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Unsophisticated investors risky for mkts: WL Ross Jr

Published on Fri, Jul 20, 2007 at 20:53 | Source : Moneycontrol.com

Updated at Mon, Jul 23, 2007 at 11:01

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WL Ross Jr, Chairman & CEO, WL Ross & Co

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WL Ross Jr , Chairman and CEO, WL Ross & Co , feels that whenever you have a lot of unsophisticated investors coming into the market it creates the potential for something unpleasant happening later on.

Excerpts from CNBC-TV18's exclusive interview with WL Ross Jr:

Q: How do you explain or assess what is going on in the world today? Almost every asset class has had a great bull run whether it is commodities, stocks, or bonds. How do you interpret what is going on today across the world?

A: There are very many characteristics of the global bubble present in liquidity, with the kind of suspension of risk management activities and the absolute euphoria with which people, both in developed and developing countries, are leaping into the stock market. I think it's a fairly dangerous time.

Q: So you are not in that club that believes that there is a paradigm shift in growth, which is what is leading the money into these markets and it is not entirely unjustified.

A: I don't think it is entirely unjustified at all. It is temporarily overdone. You had in China, for example, two million households opening brokerage accounts in the first half of this year. For the first time in many years, bank deposits by consumers actually shrank in China, both in April and May. Those are really unusual phenomenon. Whenever you have a lot of unsophisticated investors coming into the market it creates the potential for something unpleasant happening later on.

Q: Is it driven purely by liquidity and too much of it you think?

A: too many people view Liquidity as only a physical thing: the presence of a lot of cash. It is both a physical event and a psychological event. Right now, the psychological part of it is being overdone. People want any kind of asset other than money. I think that's a big pendulum, which has swung too far in that direction.

Q: You used the word unsophisticated investor, do you think there is a whole lot of them going around in the world today?

A: It is totally clear that is the case. Every indicator, in every market, has seen a tremendous increase in the presence of the retail brokerage community, relative to the institutional side. I don't think there's too much doubt about that.

Q: That's true about developed and developing markets?

A: Yes, both.

Q: What about hedge funds, because they also manage a lot of money today? What's your take on how they are approaching this whole thing?

A: I don't think you can talk about hedge funds as though they were one massive group of things. There are 10,000 or so hedge funds, and there are probably 2,000 different strategies. It's not at all unusual, in an individual trade, to find hedge funds differing on both sides of the trade. As the hedge fund community gets larger, as a percentage of the total, which it also has been, it gets harder for them to consistently outperform markets.

Q: Do you think they are at that end of the curve of it, approaching very quickly already?

A: They are getting there. The signs of it are that they are now invading each others own specialized territory, whether it is the equity tranches of COOs, to going into private equity, or into any kind of imaginable commodity or derivative of trade. It's hard to imagine that one group of humanities can be totally expert in all sectors of world markets instantaneously.

Q: Where do you find the biggest bubble? Is it in stocks, commodities, bonds, or properties?

A: The most dangerous bubbles are in debt markets.

Q: What about stocks? Do you find a bubble in emerging markets' stocks?

A: I think both India and China are a bit overdone. The idea of basic industrial companies trading at 35, or so, times earnings, can justify it temporarily, based on very rapid near-term growth. Those are fundamentally, cyclical heavy industries. There is no reason for them to trade at those kinds of multiples. Over time, as people become more sophisticated in those markets, they begin to differentiate between companies, which have true long-term prospects than those that have just popped up.

Q: What's overdone, valuations or expectations of growth?

A: More than valuations, I think it is the growth prospects especially for India and China. In our case, we are also very active in Vietnam. All of those three economies have very good structural reasons why they will continue to outperform the rest of the world. I don't think it is so much about economic growth. It is more to do with the translation of that into earnings and of those earnings into stock prices.

Q: What do you make of this whole private equity euphoria that is going around, a lot of leveraged buyouts in the US particularly? Do you think there is an element of a bubble or froth out there?

A: I think there is. When people mostly did smaller leveraged buyouts, or LBOs, I could follow the logic, as you could say that smaller companies are perhaps systematically mispriced. I find it a harder conceptual argument to make that the major companies in the world are systematically mispriced. Yet, you would have to believe that all these LBOs of giant companies could be good. It is clear that the industry has grown and the advent of very cheap money at lenient terms is fueling this LBO boom. That's fine as long as the environment within which people are going to exit, remains as permissive as the environment that we are now in. In case they try to exit at a much higher interest rate environment, they are going to find a disappointing lack of value. I think the LBO market, to some degree, is a bit of a bet on the continuity of easy money.

Q: Do you see this phenomenon of private equity players getting very aggressive and trying to buy out bite sized chunks of large companies in emerging markets as well?

A: Yes, but it is harder in emerging markets. Many of them in India, for example, are family-controlled or promoter-entrepreneur-controlled companies. In more developed markets, there tends to be a very small percentage of insider ownership. It is easier to affect a buyout in more mature markets. With the ownership being different, it tends to be more institutional than inside a family. Also, takeover rules tend to be a little more lenient in developed countries than in less developed nations.

Q: You used the word bubble and all bubbles need to be pricked. What do you think will prick this one?

A: What caused the bubble to burst is always obvious in retrospect, it is never obvious in prospect. If I had to make a guess, it would either be the collapse of one of the major emerging country's stock markets or a further acceleration of default rates, spreading from the subprime area to the corporate area and to other parts of the debt market. Those are the two big risks facing us right now.

Q: Not interest rates going up in the US?

A: Even if interest rates go up by another 50 basis points or so, they are still relatively low on a historical basis. Any LBO doesn't work simply because a 50 basis points could not have been well conceived to begin with. It would take much more than a moderate increase in interest rates to derail the LBO boom.

Q: If you had to pick one market though that could trigger off this collapse, which one would it be?

A: I don't want to point fingers at people because it is always going to be from some place you'd never imagine.

Q: What are the odds that India or China could be one of those triggers?

A: While the markets may go up and down, I really don't see any fundamental reason to be worried about the economies in either case.

Q: Would you say that the chances of a big correction in emerging markets is likely in the next six months?

A: It is very likely think within the next 18 months. Whether it would be within the next six months is a little bit harder to tell.

Q: And would that take all asset classes with it or could it be a constricted kind of correction in a particular asset class?

A: The excesses on the upside have been protracted from the point of view of time, duration, and distance. There will be a lot of synchronous bubble bursting rather than just one isolated case.

Q: How do you read the commodity cycle now?

A: There is a fundamental shift in commodity markets. They always have been somewhat cyclical as to physical demand and price. At present, because of the rise in living standards, in developing countries, there is a new secular growth trend in both demand and price that has been superimposed on the normal cyclicality. Over time, commodities would go up quite sharply because when you are talking about large populations, with USD 1,000 per capita incomes, rising living standards could only mean one thing ‑ an increase in the consumption of commodities.

Q: You don't see a bubble in commodity markets?

A: Prices will go up and down. They have always been cyclical and that's the way they will always be. In the longer-term, I think they will now have a strong secular bias towards the upside. But there will be wild fluctuations.

Q: Steel had a great run over the last many months, do you think these peaks will sustain or are we in for a bumpy ride there?

A: The steel industry has been changing quite fundamentally because of consolidation. The industry is very different from what it had been. Its old days were characterized by a large number of relatively smaller companies. They tended to produce and produce, and whatever they couldn't sell in their own market they would dump in someone else's market. So, you have extremely sharp swings in both inventory and price levels. Now with this consolidation, people are more rationale. They are able because they have more facilities to fine tuned production to the level of demand. That's why we have seen much less volatility in steel prices in recent years than you had in the decades preceding.

Q: What about the road going forward?

A: You are going to see more consolidation and it will again be cyclical. The big consuming markets for steel are automotive, appliances, oil fields, and construction. When your markets are inherently cyclical, not necessarily having the same cyclical timing, there has to be cyclicality. The volatility within steel both of product prices and earnings will be less than before. What you have been seeing in steel is a re-rating of the stocks. The multiples are still relatively low compared with other big industries. The notable change has not yet finished but somewhere in the next few years, there will be some sort of moderate downturn in steel.