Finding 'EQUITY' in the Stock Markets

SURESH KUMAR

The title of this piece may seem 'clever by half', and an attention-grabbing headline; but with some inherent humility, I would like to reflect on a subject, that has troubled me sometimes in attempts to find answers. Ever since the bursting of the technology bubble, the secondary stock markets have not been quite the same. Neither the increased volatility nor the equity aversion alone, are the problems. On the back of considerable realised and unrealised losses, that individuals and institutions around the world have totted up; one culprit appears to be the valuation of securities. This is very much both the cause and the effect of the so-called 'prices' in the secondary markets. The accounting profession applies its rule book vigorously and rigorously and then it all boils down to what is regarded as 'fair valuation'; per the International Accounting Standards (IAS) and the U.S. Gaap.

Before the august body of accountants accuse me of running them down (yet again?!), I hasten to add that I wish to engage in no blame-game. It may well be that the straight and the narrow path that accountants trod upon, is paved (like the proverbial road to hell) with good intentions! However, they could well be, causing inadvertently, damage to the investing community. We need to aim and achieve an element of equity and certainly, an equitable treatment in the actual and accounting sense. This phenomenon is not limited to the domestic or regional markets, but is indeed, much more pronounced in the 'emerging' (evolving and developing) markets than in the mature markets that are by definition, deep, liquid and whose published prices can be reasonably relied upon, to approximate fair valuation. But the accounting rules that have been evolved in the well established market place, have willy-nilly (ipso facto, if you like) found their way into the new stock markets that are still struggling to establish a firm foundation.

It is in this context, that I felt that the tails should not wag the dogs. Accounting treatment, the resultant valuations and its implications should not determine any organisations' investment policies i.e. govern the decisions to enter into or exit from investments. There is some risk of this already happening in many parts of the world including in the GCC. There has been a sudden rush now to comply with the IAS and, hence, a haste to segment and re-evaluate their investment portfolios. In a few extreme instances, the difficulties of fair valuation or the requirement to reflect them per IAS, have driven organizations to balance their portfolios with a wish to show themselves in the best light (form & results). Thus, the immediate P&L implications could end up dictating what pieces of real estate or paper security, a corporation should hold on, in its books. In the ideal world, the original intent in the light of the current investment considerations should prevail. In the case of common equities or stocks, their strategic import, should be the guiding factor. But now that all equity-exposures are to be treated as 'available for sale', corporations are compelled to move from cost or market value (whichever is lower), to 'marking the securities to market'.

IAS, BIS and the rating agencies have assumed larger than life dimensions in the financial world now; thanks to corporate misdemeanours (read Enron!). One cannot therefore, argue with the accountants / audit firms. Their policies are, no doubt, based on well-reasoned and consistent logic; supported by a whole body of technical literature, evidence and empirical data that preceded the formulation of these accounting principles and policies. But throwing the 'book' literally is not the answer or solution to this syndrome. The valuations end up being somewhat judgemental in the emerging markets, when one is required to mark securities or for that matter, real estate / properties 'to market'. At best, these can be based on informed assessments i.e. valuation computed intelligently and are regarded as robust enough to withstand intellectual challenge from industry professionals. But these are still not based on prices at which one can buy or sell. That is possible only when there are "last traded prices" used for listed securities or OTC in the public domain. But both these counts can at best be labelled as the least risky option or the most prudent under the circumstances. For instance, emerging markets (say the stock market in the UAE), generally tend to have thin and / or sporadic trading volumes.

The fact that reasonable quantities were traded one day in a few stocks, does not mean that those prices can be relied upon; for the purpose of marking to market, much larger holdings of those securities. The prices could come crashing down the next day or, for lack of liquidity, one may not find a buyer at all for days. On the other hand, bulk quantities done as negotiated block sales that are subsequently registered on the exchange, may achieve higher prices. When it comes to real estate valuations, this methodology gets even more complicated.

Some accounting rules tend to, to an extent, be looking for the ultimate will-o'-the-wisp of finding stability, consistency and realisability i.e. method in the madness; otherwise called a market mayhem. Although a sad analogy, it is a bit like the U.S. Marine(s) who unfurled the Stars and Stripes around Saddam's statue and occupied the Palace in Iraq to sit on the royal chairs. They may have laboured under the illusion that they are in charge but this illusion contrasted with the considerable confusion, looting and the severe breakdown of law and order in the country as a whole! Not unlike the auditor looking for valuations that are a touch too precise and narrow; in a market place, that, at best, permits but a range of valuations. Just as a polity that is bigger and wider than the policemen who go by the rules, the economies, the markets, and the world of investments is also much larger than would neatly fit in any professionals' pocket books!

Therefore, it was a tragic coincidence of sorts, what with the collapse of prices in 2000, that became a contagion that moved from greed to fear and resulting in a complete collapse of confidence. This was soon accomplished by a double-whammy, in the guise of the introduction of the IAS and the like, that meant that not only did some investment institutions around the world carry unrealised losses, which they had to reflect in their P&L, but were also required to recognize the fair valuation impact of equity investments and real estate exposures that they had previously held for strategic reasons and were showing it at the lower of cost or market value. Some of them had thought that they were very prudent about it previously.

Perhaps the equity markets need to come a full circle fairly soon for the confidence to return and sustain. But what will not go away are arbitrary valuations that get imposed on the genuine long-term investors, thanks to the periodic bouts of irrational exuberance of a few who take the stock prices up to dizzying levels and then, let them drop, like a thud. That capitalist (read Marx) syndrome may enrich or impoverish traders but equally punishes the hapless investors. The institutional variety particularly, are required to revalue their portfolios and absorb the impact of volatile gains and losses. Some may say that "if they cannot take the heat, they should stay out of the kitchen'. That would be unfortunate and will repel the good and loyal investors with the speculators and the traders dominating the market place at its high and leaving it high and dry!

Indeed private equity (or private companies that bring in outside investors) at valuations done independently, can gain currency as they often reward investors better. Certainly a risk premium can be agreed and factored into the valuations, without subjecting it to market mania. Ultimately, the market professionals need to debate and decide on these factors; simply with a view to restoring the health of the markets. Over the last few years, not so much in this region, but in the Far East, in the U.S., and parts of Europe, the SARS that has been raging and which is pushing big and small investors into capital guaranteed products, bonds and other safe and conservative instruments does drain the carefully built equity culture. This Severely Acute Respiratory Syndrome needs antibodies in the form of fresh inputs and a breath of fresh air and not masks even if they are of the IAS or the U.S. Gaap varieties. Hopefully, the global professional community will rise to the challenges of getting rid of this inequitable scourge of sustained market aversion and corrections.

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