Earth Hour In The Philippines: Rotational Brownouts! The Revenge Of Economics

For domestic Earth Hour fans, your dreams just came true: Earth hour is for now a reality -via rotational brownouts in Metro Manila!

2-3 hour brownouts plagued the Philippine metropolis over the week.

Of course the news has cited many "seen" factors, such as high energy costs, "extremely high prices at the wholesale electricity spot market", the weather "With El Niño still around, hydropower facilities in Luzon were likewise not performing to capacity", and the dearth of operating capacity, "Data from NGCP, the agency tasked with transporting power from generation plants to power distributors, showed that several generation facilities were either still out of commission or producing way below capacity."

Others blame it on monopoly distributor Meralco, one analyst argues that powers generators should be held responsible.

Anything else but the government.

Earlier, some conspiracy theorists associated brownouts with surreptitious plans to "sabotage" the elections in order to declare a 'failure', thereby extend the rule of the incumbent.

YET what is not reported or the "unseen" is that the Philippine energy sector is one of the tightest regulated (and most politicized) industry, which means hardly any activities are outside the ambit of regulatory scrutiny or "oversight".

Can Meralco raise rates without the approval of ERC (Energy Regulatory Commission)? Can power plants be constructed liberally without the Department of Energy's approval? The obvious answers to these questions: No.

Yet for all the power and authority vested in the presumed "expertise" of regulators, this has to happen.

What I am saying is that in contrast to all other factors cited by talking heads and the media, brownouts are simply representative of regulatory or government failure.

Proof?

Take subsidies.

The Philippine energy sector has operated on various subsidies from which the ERC has reportedly recently waived except for lifeline subsidies for the "poor".

Yet politics is always seen as operating outside the realm of economics.

Economic 101 tells us that low prices will spur greater demand. And rising demand will create pressures on supply. In free markets, these imbalances will be vented through market price signals, from where adjustments in supply will be made in order to meet demand.

But energy prices here are not determined by market prices but by prices set by the government, particularly by the ERB (via PBR for Meralco) [see earlier discussion Bubble Thoughts Over Meralco’s Bubble].

This indicates that energy prices reflects on the bureaucratic assessments, which not only deals with the market (we don't know how they define the market), its compromises with energy producers, but for its political needs too.

Moreover, subsidies made to the "poor" or the unproductive sectors create additional demand (due to subsidized prices) which are paid for by the productive sectors.

Hence, the productive sectors are paying for higher cost of energy, from which adds to the cost of doing business, which thereby reduces the rates of domestic investment.

Here is Meralco's 3rd quarter financial statement.

The table simply shows that the income from lifeline subsidies jumped by a hefty 60% through September 2009 relative to the same period in 2008.

This is simply the laws of economics at work.

This also implies that the productive sector (investors, entrepreneurs and working class) along with the rest of society is suffering from the brownouts based on the policy to subsidize energy rates on the poor.

It's essentially a manifold blackeye for the productive sectors:
-paying for a higher cost to subsidize the poor (where the latter takes advantage of) or deadweight loss,
-production and work disruption from energy outages,
-lesser income from diminished output
-reduced economic growth from high cost of doing business and work disruptions and
-personal inconvenience!

And there's the rub. Good intentions are blighted by economic reality.

And guess what? We seem to be seeing more of a rerun of 1994. The next President is likely to preside or oversee a deluge of investments that would cater to present shortages.

And these would seem as the ripe opportunities for the Return of Investments (ROI) for the political class that rightly invested on this elections.

And this is why we have predicted there will be little material change with a new government.

It's all about human nature, in terms public choice theory.

Finally there are other factors to deal with, local regulation, environment and most importantly taxes (VAT and royalty). But we will deal with these later.

Philippine Politics: Always Waiting For Godot

``In our age there is no such thing as ‘keeping out of politics’. All issues are political issues, and politics itself is a mass of lies, evasions, folly, hatred, and schizophrenia.”-George Orwell, Politics and the English Language

Philippine elections are near, and so the politicization trends have apparently been intensifying.

In contrast to the public, whom are seemingly severely obsessed with sensationalism, we think that the Con Ass is nothing but a diversionary ploy, because it lacks the time element and the legal channels and risks running the same parallels to the Honduran experience.

This means I don’t buy the balderdash that the highly unpopular PGMA will run anew or that the passing of President Corazon Aquino will “harm” PGMA’s political interest for the said reasons.

For me, the ‘Hello Garci scandal’ signifies as the apogee of any political capital damaging events that could have undone her, yet she persisted.

Media and its gullible captive audiences, simply loves to pick on fights that can’t go beyond superficialities. Worst, they promote abstractions (fair, good or evil, greed or etc…), when the truth is that political winds always see a shift in allegiances.

In politics (here or elsewhere), the rule of thumb has been ‘there are no permanent friends only permanent interests’.

As an aside, it would be downright naïve to also believe that Philippine politics runs on simple “partyline” platforms; as if ideology ever mattered.

Yet do any of the aspiring candidates have one?

Yes, every candidate wants corruption free “good” government alright, but unfortunately their aspirations operate asymmetrically on the platform of free lunch and an ever expanding bureaucratic based redistributive system of command and control. Regrettably, a system, which runs utterly in conflict to such supposed goals and which always penalizes the productive segment of the economy.

The reality is that politicians organize and run their bureaucratic network not by appointing people of virtue or by meritocracy but by political affiliations and interests.

Hence, policies are determined politically by populism or by political lobbying groups (hence the proclivity to corruption) or by the quirks of political leaders- preferences based on personal value priorities or marginal utility, familiarity (e.g. would favor industry from which the politico has experienced with), biases, perception and interpretation of events, ego, comfort zones and or preferred social networks (e.g. schoolmates, social organizations etc…).

Robert Ringer has this piquant quote to analogize our version of democratic politics ``You have to throw welfare programs at people — like throwing meat to a pack of wolves — even if the programs don't accomplish their alleged purpose and even if they're morally wrong." liberal Bennett Cerf quoted by Nathaniel Branden in Judgment Day: My Years With Ayn Rand” (emphasis added)

Political advertisements that dangle free this or free that or give away houses over media are fundamental examples.

The popular delusion is that the deliverance of the Philippines will come from a SAINT like leader. This shows that what matters for Philippine politics has been personality imagery, which signifies as the lotto mentality of short term gratification and is hardly about the realities of correcting the deeply flawed institutionalized political patronage system that relies on license based economic rents. Hence, the clueless citizenry will remain perpetually Waiting for Godot who in Samuel Beckett’s play never appears.

Moreover, since national election is just a few months away political forces have been mobilizing. And considering that the elite constituency of the Philippines have related or shared interests or direct/indirect affiliations, it is likely that unpublished alliances will determine the 2010 outcome.

This is where I think the administration and their allies will field multiple candidates, some camouflaged as the “opposition” or Trojan Horses.

So for clues of the possible contestants for the national elections, simply watch for the actions of the kingmakers involved in the ongoing Meralco episode as discussed in Bubble Thoughts Over Meralco’s Bubble.

Bottom line: The upcoming presidential election will likely have two known characteristics well described in quotes:

one, the road to hell is paved with good intentions, and

second, the more things change the more they remain the same.

Hence, I don’t expect any fundamental change in the political economy unless it is demanded for and in the interest of the political elitist segment of our society.

Bubble Thoughts Over Meralco’s Bubble

``The lies the government and media tell are amplifications of the lies we tell ourselves. To stop being conned, stop conning yourself.”-James Wolcott, American Journalist

Meralco is in the spotlight anew.

The country’s premier utility firm, which holds the exclusive franchise for the electricity distribution for the National Capital Region (NCR), caught the public’s attention following a spectacular record romp by its share prices.

And last week’s parabolic vertiginous ride appears to have been playing out the blowoff phase of a conventional bubble cycle. (see Figure 1)

Figure 1: Bubble cycle (left) and Meralco (black candle right)

Importantly, like typical bubbles, the culmination of which can be identified by delusional rationalizations aided by experts exacerbated by media- Meralco’s skyrocketing price has been attributed to speculations on a prospective ‘tender offer’ (Bloomberg)!

Allegedly one of the titans involved [see King Kong Versus Godzilla at the PSE; Where Politics Trumps Markets] in the drama of the recent corporate joust has acquiesced to a purchase price of Php 300 per share which would require a mandated offering to minority stockholders!

Yet rising prices and some special trades (block sales and cross trades) have been used as signs to confirm on such myths.

Why do we think all these rationalizations seem ridiculous?

Simply said, because logical reasoning has been totally thrown out of the window!

As financial writer and investment speaker Joe Granville warned, ``the media is the biggest enemy of the small investor, mostly headlining the wrong news at the wrong times, playing on his misguided reliance on fundamentals and his normal fears and greeds.”

Putting A Perspective On Meralco’s Price And Corporate Disconnect

To put on some level headed perspective we will deal with some key issues.

First, on a year to date basis, despite the recent turbocharged upsurge, Meralco hasn’t been the only leader with 284.87% of gains (as of Friday’s close).

Other issues like Phisix component mining giant Lepanto Consolidate (+271.43%) and Business Process Outsourcing Paxys (+358.33%) have seen the similar or greater level of share price action as seen in the above chart represented by the green and red lines respectively.

As an aside, I wouldn’t suggest that the latter two would seem in a bubble considering the U-shaped recovery vis-à-vis Meralco’s actions which appear to have replicated the motions of a bubble paradigm as shown in the chart.

Although from a trough to peak basis, Meralco, hands down based from last year, does hold the tiara for market outperformance (700%).

Nonetheless, one must be reminded that past performances are not indicative of future outcomes.

Two, Meralco’s share in the Phisix has now jumped to 7.7% from less than 1%, as we similarly pointed out in Beware Of The Brewing Meralco Bubble!, and now holds the second spot after PLDT in terms of free floated market cap.

This for a company whose profits are constrained by political forces! (see below)

Meralco has effectively, leapfrogged over former heavyweights Ayala Corp, Bank of the Philippines, Globe Telecoms, Ayala Land and SM Investments.

With Meralco’s share of the Phisix gaining more weight, any ensuing volatility from its share prices will likely be reflective on the directions of the Philippine benchmark unless counterweighted by the lagging erstwhile behemoths.

Three, financial valuations, if any of these apply at all, have ENTIRELY been jettisoned for wanton speculations and nonsensical justifications.

As we discussed in Meralco’s Run Reflects On The Philippine Political Economy, the share price movements in the local markets hardly reflects on corporate fundamentals.

The first three factors cited above have clearly been validating our Livermore-Machlup model where Philippine equities move in tidal fashion underpinned by liquidity or loose monetary landscape.

This climate essentially begets a predominant horse racing outlook or mentality, where canards touted as facts mostly emanating from the foibles of cognitive biases.

In short, NO liquidity from loose monetary policies equals NO bubbles, and all the rest are simply footnotes.

As writer Peter McWilliams warned (bold highlights mine), ``The media tends to report rumors, speculations, and projections as facts... How does the media do this? By quoting some "expert"... you can always find some expert who will say something hopelessly hopeless about anything..” Indeed.

Fourth, common sense should dictate to us that perhaps none of these engaged (supposedly cunning and astute) Taipans, whom have built their wealth and “credibility” over the years, would likely pay for excessively or overpriced assets, unless they have other undeclared agenda in mind, which are exclusive of profits meant for the institutions which they represent.

Yet, any outrageous and reckless acquisitions, that would put at risk the interests of such institutions involved, could provoke a minority shareholder revolt. That’s assuming shareholder activism is alive here. Nevertheless, even in the absence of it, we should expect the minority foreign shareholders to vote with their feet.

In short, the supposed buyout, from the alleged stratospheric levels, signifies as tremendous costs to the interests of the company they represent from both the majority and minority stakeholders’ perspectives.

Needless to say, the present day hysteria from rising share prices is temporal in nature and subject to market cycles and does NOT represent the underlying fundamentals. Unless people think that these tycoons are dimwits, I would bet on the opposite…that the so called godfathers involved are cognizant of this!

Fifth, even if the so called buyout does occur, it is less likely that such deal would be consummated in transparency or reflective of market conditions.

These titans could have such transaction wrapped up much earlier than known by the public, or have done so with attendant compromises such as rebates et.al., and could use recent actions as a partial exit point to profit from today’s insanity.

Lastly, as we have been repeatedly arguing, the Meralco brouhaha is beyond the sphere of normal financial analysis because it is a POLITICAL SENSITIVE public listed company.

You can’t just attribute earnings without comprehending on the business model from which the company operates on.

Besides, here, the interests of the owners under the said platform are divergent from the interest of the minority shareholders.

Here is why.

Meralco’s Business Model: From RORB TO PBR

Lately, Meralco’s business model has shifted from Rate of Return Based (RORB) to Performance Based Rating (PBR).

According to GMANews.tv, ``The new PBR scheme also replaces the return on rate base (RORB) formula, which charges customers for using Meralco assets — including posts and cables — in bringing electricity to its end-users.

``Under the RORB, public utilities such as Meralco are disallowed from charging rates exceeding 12 percent of the worth of its total assets.”

So what’s PBR?

According to the same article, ``The new scheme provides “rewards and penalties for performance and non-performance respectively, Jose de Jesus, Meralco president said.

``Under the said mechanism, Meralco may be required to pay fines should its performance — such as failing to immediately respond to a blackout — fall below certain standards.”

And why PBR?

According to the “quasi independent” regulator of Meralco the Energy Regulatory Commission (ERC),

``The ERC adopted the PBR for distribution utilities starting in 2005 pursuant to its authority under Section 43 (f) of Republic Act No. 9136 (EPIRA) to adopt internationally accepted rate making methodologies. PBR strives to achieve a balance between efficient price levels, allowing utilities efficient revenue to ensure their sustainability, and maintaining or improving network service performance levels. It provides strong incentives to improve operational efficiencies. International experience (Australia and United Kingdom) indicates that, over time, with its built-in mechanisms for incentives and fines depending on the utilities’ performance, PBR leads to reductions in the real price of electricity distribution while improving service levels.”

Aside, the ERC has required Meralco to implement a subsidized rates for the poor by the so-called “NEW LIFELINE program, where ``The ERC reiterated that customers consuming only 20 kWh and below shall continue to enjoy the 100% discount granted them and shall pay only the adjusted PhP5.30 per month metering charge, while the other lifeline customers shall enjoy a discount corresponding to the consumption level under the new lifeline program approved under the DTI case, including the PhP21.00/customer/month minimum charge.”

Implications Of The Business Model: Absolute Dependence On Political Discretion!

What ALL of these means:

1. Basically prices charged to the paying consumers of Meralco are solely determined by the ERC and NOT by the markets.

This means that Meralco’s profits are ultimately determined by fickle political winds.

As Ludwig von Mises described of Bureaucratic Management of Private Enterprises, ``But ours is an age of a general attack on the profit motive. Public opinion condemns it as highly immoral and extremely detrimental to the commonweal. Political parties and governments are anxious to remove it and to put in its place what they call the “service” point of view and what is in fact bureaucratic management.”

Think $100 oil. Rising energy prices are likely to stoke political discomfort among the society’s underprivileged from which would force politicians to focus on “windfall profits”.

Yet, in a world where profits will be deemed as inconsistent with political interests, the owners of Meralco will likely wring profits out through other mechanisms, e.g. off balance sheet transactions, loans or contracts to affiliated parties, transfer pricing and etc.

In short, where financial reports will unlikely be transparent, the interests of the owners of Meralco and the minority shareholders departs.

2. Meralco maintains a subsidy for the poor from which are tacitly charged to the account of the middle and high income consumers.

This exemplifies as a “private” company, functioning under stringent control of political interests, conducting the political redistribution aspect in behalf of the government. Hence Meralco acts as a subcontracted implementing agent under political behest.

This implies that economic rents or “profits” for Meralco’s owner managers will only be attained under the auspices of the political leadership for as long as the political interests are served.

3. Under the PBR, the ERC determines the “carrot and stick” for Meralco.

Basically, Meralco’s lifeline hangs on ERC’s dictate!

This implies that the ERC and Meralco will haggle over what comprises as sufficient or inadequate under the PBR guidelines and NOT the consumers.

And since rules are always technically subjective and subject to nonlinear or amorphous interpretations, they will be subject to compromises. Ask the lawyers.

Therefore this implies two things:

One absolute subservience to the political office, where to quote Ludwig von Mises in Bureaucracy, ``Under this system the government has unlimited power to ruin every enterprise or to lavish favors upon it. The success or failure of every business depends entirely upon the free discretion of those in office.” (bold highlights mine)

Second, instead of looking after the welfare of its clients (Metro Manila consumers), the unlimited dependence on the discretion of the government bureaucracy means conflict of interests from parties involved abound.

Principally, the owner’s priorities will mostly be directed into the realm of public relations; of wheedling or currying favor with that of ‘The Powers That Be’. Satisfying the public will requirements will be subordinate to this.

Again from Ludwig von Mises, ``In such an environment the entrepreneur must resort to two means: diplomacy and bribery. He must use these methods not only with regard to the ruling party, but no less with regard to the outlawed and persecuted opposition groups which one day may seize the reins. It is a dangerous kind of double-dealing; only men devoid of fear and inhibitions can last in this rotten milieu. Businessmen who have grown up under the conditions of a more liberal age have to leave and are replaced by adventurers.” (bold emphasis mine)

The sordid and unfortunate experience of the current managers in the besieged Lopez group (who appear to be outgoing****), having to oppose the PGMA administration politically, serves as fundamental and shining example of the consequences of political defiance.

So those nurturing the view that owner-managers of political enterprises will be looking for one dimensional financial bottom line growth are living in a world of fairy tales.

Thus, financial statements have little relevance to Meralco’s valuation as a financial security because economic rents accruing the owner-managers of Meralco may come in sundry forms, than simplistically “profits” as defined by textbooks.

Besides, as pointed out in Has Meralco’s Takeover Been A Good Sign?, the current managing owners of Meralco have to deal with socio-political, bureaucratic and political risks, which ultimately mean that they need to be in constant harmonious relations with the current and forthcoming political leaders.

These are things that are learned outside of traditional or mainstream school curriculums. And yet these signify as unorthodox or contrarian views that operate realistically.

4. The ERC’s leadership is appointed by the President of the Philippines.

This makes the agency hardly independent as purported to be, but instead beholden to the administration.

Again since political appointments are almost always based on political affiliates or interests and are hardly ever about virtues or meritocracy, the direction of regulatory implementation and compliance will likely be dependent on the caprices of the political leadership.

Conclusion/Additional Comments

All these imply that the rewards from the ownership of Meralco comes with the blessings of the ‘Powers That Be’ combined with a possible implied backstop (guarantee) in the case of failure or bankruptcy, provided that the interests of the company’s owner managers or political entrepreneurs operate along the lines of interests of the incumbent political leaders.

Therefore it would be foolhardy or naïve to believe that the tycoons that got engaged in Meralco with billions of pesos of investments, had been there to only leverage on the political misfortunes of the present owners and to speculate on share prices while at the same time ignoring the risks associated with the political aspects of having a stake in Meralco.

Also, this implies that the changing dynamics of the ownership structure of Meralco strongly alludes to the next president-the identity of which only the kingmakers or the chief Meralco proponents know.

****The prevailing notion is that there has been an ongoing power struggle in Meralco.

For me, this seems like an oversimplistic crock.

In my view, both protagonists appear like unheralded allies, only awaiting the appropriate opportunity for a graceful exit for the Lopezes, which I think should come after the elections.

As per Joe Studwell in Asian Godfathers, ``The reality is that tycoons are typically forced to invest together because of the environment in which they operate.” (emphasis mine)

Considering that Meralco’s destiny is fundamentally intertwined with the Presidency, this probably implies that both godfathers could be straddling in support of different candidates in the forthcoming Presidential elections where its outcome will decide who among the two groups will takeover.

Although it is most likely that a price agreement for the prospective exchange may have already been sealed but perhaps at prices much less than the rumors (my guess is anywhere Php 90-120).

Moreover, it has been my inclination to believe that the Meralco saga will unfold similar to the Philippine Airlines privatization, where former PLDT chair Antonio Cojuangco initially fronted for the bidding which ultimately landed in the laps of Taipan Lucio Tan, the current owner.

Finally, of course, both parties would want to see Meralco’s share prices remain elevated, hence through various associates or intermediaries, they might continue to float stories from which the public so eagerly yearns for, as appetizer for their innate speculative instincts operating under today’s loose monetary environs.

However, the idea is-once the political matters have been settled, excess shares could be sold through the markets or that if any contingency arises (such as a dark horse winner in the Presidential elections) both parties can avail of present lofty prices as an exit strategy.

Meralco’s Run Reflects On The Philippine Political Economy

``When the government, along with the pay-for-favors thieves in Congress and special interest power players, nationalizes and runs a business, decisions will always be made with political considerations/favors being first up on the agenda. Decisions will never be made on the basis of profit-and-loss and winning and retaining satisfied customers… Governments are not in the business of profit-and-loss; they are in the business of steal-and-spend.” Karen De Coster Politicians Act Surprised by Lack of "Business Criteria" for Decisions at New Government Motors

For those fixated with “prices driven by fundamentals”, they ought to explain to us in fundamental lingo why the sudden outperformance of Meralco, a Philippine electric utility company whose legislated monopoly covers the franchise of the national capital region of Metro Manila.

Meralco surged 23.45% over the week and is up by about 200% year to date. Of course, I’d like to congratulate those whom have been presently profiting from the recent activities.

To consider, given Friday’s close at Php 179 per share, this puts Meralco’s Price Earnings Multiple to high 68 (based on PSE calculations) or 32 (based on technistock). Price to Book is now 3.74 (technistock) and 3.73 (PSE) while dividend yield is .56% (technistock) and .3% (PSE). [Yes, as you probably noticed, financial fundamentals also come in diverse interpretation depending on the institution.]

Meralco hasn’t been driven by foreign investors as modest foreign selling has been accounted for during the past 4 weeks.

Has Meralco stuck gold as to merit its present price levels? Or has Metro Manila consumers suddenly been bequeathed with a windfall as to boost its electric consumption, thereby translating to bigger top line and also fatter bottom line?

The obvious answer is no.

If there has been a precipitate boom in electricity consumption then activities that underpin electricity usage such as TV programming could likewise be booming too and should be reflected in share prices of TV stations as GMA-7 or ABS CBN . Unfortunately both TV stations have been consolidating alongside the major indices [see figure 5]

Figure 5: PSE: Meralco and Sectoral Indices

Meralco (light green) which falls under the category of Commercial industrial (pink) both of which has seen outperformances relative to other sectoral indices [in pecking order] such as the Mining (green), All Index (Maroon), Holding (red), Properties (Blue) market laggards in Service (gray) and Bank (Black candle) index.

The reason I highlighted Meralco movements in March is to show that Meralco and the energy sector has led the general market’s rebound. Today’s sizzling performance could portent for a replay sometime in the near future.

Going back to the issue of fundamentals, the electric utility company projects a flat growth for 2009! So the present market activity is hardly about positive change in the traditional fundamental aspect.

And the only “fundamental” driver appears to be the transitioning of the ownership structure of the prized utility company.

In a word…POLITICS!!!

Meralco’s Possible Role In The Presidential Elections

The formerly Lopez dominated Meralco, whom has been associated with the political opposition, has been subjected to political harassment by the incumbent administration since last year.

The corporate struggle has drawn in an apparent ally of the administration in Danding Cojuangco owned San Miguel Corporation [SMC], who in a dramatic fashion overhauled its business model almost overnight by selling its beer business and has swiftly bought into Petron and Meralco, as previously discussed in Has San Miguel's Shifting Business Model Been Linked To The Philippine Presidential Elections? Lessons and San Miguel’s Shifting Business Model: Risks and Opportunity Costs.

The struggle over the company’s leadership seems to have diminished when a white knight in the Manny V. Pangilinan controlled Philippine Long Distance Telephone , the largest publicly listed company in the Philippines, came to the rescue of the Lopezes as discussed in King Kong Versus Godzilla at the PSE; Where Politics Trumps Markets and in Has Meralco’s Takeover Been A Good Sign?

Today, the acquisition process has apparently been unfinished, as PLDT through subsidiaries Metro Pacific [MPI] and Pilipino Telephone [PLTL] are said to be adding to the its holdings by acquiring through the open markets (Reuters).

Of course, we can’t discount that the other party SMC could also be behind the same activities in order to improve on their shareholdings for a potential showdown into next year’s annual stockholders meeting over management control.

In my view all of this is tied to the 2010 presidential elections.

The first scenario could be that the 2010 elections will possibly see an administration planted Trojan horse among the field of opposition candidates who will contend with the administration bet.

The winner of the 2010 elections will likely be covertly affiliated with either MVP’s TEL or Danding Cojuangco’s San Miguel Corp.

Here, depending on whose side the assuming President will be, the “opposing camps” will possibly sell their shares in blocks to the other party, where the Lopez camp could be eased out.

Or the other scenario could be that Meralco could be used as a vehicle to fund or finance an affiliate candidate of the new Meralco owners in next year’s election.

Joe Studwell in his book Asian Godfather: Money and Power in Hong Kong and Southeast Asia aptly describes how the ASEAN political economy operates,

``Centralized governments that under-regulate competition (in the sense of failing to ensure its presence) and over-regulate market access (through restrictive licensing and non-competitive tendering) guarantee that merchant capitalists-or asset trader, to use a more pejorative term-will rise to the top by arbitraging economic inefficiencies created by politicians. The trend is reinforced in South-east Asia by the widespread presence of what could be called as ‘manipulated democracy’, either in the guise of predetermined winner democracy (Singapore, Malaysia, Suharto’s Indonesia) or else in the scenario where business interest gain so close a control of the political system that they are unaffected by the changes of government that do occur (as in Thailand and the Philippines). In both instances politicians spend huge sums to maintain a grip on power that has some semblance of legitimacy. This can only be financed by through direct political ownership of big business or more usually, contributions from nominally independent big business that is beholden to politicians. Whichever, the mechanism creates a not entirely unhappy dependence of elites between politicians and tycoons.” (bold highlights mine)

At the end of the day Meralco will ultimately serve as a trophy for the winner of the political crony capitalist football.

As you can see, the nations’ political structure shapes the local economy. Hence, it would be a reductionist fallacy to presume markets operate evenly everywhere or that traditional fundamental metrics apply straightforwardly to disparately constructed political economy. Again operating reality and mainstream expectations don’t match.

Again Joe Studwell describes how wealth is generated in Southeast Asia and the function of the tycoon class to the economy,

``The tycoon class served its political purpose, and generated enormous personal wealth, but did little to promote overall economic growth. Instead growth came from a combination of small scale entrepreneurs, many concentrated in and around manufacturing, and a policy of renting out the local labour force to efficient multinational exporters.” (bold highlights mine)

In other words, it would be overly simplistic and imprudent to simply assess a security or a publicly listed company based on financial fundamentals without taking into consideration the security/company’s position in the nation’s political economic structure or even the political class behind the issue or the industry.

That’s because politicians and the domestic elite group have the laws and institutions behind their interests from where economic rent can be generated for the advancement of their personal wealth.

This means you can’t buy simply because of “cheap” PE ratios, because PE multiples won’t be enough to bring about economic windfall to the privileged class, it would take monopolies, laws that circumvent competition, political privileges (e.g. licensing), tariffs and other forms of implicit government support to attain these.

And it is of no question for me why some market participants’ position (including my mentor) have been based on “jockeys” or on “political affiliates” than from financial fundamentals.

At the end of the day, it seems hardly about markets but about political trends, networks and the underlying policies.

Nonetheless, inflationary policies still is the major force which drives the local equity market.

The Myth Of Money Flows Into The Stock Markets

``To understand reality is not the same as to know about outward events. It is to perceive the essential nature of things. The best‐informed man is not necessarily the wisest. Indeed there is a danger that precisely in the multiplicity of his knowledge he will lose sight of what is essential. But on the other hand, knowledge of an apparently trivial detail quite often makes it possible to see into the depth of things. And so the wise man will seek to acquire the best possible knowledge about events, but always without becoming dependent upon this knowledge. To recognize the significant in the factual is wisdom.” Dietrich Bonhoeffer (1906-1945) German Lutheran Pastor

I recently picked up a short remark on the cyberspace about how the most recent febrile punts from “Meralco” could have caused a “rotation” in the general markets. The idea is that those who profited from the recent upside volatility in Meralco may have buoyed the general market by using profits earned from recent trades to shift into other issues.

This seems similar to the conventional thinking where occasions of huge IPOs or other security offerings (e.g. preferred shares, bonds) in the domestic financial system are deemed as having to adversely “suck the liquidity out” of the Philippine Stock Exchange.

The general idea for both assertions is that money flows “in” and “out” of the Philippine Stock Exchange .

The fact is that money DOES NOT flow in or out of the stock market.

Why?

On any given trading day unless a publicly listed company issues new or additional securities, shares available to the market are fixed.

This means that a transaction occurs only when buyers and sellers agrees to voluntarily exchange cash for a specified security at a particular price.

Let’s say Pedro has Php 100 in cash and agrees to buy Juan’s ownership of publicly listed XYZ company shares for Php 10 a share. The transaction would prompt for a shift in ownership: Pedro’s cash will be credited to Juan’s account while Juan’s XYZ shares will be transferred to Pedro’s account.

In short, in contrast to conventional thinking there is no money flows.

The price directions in the exchange merely reflect on the aggressiveness of the buyers in bidding up the price level of a security (hence, higher prices) or of the assertiveness of sellers in selling down a security at certain price levels (hence lower prices).

As we recently wrote at A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino, ``Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.”

As in the case of Meralco, there had been buyers and sellers at recently low prices as much as there had equally been buyers and sellers at the recent high prices. Thereby the suggested “rotation” from punts signifies as “rationalization”-probably holds true for some but not all (fallacy of composition)-than of reality.

In addition, the “sucking out of liquidity” from a monster $800 million record bond offering of San Miguel Brewery , which was reportedly oversubscribed by 16 times, to exclusively the domestic market hasn’t drained liquidity from the PSE, the fact is that despite the resurgence of broadmarket NET foreign selling, the Phisix is up by about 15% from the close of the SMB bond offering last March 16^th.

The SMB offering only suggests that there is a vast pool of non-equity market liquidity sloshing in the domestic financial system.

Importantly, the recent recovery in the Phisix likewise extrapolates to local liquidity substituting for the net foreign selling which has been accounted for in the market since the credit crisis erupted in 2007.

Figure 1: PSE: NET Foreign Selling (above), Transition from Foreign Dominance to Local Dominance

Figure 1 from the PSE gives an abbreviated view of the ongoing dynamics in the local exchange.

The chart manifests of the prevalent net foreign selling since last quarter of the 2008 and the shifting regime of trading ascendancy which was previously controlled by foreign investors (grey line) to presently local investors (maroon line) seen at the lower pane entitled ‘Total Value Traded By Investor Type’.

The other vital point to consider is that the transactions in the PSE represents for as a continuing flux of the character of ownership than one of technical “money flows”. As cited above, one of the current tangible alterations in the ownership has been that of local money replacing foreign money.

Fundamentally, it would rather be irrelevant if the issue of ownership transfers will be just from speculators to market punters or scalpers whom are looking to profit from minor price fluctuations.

But it would be materially relevant if the conveyance reflects a shift from major stockholders to a wider spectrum of public shareholder ownership because a larger breadth of public participation should entail a broader cognizance of the basic functions of capital markets.

And since capital markets operate as non-banking alternative option to raise, access, avail or price in or value investment capital, it has an economically vital function of channeling society’s savings into productive investments.

Moreover, when we argue about the low penetration rates of domestic investors in the local equity markets, which according to the PSE is estimated at less than half of 1% of the population even at the peak of the market, we are thinking along the premise of concentrated degree of ownership or of the limited float on the supply side (of listed companies) and or the lack of widespread market participation from the local public savers on the demand side. Of course, here the PSE looks at only direct investments, but glosses over the indirect investments through Unit Investment Trust Funds and mutual funds-where we estimate market exposure increases to somewhere at 1%.

The point is that these glaring deficiencies essentially reflect on the severe underdeveloped nature of the local equity markets.

And these are further compounded by the dearth of sophisticated instruments to hedge on “naked” positions, the “gambling” or overtrading culture disseminated as “education” by conventional brokers and the high cost structures from regulatory compliance that serve as material barriers to entice additional listing from privately owned unlisted enterprises into tradeable or investable publicly listed financial instruments.

Market Ignorance and Political Serfdom

Let me add that it doesn’t help or do justice to the public or to society to induce “trading” assimilation programs because it “tunnels” vulnerable neophytes to believe that the stockmarket is merely a gaming platform to play with, based on a very narrow time frame expectations regardless of prevailing risk conditions.

Ironically, what is the use to study the risk reward nature of markets (or even to obtain course certificates as Chartered Financial Analyst-CFA) if only markets operate in the analogy of games played in the casino or the racetrack?

People who get burned from wrong expectations tend to shy away from a bad experience. It is out of such adverse outcome that the “casino” imprint gets etched into mainstream psyche. And worst, a tarnished image has viral (word of mouth) repercussions. So short term gain always come at the expense of long term losses (in the form of monetary loss and mental anguish) which equally poses as a considerable obstacle to economic development.

On the philosophical aspect, the paucity of exposure to the capital markets is one substantial reason for the “overdependence” of Filipinos to the government as the ever elusive elixir for societal ills.

The problem is that government as the solution has served as perpetual illusion. The problem isn’t due to the “bad” attitudes by the Filipinos, as repeatedly floated in emails, but attitudes fostered by an entitlement and welfare privileged class or the “dependency culture” which is a common trait to a society highly dependent on government.

Yet the eternal search for virtuousness can’t be reconciled with political realities, where each incidence of hope from a new beginning eventually turns out as a mass frustration.

Mr. Robert LeFevre in his The Nature of Man and His Government tells us why, ``Government is a tool. The nature of the tool is that of a weapon…government, designed for protection, always ends up by attacking the very persons it was intended to protect…Government begins by protecting some against others and ends up protecting itself against everyone."

Notwithstanding, we Filipinos have not yet to realize that entrepreneurship and its quintessential feature of risk taking serve as fundamental conditions for economic and financial progress.

The Law Of Demand And Supply Applied To Equities

Going back on how the law of demand-and-supply of equities impact pricing, two charts from Northern Trust reveals of the basic laws of economics at work in the recent collapse of the US equity markets…

Figure 2: Northern Trust: How Demand and Supply Impacts Stock Prices During the Recent Crisis

Last year’s meltdown came in conjunction with a record amount of net equity issuance which totaled $986 billion during the fourth quarter of last year, or at a seasonally-adjusted annual rate or equivalent to 6.9% to nominal GDP.

And who was doing the record issuance?

Northern Trust Chief Economist Mr. Paul Kasriel makes as an astute observation, ``it was the financial system, desperate for new capital to replace a huge amount of old “depreciated” capital, that was doing all the issuing. At a seasonally-adjusted annual rate, financial institutions were net issuers of equity to the tune of $1.4 trillion in the last year’s fourth quarter while nonfinancial corporations were net “retirers” of $450 billion of equity.

``At the same time the financial institutions were issuing record absolute and relative amounts of new equity, I think it is safe to say that investors’ demand for financial institutions’ equities was somewhat inhibited…”

So as the US financial institutions had been undertaking intense balance sheet deleveraging by selling off liquid assets worldwide to raise capital, which further crimped on general market sentiment and which similarly contained demand interests for equity assets, we also saw financial institutions flooding the equity markets with new issuance or simply supply overwhelmed demand which prompted for a meltdown.

Mr. Kasriel rightly concludes, ``In sum, there is no mystery as to why the broad U.S. stock indexes took a dive in the fourth quarter of last year. It simply was a matter of an increase in supply accompanied a decrease in demand.”

The equity demand supply dynamics in the US hasn’t been the case in the Philippine equity markets as the latter has suffered mainly from the contagion impacts, as the exposure to “toxic” assets had been inconsequential that didn’t require equity issuance to plug losses.

The Myth Of Cash On The Sidelines

To further expand the thought about the misguided “money flows” in and out of the stockmarket, this should include the misimpressions about sitting “cash on the sidelines” as potential drivers of the market.

Dr. John Hussman rightly and eloquently argues (bold highlight mine), ``savings equals investment, and new savings can finance new investment. But what investors often point to and call “cash on the sidelines” is really saving that has already been deployed and used either to offset the dissavings of government or to finance investments made by other companies. Once those savings have been spent, you can't, in aggregate, use the IOUs (in the form of money market securities) to do it again.

``In other words, the amount of cash that investors hold “on the sidelines” is determined by the amount of borrowing that has occurred in the form of money market securities like T-bills and commercial paper. It's a lapse of proper thinking to believe that investors, as a group, can move their “cash on the sidelines” into the stock market, or that companies, taken together, can turn their “cash on the sidelines” into new investment and capital spending.”

Technically speaking, money invested in corporate or government bonds account for as money having been already spent and thus a shift into the equity markets does not account for as “money flows” into “new” capital investment.

So what is commonly perceived as drivers for equity prices in terms of “cash in the sidelines” isn’t accurate. Equity prices again are driven by the aggressiveness of either buyer or seller in the marketplace.

Other than that the exercise of paper shuffling, the switching of assets simply can be construed as realignment or rebalancing of portfolio holdings.

Applied to the Philippines, this implies that a genuine measure of money flow into the equity market should translate to savings financing a new equity issuance in the form of an IPO, which generally flourishes during boom days or is pro-cyclical [see The Prudent Way To Profit From IPOs!], and or secondary listings which are meant to finance fresh projects or company expansions.

Summary and Conclusion

The point of this article is to refute the fallacious mainstream notion that daily transactions signify as some mystic form of money flowing in and out of the equity markets.

Money flows into the equity markets only occur when savings are utilized to finance new capital spending projects by virtue of new corporate equity issuances in the form of IPO or secondary listing.

Instead, the directions of equity prices are driven by the aggressiveness of buyer or seller, where daily transactions only reflect on the dynamics of changing of ownership of mostly marginal investors.

In addition, the fundamental laws of demand and supply applied to equity distribution have been shown to have a material impact on its price values. Thus it is important not only to look at the elements encompassing macro or micro environment dynamics and its impact to earnings or to the national economy but likewise on the variables that may directly influence the demand and supply allocation of equities.

Finally the population penetration level of equity investors can be reflective of the nature of a society’s understanding of how capitalism works. The small diffusion of domestic public investors seems highly correlated to the statist biases of the local populace. Since the capital markets function as an important conduit of capital accumulation through the development of the country’s production structure, the corollary of the underdevelopment of the capital markets is manifested by the nation’s suboptimal economic growth.

Hence, until the local population can materially increase their comprehension over how markets fundamentally work or how their savings can be recycled into productive investments, the local markets will remain underutilized and underinvested if the misperception that markets are simply “games” to dabble with remains.

We hope that our industry colleagues will authentically “educate” the public that sets aside short term gains in exchange for long term economic progress.