The fundamental objective of insurance is to provide a means to offset the burden of financial loss. Think of insurance as a premium paid for “transfer of risk” premium. An alternative method of dealing with risk. You are paying an insurance premium (small cost) to avoid paying the total cost for a catastrophic loss (such as your house burning down). So it is fairly obvious that you will not insure your mobile phone (you can afford to carry the risk on your own self) but will insure your house (the burden of this risk is too heavy to carry). So the house risk you transfer, by paying a premium. Mobile loss risk you keep on your own self. As simple as that.

A sound insurance program should answer the “what ifs” in your life. For example:

What if you were faced with a major medical expense? (health & illness insurance)

What happens if you were unable to work for a long period of time due to a severe illness or accident? (disability insurance and/ or critical illness insurance)

What if your most important employee dropped dead? (Keyman Insurance)

What if a fire destroyed many of your personal possessions? (home owner’s insurance)

What if an employee stole data from your company (D&O insurance)

What if you were involved in an automobile accident? (auto insurance)

What if you were to die tomorrow? (life insurance)

So if there are some more “What if” kind of questions….just see whether the risk can be measured. If it can be measured, it can be transferred. Transfer costs money (premium) and the benefits are – the insurer will pay all genuine claims. That is all.

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Whether you’re investing in real estate, stocks, bonds, or gold coins, you are rewarded primarily for your exposure to one thing – risk. After all, markets are only risk transferring mechanism.

In the summer of 2007, I warned friends that if they were “speculating” in the current housing market, the time had come to cash in their chips and get out of the game. I listed a number of reasons, but the biggest one was that ordinarily sensible people were talking and acting as if highly-leveraged home purchases were “risk-free” transactions. After all, they kept telling me, “real estate always goes up.” I think this is pure BS. Real estate is as much a commodity as cement or steel (oops, it is that?) so the supply and demand will determine price. So real estate does not keep going up.

It doesn’t, of course. And now everybody knows it. Now!

Unfortunately there is no “real estate index” in India. There is no scientific measurement of real estate price movement – and the press is not credible enough in its reporting.

I would love to tell you that the worst is over. (After all, I own a home myself.) But the reality is we may be only in the beginning! Real estate has much further to fall and you should govern yourself accordingly. Here’s why…

Residential Housing Market

Last year was the most painful in decades for the residential housing market in the US of A. Home prices fell, home ownership dropped, foreclosures soared, and the housing market emerged as perhaps the weakest part of the entire U.S. economy.

But in Indian conditions housing prices maybe set to slide considerably further. Banks and mortgage lenders are raising their lending standards. That means credit will remain tight, boxing out many potential buyers. Interest rates on many mortgages are about to reset, increasing the pain on many borrowers and triggering more defaults. Home inventory is still growing and must be worked off before the market gains some kind of equilibrium.

My take on the Indian Housing market however, is a little different. When the rents do not go up as fast as housing prices, it creates panic in me.

An Accurate Gauge Of Home Value: Price-to-Rent Ratio

Economists feel the price-to-rent ratio is perhaps the most accurate gauge of fair home value. Most human beings are rational animals (assumption, sorry!):

• If home prices get too high, many will choose to rent. If rents get too high, many will choose to buy.
• Unfortunately, no detailed studies in India is available regarding the relationship between rents and base price of a house.

So let us go the US of A and see what a Federal Study on Housing has to say. Here I quote from the study:

• “The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995.

But starting in 1996 – the birth of the housing bubble – home prices soared much more rapidly than rents. In fact, by the end of 2006 they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%, a third below its long-term average.

The study concludes that to reach equilibrium, housing prices need to fall 3% a year for a decade, even if rents grow in line with their average 4% annual increase. (Of course, if home prices fall faster – and harder – equilibrium could be reached sooner.)”

How does this translate in Indian conditions?

The Current Housing Market Has Yet To Hit Bottom

In other words, we’re still a long way from the bottom of the current housing market. And there may be some further anecdotal evidence to prove it.

Most homebuilders know the score, of course. But friends who are out looking for homes right now tell me that many sellers remain deluded.

I find the lack of good proper information in the real estate market a big killer of liquidity. If real estate could be listed like equity shares you would know the price of your house (you may not want to buy or sell). Now you are completely at the mercy of a few “informed” people in the business. And you can only guess whether they are lying or just hoping. I have met mid level employees holding on to a living house, a second house and an investment house – hugely leveraged. These would be the first guys to get lynched. Of course when you believe your area sells for Rs. 7000 psf and your neighbour sells for Rs. 4800 psf, you get into denial mode. Like my friend Prakash Natrajan says “My house has a green window, so it will fetch 7000 unlike my neighbor who had a red window” is Denial mode!

No one has a crystal ball, of course. Even the experts on TV only have a teleprompter…

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When in 1941 FDR, the then President of USA said freedom means freedom of speech, freedom of worship, freedom from want and freedom from fear, I thought it was a good workable definition.

Today when I was reading Obama’s book and he quoted FDR, I started wondering how many of the countries that we know are really free. Forget Warren Buffet, forget Bill Gates, forget George Bush. How many of us can say we are in a free world? Or when Rabindranath Tagore said “Where my head is held high and mind without fear….

Is India a free country? Do not ask a few of us upper caste male living a cocooned life – the lifestyle that we lead in this country is less than a statistical error. Ask the SIMI activists, ask the people near Asaram Bapu’s ashram whose land has been taken away, ask the parents of children who have died at the ashram, ask Shahid Badr Falahi, ask M Hasan in Jaisalmer, ask Moutasim Billah, ask Yasin Patel, ask Jawahar Raja, ask Mobin Akhtar, ask Judge Geeta Mittal, ask Richard Crasta, ask Dr. Binayak sen.

In case you do not know who these people are read Tehelka. Vol.5, Issue 32, dated 16th August 2008

Financial freedom? you got to be joking. These people’s basic freedom to open their mouth rests with the state. Long live Freedom? Independence day, is 15th August, just a reminder
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Investing and money management is a lot like eating. So is losing debt like dieting? maybe…maybe not. Is getting out of debt a little like going to a gym? Well maybe…maybe not.

However getting out of debt is also a slow process. You first need to analyse what got you there first. You were not born obese or born in debt. If you did get into debt, it was slowly. You bought yourself an item far beyond your monthly “can i afford it” . Instead of saying “I will save for it” you decided to buy it. Then it was a night out at a disco. You thought it will cost you (and your partner) Rs. 8k for the night out, but it just cost a lil more – 12k went to the card. Then you got a raise. So the car changed from a Santro to a Lancer. Never mind it gives only 4km to a litre – the fuel went to the card. Suddenly on a 6L ctc you were paying 20k rent, car emi, 2 nights out , the latest Nokia was too good to be missed. Hey bingo you now had a debt of 82k!

How to come out of it? Well many of the kids I meet these days just raid BANK PAPA and tell themselves they will never do this. NO that is not a solution. First stop the bad habits – buy what you can afford to pay cash. Carry cash rather than card – for many people it hurts to see cash go – signing is much easier. Then start leaving the credit card at home. If possible shift to a zero transfer charge, new card. Start repaying at least 2-3 times what the card company says is “MINIMUM AMT TO BE PAID”. In case you get a bonus, commission, gift, etc. do a lumpsum payment. If you are not so disciplined, cut up the card and throw it away.

Once you have controlled the spending habits, cut up the card, and made the payments make sure you stick to the new found habits.

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What you end up with is a highly subjective number about the growth of the company’s business and other performance measures. It’s little more than an educated guess. Moreover by the time the report comes to your hand it has gone to all the “news’ and “business” channels. After that you know how useful that report is, do you not?

So if following analyst reports isn’t the answer, what should we look at?

• Cash Balances and Debt
  When the economy turns down, the highly leveraged firms are the ones that get in trouble first. This is part of the problem for GM and Ford right now, and it was the problem with Bear Stearns. In Indian conditions the amount of leverage is not so high. However a lot of foreign debt has been “hidden” as PE. We have no clue how much of this will hit us one the conditions worsen. If you have large debts, the interest payments alone are a constant drain. On the other hand, a company like TCS – with large stores of cash and no debt – can weather any storm. However you may have to worry about Tata Motors. Amazingly, sometimes a firm’s stock price won’t adequately value the cash it holds. This is because analysts do not understand the importance of cash in a bear market.

• Cash Flow
  The market will – over time – value cash flow in similar ways. Look for times when the market undervalues a company’s cash by finding out how much cash a company is producing today. Cash flow is the lifeblood of a company. 2 great examples are Coromandel fertilizer and EID Parry. You can reasonably expect that analysts who look for sex appeal in shares will appreciate the value of free cash flow in the future, even if the firm is out of favor today. Therefore, keep track of the cash a firm generates.

• Dividends
  Analysts at least in Indian conditions do not value dividends very highly. This is patently stupid. Given the quality of Indian reporting, dividends should be valued very, very highly. EPS is just an opinion, dividends are a reality. Reinvested dividends have contributed a big part of the total return. Favor a stock with dividends for this very reason. You’ll get paid to hold a stock while the market takes time to recognize its value.

These three simple guides have worked wonders when analyzing many different stocks.

Many of today’s stocks show large differences between their price and their historical earnings ratios. You may find the market is incorrectly valuing many companies in relation to their cash balances and its ability to generate cash flow and dividends.

So instead of listening to analysts, do your own research and ask the right questions, like these:

Can the company rebound to its historic price-to-earnings ratio?

Is the market undervaluing a company?

Can it continue to generate healthy cash flow and earnings?

Will it be able to pay dividends and interest payments on debt?

In short, cash and cash flow can be a more reliable predictor of the future of a company’s stock price than your gut… and especially an analyst’s educated guess. Especially if he is peddling his wares “free” in the pink papers or the idiot box. Use your brains.

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However if you define experts a Morgan Stanley, J P Morgan, Citibank, UBS….please think again. They are not experts, they are in the business of selling financial products. Look at the amount of write-offs that they are doing. Look at the amount of down sizing.

Did you see the apologies that UBS and Citibank have been giving. Did you see the amount of credit derivatives that Citi has been forced to take back from clients? It is scary.

Citibank in one of the TV interviews said “we will make money in India for the losses in sub-prime”.

Unless they make 70% commissions in unit linked insurance and fantastic commissions in Mutual funds, I do not know how.

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Let us see some simple examples:

It rained 90mm in Mumbai on 22nd July. If it rains like this for 6 months continuously, Mumbai will be drowned.

It was 43* C in Lucknow on 23rd May. If it scorched like this for 9 months continuously, all of Lucknow will be dry.

Sir our fund has given 30% p.a. return in equities last year, if you get this kind of return for the next 30 years, your investment of Rs. 1 LAKH will become Rs. 26.19 CRORES.

Sir RBI bonds are giving you a negative return – 8% gross means about 5.4% net of tax. If inflation is assumed to be at 11.98%, you are actually getting a NEGATIVE RETURN OF 6.58%. If this continues for 20 years, your money will be worth NOTHING.

Can any reader refute these 4 statements? If you cannot, you should believe all the 4 statements, should you not?

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Money is such a personal issue, that if your portfolio manager has created a portfolio that is ensuring that you are awake at 3am, your portfolio is wrong. So the question to ask is “How well does your finance let you sleep?”

Once upon age of 45 was the age to do regular health check ups. Now it is perhaps 30 years when you should be starting your regular medical check up. However, a financial check up is necessary from the day you take up a job – or you take up a loan.

1. Which is the breaking point for you?
What would happen if you got a big bill for an unexpected expense? In other words, what is the last straw for you? Will it break you? Your personal financial situation is a lot like that camel. If you are on a tight leash – say the EMI is taking 45% of your take home pay. A small increase in the floating rate can be the last straw. If you are on solid financial footing, you can bear the burden of your daily bills and afford an unplanned trip to the local auto mechanic to put a new fuel pump in the car.

On the other hand, if one, big unplanned expense would throw your life into disarray; it is time to take a closer look at your lifestyle. While you may be comfortable today, if a single expense is all that stands between you and financial disaster, you are heading for trouble, and you need to take steps to avert it before it arrives.

2. How many months can you live without your income cheque?
What would happen if your next salary cheque does not come in? Or even worse, your company told you a great tax saving device – of being on contract? It means a stroke of jaundice or even a fracture can mean no income for a month at least! Will you be evicted from your house? Will the bank foreclose your home loan? Can you afford to send money to your parents? Or to a younger sibling whose education you are funding? Bluntly, how long can you afford groceries? If you cannot live for at least 4-6 months if you suddenly stop collecting your salary, you have a serious problem that needs some serious attention.

I would list the creation of an emergency fund as a critical part of a sound financial plan. Putting three to six months’ worth of your income in the bank (floating rate mutual fund for some people) so that you have it on hand should you need it is a great way to give yourself some breathing room if your income come to a temporary halt.

3. Are you “maxxed” out?

Credit-worthiness is another way to gauge your fiscal health. Do you pay your credit card dues in full or do you pay only the minimum amount due? That figure appears in bold. Can you qualify for a loan? If you have high balances on your credit cards or cannot get a loan or another credit card, chances are that the amount you owe and the amounts you earn and save are out of balance.

“Income rupees one hundred, expenses rupees 99, life is fine, Income Rs. 99, expenses Rs. 100, life is in despair” – with due apologies to Charles Dickens!

Clearly if you are buying food, basic clothing, CDs, MP3, cell phone bills, electricity bills, with your credit card and paying only a portion of the bill on a monthly basis, you are living beyond, perhaps far beyond your means.

4. What about your savings and er..investments?

If you have enough cash on hand to address any emergency expenses, can afford to live for half a year without another income cheque and still have the ability to tap some credit, the next thing to consider is the amount of money that you are able to save and invest.

Is there anything left from your income after the bills are paid? Does your savings account always show some balance? Then you are comfortably off – at least you can start thinking about saving and investing. However if you do not have an emergency fund (cash or a rich dad) are maxxed out on your credit card, cannot get a new card and the bank thinks you are “negative” for a new card or a personal loan, man you are in trouble!

What to Do If You’re in Trouble

If you do not know the right answers to the financial checkup questions, you need to take immediate steps to get your financial house in order. The first step is to cut your spending.

Immaterial of how mathematically inclined you are, or disinclined you are, it is time you put all your numbers together and start living on a budget.

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However, I do few, very few transactions in a year. That is why I realised the great pleasures of inaction. I normally use only equities or cash – am too lazy to move in and out of liquid funds and FMPs. Like preparing for a war can take a long time, and the war itself a short time – remember Field Marshall Sam Manekshaw  told the  then Prime Minister Indira Gandhi  it  would take him  6 months to prepare for the war?  Well Indira  Gandhi wanted the war in  September,  Sam  said  December, and  Dec,  1971 it was.

Similarly preparing a portfolio, construction, asset allocation, goal oriented investment planning, creating an investment strategy, drafting the investment policy statement / strategy statement etc. are the things which take time. Trading / doing the transaction takes very little time. So spend time on all these and little time in trading. It will help.

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