a fool and his money are soon invited everywhere

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A Fool And His Money are Soon InvitedEverywhere

In the early 19th century when the United States was an "emerging market," millions of Europeaninvestors burnt their fingers by speculating in bonds and stocks sold by American companies to financethe building of a huge network of canals. The impetus of the canal boom came from the successfulcompletion 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 toduplicate 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 competingones.

The prospectuses offering these securities made extraordinarily optimistic projections of profitabilitywithin 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 Europeanemerging-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 ratestwice. Speculators, who had earlier bought the canal bonds and shares, switched back from America toBritain almost overnight, just as demand for money in America was at its highest. Starved of capital toconstruct the canals, many canal construction companies went bankrupt. Most of the securities bought atthe height of the mania, turned into worthless pieces of paper. By 1850s even completed canals becameobsolete after the advent of the railroads.

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

In 1980s, the British Prime Minister Margaret Thratcher dreamt up a grand project of building a hugeunder-sea railway tunnel connecting Britain and France. Financed by private money, the project - calledEurotunnel - promised huge payoffs to the initial investors. 225 banks eagerly lent money to finance theproject 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 projectionsturned 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 1995alone was a huge £700 million a year, a third higher than its total turnover for the same year. Notsurprisingly, its shares quote at less than a fifth of their peak value. The company is not likely to pay adividend before 2005.

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

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From time to time the public becomes far too optimistic about the prospects of a new industry or anew region about which they usually know little. In fact, the evidence suggests that the moreglamorous the project or the more distant and unknown a region, the more enthusiastically investorswish to participate in the illusionary bonanza.There is always a seductive plan to sell securities to finance the project. The prospectus inviting thepublic to subscribe is often based on absurd projections of profitability. However, convincing thepublic to subscribe is not too difficult. As John Kenneth Galbraith, a respected economist, oncewrote: "This is a world inhabited not by people who have to be persuaded to believe but by peoplewho want an excuse to believe."Most of such projects, being long-term in nature, are financed in stages through a sequence ofsecurity issues. As the project progresses, interim difficulties may be more easily overcome thanhad 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 theproviders of capital for the risks they have undertaken. This happens because earnings fall short ofprophecy. This may happen due to a number of reasons. First, the promoters may have painted afalse image of the profitability of the operation. Second, the promoters may be engaged in apyramid 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 ofprofit may arise from incorrect analysis. (After all, the combination of precise formulas with highlyimprecise assumptions can be used to justify practically any project, no matter how silly). It is alsopossible that the project, though sound in its ultimate vision, may fail because of lack of adequatefinancing.When the public realises that a project will not succeed, securities issued in its financing fall inprice. This fall may be gradual if the information about failure appears gradually. A suddenappearance of negative information, however, causes a precipitous fall in the price of the project'ssecurities. One recent example is that of MudiLuft Limited.Failure of the project leaves investors embittered and holding worthless claims. But, public memoryis short. When another grand project materialises, enough members of the public enthusiasticallycome forward to participate in it. As one wise man once said: "We learn from history that we don'tlearn from history."

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

In 1991, when the private sector was allowed to operate airlines in India, many companies, attractedby a huge, glamorous industry jumped in the fray. Ambitious projects were drawn up in record timeand the public was invited to finance the setting up of several private airlines. The prospectusselling all these public issues made rosy predictions about costs, revenues and profitability. Thepublic, enamoured by the prospect of minting money, eagerly bought the shares. Successive rightsissues were also made at premium prices which also the public lapped up. The results wereinevitable. The financial projections turned out to be far too optimistic. The operating results ofmost private airlines have turned out to be dismal. Most airlines cannot generate enough cash to payeven lease rentals, leave alone finance the acquisition of more aircrafts. As expected, the stockprices of these companies currently sell at a fraction of their offer prices. Realising the dismal stateof affairs of his dream project, one promoter - Mr Parvez Damania of Damania Airways sold out hisstake to the NEPC group. Mr Damania may have learnt important lessons in financial projectionsand 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

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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 forprime cities on the basis of financial projections that will, in all likelihood, prove to be far toooptimistic.TV channels are being launched almost on a monthly basis. Most of them will not earn enoughadvertisement revenues to even cover their operating costs, leave alone generating cash forinvestors.

Note that all the above examples come from glamorous industries - airlines, paging, cellular phones, basictelecom and television. Why do people sometimes prefer to put their money in glamorous companieshaving 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. Somethingnew, exciting and innovative always captures their imagination. They would much rather invest in acellular phone operator than in a cutlery manufacturer. As Warren Buffett once said, "These investors liketo 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 glamorousprojects. (According to him, "A fool and his money are soon invited everywhere.") Instead, he's made hisfortune by investing in well-run existing companies running mundane businesses such as furnitureretailing, beverages, chocolates and confectionery products, shaving equipment, vacuum cleaners, steelwarehousing, 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 investmentopportunities 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, conservativeinvestors might miss a couple of hugely profitable opportunities. They will also reduce their chances ofsuffering horrendous losses.

Note

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

© Sanjay Bakshi. 1996.

a fool and his money are soon invited everywhere

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