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Venture capital - global and Sri Lankan perspective

by Nissanka Weerasekera

Venture capital (VC) is variously understood. Before the advent of internet, venture capital was considered patient, long-term money. Most textbooks on finance used to introduce the concept of venture capital by narrating the story of American Research and Development Corporation (ARD). ARD invested $70,000 for a 77% equity stake in Digital Equipment Company (DEC) in 1957. After 14 years, by which time DEC had become a publicly listed company, ARD sold its stake for a reported $ 355 million. The internal rate of return (IRR) on this investment was an unprecedented 83%, but the more important point is that this IRR was achieved over a period of 14 years. Money cannot be more patient than that, but in this case the wait was obviously worthwhile to the investor.

In subsequent decades, venture capital continued to retain its long-term nature. Holding periods of venture capital investments stayed between 7-10 years. This perception changed radically during the so-called dot.com boom of the late nineties. Stories were commonplace of internet startups funded by Venture Capitalists (VCs) going for initial public offering (IPOs) in less than two years, at several hundred times their original valuation. Often, the IPOs happened even before a company showed a single dollar in net earnings.

For a period of time, markets accepted business valuations based on the top-line rather than the bottom line. However, this was short-lived. For each well-publicized story of huge gains made during the boom by VCs and the entrepreneurs they funded, there were many more stories of financial disasters for VCs and their investors when the bubble burst.

Globally, therefore, VCs are said to be going back to basics. This means that, once again, VCs are selecting their investments more carefully, employing time-tested due-diligence and valuation techniques, emphasizing the bottom-line. The returns expected from the investments are calculated based on the projected intrinsic value of the investee companies rather than on the theory that you can always find a "bigger fool" to buy your investments. VCs are back to the 4-5 year time cycle. The contraction from the pre-nineties average of 7-10 years is understandable because, despite the dot.com debacle, most analysts agree that there has come about a technology-driven acceleration in the way even non-technology businesses reach maturity.

In the early days, VCs were not very public figures. They were very well-known in their own areas of business or technological expertise but not very much beyond. They were the types that prowled the corridors of MIT or Stanford. Public attention was focused on the success of the investee company rather than on the VCs who helped in that success.

This changed during the internet age when some VCs themselves became sort of celebrities. Some entrepreneurs who became wealthy by selling their technology startups at huge valuations became VCs. Since these people were already famous their new role as VCs also attracted a lot of attention. One consequence of this was that while the concept of venture capital became more widely known, it came to be too closely associated with new-economy startups. When too many investors lost money in ill-conceived business models disguised as technology start-ups, the fall out affected VCs as a whole. When VCs made successful exists from some investments making huge gains, and when the stock prices of these companies crashed soon thereafter, the VCs were seen as greedy dishonest people who misled unsuspecting public investors. On the other hand, when VCs themselves lost substantial amounts of money when portfolio companies went bankrupt, sometimes even before going public, the investors whose money the VCs managed and invested, blamed the VCs for being dishonest or stupid or both. The new generation VCs became victims of their own hype. Unfortunately, everyone in the industry got painted by the same brush.

However, the truth is that established and longstanding venture capital firms continue to play a crucial role as they have always done in helping create innovative businesses by investing in start-ups and early-stage companies that show growth potential. This is a risk that banks and other financial institutions do not want to take. Not only do VCs help create new and innovative businesses; they also play the traditional role of the Venture Capitalist by adding value to the portfolio companies in a variety of ways, playing a partnership role in these companies. Such VCs are patient and are not in a hurry to push the portfolio companies to premature public listings or trade sales, just in order to exit at a profit only to the VCs. For good VCs, it is important to see that their portfolio companies continue to grow in valuation even after the VCs exist. This is because if you have a track record of making other people lose money on a regular basis, then your long-term prospects as a Venture Capitalist are not going to be very good. The VCs who understand this wait for the optimal moment to exit.

They carefully nurture portfolio companies until maturity and realistic valuations that are acceptable to the Venture Capitalist as well as to the market. Shares of such companies maintain their value, even during periods of extreme market turmoil.

During the Bull Run, massive amounts of money flowed into venture capital funds. Hitherto conservatively managed institutional investors such as state-controlled pension funds, allocated significant amounts to new funds that were being raised by experiences as well as not so experienced VCs. Big companies that led the internet revolution pumped part of their large cash reserves into captive venture capital funds. According to Venture Economics, total venture capital investments in the US which averaged around $20 billion per annum during the few years up to 1998, shot up to nearly $60 billion in 1999 and over $100 billion in the year 2000. As a consequence, the average fund size ballooned.

$1 billion funds were not uncommon. This exponential expansion of the size of funds coincided with the contraction of the average venture capital time cycle. It is not surprising that VCs ended up screening and choosing their deals in impetuous style, resulting in buzzwords such as the "Elevator Pitch". It is said that VCs during the year 2000 were so busy, that they did not have enough time to carefully review the hundreds of business plans that landed on their desks every week. A prospective entrepreneur had to convince the Venture Capitalist during the few minutes that it took the elevator to go from the lobby to the office! In Silicone Valley consultants gave seminars on how to prepare an effective elevator pitch. This trend is changing too.

According to Venture Economics total venture capital investments dropped to about $40 billion in 2001 and are estimated to be back to the pre-1999 level of $20 billion in 2002. As a consequence, the average fund size is reverting to the more manageable levels of $100 million at the lower-end and rarely exceeding $500 million at the other.

Some people lament that the venture capital industry is dying. Actually the industry is returning to normal. The 1999-2000 period was characterized by too short time cycles too many inexperienced VCs, and too large venture capital funds. Since evidence indicates that the industry is regaining its original attributes of more realistic time cycles predominance of more experienced practitioners and manageable fund sizes, we can look forward to a period of revival in the global venture capital industry leading to business innovation and value creation that the VCs used to be credited with in the not too distant past.

The Sri Lankan scenario

The Sri Lankan venture capital industry to a great extent has been insulated from the global trends discussed above. There have been advantages as well as disadvantages of this insulation. Whilst the local VCs as a group may not have made the kind of gains that their international counterparts made during the upswing they have not suffered massive losses either.

None of the local VCs have lost their capital altogether, and in fact most of them still retain at least the value of the initial capital. The reasons for this insulation from global trends need no elaboration, Sri Lanka being a small developing country. More relevant is the fact that the local venture capital industry is still at an early stage of its development. The performance or otherwise of the local venture capital industry has to be viewed within that context in order to arrive at meaningful conclusions regarding its current status and the way forward.

The venture capital industry in Sri Lanka began in the early nineties. Not a single venture capital firm existed before 1990. By 1992 there were seven companies. How did this happen? In 1990, the Government of Sri Lanka introduced a set of fiscal incentives to prospective venture capital investors. Section 22/DDD introduced in 1990 to the Inland Revenue Act provided: a). Investment relief (i.e. tax deductibility) to investors in approved venture capital funds; and b). 10-year tax holiday for profits made by approved funds.

The two development banks (NDB and DFCC) one state bank (People's Bank) one private bank (Commercial Bank), two investment banks (DCIC and Asia Capital) and one finance company jointly with another private bank (Central Finance/HNB), floated venture capital subsidiaries. The defining feature of the first round of venture capital funds was that they were all subsidiaries of Banks. The total venture capital funds base of all the seven companies was estimated to be Rs. 1.5 billion. According to a USAID-funded study published in July 2000 by John Burr, a venture capitalist from the US and Consultant to the Venture Capital Association of Sri Lanka (VCASL) all seven companies collectively invested Rs. 1 billion in 101 projects during the 9 years from 1991 to 1999. Burr's study further revealed that the performance of only 1 out of the 101 investments truly qualified as a successful venture capital investment in terms of a return equal to a significant multiple of the value of the original investment.

What did Burr mean by a "significant" multiple? In order to be "significant", the size of the multiple has to increase with the time it took to obtain the return in cash. For instance doubling the money can be considered significant in one year or at most in two years. If it took three years to double the money, it is not really a multiple return but an ordinary return of 26% per annum. If it took five years to get a return the multiple should be at least 10 in order to obtain an internal rate of return (IRR) of over 50%. At first glance it may seem that VCs are expecting excessive returns from their investments but a closer examination will show that this is not the case. If a Venture Capitalist makes investments by targeting each investment to yield a given IRR of say 50% the actual return on investment across a portfolio of investments will be much lower due to the high probability of failure of typical venture capital investments.

VCs take equity positions in portfolio companies in return for their investments. Such equity investments by VCs typically in start-up or early-stage companies carry the risk of loss of entire invested capital unlike other debt-related investments where the risk is generally limited to the loss of surplus gains but the capital is secured. Since most new businesses fail it follows that most businesses in a venture capital portfolio will also fail. In actual fact, however, the rate of failure for venture capital-funded start-ups has been found to be less than that of new businesses in general.

That ought to be the case, certainly with the value addition that VCs provide. Nonetheless, the fact remains that most businesses in a venture capital portfolio will fail and therefore most investments by VCs will be lost. Thus the few businesses that succeed have to provide an acceptable return on the venture capital investment, after setting off the cost of all the lost investments. Viewed in this light, a 50+% IRR or a 10 times multiple does not look excessive at all. For example, take four investments of Rs. 10 million each. Assume that all four investments are in start-up companies and that three of them go bankrupt.

The remaining investment of Rs. 10 million has to give a multiple return of 4 times in present value simply to recover the original total investment. Even a 10 times multiple in five years on an investment of Rs. 10 million actually translates to an IRR of only 20% when you consider that the initial outlay was not just Rs. 10 million but Rs. 40 million. If a Venture Capitalist is looking at an overall IRR of say 30% in five years then the Venture Capitalist has to target investment opportunities that have the potential to return a minimum multiple of 15 times, based on a 25% hit rate.

One might argue that if businesses are selected carefully such that only a few of them fail venture capital investing need not be such a risky endeavour. This is true if one were to measure success merely by the number of businesses that survive in a portfolio. But what really matters to an investor is the actual realized return, and not a head count of solvent companies. Most investors intuitively know that businesses selected for the relative safety of the capital invested have limited "upside potential", if at all. For VCs, "downside protection" does not necessarily guarantee safety in a real financial sense. Consider the same example of four investments of Rs. 10 million each. Let us now assume that these investments are relatively "safe" and therefore only one will go bankrupt and the other three will be successful. Because the investments were selected for their "safe" or "low risk" nature, the yield from these investments will be realized not in multiples but as a percentage return on the amount invested. Even if the IRR of each of the successful investments is a healthy 20%, the overall IRR of the entire portfolio over a five-year period will be only 13%. Given that even the risk free rate in Sri Lanka is more often than not higher than 13%, this actually means a negative return in real terms.

Getting back to the performance of the Sri Lankan venture capital industry during 1991-1999, whilst only 1 out of 101 investments had actually produced a true venture capital type of return, another 40 investments were found to be "moderately successful" meaning that these 40 companies were operating at varying degrees of profitability. The remaining 60 were rated as "poor"or "lost". "Poor" signified a high probability of sliding into the "lost" category. A 40% hit rate cannot be considered a bad performance at all from a venture capital standpoint. But why was it that taken as a whole, the venture capital industry was not considered a profitable one at the end of this 10-year period? This was attributed to a preoccupation with downside protection, thereby seriously limiting upside potential. Thus, even with a healthy hit rate of 40% in picking companies that eventually reached profitability, the VCs were not able to obtain a return that could compensate for the 60% that was lost or almost lost.

It was stated earlier that all seven VCs were subsidiaries of Banks. Not only were the Boards of Directors of these companies dominated by veteran bankers, even the top management positions of the venture capital companies, except in very few cases, were filled up by bankers seconded from the parent companies. An important aspect of banking practice is downside protection. Viewed from this perspective, the results of 1991-1999 become quite understandable. Bankers are trained to minimize the overall risk of an investment portfolio by diversifying across the different variables such as the sector, stage of growth, and size of investment. The "do not put all your eggs in one basket" approach or, in the jargon of investment theory, hedging against the downside risks of an investment portfolio by investing in assets whose movements are negatively correlated with each other. John Burr wrote that:

"The six equity funds invested in an extraordinarily wide range of projects. It seems there is no TYPE of Business that is not a reasonable target for Sri Lankan venture capitalism.

* Manufacturing, services, real estate, hotels, aquaculture, utilities, etc., etc.

* Among them, Start-ups and Existing businesses, that is, businesses at quite different Development Stages;

* And running a gamut from very High Tech to quite Primitive manufacturing;

* A variety of Forms of investment have been used: Common and/or Preferred Stock, sometimes exclusively and sometimes together with some form of DEBT. Sometimes, Convertible Debt exclusively.

* When stock has been involved, it has represented Ownership running all the way from 100% down to 1.7%;

* And the range in Size has been wide-from Rs. 500,000 at the low end up to the largest investment of more than Rs. 43 million,

This extraordinary diversity of the industry as a whole is generally reflected in the portfolio of each of the six equity investment funds that comprise the industry. All of them have taken what might be described as an "ecumenical" approach to investing. How effective has this ecumenical investing approach been?" It was clear from Burr's findings that the so-called ecumenical approach has not been very effective. Thus, the evidence appears to support our analysis using the IRR model that VCs can obtain returns commensurate with the high risks inherent in venture capital investments only by targeting investments with high upside potential. Thus the more appropriate approach for VCs should be to "put all your eggs in one basket and look after the basket well".

There is evidence to indicate that from about the year 2000 onwards, the local VCs have tended to focus on investments showing upside potential, particularly in knowledge-based businesses including information technology (IT). Whilst upside potential is not limited only to technology-related businesses, it is not difficult to understand why a focus on high returns would draw VCs to such businesses. The amount of capital investment required to generate a dollar of net earning in a computer software company, for instance, is much lower than that for manufacturing or other industrial applications. the value of a knowledge-based business is captured in the intellectual property it owns, and when realized, the cash generated is as real as the cash generated by selling tangible assets such as land, buildings, machinery and equipment. Since the initial investment relative to the future realizable gains is very small, the reciprocal of the equation provides the much sought after multiple returns.

Unfortunately, by the year 2000, all but three venture capital companies in Sri Lanka had fully invested their funds. Hence the trend towards an upside-oriented investment strategy by the remaining VCs does not appear to have much of an impact. Nonetheless, a paradigm shift had indeed occurred, and if the decade of the nineties can be termed as the first phase of Sri Lankan venture capital industry, the period beginning year 2000 to date can be seen as the second phase, in which the industry seems to be stabilizing itself. The current period is also characterized by many other aspects that make it distinct from the first phase, such as:

. VCs with industry experience as opposed to banking experience

. Focus on intellectual property in selecting investments

. Focus on upside potential and willingness to assume the associated risk

. Strategic management inputs to portfolio companies

. Awareness and adaptation of global trends in the venture capita business

. Emphasis on pragmatic exits through trade sales and M&A deals as opposed to theoretical promoter buy-back agreements and/or undertakings to list in a stock exchange.

. Emphasis on strategic alliances with international players

. Relationships with the technologically oriented sections within the Sri Lankan Diaspora.

. Alignment of interest between investors and the VCs.

Certainly, if a study similar to that by John Burr were to be carried out covering the period 2000 to date, the author has no doubt the portfolios of the remaining three venture capital firms will show a much-improved result. Perhaps it is an opportune time for the Venture Capital Association of Sri Lanka (VCASL) to commission an independent study to corroborate this opinion, which is based on the performance of the venture capital fund of which the author is the Managing Director, as well as anecdotal evidence from colleagues managing the other funds.

If a paradigm shift accompanied by improved portfolio performance is proven to be the defining trait of the Sri Lankan venture capital industry today, it would then appear that we are on the threshold of a third phase in which the industry would be characterized as mature and market-driven. In this phase, one would expect to see new funds being raised based on the market need. The ability of VCs to raise new funds targeted for venture capital investments will be determined largely by the perceived demand for venture capital by entrepreneurs and businesses in various stages, as well as by the past track record of the VCs who are raising such new funds.

The new funds, if so raised, will have to be managed quite differently from the early funds in Sri Lanka, based on the expectations of the new breed of investors who will be different to the banker-shareholders of the early funds at least in one important aspect. The new investors in the next generation of venture capital funds in Sri Lanka will have a clear understanding of the risks, and the potential rewards, inherent in venture capital investing, in contrast to the investors in Sri Lanka's first generation venture capita funds who invested mainly to take advantage of fiscal benefits, but never really followed a coherent strategy appropriate for venture capital investing.

However, such a development is unlikely to take place automatically. Certain positive and enabling conditions are in place as a result of the historical evolution of the venture capital industry in Sri Lanka, but there are many constraints imposed by the regulatory environment, and these must be corrected. The positive conditions include the availability of a critical mass of venture capita expertise in the country, as well as a demonstrated ability by local entrepreneurs to create world-class products and services, particularly in the knowledge-based sector. Another positive feature is the global trend in the venture capital industry that is reintroducing the "back-to-basics" approach of venture capital. Hence, the dizzying heights to which international venture capital funds rose, and the roller coaster rides they rode during the internet bubble, which made one question the relevance and applicability of venture capital to emerging markets such as Sri Lanka, no longer appear as the mental blocks they once were.

The universality of the idea that all communities can produce their share of world-class entrepreneurs with dreams to be amongs the best in the world, and from that community should emerge the risk takers willing to help make those dreams come true, seems to be taking hold once again. The emerging trend of technologically oriented sections of the Sri Lankan Diaspora setting up companies in Sri Lanka to take advantage of the availability of high quality technological manpower at relatively low cost, whilst being in a position to provide access to the products and services of these companies in the markets into which they already have made inroads, could be the beginning of a powerful force that could transform the country. Availability of a significant mass of venture capital locally to attract and finance such businesses, as the existing VCs have already done in small way, has the potential to catalyze a process that can take the country out of its doldrums.

The contribution by the non-resident Indians (NRIs) as entrepreneurs setting up tech companies in India, and as key investors in Indian venture capital funds, towards the development of that country's IT industry, is well known.

In Sri Lanka, when by a combination of historical circumstances, luck and the extremely hard work by a few dedicated people seem to create the conditions that can take the country to world-class achievements in any field, arcane policies and bureaucratic lethargy have a habit of getting in the way. Venture capital industry is no exception. It is not the purpose of these paper to address the policy constraints that are impeding the growth of venture capital in Sri Lanka. Suffice it to say that despite setting in motion the process of liberalization many years before India, Sri Lanka is yet light years away from creating the enabling environment put in place by the Government of India to fuel the growth of venture capital in that country and thereby the phenomenal growth of the IT industry in India. The sheer magnitude of this phenomenon and its impact on the Indian society as a whole is well documented. Whilst in Sri Lanka it has become very fashionable these days to promote IT, one of the essential ingredients of a knowledge based economy has been overlooked. Whereas the governments of countries like Singapore, Korea and even India have gone the extra mile and created state sponsored venture capital funds, not content with merely creating the enabling environment, Sri Lanka seems unable to clear the road for the few private initiatives that have been taken in this regard.

In conclusion, however, it must be stated that it is up to both entrepreneurs and venture capitalist and their investors to look at the conditions as they are, and try to make the best out of them. Highest rewards accrue to those who are willing to take the highest risks. Leaving the complaining about the "country situation" the rent-seekers who comprise the bulk of the Sri Lankan business community, the new generation of hard-working, self-made entrepreneurs and risk-oriented investors who are looking for a holistic return on their investments, should together find ways and means of unleashing the extraordinary power of value creation that will result when the two ingredients of entrepreneurial spirit and risk capita are mixed together. In their quest for such ways and means", they will no doubt come across the critical mass of venture capital expertise that is available in the country today. Critical mass is a term from nuclear physics. It needs only a minuscule intervention to unleash powerful forces. Taken out of the enabling environment of the reactor, however, the critical mass is not of much use to anybody. It is thus a very apt analogy for the present status of the venture capital industry in Sri Lanka.

The CSE, market fluctuations and stock returns

by Dinesh Fernando

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

- Warren Buffett, Berkshire Hathaway annual report, 1997.

For those who are unaware, Warren Buffett is regarded in the investment community as the best investor ever, with an unparalleled performance track record since 1956.

My experience with investors and Buffets quiz confirms that the majority of investors get the third question wrong. In fact, no one was able to give the correct answer immediately and most amateur investors remain confused and/or unconvinced, even after explaining the rationale for it.

Investing means laying out money today, to receive more tomorrow. Investors often forget this simple fact. There are several adages in the stock market, one of which simply says "buy low and sell high". Buying low refers to purchasing securities at a lower price than its intrinsic worth, and selling high refers to the opposite. This seemingly inconspicuous truism is not always clear to investors, who frequently act as a herd rather than rational individuals. Investors purchase stocks in a bull market simply because prices have increased rapidly and, in the process push prices higher, attracting more investors ... During this process, stock prices appreciate faster than increases (if any) in their underlying intrinsic values. This process also works in reverse during bear markets where investors, panicking at seeing declining stock prices, sell their holdings leading to further price declines which begets further panic selling. In other words, investment decisions appear to be made based more on price movements than intrinsic values.

Buffets quiz helps to highlight the lunacy of such actions. After all, if you regularly consumed beef, would you consume more simply because beef prices increased rapidly, or would you consider the (intrinsic) values of alternatives? Stock prices cannot increase faster than intrinsic values forever. Prices have, however, outpaced intrinsic value growth over limited time periods - time periods that have frequently amounted to several years. At the end of such a period, there is a large divergence between market prices and intrinsic values. As Buffett points out, it is the seller who benefits during this time and a significant difference between the forecasts of most professionals (economists etc.) and subsequent actual experience. This is not the fault of the economist - it's just that the variables are too difficult to predict. History shows that very high valuations are unsustainable and usually precipitate a significant decline.

Research on US markets indicate annual returns for large company stocks of 10.5% (7.2% after adjusting for inflation) in the 1926-1995 period. Small company stock returns were higher (12.5% or 9.1% inflation adjusted).

The inflation-adjusted rates of return are highly satisfactory, especially when compared to Treasury Bill and long-term Government Bond yields of 0.6% and 2.0% respectively (inflation adjusted). These data and a lot of additional research have conclusively shown that long term stock returns in the US outperformed those on Treasury Bills, Government and Corporate Bonds. Therefore, investors should consider stocks as a viable investment opportunity.

So, what does that mean for a local investor, who can only invest in the CSE? Can past performance of the CSE provide some guidance on prospective returns? Specifically, can stock investments outperform returns from Treasury Bills/Bonds and the yields currently available from listed debentures?

For the nine years ending 1993, stocks compounded at over 8% per annum, yielding a very high premium over inflation rates and yields on fixed income instruments. Subsequent returns were poor, however, with annual losses exceeding 5.5% for the eight years ending 2001.

Some observers would attribute the wide difference in returns to different political regimes that existed during the two sub-periods. There are, however, two broader questions that need to be raised:

1. Is it normal for stock returns to fluctuate drastically between differing time periods?

2. If so, what are the long run returns that can be expected by investors in the CSE?

To answer the first question, let's look at some statistics on the US market over the 20th century.

Barring the 1910-20 period, the US economy grew at a very satisfactory rate over the past century. Now, if you were to argue that stock returns are closely linked to economic growth (the basis on which some people judge CSE returns), then US stock returns should closely correspond to the above economic growth rates (plus a premium for inflation). The Dow Jones Industrial Average "Dow Industrial" is a US stock index that provides details of returns over the 20th century. Let's look at some statistic for selected time periods. Down Industrials

* 31-Dec.-1899: 66.08

* 31-Dec.-1920: 71.95

During this twenty-one year period, stock prices increased at a minuscule 0.4% p.a., a rate of return lower than treasury rates at that time and well below those implied bye economic growth over the period. This period was followed by a market boom in the 1920s, when the Dow Industrials jumped 430%, to 381 by September 1929.

19 years down the road in 1948, the Dow Industrial declined to 177, or less than half the level of 1929. That happened despite the 1940s displaying the largest per capita GNP growth in any 20th century decade. Next came another boom period, when the market advanced nearly five-fold.

Dow Industrials

* 31-Dec.-1964: 874.12

* 31-Dec.-1981: 875.00

For the next seventeen years (1965 to 1981), the Dow Industrials returned approximately 0%. Returns over the seventeen years from 1981 were, however, anything but stagnating, as the Dow Industrials made a breathtaking climb to 9,181.43 by 31-Dec.-1998.

The point I'm trying to make is that despite solid economic growth throughout most of the 20th century, US stock returns were concentrated around three bull markets lasting, in aggregate, around 44 years, during which time the Dow Industrials gained around 11,000 points. The country made major economic progress during the remaining 56 years, yet the Dow actually came down. Economic growth is a major factor driving long-run stock returns, yet the above data tells us that the timing of stock returns do not coincide with economic growth.

Returns

These figures provide additional lessons on stock returns: They can be poor or negative over extended time periods, even a couple of decades. Long-term returns tend to be realised in spurts. Furthermore, stock returns are highly unpredictable in the short-term - there are very few people who have successfully timed stock markets consistently (purchasing stocks when they are about to increase and selling them before they go down).

Investors are well advised to stay invested over the long-term as missing out on a couple of spectacular years can significantly lower realise long-term returns. Witness the triple digit gains on the CSE during 1990 and 1991. Or the sudden rise in stock prices in late 2001, which more than made up for the losses of the previous two years. Volatile returns are a feature of stock investments: learn to live with it, or stay out of the market.

Answering the second question is more difficult as seventeen years is a fairly short time period to evaluate a stock market and its potential returns. Therefore, it is probably to early to forecast long-term (say 25 years +) returns with a reasonably high degree of confidence.

Corporate profitability, however, has been poor for the past few years and, as I write, the market Price to Earnings Ratio (PE) stands at 7.9. I believe current corporate profitability is significantly lower than the long-term average and that average future profitability will be higher than today (unfortunately, I have not come across any studies of Sri Lankan corporate profitability).

NOT the buyer. Sadly, a large number of buyers are attracted to the market in these time periods. Eventually, the "bubble" bursts, reality sets in, stock prices collapse and investors lose billions of rupees, causing them to swear off the stock market. This exposure to loss keep investors away from stock even after large price declines, when valuations are cheap and expected returns from investments made at those (low) prices are high. The result is another large divergence between market prices and intrinsic values, only this time the difference favours the buyer.

History has repeatedly shown an inability among investors to maintain rationality in bull and bear markets. Buffett attributes this inability to a "rear-view mirror" approach among investors, who habitually form expectations about stock returns based on returns observed in the recent past.

Consider our own stock market. In 1994, I remember the CSE trading at a Price to Earnings Ratio (PE) in the region of 30, whereas it had declined to less than 5 by 2001. (The PE ratio is calculated by dividing the stock price by its earnings per share. It indicates how much investors are willing to pay for one rupee of earnings. A PE of 30 indicates that they were willing to pay thirty rupees per share for a company earning one rupee per share).

In an economy with double digit inflation and Treasury Bill rates ranging from the mid to high teens, a PE multiple of 30 for the aggregate stock market is a very high premium. It translates to an earnings yield (earnings per share divided by price per share) of 3.33%, vs Treasury Bill yields in the 15% - 20% range (exact TB rates at the time are not available to me). When interest rates are high, other things being equal, valuations of equity markets are lower.

In late 1993 and early 1994, investors piled into stock in record numbers when valuations were high, yet in 2000, when valuations were extremely cheap, they avoided stocks like the plague. For confirmation, you need only look at the annual reports of some of our large institutions. Equities (measured either at cost or market values) as a proportion of total assets were far higher in 1994 than in 2000. These companies blame declines in the stock market for mark-to-market provisions that have been made since 1994. Managers of these institutions do not have any 'control' over stock prices. They do, however, have full control over the prices at which they purchase stocks. The truth is that a big chunk of those losses (whether realised or not) were due to purchasing securities at overvalued prices. Somehow, investors do not seem to have confidence in equity market when prices are low. They seem to start gaining that confidence after a significant rise in stock prices and are happy to increase their stock exposure as prices continue to increase - when prospective returns on stock investments are diminishing.

Several assumptions are required to justify high valuations. Examples of such assumptions include: high real (net of inflation) long term economic growth, high rates of corporate profitability and earnings growth over an extended time period, declining inflation and interest rates etc. etc. Forecasting most of these variables accurately over the long term is incredibly difficult. Research in the United States has shown that there is If that belief is correct, then investors are capitalising those "low" earnings at a multiple of 7.9. The next question is if the PE of 7.9 is "fair"? i.e. does it compensate for below average profitability? Sadly, there are no easy or "correct" answers for questions of this sort. Two equally competent and knowledgeable analysts can arrive at widely varying PE estimates.

Profitability

I believe the CSE warrants a higher PE than 7.9 under normal economic conditions and average corporate profitability (my best guess is in the range of 9 to 12). When low profitability is capitalised at a relatively low multiple, the result is a group of undervalued securities and a source of potentially lucrative investment returns. It goes without saying that there are heavily undervalued individual issues with potential to yield spectacular returns.

A word of caution about using PE ratios though: I have used it as an imperfect, though convenient, shortcut to evaluate an entire market. The ratio can be misleading when used to evaluate individual securities.

It would be interesting to see if institutional investors have the courage to purchase stocks at today's prices, or if they will wait until prices go up. If so, the investment mistakes made in 1993/94 may be repeated.

(The writer is a Senior Project Executive at DFCC Bank and can be contacted by e-mail: [email protected]. Data on US markets from Dow Jones, Fortune magazine and Investment Analysis and Portfolio Management (fifth edition, Reilly and Brown, Dryden Press)

Shopping sprees clip savings of Thai consumers

BANGKOK, Sept 2 (Reuters) Twenty-six-year-old Tuti loves to buy things so much she named her dog "Shopping".

"When you go shopping, it gives you the ultimate fulfilment. You get something material to replace your emptiness," she says, running her fingers along the hem of a recent acquisition - a 2,330-baht ($55.53) skirt from a local design house.

Tuti says she tries to limit her purchases to "once a week" and is planning her next conquest: a pair of black pants by a local designer priced at 1,500 baht.

"I try to organise my spending carefully because I don't want to be broke," she says. Five years on from a major financial crisis that rocked the country, Thai consumers are at it again - spending more and saving less.

Bad memories of the Asian financial crisis of 1997/98 and Thailand's deepest recession in half a century are fading. Then, companies faltered, workers were laid off in droves and cash-strapped Thais sold off luxury cars and branded clothing at yard sales called "The Marketplace of People Who Used to be Rich".

But the economy has since shown a steady recovery and consumer confidence and spending has rebounded.

The central Bank of Thailand expects the economy to grow a robust three or four percent this year, helped by shoppers like Tuti. The economy expanded 1.8 percent last year.

Consumption generates about 56 percent of gross domestic product (GDP), above pre-crisis levels. Household savings fell last year to half the 12 percent of GDP seen in 1998.

A university survey in July showed consumer confidence was at its highest since the crisis, signalling a domestic consumption-led recovery was in full force. Thai policymakers don't seem worried at the moment that a boom might lead to a bust.

In Asia, South Korea, which has seen a similar burst of spending, has tightened credit card rules to rein in consumers. Many Japanese retailers have suffered for years after the spending excesses of the 1980s came to a grinding halt in the 1990s.

"When you look at it, one individual and how much money, it doesn't add up to much," Chom Sumanaseni, president of the Thai Credit Bureau said recently. "If you pull a single blade of grass out, it's not going to kill the whole yard."

Thi, a young executive in the finance industry, bought a house for 10 million baht ($238,000) at a housing project near the city to go with another recent acquisition, a BMW. "Now is the time to buy a house," he said, adding that six other people at his company had also bought houses in the same project. "If I sold my house now, I would make a capital gain of 10 to 15 percent after buying it a year ago."

Domestic automobile sales surged nearly 50 percent year-on-year in July. Property and construction firms have also enjoyed a boom, due to pent-up demand.

Thi, who has seen the number of employees in his department shrink to five from 60 before the crisis hit, says surviving the crisis has made him more secure in his spending now.

"You feel a little more comfortable because now you've lived through the crisis and you're not afraid because you've seen it already," he said. He said he was confident Thailand had learned its lessons from the 1997/98 crisis and reforms were on track - for now at least.

"We have changed a lot of things," Thi said, citing the floating exchange rate system. "This generation will not do exactly the same things as before the crisis. But my future son or daughter will, and they will start another crisis."

The maker of Tuti's new skirt, designer Duangta Nantakwang, says Thais haven't been the only ones filling the coffers of local companies.

Treading a path that made Singapore a major Asian shopping centre, Bangkok is attracting increasing numbers of Chinese, Taiwanese and Japanese - spurring sales of Duangta's label, "Soda", by 20 percent so far this year.

"Sales have always been good," she said at a cafe on the ground floor of a swanky shopping centre. "But this year, they've been even better."

Human resources development through proper disciplinary management

by D.A. Wijewardene

If a manager, in any sphere of work, is to succeed in his career he has to be able to manage his staff (the human resources) efficiently. In spite of the best intentions of the Management we often find indiscipline among employees or workers. This indiscipline may take various forms such as neglect of duty, disobedience, disregard for authority, dishonesty, lack of integrity and so on.

This indiscipline must be arrested immediately, for otherwise it will have serious repercussions even to the extent of disrupting the smooth functioning of the company or other organisation. It may also affect the productivity of the company. The question then arises as to whether an employer could resort to the remedy of directly dismissing or otherwise punishing such misconducting employee. No, he cannot do so. If the employer does so the employee concerned will lodge an appeal in the Labour Courts. The employer will then be called upon to show good cause for such punishment being imposed on that errant employee. The minimum requirement that the employer should then satisfy is to show that he had dealt with this employee in terms of the principles of natural justice.

Principles

Observance of these principles requires that the employee concerned should be given a fair hearing in his defence before the imposition of such punishment on him. How would you ensure this requirement? This would be by holding a formal inquiry, particularly where the employee has been dismissed. A formal inquiry has to be initiated on the basis of charge sheet issued against him. A charge sheet could be framed only after holding a preliminary investigation. In this process the management is called upon to train its officers in these procedures in disciplinary management.

In pursuing disciplinary action against an employee one of three courses of action can be followed, depending on the gravity of the offence. If it is a serious offence warranting even the dismissal of the employee, three steps in procedure are taken, before the termination of his services or the imposition of a major punishment. If the offence is of a minor nature it can be disposed of without the requirement of a formal inquiry.

Then the steps would be a preliminary investigation, a charge sheet and then a disciplinary order or a punishment. Here the punishment itself has to be of a minor nature. However, we often observe that every charge sheet, whether relating to a major or minor offence, proceeds to a formal inquiry before deciding on a punishment. This results in a waste of man power and finances of the company concerned, since a formal inquiry entails the deployment of a number of persons as inquiry officer, prosecuting officer, accused, defence representative and a number of witnesses. And some of them would have to be paid for their services. Thus the employer is put to extra expenditure and waste of man power, when this matter could have been disposed of initially without a formal inquiry, if these procedures had been known and followed by the management.

There is yet another procedure that could be followed. And that would be in the event of a minor lapse or dereliction of duty. This is generally known as the summary procedure, where the employee concerned is called for his written explanations and dealt with, where necessary, with a very minor punishment, without the necessity of even a charge sheet.

Model

These disciplinary procedures are set out in volume II of the Government Establishment Code. Government is generally considered as the model employer. Therefore it would be safe for any other employer such as a private sector company to follow these procedures.

This also illustrates the necessity for every organisation whether public or private to compile and maintain a disciplinary code of its own, laying down these procedures as also their particular requirements and the obligations of the employees towards the employer. In such circumstances, if a punishment imposed by the employer is contested in a Labour Court, the employer could often urge that he had acted in terms of the provisions of their own disciplinary code. The employee also would know what his obligations are towards the employer as well as of the opportunities afforded to him to prove his innocence, where he is accused of having committed an offence.

It must be stated finally that such proper Disciplinary Management procedures will necessarily contribute to better Human Resources Development in the Institution. This would lead to improved relations as between the employee and employer, which in turn would contribute to enhance the productivity of the organisation or company.

The writer is Director, Centre for Studies in Disciplinary Management.

Corporate misdeeds expose Japan's structural faults

TOKYO, Sept 3 (Reuters) Who's watching the watchdogs? That, analysts and activists say, is the question that should be foremost in citizens' minds as they ponder the latest in a long list of scandals to hit the cream of corporate Japan.

The disturbing answer - "often, no one" - is one reason Japan finds it so hard to reform its economy despite more than a decade in the doldrums and policy-makers' promises of change.

The president of Tokyo Electric Power Co (TEPCO), Japan's largest power utility and a firm closely linked to the nation's policy elite, said on Monday that he and four other top executives would resign over a scandal involving the falsification of reports to cover up damage at nuclear reactors. The scandal came to light on Friday, more than two years after an employee at the unit of U.S.-based General Electric Co which conducted the safety checks told authorities that there appeared to be problems with TEPCO's reports.

Critics said the sluggish official response was symptomatic of a deeper problem - the cosy ties which for decades have linked top companies, their official overseers and politicians in a triangle of mutual interests. "The watchdog issue, the whistleblowing, it's all part and parcel of the same thing. A company like TEPCO is in there at the heart of policy-making and is very, very representative of corporate Japan," said Noriko Hama, director of research at Mitsubishi Research Institute.

"It's very much a sign of the times that this kind of cooperative relationship has turned to collusion," she said.

"It shows that the edifice upon which postwar Japan relied is dysfunctional."

Industry Minister Takeo Hiranuma declined to say on Tuesday if anyone in his ministry would be disciplined but conceded that the scandal had hit the credibility of the nuclear industry and government energy policy, already tarnished by several accidents.

"I must say that, from common sense, two years is too long," Hiranuma said, referring to the time that elapsed between the authorities being told something was wrong and their reaction. Consumer activists said Hiranuma's METI ministry and the Nuclear and Industrial Safety Agency could not escape blame.

"If METI and the safety agency knew about it, naturally they also have responsibility," said Yukiko Miki, executive director of Information Clearinghouse Japan, a group pushing for laws to protect whistleblowers and systems to deal with their complaints.

"More and more people have lost trust in companies and the government agencies to which they are closely tied," she added.

METI officials say their investigation was delayed by the difficulties of perusing old records and contacting those potentially involved in a case that may stretch back to 1986.

Critics, however, say TEPCO's long-standing and tight ties with the bureaucratic and political establishment - relations typical of many blue chip companies - probably played a role. Outgoing TEPCO Chairman Hiroshi Araki, for example, was not only a vice-chairman of powerful Keidanren business lobby, but chairman of the group's Committee on Corporate Behaviour, set up to address issues of business ethics and corporate governance.

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