The Alchemy of Finance at Reliable Engineers

Act 1: Before the Founder’s Death

Reliable Engineers was started by Raman Sudan in 1960. It’s sole business was to design, and supervise construction of modern and highly efficient cement plants. Raman, who was an engineer from IIT, held several important patents in the field of cement manufacturing processes.

At IIT, Raman had learnt engineering concepts like Backup Plans, Redundancy in System Design, and Margin of Safety. For example, the idea of redundancy in engineering means building something that is reliable or fail safe. He had learnt, for instance, that in triply redundant systems, there are three sub-components and all three systems must fail before the system fails and since one is rarely expected to fail and failure of sub-components is independent of each other, the probability of all three failing at the same time is very very small.

Building safe and reliable systems was so dear to Raman’s heart that he decided to name his company “Reliable Engineers.” However, Raman’s love of safety and reliability was not just limited to the name of his company. He incorporated his love of engineering in all aspects of his business. For example:

Reliable Engineers was a privately held company because of the founder’s skepticism of public markets. He always felt that short-term focus on earnings imposed on him by the market was unacceptable. It would shift his attention from creating long-term wealth by delivering exceptional value to his clients to short-term decisions which would do nothing to create value and which may actually destroy it.

The business employed zero-leverage which over the decades had provided Reliable Engineers with immense financial flexibility. This flexibility had helped in two important ways. First, the absence of leverage enabled Reliable Engineers to suffer much less than its competitors when economic conditions were tough. And second, it allowed him to take market share from competitors and occasionally to buy them out at distressed prices when things were really tough.

During the course of twenty five years, Reliable Engineers acquired four competitors and was by 1985 the dominant firm in the industry. All M&A deals were structured as cash deals which employed zero leverage and were done at depressed prices during recessions. Frequently, Reliable Engineers was the only bidder. Post acquisition, any debt assumed by the acquirer was promptly paid off often at a price substantially below its stated value on the acquired companies’ balance sheets. Moreover immediately after each acquisition, acquired company were merged into Reliable Engineers because Raman believed in the idea of keeping things simple.

These acquisitions became possible in part due to a conservative dividend-payout policy adopted by Raman. Under this policy, Reliable Engineers paid a dividend of only 20 percent of its earnings and reinvested the remaining earnings in the business. This policy made economic sense because Reliable Engineers earned a return on invested capital which was several times the returns available to investors generally in the market. Reliable Engineer’s high return on capital was made possible due to the patent protection the firm enjoyed, Raman’s exceptional management skills, and shrewd buying of its competitors over the years at bargain prices. While in the early years of its life, this conservative dividend policy allowed Reliable Engineers to grow without resorting to any debt, when growth slowed down to a more reasonable rate in later years, as it inevitably must, the same policy resulted in building up of a substantial treasury.

Over the years, Raman invested this treasury in the equity shares of well-managed companies bought at reasonable prices and the portfolio grew substantially over the years due to earnings retention, dividend income and capital appreciation. By the end of 1985, Reliable Engineers was a prosperous, debt-free, and cash-rich firm.

One consequence of the ultra-conservative financial management policies of Reliable Engineers was that the company paid large taxes in relation to its income. Often, the company’s accountants told Raman that by having some debt on the balance sheet, the taxes could be substantially reduced because the interest on the debt was a tax deductible expense. Raman was never convinced about the trade-off between reduced taxes and increased chance of distress or disgrace. His engineering education forced him to build a “fault-safe” system.

Raman’s engineering education also showed up in Reliable Engineers’ accounting policies. For example, when working on a long-term project which lasted over several years, the company recognized revenue from the project only when it was substantially completed. This policy was very much in contrast with “front ending” practices used by its publicly owned competitors. The conservatism displayed by the company in its accounting was a direct result of its founder’s belief in the words of a wise man who said that “bad accounting encourages bad behavior.”

Raman had four sons – a doctor, an architect, a musician and an MBA in Finance from an internationally-acclaimed business school where he had learnt modern financial concepts like LBOs, derivatives, stock swaps, credit default swaps, securitization of sub-prime debt, shareholder value, and financial engineering. None of the sons except the youngest one – the one with the MBA in finance (Let’s call him Raghav MBA)- had any interest in joining the family business. Raghav MBA, after having spent, three years on wall street in an investment bank, was now an apprentice at Reliable Engineers.

Act 2: The Founder’s Death

Raman died of a stroke in January 2000.

In his will made an year before his death, he bequeathed 25% of his ownership stake in Reliable Engineers to each of his four sons with the condition that Raghav MBA would become CEO and draw the same nominal salary which Raman used to draw from the company while he was alive.

The four sons of Raman were now co-owners of the business founded an nurtured by their father. However, within two months of their inheritance, the musician son who after publishing many failed albums due to sheer bad luck and not necessarily due to lack of musical talent was now practically broke except for his stake in Reliable Engineers. He approached his three brothers and offered to sell his shares.

A dispute broke out between the brothers almost immediately. Since each of them owned 25%, the acquirer of the selling brother’s block of shares would end up owning 50% of the company’s equity and would effectively control the company. This was unacceptable to the bothers. Moreover, there was also a dispute on the issue of valuation. How could the brothers decide how much is their stock really worth?

The four brothers mutually decided to approach their father’s lawyer who had drawn up his will. It turned out that the lawyer was now hospitalized due to paralysis and was in no condition to offer his counsel. His son, who was also a lawyer from a prestigious law school where he had learnt structuring of IPOs and M&A deals, had now taken over the practice. He naturally advised the four brothers to take Reliable Engineers public. He justified his views by stating that the musician son could sell his shares to the public in an “Offer for Sale” at a price to be fixed by a reputed investment bank. This will enable the seller to deal with his personal financial problems; the company could raise additional capital from the market through an IPO; and options on the listed stock of Reliable Engineers could now be issued to senior management in order to incentivize them adequately.

Act 3: The IPO and Offer for Sale

Raghav MBA could immediately recognize the opportunities that could be exploited if the lawyers advice was followed. Accordingly, he spent the next three days convincing his brothers to agree to the idea of going public. Finally, they relented. After all, for the first time they could visualize just how wealthy they were.

The brothers hired an investment banker (we will call him “Raju Banker”) who incidentally was a business school buddy of Raghav MBA.

Raju Banker indicated to the brothers that he would be able to do the IPO and offer for sale at 50 times earnings because other listed firms in the same business with much inferior financials were currently quoting at 40 times earnings. At this time, each brother mentally took out a calculator to estimate his wealth! All of them agreed to the plan to go public.

Financial Alchemy # 1

Aggressive accounting is a useful tool for those selling IPOs

After a few days, Raju Banker, who now had the mandate to take Reliable Engineers public for a hefty 6% fee, arrived at the company’s office armed with detailed projections of revenues, costs, margins, earnings, cash flows, dividends, interest rates, net present values, market multiples and peer valuation. He wanted to make a few changes in order to “dress up the bride.”

One of them was to do with changing the accounting policy for revenue recognition from “completed contract” method to “percentage of completion” method with aggressive assumptions about extent of completion of projects being executed at that time. This policy, which was changed retrospectively, had the immediate effect of dramatically increasing the revenues of the company, without corresponding increase in the costs with the result of a very significant jump in reported earnings. The brother had no objection whatsoever because they were now thinking about getting a valuation of 50 times inflated earnings.

This was the appearance of Financial Alchemy # 1 in this story.

The second instruction from Raju Banker who was very keen to sell the shares of Reliable Engineers to the public for 50 times inflated earnings was to do a massive stock split so that the per share price at which the IPO was to be done was brought down to an “affordable” level.

When Raman had formed the company it had only 12 outstanding shares. The investment banker wanted to increase the total number to 120 million shares. According to him it was easier to sell ten $10 bills than to sell a single $100 bill. This was Financial Alchemy # 2.

Financial Alchemy # 2

People can be deceived into feeling richer when they receive  ten $10 bills in exchange of a single $100 bill.

The IPO and Offer for Sale structured by Raju the Banker was a roaring success and was subscribed 20 times over thanks to a raging bull market in operation at that time in which the public was willing to buy anything at almost any price.

The high price of the IPO post the “dressing up of the bride” as described above and also due to the gullibility of the public in a bull market (“a world,” according to Galbraith, was “inhabited not by people who have to be persuaded to believe but by people who want an excuse to believe”) resulted in the discovery of another Financial Alchemy by the brothers.

Financial Alchemy # 3

Insiders can make money OFF investors instead of WITH them.

This opened up a whole new world for the brothers for they could now for the first time see how money can be made off people like in a zero sum game. The smart Raghav MBA, who had learnt about many modern financial concepts in his business school was quick to rationalize the IPO’s pricing and dressing up of Reliable Engineers. Almost anything can be rationalized after all. Indeed it can be stated with confidence that man is not a rational animal, rather he is a rationalizing one. It was quite easy to rationalize the IPO pricing by using the following reasons: Every company should endeavor to maximize the spread between the return on capital and cost of capital and higher the P/E multiple in an IPO, lower is the cost of equity capital so raised. In fact, its the duty of the company to do this in the interest of “shareholder value creation.”

Act 4: After the IPO

Immediately after the IPO, one of the three brothers who jointly controlled the company  – the one who was an architect – sold off his stake in the market. However, the combined stake of the remaining two brothers was comfortably close to majority control over the company.

Raghav MBA, who was now CEO of Reliable Engineers, experienced much envy when he compared his 3 million shares at Rs 75 per share, which was the price at which the shares were trading immediately after the IPO, having a total value of only Rs 2.25 billion while three of his business school friends, each of whom had done worse than him in his grades, sold their start up company at a fabulous and were now worth Rs 10 billion each. This envy made him miserable despite the fact that he was comfortably rich. This brother was like the typical subject in many psychology experiments which demonstrate that many men would much rather prefer to earn Rs 40,000 a month when others in their peer group are earning Rs 35,000 a month than to earn Rs 50,000 a month when others are earning Rs 60,000.

Envy is the deadliest of the seven deadly sins because its the only sin which, from an investment perspective, has no upside at all. The envious person feels miserable all the time. Each of the remaining six sins being Pride, Greed, Gluttony, Sloth, Anger, and Lust have something nice to offer to the sinner. Envy, on the other hand, is the only sin of the seven deadly sins, which makes the sinner miserable, while providing no benefit whatsoever.

So Raghav MBA, the envious CEO of Reliable Engineers meticulously complied with the observation often made by the wise Warren Buffett that “its not greed but envy that drives the world.”

The envy of Raghav MBA made him discover the Financial Alchemy # 4.

Financial Alchemy # 4

Accountants will help you inflate profits.

In order to boost the reported earnings of the business, the accountants came up with an ingenious plan. The plan involved the creation of a very large stock option system whereby large amount of stock options were granted to senior management team of Reliable Engineers. Since the exercise price of these very long-term options were above the current stock price of the company, the difference was not treated as business expense. Driven by envy, and the consequent desire to increase the stock price of the company, Raghav MBA decided to go all the way and replace all variable cash pay due to senior management with stock options. This resulted in a very large boost in reported earnings because variable cash expense used to be 20% of revenues.

The auditors of Reliable Engineers, driven by self-interest (“whose bread I eat, his song I sing”) and social proof (“everyone is doing it so it must be right”) blessed this accounting shenanigan. Reported earnings soared and the market was fooled into thinking that these incremental “earnings” were real. The company’s stock price soared.

The sudden rise in the stock price of the company had one major consequence, which changed much of what went on at Reliable Engineers.

When the engineers at the company, as well as its owners, saw very sudden leaps in the company’s stock price and their own paper wealth, their brains were flooded with the chemical of addictive pleasure called dopamine. Dopamine makes you feel so good that you want more and more of what caused it’s increased supply much like a cocaine addict who is high after taking a shot. In fact fMRI scans cannot distinguish between a man who is high on cocaine and a man who has acquired sudden wealth.

In lab experiments, rats are wired up to receive tiny pulses of electrical stimulation in the dopamine centers of the brain when they press a lever. This suddenly releases oodles of dopamine in their brains causing intense pleasure. The rats quickly learn to associate the tapping of the lever to the pleasure they are getting and now begin tapping it nonstop to the exclusion of other activities, including eating and drinking. They would rather starve to death than live without that dopamine surge inside their brains.

The human equivalent of this lab rat was now there in the workers and owners of Reliable Engineers. Mesmerized by the sudden rise in their paper wealth all they could think of was: “I Want More.”

Instead of focusing on their designs, engineers were now looking at their company’s stock price flashing on CNBC monitors installed all over the company’s premises. The focus had shifted from long term wealth-creation, to short term stock price movements.

Like the cocaine addict or the lab rat, Raghav MBA, whose brain was now laced with dopamine, wanted to see a higher and higher stock price of Reliable Enginners. Suddenly it occurred to him that virtue of optimism which he acquired from his father, can also be transported into the field of accounting. This led to the discovery of Financial Alchemy # 5.

Financial Alchemy # 5

Optimism in business can be ported to optimism in accounting with amazing results.

Raghav MBA approached his buddy Raju Banker for advice on how to raise capital without accounting for its cost. For a 6% commission, Raju Banker promptly structured a Zero Coupon Foreign Currency Convertible Bond (FCCB) issue for Reliable Engineers. The bond, issued at Rs 100 was to be redeemed at Rs 215 (implied rate of 10% p.a.) after ten years. Moreover, the bond was convertible after five years, at the option of the bondholder, at 200% of the current stock price.

Raju Banker produced a “deal book” for potential foreign investors wherein he included the glorious history of the company under its founder’s control, followed by a period after the founder’s death, when the “earnings” grew even more rapidly under the leadership of Raghav MBA. He then put an arrow at the end of this trend line, projecting into the next two decades an even more glorious future.

The human mind is always looking for patterns and nothing is more dramatic to a financial mind than a trend line of ever risings sales and profits. The urge to put an arrow at the end of the trend line is almost automatic. But underneath all trends and future projections made by Raju Banker, was a huge dose of overoptimism. It seemed to the careful observer, that Raju Banker like many entrepreneurs could only see “best case scenarios” and then mix them up with “most realistic scenarios.”

The idea behind this over-optimism was, of course, simple. Raju Banker wanted to convince Raghav MBA, the potential investors, and himself (in that order) that the future of Reliable Engineers was so bright that no bondholder would ever ask for redemption because the stock price of the company, by the time the bonds come due, would be well above their conversion price. In that endeavor, Raju Banker succeeded in convincing at least two thirds of the people he was trying to convince. As for the remainder, the 6% commission made him swallow whatever doubts he had about his own claims.

More important than convincing Raju Banker was the task of convincing Reliable Engineers’ auditors about the accounting treatment for interest on the FCCBs issued. Since the bond was carrying a coupon rate of zero, no interest was payable. And since, according to the past track record of the company and according to the very convincing deal book prepared by Raju Banker, it was “certain” that the bonds will “never” be redeemed, the idea of treating the difference between the redemption value and issue price as implied interest to be amortized over the life of the bond, appeared rather silly. And so, based on claims made by Raghav MBA and Raju Banker, and last but hardly the least, the presence of a large “audit” fee paid to them, the auditors blessed this accounting treatment. And so, as far as accounting experts were concerned, Reliable Engineers had just raised a very large amount of free capital.

While making this judgement however, the auditors forgot an elementary principle once enunciated by the wise Mr. Charlie Munger: “Optimism has no place in accounting,” and thereby started a downward death spiral for Reliable Engineers from which it would be impossible for the company to be rescued…

Act 5: The Creation of a Conglomerate

After Reliable Engineers had raised more money than it needed, Raghav MBA, who by now was rather bored with the business of designing cement plants, unwittingly decided to conform to the “Bladder Theory of Corporate Finance,” coined by Peter Lynch, a wise money manager. This theory states that “the more the money that builds up in the treasury, the more the pressure to piss it away.”

Not knowing what do with the newly raised money, Raghav MBA once again approached his buddy, Raju (Investment) Banker and asked him if he should do an acquisition or two. That was like asking the barber if he needed a haircut.

Raju Banker invited Raghav MBA to participate in an auction of a controlling block of a large, leveraged, and struggling retail company. The block was being auctioned by Raju Banker’s firm to raise money to partially pay the retail company’s lenders. Intrigued by the idea of attending an auction, Raghav MBA ignored the very brief and very wise warning about auctions given Mr. Warren Buffett many years ago. The advice was: “Don’t Go.”

Social psychology experiments show that bidders in auctions often get carried away and end up bidding far more than underlying value of the objects being auctioned. Such outcomes are almost always caused by a combination of multiple forces working in the same direction. In auctions, these include greed, bias from commitment (every bid is a public endorsement of the bidder’s belief that value exceeds his bid), social proof (when there are lots of bidders, bidding is more frenzied), envy, low contrast (every successive  bid is only a tiny increment over the previous one), and deprival super reaction (the tendency to over-react to losses and near misses).

Not realizing that he was walking into a trap, Raghav MBA soon found himself participating in a bidding frenzy giving in to all the psychological tendencies mentioned above. Moreover,  his girlfriend was sitting right beside him in the auction room holding one of his hand while he was bidding with the other one. And so he had to impress her didn’t he? He just had to come out of the auction as a “winner” didn’t he? And so he bid so high that, when the auctioneer’s hammer fell, he Raghav MBA found himself in possession of a business he knew nothing about, at a price, which he will soon learn a lot about.

But that was not a moment to regret. Raghav MBA was a winner today and his girlfriend was thrilled with him. Suddenly Raghav MBA felt even better about his acquisition than ever before. This, my dear readers, is what psychologists call as the “endowment effect,” under the influence of which a man’s decisions are regarded by him as better than was the case just before he made them.

Regardless of the real reasons explaining why Raghav MBA bought the retail company, there was the little matter of explaining it to the company’s stockholders. Social psychology, as opposed to academic finance theory shows that man is not a rational animal but a rationalizing one. He is capable of inventing reasons and justifications for what he has already done or decided to do. Sir Francis Bacon was right when he wrote:”What a man believes, he prefers to be true.”

Raghav MBA came up with a clever rationale for his having bought a retail company in an auction with the money he made Reliance Engineers borrow plus the entire treasury of the company built by his father over more than two decades. This is what, roughly speaking, he told the company’s stockholders: “The cash flows of Reliable Engineers have been volatile in the past because they are dependent on the fortunes of one industry. Henceforth the volatility in these cash flows will decrease because the co-relation between the cash flows of the cement industry and those of the retail business is low. This reduction in volatility in cash flows is good news for you because the earnings multiple will rise.”

That this rationale was deeply flawed was lost on Raghav MBA, and interestingly on the stockholders. It was flawed because Raghav MBA paid a control premium over the prevailing market price of the retail company to buy it. He justified this payment in the interest of diversification. However, the benefits of diversification could have been achieved by Reliable Engineers’ stockholders themselves within their own portfolios, without paying any control premium. This singular and fundamentally useful lesson from Modern Portfolio Theory that investors can achieve the benefits of diversification within their own portfolios instead of achieving it at the corporate level, however, was lost on almost everyone. Everyone, after all, loves a winner and today Raghav MBA was a winner. The stock price of Reliable Engineers soared even higher and Raghav MBA had now found Financial Alchemy # 6.

Financial Alchemy # 6

You can fool some investors all of the time and all investors some of the time.

A foolish acquisition of a business in which Raghav MBA had no experience, financed with borrowed money was being applauded by the markets. Raghav MBA naturally wanted more.

His buddy Raju Banker showed Raghav MBA how to hone his skills in Financial Alchemy # 6. He presented him with the following table:

“High” is a high growth firm whose stock sells at a high P/E multiple of 30. “Low” is a low growth firm whose stock sells at a lower P/E multiple of 20. Both firms have equal earnings of $5,000 at this time, however, and also the same number of shares outstanding.

Now imagine that “High” buys “Low” in an exchange of shares and let’s ignore synergies and let’s ignore the need to pay control premium. How many new shares of “High” would need to be issued to retire all the shares of “Low?”

“Low’s” current market value is $100,000 which when divided by “High’s” stock price of $30 results in 3,333 new shares. The combined firm will now have 8,333 shares as the table shows. The combined earnings won’t be any different than the sum total of the earnings of the two firms before the combination because there are no synergies.

Notice, however, that the EPS of the combined firm will be higher than the EPS of “High” before the combination. This is nothing but the arithmetical result of retiring a low P/E stock with the issue of a high P/E stock.

A rise in the EPS, however, would be compensated by a drop in the P/E multiple from 30 to 25. This would this happen because when you combine high growth earnings with low growth earnings the earnings growth rate of the combination must be lower than the earnings growth rate of “High” before the combination. This drop in growth rate must be reflected by a drop in P/E. This is what one should expect if the market was efficient.

Raghav MBA agreed with Raju Banker. But what if the market was not efficient, asked Raju Banker? What if by creating incremental EPS simply by retiring a low P/E stock by a high P/E stock, the market could be fooled into thinking that this “growth” in earnings is not any different from organic growth? Then what would happen?

Suddenly it hit Raghav MBA as to what Raju Banker was telling him. If the market was fooled into thinking that growth in earnings was real then there was no need to reduce the P/E multiple. In the above example, if the P/E multiple of the combined firm remained at 30 then the combined EPS of $1.2o would be valued by the market at $36 per share instead of $30 per share. This additional market value of $6 per share, moreover, would be worth a total of $50,000. Also, this rise in market valuation would be obtained without the need to deliver any synergies. This meant that Reliable Engineers, which had a high P/E stock could now go an acquisition spree without worrying about business economics, control premiums, or the need to create synergies so long as the businesses being acquired had stocks selling at much lower P/E multiples.

And so, over the next few years, much like the conglomerate wave in the US in 1970s, Reliable Engineers bought company after company using its high priced currency in stock swaps and often substantial debt to become one of the most diversified conglomerates in the country.

If something can’t go on forever, it will end. By the end of 2006, markets had become wiser about the tricks played by Reliable Engineers. The company ran out of acquisition targets available at P/E multiples lower than its own P/E multiple. Moreover, it suffered from major growth pangs. The company, as a huge conglomerate, had become unwieldy, and bureaucratic. The stock price started to decline and the market was now valuing the company at a large discount to its break up value.

Therein lied an opportunity for Raghav MBA. He started planning for Financial Alchemy # 7

Financial Alchemy # 7

With M&A 2+3 can equal 7. With spinoffs, 7-4 can equal to 6.

Raghav MBA noticed that retail sector was hot in the stock markets and pure retail companies were selling at very fancy P/E multiples. Reliable Engineers, by now, had many retail businesses in its fold, which had a possible stock market value more than the market value of the whole firm. Voila! Raghav MBA decided to spin off 49% stake in the retail businesses to the company’s stockholders. Market applauded the move and soon Raghav MBA was covered by business magazines as one of the most value creative CEOs.

Act 6: Approaching the Line

A leveraged company with a huge amount of convertible debt faces market pressures to keep the stock price up. If the stock declines below the conversion price of the debt, the holders of debt instruments would ask for their money back which the company may not possess nor be in a position to raise. When you are at the mercy of “kindness of strangers,” you are very vulnerable indeed.

Such was the situation now prevailing at Reliable Engineers. Its stock price was not much above the conversion price of its bonds and moreover the bonds were coming due in an year’s time.

Time was short. Something had to be done to increase reported earnings, and hopefully the company’s stock price. Raghav MBA, once again come up with another scheme. The scheme involved getting very close to the line between what’s legal and what’s illegal. Up until now, whatever financial alchemies Raghav MBA had been involved with were legal. Was he now getting prepared to approach the line, and perhaps cross it? Let’s find out.

The scheme involved the utilization of Financial Alchemy # 8.

Financial Alchemy # 8

Stock market proceeds can be converted into revenues.

Perhaps the best way to describe this alchemy is by showing you the diagram below, borrowed from Martin Fridson’s marvelous book titled, “Financial Statement Analysis.”

As the diagram depicts, the franchise model of doing business is prone to major abuse because of the alchemy involved. Since Reliable Engineer’s still owned a 51% stake in a listed subsidiary in the retail business, Raghav MBA decided to use this alchemy to boost reported earnings. Over the next few months the company appointed several franchisees to which it gave loans financed from issue of shares to the gullible public hungry to “invest” in this hot sector. The money flowed from the investors to the company and from the company to the franchisees.

So far so good. But then the same money started flowing back to the company in the form of “franchisee fees” which when received by the company were recorded as revenues. Since these “revenues” were well in excess of the interest on the debt, the reported earnings of the retail company were high even though true economic earnings were nonexistent.

But markets focus on reported earnings, and not economic earnings, at least in the short term. This resulted in a high P/E multiple for the stock. A high P/E multiple, in turn, made it easy for the company to raise more money from the equity market on favorable terms. Once this money was raised, the process of recycling it to franchisees as loans and from them to the company as fees was repeated. This head-spinning merry-go-round of cash will eventually come to a grinding halt, but then don’t we know by now that you can fool some investors all of the time and all investors some of the time?

The equity markets loved the new business model of the retail operation and rewarded it with a huge valuation. Since, Reliable Engineers had a significant stake in the company, its own stock price also rose.

Interestingly, the retail operation was unable to raise any debt from banks because the banks could see that there were no real earnings in the retail operation and therefore, the business was a bad credit risk. No prudent banker would lend money to the retail business. But would a banker lend money against the security of shares of the retail company which had a gigantic valuation? The answer is yes, thanks to the introduction of Financial Alchemy # 9

Financial Alchemy # 9

Bad credit risks can become good credit risks if they can be converted into highly liquid pieces of tradable paper.

In order to desperately raise money to pay off its lenders, Reliable Engineers invited its bankers to raise debt which is when Raghav MBA discovered this alchemy. He found that the retail company in which Reliable Engineers had an equity stake, was a bad credit risk for bankers. However, bankers would gladly give a loan to Reliable Engineers against the security of the shares of the retail company, and ask for no additional collateral. This was true even though the ultimate comfort for the loan must eventually come from the operating business model which was broken. But to a banker, a tradable liquid security has a value of its own which is independent of the underlying business on which it has a claim.

And so, Reliable Engineers was able to raise a loan against the security of its stake in its retail arm. That was it. There was no more collateral security left. Credit markets very firmly shut their doors in the face of Raghav MBA.

Act 7: Crossing the Line

By now, Reliable Engineers was a mess. It was over-leveraged, over-diversified, and over-valued. It’s debt was coming due and there was no cash, no debt capacity, and no reputation in credit markets. The equity markets were also very cold and repeated offers to sell new shares were routinely rejected by the stockholders. Some of the bankers who had lent money to the company, however, were not as foolish as may seem to us. You see, they had hedged themselves from credit risk by buying credit default swaps issued by a few very foolish investment banks.

These investment banks, comprised of MBAs in finance like Raghav MBA, had learnt much about “modern financial innovation,” examples of which we have seen above. In this particular case, the idea was to create an insurance product which protects investors from credit default risk on firms. This genie when it came out of the bottle was not willing to go back in and in a matter of a few years credit default swap market participants had several trillion dollars worth of contracts outstanding. This was the result of our last Financial Alchemy # 10.

Financial Alchemy # 10

You can create an insurance product and sell it to people who have no “insurable interest”

Once a financial product has been created, it can have a utility not previously envisaged by its creators. Credit default swaps is one such product. The product, originally designed to allow banks to lay off credit risk to counterparties willing to assume this risk. The banks, who had lent money had an “insurable interest” in the borrowers. If the borrowers suffered, so would the banks who had lent them money, and hence the need for credit default swaps.

So far so good. Now, let’s introduce hedge funds, who had no such insurable interest. Many hedge funds routinely short the stocks of vulnerable companies which could go bankrupt allowing these hedge funds to cover their short positions at a hefty profit. When such hedge funds started buying credit default swaps on companies on which they had short positions, the financial world of credit markets resulted in the substitution of “insurance interests” to “perverse incentives”. These hedge funds had nothing to lose if the borrowers went bankrupt (absence of insurable interest), and a lot to gain if they did (i.e. perverse incentives). And it was very much in the interest of these hedge funds, to hasten the demise of such companies.

One such company was Reliable Engineers. A group of hedge funds, who had been keeping tabs on the gradual but definite deterioration in the fundamentals of the company, had taken large short positions on its stock. They had also bought a huge number of credit default swaps on the company which would pay very handsomely if the company went under. For the first time, Raghav MBA had formidable opponents who wanted to expose his previous alchemies to force a quick bankruptcy.

Raghav MBA was now a man with back against the wall. He made the decision to cross the line and ordered the company’s accountants to do whatever was necessary to keep reported earnings high. These techniques, which were illegal, involved various shenanigans such as booking fake revenues, treating revenue expenses as capex, and failing to record liabilities. He knew these games could not possibly save his company, or him from disgrace, but he felt he had no other choice. The hedge fund vultures who owned credit default swaps on Reliable Engineers were closing in.

Act 8: The End

On 3 January, 2010, ten year’s after his father’s death, Raghav MBA did not reach home. He did not answer his phone. His family informed the police who went to his office in the middle of the night to search for him. They found him in his room slumped in his chair with a pool of blood on the floor. There was a gun in his hand.

The police never found a suicide note. What they did find was a document lying next to Raghav MBA’s body. It was his project submission for his term project in his favorite subject of “Financial Innovation” in business school. It was titled, “The Beneficial Role of Credit Default Swaps in the Management of Financial Risk.”

37 thoughts on “The Alchemy of Finance at Reliable Engineers

  1. Rohit says:

    Awesomely written sir…

  2. Vincent says:

    Dear Sir, Thank you for putting up Mr Munger’s essay in an indian context. Act I in particular should be a model for future entrepreneurs.

  3. Mayank says:

    Brilliantly put !!!

  4. Dev says:

    This is the first time ever that I have read such a phenomenal writeup on ‘financial innovations’ in our financial world.
    It is an eye opener which has made me realize about how things can deteriorate.
    But I would also like to know the solution of it all.
    Wherever you have given the wrong, or for that matter a negative approach taken by the character; it would be helpful if you could have added the correct path, that should have been taken.
    But, I am highly impressed by this sir.
    I am a fan of yours from now.

  5. Timus Rawlat says:

    Appreciate the article, I am not a fin major/minor and could understand 50% of what is written. I am just a small time investor who needs to earn more than what a MF/FD can offer.
    Request you to make it simpler for someone with highlight of where an investor should listen from management and what are the listening points warning about non sense from the management of a company.
    Wont belittle your effort by saying that its good. Ofcourse it is

  6. Arjya says:

    This reads like a movie script – and since the ending should always be happy in a Bollywood movie – even if it is a tragedy – I propose to this august forum that our much beloved author give us a sequel – one that will eventually have a happy ending.

    Some thoughts come to mind – we can call it “Alchemy Reloaded: Now The State Spins a Bailout” which given how governmental intervention usually play out over time in most complex things like guns, money and derivatives, should make the sequel a parody (on market based economics) and the entire series a sort of comedy in two tragic parts.

    My imagination constrains me at this point though – marrying the government with a happy ending requires a creative ingenuity which I leave to a master like Sanjay.

  7. Aditya Kumar says:

    …what they dont teach you at MBA schools, eh?


  8. Raghu says:

    Execellent Narrative..

  9. Fantastic, Brilliant. I loved the story line, and it er, reflects the story of a certain fast growing group that didn’t start with cement.

    I’m not sure I agree with the “absence of interest” as only applicable to CDS.

    Banks have perverse incentives when originating a loan that is meant to eventually be packaged into an Asset based security. There’s no reason then for them to bother about the quality of the loan. It’s basically a fee transaction.

    Sometimes banks will do this, but also later buy CDS even if they are privy to information that is otherwise unavailable (like debt levels, any info revealed to creditors that is not revealed to other parties etc). The CDS has no corresponding interest, since the bank originated the loan but passed it onwards. But that’s not how the industry might view it.

    One thing you might add; buying up founder-owned subsidiaries to create wealth for the founders. JPAssociates did it recently, as has DLF.

    If you look at the market, everyone, from Network 18 to Indiabulls to (name the company) has one or more of the alchemies listed.

  10. Ashish says:

    Fantastic read – this should be recommended reading for anybody with even a peripheral interest in finance.

  11. Ashok says:

    Thanks for the excellent article

  12. Praveen says:

    Give this story to ram gopal varma and ask him to make a movie.
    Movie Name: GolMaal.. GolMaal🙂

  13. chirag says:


    What a shit article.

    This a article written by a guy who has not produced or created anything in his life and using quotes from “BUFFETT” who hasn’t done anything other then push papers around. Where the most danger anyone has of having a paper cut.

    And the article talks about a guy who is MBA, who killed his fathers company.

    So to me the motto of the company is ban all commerce, MBA and all the finance companies.
    Stop all this paper based occupations.

    WOW a stock market operator talks about how a civil engineering firms engineer and manager should operate.

  14. chirag says:

    Thanks for posting my rant.

    Forgot to mention that if it weren’t for this MBA guy the whole indian stock market bubble wouldn’t have happened. Plus without US subprime and zero interest rate there wouldn’t be so many FII in here. So you wouldn’t have been able to build your bungalow.

    So rather then criminalize this type of guy you should have been praising him.

  15. This would easily be the lengthiest post I’ve ever read and luckily it was all worth a read.

    Good one Fundoo Professor🙂

  16. chirag says:

    Hello Sir,

    I may sound as a annoying person to you, maybe i am the man with the hammer syndrome.

    I did read your PDF file ” confession of value investor”. well not completely it’s too much buffet and munger preachy.

    In that doc you have said buffet bought berkershire and sold it because it wasn’t profitable in the non competitive industry, With the calculation and quotation and excel sheet as evidence.

    But to my understanding after reading the biography ” SNOWBALL ” that buffet was a corporate raider who would buy mismanage company then dismantle the company and sell it like he did with some ” DEMPSTER” named company.

    From his authorized biography SNOWBALL

    A textile maker in New Bedford, Massachusetts, that was selling at a discount to the value of its
    assets. (10) His idea was to buy it and liquidate it, to sell it off piecemeal, and to shut it down. Its name was
    Berkshire Hathaway

    other snippet

    He vowed that he would have Berkshire; he would buy it all. He would own it lock, stock, loom, and spindle.
    That Berkshire Hathaway was a failing, futile enterprise daunted him not. It was cheap, and he craved it.
    Above all, he wanted Seabury Stanton not to have it. Buffett and the other shareholders deserved it more. In
    his determination, he ignored all the lessons learned from the experience at Dempster—save one.

    if the above is not corporate raiding as we say in india “KABZAA” then what to call it i don’t know.

    From the same book he was afraid of worker backlash from the berkshire mills so he kept it alive for some time.

    To my mind the only greats in the markets are Livermore, RJ, Ed sakoyta and all this guy not buffet. Livermore & RJ took personal riske didn’t use pooled money or used mutual fund and that kind of stuff.

    Why i am typing so much is beyond me and i am bored to hell. But i hate it when people get too preachy about munger and buffet like they are saints which they are not.

    The new article from munger about america and parable, please don’t even get me started on that sir.

    I mean you would be busy as hell but if you find some fault in the above do tell me.

    i mean 2003-2007 was like once in a 25 year event. day traders, F&O PLAYERS investors , momentum trader all have made money big money.

    As livermore would say only to remain bull in bull market and bear in bear market.

    • Chirag, the reference in the document “Confessions of a Value Investor…” to Mr Buffett’s decision to shut down the textile operations of BRK was an example to illustrate the idea that traditional DCF analysis often fails to capture important aspects from disciplines other than finance while making a financial decision.

      If you want, you can read more about it from the section “Shutdown of Textile Business” from Mr Buffett’s letter:



      • chirag says:

        Hello Sir

        Thanks For The Reply.

        Now i may sound like an asshole which i am. With nothing better to do.

        I would just like to point this out to you that you are using completely fabricated stories about BKH and using too many quotes from buffet and munger. Which would be like misleading your students with baseless and rampant lie and lewd stories. and all this mental bias examples are completely useless.

        All the thing boils down to is to one and only one thing KABZAA pure and simple KABZAA.

        In Munger basicland article he goes on preaching about virtue of early settlers while in reality it was a pure and simple KABZAA from native american. African slave labours and genocide of natives which was not even mentioned in the articles. Plus talk about derivatives market while BKH holds 65b dollars worth of derivatives positions without any collaterals which like naked positions very dangerous.

        So in reality what buffet and munger stands for is simple KABZAA.

        You should teach your students the real thing which is pure and simple ” KABZAA” from the weak hands.

  17. WOW! What a reading experience you gave me!

  18. Raghuram says:

    What a gravy train you have painted. But you forget the hyenas who feed off this train. The consultants who hype the conglomerate strategy, the lawyer and rating agencies who package the risk, the Government which bails the bank and the insurance company

    The market is a zero sum game. One mans gain is another man’s loss

    Thank you professor

  19. Aditya Kumar says:

    @chirag if you dont know Prof Bakshi’s credentials, it would do you good to find out… if you do, then well…

    The article doesnt say anything on whether its good or bad, those are the reader’s personal opinions. Sure go ahead and create more bubbles, if you want.

    The alchemies in the article are common place in the financial world and i think this post is a good summary of most of them in a single place.

    How you now use this knowledge is purely up to you, but to me you sound like the person who says that lets have more Katrinas, and more chances to loot.

  20. chirag says:


    First of all i don’t care about katrinas since i am from india. katrina kaif is hot.

    Now i did mix up of my posting about the professor’s “confession” pdf file post.

    Now i personally hate munger and buffet and likes of them who do legal/illegal form of “KABZAA” very popular in land deals.Now the pdf file had tons of page of the sage buffet saw berkshire as a “loss making” ( buzzword 1 ) and “non competitive industry” ( buzzword 2 ) with quotes superimposed on pics and excel sheet calculations ( Jazzing Up The Documents ) while the truth is he wanted to buy it from weak hands and break it and sell it in pieces. ” SNOWBALL ” his authorised biography says it all.

    i don’t wanna start about MUNGER ( an uber donkey) Truly hilarious articles by him. the basicland was funny as hell.

    My real gripe is since professor(“would”) know about it why is he misleading his students about this stuff in his lectures.

    why hide the fact buffet was good ol corporate raider a few notches down from the guy in this article.

    i just stopped reading that file since that point and gave up. My most of the anger is on that point well and plus maybe jealousy since i haven’t made much money in the stocks.

    To me the only real gem in investing/trading.speculation world is “Reminiscences of a Stock Operator” obviously lot of spiced up stuff there but hell the best book out there.

    Unfortunately the only bubble i can create are sop bubbles even that very poorly.

    ” Don’t be a sucker fool “

  21. Atul Mittal says:

    Amazingly depicted story sir..
    Couldn’t stop myself from reading till the end despite of it’s length.. You nicely summarized all the concepts taught us in BFBV course..

  22. Aniket says:



  23. Vihang says:


  24. Vipul says:

    Excellent narration and full of worldly wisdom🙂

  25. chirag says:

    Dear sir,

    Why no new article. If it is because of my blabbring then please ignore could have deleted the comments.

    Other fans will be angry towards me cause you would have stopped posting articles.

  26. Sidhima says:

    Wonderful article sir….hoping to read more from you.

  27. kundan kumar roy says:

    thanks a lot sir

  28. Sarvesh says:


  29. Mahendra says:


  30. Vikas says:

    Thanks a lot prof…
    This is among the best articles ever read on financial literacy. An amazing insight into how easily things can be manipulated and also as to what level any firm needs scrutiny by a minority shareholder. An article to preserve and to be read again and again.

  31. […] the rest. You can also find the presentation here. Tweet Published: March 29, 2010 Tags: Bias from […]

  32. Am late to this post, but I guess nobody else registered the Freudian slip of “Reliance Engineers” towards the middle of the post.😀
    Great post nonetheless Sanjay. Thanks!

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