What was the Harshad Mehta scam?

Who was Harshad mehta ?

Harshad Shantilal Mehta was born in a Gujarati Jain family of modest means. His early childhood was spent in Mumbai where his father was a small-time businessman. Later, the family moved to Raipur in Madhya Pradesh after doctors advised his father to move to a drier place on account of his indifferent health. But Raipur could not hold back Mehta for long and he was back in the city after completing his schooling, much against his father’s wishes.

Mehta first started working as a dispatch clerk in the New India Assurance Company. Over the years, he got interested in the stock markets and along with brother Ashwin, who by then had left his job with the Industrial Credit and Investment Corporation of India, started investing heavily in the stock market.

As they learnt the ropes of the trade, they went from boom to bust a couple of times and survived.

Mehta gradually rose to become a stock broker on the Bombay Stock Exchange, who did very well for himself. At his peak, he lived almost like a movie star in a 15,000 square feet house, which had a swimming pool as well as a golf patch. He also had a taste for flashy cars, which ultimately led to his downfall.

“The year was 1990. Years had gone by and the driving ambitions of a young man in the faceless crowd had been realised. Harshad Mehta was making waves in the stock market. He had been buying shares heavily since the beginning of 1990. The shares which attracted attention were those of Associated Cement Company (ACC),” write the authors. The price of ACC was bid up to Rs 10,000. For those who asked, Mehta had the replacement cost theory as an explanation. The theory basically argues that old companies should be valued on the basis of the amount of money which would be required to create another such company.

Through the second half of 1991, Mehta was the darling of the business media and earned the sobriquet of the ‘Big Bull’, who was said to have started the bull run. But, where was Mehta getting his endless supply of money from? Nobody had a clue.

What was the Harshad Mehta scam?

Let's say we have three banks A, B and C. And a broker X. And obviously, the government.

Now the banks want to make as much profit as they can by using the money just the way they want. And the government wants to regulate them by making it compulsory for them to invest some of the money in Government bonds. So the government puts a simple rule that at the end of every day, A,B and C have to show them a balance sheet and a minimum amount has to be invested in bonds. 

The banks do it for some time but they ask the government for some kind of relaxation. So a new rule comes where you need to show the balance sheet only on Fridays. The average amount per day in the bonds has to be over the fixed amount, however, there is no such limit on the daily amount now.

Now X comes into the scenario. Since A would sell some bonds to invest elsewhere and B may buy some bonds as well, the banks will now have different amounts of money invested in bonds everyday and some will have less while some will have more. But all of them need to have that minimum amount on Friday, so the banks with lesser amounts, i.e, A in this case, would need to buy the bonds to keep up with the average. 

So what does A do? It contacts X to get it some bonds from either B or C. 

X is a trusted broker and all the banks know him pretty well. So X tells A that he'll get the bonds but right now he isn't sure that from whom will the bonds come, B or C. So instead of making the cheque on the bank's name, A should sign the cheque for X. (Which was illegal, BTW). 

So A does that. Now X goes to B and ask for the bonds and using the power of trust, X tells B that he'll pay the money the next day to which B agrees because he also offered a good return on the money. See, bonds are important, money may come later too.

Using this trick, X makes sure he always has some money with him. 

Now comes part two. The money he had, he invested heavily in the stock market to create a turmoil, specifically for a few companies like ACC. The market saw a huge run like never before and share prices of ACC and some others went over the tops. 

Once he knew the market was at a peak, he started profit making and markets crashed. The bank people who were involved with him in the illegal acts panicked and one of them even committed suicide. 

Prof. Shivanand Mankekar, The Genius Stock Picker With A Concentrated Portfolio

Prof. Shivanand Shankar Mankekar has always been a believer in the merits of a concentrated portfolio with only a few high conviction stocks in it. However, this time he has outdone himself with 70+% of his net worth in a single stock.

When you study the portfolio of Prof. Mankekar, his wife Laxmi Shivanand Mankekar, his son, Kedar Mankekar and company, Om Kedar Investments, three things become apparent. One, the Prof likes to takes concentrated bets on a few stocks. Two, the Prof is not looking for “cheap” stocks. He wants stocks that are proven out-performers and he is prepared to pay the full price for them. Three, the Prof likes to periodically shuffle his portfolio to weed out the non-performers.

Prof. Mankekar made his first big fortune in Pantaloon (now known as ‘Future Retail’), a company promoted by Kishore Biyani. In Biyani’s book “It happened in India” Prof. Mankekar talks about what fascinated him about Pantaloon. He says that when he went to see the ‘Big Bazaar’ mall in Bangalore, he was very excited and he rushed to the hotel, called the broker and asked him to buy 4% of the equity capital of Pantaloon. Interestingly, Prof. Mankekar says that “We didn’t do any of the typical things expected from finance professors, i.e. analyze the balance sheet or meet the management. The simple reason for this was that the Big Bazaar outlet spoke much more, it screamed out that here was a guy who really understood retailing the Indian way”.

Prof. Mankekar also recollects that when he met Kishore Biyani, he told him that Pantaloon would have a market capitalisation of Rs. 1 lakh crore in 13 years. Kishore Biyani did not believe this and laughed it off because Pantaloon’s market capitalisation then was barely Rs. 50 crore.

Prof. Mankekar’s prediction come partly true because Pantaloon Retail did become a blockbuster multibagger. While the Prof. bought the stock in 2002 at about Rs. 9 (adjusted for rights & bonus), the stock touched a peak of Rs. 800 in January 2008, giving an incredible return of nearly 90 times in just 6 years.

Wockhardt, Prof. Mankekar’s second mega stock pick, is a classic example of his brilliant stock picking ability. However, ironically, it also represents a classic example of how multi-bagger profits can slip out of your hands and remain on paper if you don’t encash them on time.

How the Prof homed in on Wockhardt out of the hundreds of pharma stocks in the universe is a big mystery. Nobody knows the answer but it must be the same intuition that was at work in Pantaloon.

Magically, soon after the Mankekars (actually Laxmi Mankekar) began aggressively buying Wockhardt stock (at the peak in June 2012, she held 22,00,063 shares, comprising 2.01% of the capital), it began its vertical climb. While Laxmi Mankekar bought the bulk of the stock in the September – December 2011 Quarter, when the price was about Rs. 240, the stock surged to an all-time high of Rs. 2,166 in March 2013. At the peak, Mankekar’s holding in Wockhardt was worth nearly Rs. 470 crore, nearly a ten-bagger.

Now, in hindsight, one can lament that the Mankekars should have booked some gains because when the fall came, it was swift and brutal. Over concerns raised due to the FDA warnings, Wockhardt’s stock price went into a free fall and plunged to a low of Rs. 340 in August 2013. Desperate investors wanting to bail out worsened the situation. The Mankekar’s were caught in the stampede and trampled upon. They sold off all their holdings by September 2013, without much to show for the brilliant stock picking and holding of 4 years.

The Wockhardt episode reveals a serious chink in Prof. Mankekar’s armour. How is it a visionary like him did not anticipate the FDA risk factor for Wockhardt when it is well known that this is the biggest risk factor for pharma companies? Also, was not the Prof over-confident in not booking some profits when the going was good? Surely, he should have sensed that such quick gains cannot be sustained and he should have encashed some of it.

However, the other aspect that the Wockhardt episode reveals is the absolute emotion-less approach that Prof. Mankekar has towards investments. After the debilitating loss in Wockhardt, a lesser person would have crumpled and sworn off concentrated bets.

Prof. Mankekar remained unmoved. He did not spend a moment ruing the lost opportunity in the Wockhardt debacle. Instead, he was busy scouting for the next stock in which he could make a concentrated bet.

And he found it in United Spirits.

Here again, the surprising aspect is the timing of Prof. Mankekar’s purchase. A lot of savvy investors had foreseen that due to Vijay Mallya’s profligacy and imminent bankruptcy, he would have to sell his stake in United Spirits sooner or later to Diageo or some other liquor behemoth and they had begun cornering the stock when it was at Rs. 600. For instance, S. P. Tulsian and N. Jayakumar of Prime Securities openly declared that they were heavily buying United Spirits’ stock in anticipation of a stake sale by Vijay Mallya. Even Rakesh Jhunjhunwala bought huge volumes of the stock at Rs. 900 levels.

Instead, Prof. Mankekar waited till 12th November 2012, a week after Diageo Plc had announced that it would buy 53.4 per cent stake in United Spirits at Rs. 1,440 each, for Rs 11,166.5 crore. The frenzy was at its’ peak at that time, with the stock having surged 35% in one trading session. Prof. Mankekar bought 1.45 lakh shares at about Rs. 1,540 each.

Now, this is surprising for two reasons. First, Prof. Mankekar would have had his eye on United Spirits for a long time and would have known that big-ticket investors were loading onto the stock. Why did he not buy the stock at that time? Secondly, his buying the stock immediately after the official announcement is odd because conventional wisdom tells you that you must wait for the frenzy to cool down before you buy the stock. Also, the stock was then quoting at a frightening P/E of 158 times its TTM EPS.

Of course, as it turned out, Prof. Mankekar was lucky to have grabbed the stock when he did because even when the frenzy cooled down, the stock never went back to the price of Rs. 1,540. He later bought his balance holding of 15 lakh shares by the June 2013 quarter, paying a much higher price than what he paid for his first purchase.

One way to rationalize Prof Mankekar’s buying decision is that he had anticipated that the open offer announced by Diageo to buy the stock at Rs. 1,440 would fail given the sharp run up in the price. As Diageo had indicated its keenness to take control over United Spirits, it was only a matter of time before Diageo announced a second open offer, at a much higher price.

If so, it was a brilliant strategy and it came true on 15th April 2014 when Diageo announced an open offer to buy a 26% stake in United Spirits at Rs. 3,030 each, for a total consideration of Rs. 11,448 crore ($1.9B). The price now offered by Diageo is more than twice the price that it offered in November 2012.

The result: Shivanand Mankekar, one of the largest individual shareholders in United Spirits, sold his 1.09 per cent stake in the liquor maker between April and June 2014 . The unassuming investor, who is also a management professor, may have pocketed a neat profit of Rs 150 crore .

Stock Market VS Mutual Funds

Stocks

In the simplest of terms, stock/share/equity is an instrument that allows you to buy ownership in a company. So when you buy 100 shares of a particular company, you are basically sharing ownership in that company’s assets and future earnings with all the other people who have bought its shares. You can buy/sell stocks of listed companies on a stock exchange (which is nothing but a marketplace) where buyers and sellers decide the price at which they are willing to buy/sell those shares. The fundamental dynamics of demand and supply determine if the price of a stock goes up or down over time.

Mutual Funds

The dictionary definition of a mutual fund is “an investment program funded by shareholders that trades in diversified holdings and is professionally managed.” Huh!?

Without the jargon? A mutual fund is a product that takes money from a lot of people (shareholders), pools it all together and invests that money in financial markets with the aim to provide returns. Each fund will have its own investment objective. This defines the ground rules of where the money can/will be invested within that fund. So depending on the objectives, you can have a bunch of different kinds of funds - open/closed ended, equity, debt, hybrid, money market, diversified, etc.

Typically, the each fund will have a fund manager responsible for deciding where, when and how all the money gets invested - so long as he sticks within the parameters of the investment objective. Since the investing decisions are being taken by a person, we call this an actively/professionally managed fund.

BTW, since we are comparing stocks and mutual funds, I will use the term “mutual funds” to mean “equity mutual funds” because debt/liquid funds etc. are a completely different asset class and hence not within the scope of this comparison.

Stocks vs. Mutual Funds

So now that we have figured out what these are, the question is “which is a better investment option”?

Like most real world problems, the answer here is not a simple black or white. Both these investments have pros and cons and their suitability depends on the individual. So let’s start by comparing them across a few important criteria -

1: Returns - When we talk about investing, returns are probably the first thing that comes to mind. So how does investing in stocks compare with mutual funds? Although there are exceptions, most actively managed mutual funds are not able to provide higher returns than the benchmark index over long periods. Below is a table comparing the average performance of Large Cap, Small/Mid Cap and Diversified equity mutual funds with the Nifty 50 Index over 1, 2, 3 and 5 years (source: Moneycontrol.com).

The index has actually outperformed all three categories over 5 years. You might be tempted to say that the top 10 mutual funds give much better returns than the average fund so all you have to do is invest in the top 2–3 funds in order to beat the market. Well that is true, but only if you have a time machine. The problem is that it is very unlikely for funds to keep giving above average returns over multiple years. So the funds that gave the best returns from 2011–2016 won’t be the same that would give the best returns from 2016–2021. So unless you have a time machine in your garage, how do you pick the 2–3 “top” funds to invest in today?

By comparison, you could invest in a well-researched and diversified stock portfolio that will be able to provide better than benchmark returns over long periods of time (more on this later).

2: Risk - The second most important factor to consider is risk (some might argue that this is actually more important than returns, and they are right to some extent). Investing in mutual funds is considered much less riskier than stocks. There are 2 primary arguments in favor of this -

1. Professionally managed - It is widely believed that since an expert is making the decisions of where to invest, it is less riskier than investing in stocks on your own.
2. Diversification - A single equity mutual fund will invest money across a large number of stocks. In other words, they invest in “diversified portfolios” in order to reduce risk.

These are 2 valid points in favor of mutual funds. A lot of retail investors who invest directly in stocks are not able to manage their risk because building and keeping track of a strong, well-diversified stock portfolio requires more time and energy than most people can afford to spend.

3: Cost of investment - This one goes clearly in the favor of stocks. The only cost is the brokerage that you have to pay at the time of buying/selling. In comparison, mutual funds charge a hefty sum of 2–3% each year to manage your investments. Although this seems like a small number, but over long periods of time, this fees can accumulate into a large amount. For instance, a 2% annual fees paid over 20 years will reduce your returns by as much as 5-times your initial investment.

There are no free lunches. So the question is how much a mutual fund can charge? Is it one time in nature or regular?

There are broadly two types of charges:

1.One time charges:

Entry Load: The charges that are levied when the units are being purchased. The mutual fund would sell the unit price higher than the NAV. At present Mutual Funds cannot charge entry load.

Exit Load: The mutual fund would buy back the units at rate lower than the NAV. There are no fixed exit loads which are charged. It varies based on the scheme. The current practice is the funds could charge any way from 0.50% to 3.00% depending on the holding period. If the investors continue to hold the investment beyond the specified period, no exit load is charged.

For eg: An equity fund currently at an NAV of Rs. 72/- per unit charges exit load of 1% if the investor exits within 1 year of investment. If an investor wants to sell his mutual fund units, which were bought 7 months back the redemption NAV for such investor would be Rs.71.20/-

If the investor has sold 1000units, the total exit load applicable would be Rs.720/-. A Mutual Fund cannot use these charges for paying commission or meeting any of their expenses. This Rs. 720/ should be invested back to the fund, which would benefit the investors who remain invested for long term.

If the investor redeems after 1 year, there is no exit load.

Transaction Charges: These charges are one time charges applicable when the money is invested. This is applicable for the investments of over Rs. 10,000/-. This would be paid to the distributor/intermediary who is selling the fund.

The transaction charges of Rs. 100/- is charged for the SIP commitment of Rs. 10,000/- or above (not monthly SIP amount). The SIP transaction charges are deducted over 4 installments starting from 2^nd installment to 5^th installment.

2.Recurring Charges (Ongoing expenses/Fund Running Expenses):

The expenses are charged on Daily Net Assets of the specific mutual fund. The guideline rates are given by the regulator and Mutual Funds cannot charge more than the stipulated structure. The expenses are deducted every day from the Net Assets of the fund and NAV declared is after adjusting the expenses.

Does the expense ratio vary between funds?

There are two category of diversified equity funds offered by different mutual fund companies. Fund A has a total size of Rs. 1000crs and Fund B has a total size of Rs. 100/- crs. Does it make the difference in-terms of the total expenses charged by the fund?

Even though the expense ratio structure is stipulated by the regulator, it varies based on the size of the net assets of the fund. Higher the net assets, lower expense ratio and lower the net assets higher the expense ratio.This, in turn impacts the returns generated by the respective mutual fund. In case of funds like Liquid funds, the difference in expense ratio would be one factor.

4: Ease of investment - At first glance, investing in a mutual fund can seem very simple. You just pick the “best” 2–3 funds and simply allocate equal amount across them. But as we have seen in my first point, the hard part here is to identify the “best” fund. The human element that comes from active management of funds makes it nearly impossible to predict the “top” funds of the future!

Of course, investing directly in stocks is no walk in the park. As I have pointed out earlier, most individual investors will find it impossible to keep up with the amount of time and resources needed to manage their stock portfolio investments over long term.

In conclusion…

So just to summarize, stock portfolios have the ability to outperform mutual funds in terms of returns, the risk in both investments can be “managed” equally well, the cost of investment is much lower in stocks but the ease of investment is higher in mutual funds.