A Fool And His Money are Soon Invited Everywhere

In the early 19th century when the United States was an "emerging market," millions of European investors burnt their fingers by speculating in bonds and stocks sold by American companies to finance the building of a huge network of canals. The impetus of the canal boom came from the successful completion of a huge canal connecting New York and the Great Lakes. Its success sparked a canal mania. Every city that had two or more bodies of water drew up ambitious plans to connect them, hoping to duplicate the success. The reasoning was this: Canals were the cheapest method of transporting goods. Commerce could not get along without them. Moreover, it was difficult and costly to make competing ones.

The prospectuses offering these securities made extraordinarily optimistic projections of profitability within a few years of completion. It worked like a charm. Millions of investors bought the securities. Toward its peak of the canal mania, the demand for American canal bonds and shares from European emerging-market investors was so great that there were not enough new issues to satisfy them.

The speculative bubble burst in 1836, when, to attract capital, the Bank of England raised its interest rates twice. Speculators, who had earlier bought the canal bonds and shares, switched back from America to Britain almost overnight, just as demand for money in America was at its highest. Starved of capital to construct the canals, many canal construction companies went bankrupt. Most of the securities bought at the height of the mania, turned into worthless pieces of paper. By 1850s even completed canals became obsolete after the advent of the railroads.

The arrival of the railroads, inevitably, led to a railroad mania. Ignoring the lessons from history, once again foreigners lapped up American securities issued by American companies to build railroads. As usual, the prospectuses talked more about hopes and dreams than about facts. This bubble was burst by the Crimean War (1854-1856). In raising money to pay for it, European governments pushed up interest rates, draining investment from America at the very moment the railroads needed capital to finance their expansion. Unable to obtain funds, numerous railroads and banks failed in 1857. Ironically, just as most canals became obsolete after the advent of the railroads, the railroads, in turn, were eclipsed by the arrival of the automobile.

In 1980s, the British Prime Minister Margaret Thratcher dreamt up a grand project of building a huge under-sea railway tunnel connecting Britain and France. Financed by private money, the project - called Eurotunnel - promised huge payoffs to the initial investors. 225 banks eagerly lent money to finance the project and hundreds of thousands of individual investors lapped up the shares. As usually happens, Eurotunnel's financial forecasts turned out to be an exercise in wishful thinking. The revenue projections turned out to be as over-estimated as the costs were under-estimated. The cost of the project ballooned to £11 billion from £4.7 billion and its opening was delayed for a year. The company's interest bill for 1995 alone was a huge £700 million a year, a third higher than its total turnover for the same year. Not surprisingly, its shares quote at less than a fifth of their peak value. The company is not likely to pay a dividend before 2005.

Financial history of Europe and America is full of similar examples of grand projects dreamt up by ambitious promoters and financed by foolish speculators who subsequently lost most of their money. There are common threads in most of such episodes.

From time to time the public becomes far too optimistic about the prospects of a new industry or a new region about which they usually know little. In fact, the evidence suggests that the more glamorous the project or the more distant and unknown a region, the more enthusiastically investors wish to participate in the illusionary bonanza.
There is always a seductive plan to sell securities to finance the project. The prospectus inviting the public to subscribe is often based on absurd projections of profitability. However, convincing the public to subscribe is not too difficult. As John Kenneth Galbraith, a respected economist, once wrote: "This is a world inhabited not by people who have to be persuaded to believe but by people who want an excuse to believe."
Most of such projects, being long-term in nature, are financed in stages through a sequence of security issues. As the project progresses, interim difficulties may be more easily overcome than had been anticipated and successive shares may therefore be sold at higher prices.
Often, however, the project fails to generate sufficient long-term returns to compensate the providers of capital for the risks they have undertaken. This happens because earnings fall short of prophecy. This may happen due to a number of reasons. First, the promoters may have painted a false image of the profitability of the operation. Second, the promoters may be engaged in a pyramid scheme as part of a fraud, using newly invested funds to pay off earlier investors. Finally, the scheme may be based on the best information available and still not succeed. Prediction of profit may arise from incorrect analysis. (After all, the combination of precise formulas with highly imprecise assumptions can be used to justify practically any project, no matter how silly). It is also possible that the project, though sound in its ultimate vision, may fail because of lack of adequate financing.
When the public realises that a project will not succeed, securities issued in its financing fall in price. This fall may be gradual if the information about failure appears gradually. A sudden appearance of negative information, however, causes a precipitous fall in the price of the project's securities. One recent example is that of MudiLuft Limited.
Failure of the project leaves investors embittered and holding worthless claims. But, public memory is short. When another grand project materialises, enough members of the public enthusiastically come forward to participate in it. As one wise man once said: "We learn from history that we don't learn from history."

India is no different from the rest of the world. In recent years many high profile infrastructure projects have caught the promoters' and the public's fancy. A huge amount of money has been raised from the capital market through successive public and rights issues to finance these projects. Many lofty claims have been made in the prospectuses. The results, as expected, are not very flattering. Some high profile examples:

In 1991, when the private sector was allowed to operate airlines in India, many companies, attracted by a huge, glamorous industry jumped in the fray. Ambitious projects were drawn up in record time and the public was invited to finance the setting up of several private airlines. The prospectus selling all these public issues made rosy predictions about costs, revenues and profitability. The public, enamoured by the prospect of minting money, eagerly bought the shares. Successive rights issues were also made at premium prices which also the public lapped up. The results were inevitable. The financial projections turned out to be far too optimistic. The operating results of most private airlines have turned out to be dismal. Most airlines cannot generate enough cash to pay even lease rentals, leave alone finance the acquisition of more aircrafts. As expected, the stock prices of these companies currently sell at a fraction of their offer prices. Realising the dismal state of affairs of his dream project, one promoter - Mr Parvez Damania of Damania Airways sold out his stake to the NEPC group. Mr Damania may have learnt important lessons in financial projections and industry economics but his tuition fees was paid by the shareholders of his company.
Paging service and cellular phone operators have found to their dismay that their initial calculations about the size of the Indian market and its growth potential were wide off the mark.
Basic telecom service providers such as HFCL have bid huge sums of money to obtain licences for prime cities on the basis of financial projections that will, in all likelihood, prove to be far too optimistic.
TV channels are being launched almost on a monthly basis. Most of them will not earn enough advertisement revenues to even cover their operating costs, leave alone generating cash for investors.

Note that all the above examples come from glamorous industries - airlines, paging, cellular phones, basic telecom and television. Why do people sometimes prefer to put their money in glamorous companies having no track record rather than investing it in profitable companies having long operating histories? The reason has to with psychology. Even while investing, most people like to be fashionable. Something new, exciting and innovative always captures their imagination. They would much rather invest in a cellular phone operator than in a cutlery manufacturer. As Warren Buffett once said, "These investors like to fantasise about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be."

Buffett knows what he's talking about. He has kept well away from companies involved in glamorous projects. (According to him, "A fool and his money are soon invited everywhere.") Instead, he's made his fortune by investing in well-run existing companies running mundane businesses such as furniture retailing, beverages, chocolates and confectionery products, shaving equipment, vacuum cleaners, steel warehousing, jewellery retailing, newspaper publishing, encyclopaedia publishing, uniforms, shoes, cutlery and insurance.

Indian investors would do well to follow Buffett's example and ignore the so-called investment opportunities in glamorous industries and instead look for bargains in simple, existing businesses. Investment is a negative art. By giving the miss to glamorous infrastructure projects, conservative investors might miss a couple of hugely profitable opportunities. They will also reduce their chances of suffering horrendous losses.

Note

This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.