabillionaire Warren Buffett hosted 150 students from the University of Pennsylvania's Wharton School and offered to have a Q&A session with him. One of the students asked the following question related to CDOs and the answer to it by Mr. Buffett really clarified the complexity and the blunder of the CDOs.
here is one of the excerpts from his question-and-answer session with the students.

Do you find it striking that banks keep looking into their investments and not knowing what they have?

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

Direct Link to the Q&A session

Charlie Munger's Wesco Financial Corp. (WSC) Annual Shareholders meeting on Wed, May 07, 2008 in Pasadena, California

Charles Munger, Vice Chairman of Berkshire Hathaway will host Wesco Financial Corp. (WSC) Annual Shareholders meeting on Wed, May 07, 2008 in Pasadena, California. Charlie is the Chairman, Chief Exec. Officer and President of Wesco, which is 80% owned by Berkshire Hathaway.

Charlie himself is very intelligent businessman and investor just as smart as Warren Buffett.

Link to some of the quotes by Charlie Munger

Notes from Berkshire Hathaway Annual Meeting 2008

Berkshire Hathaway Annual Meeting, Omaha NE 2008
May 3, 2008
Typewritten notes courtesy of Peter Boodell(As is standard, no recording equipment was used to reproduce these notes. As a result, these notes are recollections only – not quotes, and should not be relied upon. –PB)

Link to the Annual Meeting notes