The Rhyming of History

Studying Parallels From the Past To Discern The Future 

“History does not repeat itself, but it rhymes.”

If this be true, it would be a good idea to recount the history of The Great Depression and the subsequent monetary evolution of currencies and markets, to understand where we stand today, if history where to ‘rhyme’. I will try and explain why we should be feeling optimistic just after the recent earthquake.

The story of the Great Depression starts with the creation of the US Fed in 1918, shortly after World War I. The reflation and money- printing policies of the new Fed led to an unprecedented creation of infrastructure spending, which set off parallel booms in the steel, construction and auto industries. At one time, there were 108 car cos in the US, of which, about 3 survived after the Depression.

The current parallel  is with the similar booms over 1998-2002 in IT & Communications first, followed by a housing boom, which was a purely monetary phenomenon, created by an excess supply of money meant to fight the Dotcom bust. The whole thing took a decade.

In 1929, this led to a collapse in asset prices, led by a mistaken squeeze in liquidity, which converted a bad recession into a full blown Banking crisis and a Depression. This created a currency crisis in 1933, with the Pound Sterling going off the Gold Standard.

A currency crisis has been avoided this time, with the various TARP programmes, which (at least in the US) have worked surprisingly well. If the new European TARP works similarly, it will have been the best outcome possible, under the circumstances. But the 2008 crisis still created a currency crisis in Europe, because of their internal Banking crisis caused by a crisis of confidence in Sovereign debt cross-holdings. But it took the same 3-4 years, for an asset price collapse in one part of the world to expose a currency/ monetary crisis in another part of the world.  

After Britain took the Pound off the Gold Standard, the world economy had no reserve currency for 11 years, till 1944. In between came the World War, which forced some countries to print currency, run up huge deficits and lose their Gold reserves. A parallel development was the loss of some ships carrying Gold from Europe to the US. This led to the emergence of the US Fort Knox as the “custodian of the world’s Gold”, creating the ground for its subsequent emergence as a Reserve Currency. At Bretton Woods in 1944, this was given a formal shape under the Bretton Woods Agreement.

 If we assume that we are now in 1933 equivalent, we have to look out for this evolution, and this is what should set our long-term strategy. The new Reserve Currency WILL NOT be the USD; it could be any one of:

·         A strong (but post-division) Euro made up of Germany, the other AAA countries (Finland, Netherlands, Austria, Denmark, France, etc). This currency may not be large enough to replace to USD.

·         Chinese Yuan, but this is unlikely, given the current maturity of the Chinese financial system. They will have to convince the world that they will not monetise their coming Banking crisis.

·         A currency evolved by a new Bretton Woods, which considers a composite currency that takes its value from Gold, Silver, USD and Euro, perhaps. This will be a possible return to some kind of Gold Standard, reducing the panic in currency markets.

Right now, we have seen that in a panic, people rush into USD. Even Gold is not the safe haven that it used to be; Silver has proved positively dangerous for many people. But this may not continue. In fact, I would want to bet on the fact that Silver will go into a long-term (relative) decline to both Gold and currencies. I will argue this today with technical data. If we get this right, it will create very long-term profits; how big depends on how much we believe in the above “history rhyming”.

So one should be long-term bearish the USD, long-term bullish the (post-division) Euro, long-term bearish Silver. I am unable to give an opinion on Gold, which has already fallen 20% from its Dollar peak. Silver has dropped 40%. But while the USD has not yet started its (long-term) decline, Silver is already half-way through its long-term decline. The CNY will appreciate in relative terms, as will the Re and other major EM currencies.

Between 1944 and 1971, there were NO Banking Crises, despite a long-term boom starting in 1955. The big change happened after the Oil Crisis, when Nixon took the USD off its Gold peg. Immediately, this started off the run-up to the Latin American debt crisis, followed by the Plaza Accord in 1985. The resultant increase in the (relative) purchasing power of the Yen led to the Japanese asset bubble of 1989 (when the palace of the Japanese Emperor was worth more than the whole of Manhattan). The subsequent bubble collapse, combined with their demographic decline, has created the only Deflationary Crisis we have seen this last century.

It is now pretty clear that the US does not have the demographic decline that Japan has, nor did it leave its reflationary policies too late. The deleveraging of the US household should be completed in about 4-7 years, while the US corporate sector has already reached stability (as seen by the very shallow decline in the US Dow Jones Index, despite such a cataclysmic decline across the world). The only problem left over will be Govt indebtedness, which might follow the same pattern as in Japan: i.e. everyone will keep talking about a coming crisis of confidence, but since most borrowings will be held by domestic savers, this crisis of confidence will be pushed back indefinitely.  

 CONCLUSION: we should bet on the long-term (relative) decline of the USD, long-term appreciation of some other (Gold) standard currency, shallow and long-term decline of Silver, with a lot of uncertainty about whether Gold will also follow Silver.

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An Agenda For Inflation

A Prescription For Increasing Productivity

Inflation happens when too much money is chasing too few goods and services. That is why Milton Friedman once said that “Inflation is everywhere and always a monetary phenomenon”. At this point, when the monetary authority (the RBI) has just passed on the (inflation fighting) baton to someone else (the Govt), it would be appropriate to evaluate this statement again.

In India, we have to contend with red hot demand for everything, particularly food and energy, besides incremental money supply. We are perhaps the only part of the world that has regular bouts of demand-side inflation; Mr. Friedman was probably referring to the much saner developed world, when he talked about Money Supply as the only driver of (supply-side) Inflation.

I cannot fault the RBI for anything they have done in Monetary Management. Given the recent standards by which we should judge them by (Greenspan/ Bernanke/ ECB), our Governors at the RBI have uniformly shown much more character. The fault, it would seem, lies in what the rest of Govt has done to produce the things that are in short supply.

Starting with energy. We went down the thermal (coal) route, rather than renewables, in particular Solar. A high capital cost for energy can be managed with a high Savings Rate, which we have. Big fiscal incentives for driving savings into Solar, will reduce the Cost of Capital. Now more than ever, with the cost of Solar dropping to a more affordable Rs.7.5 per unit, we should drive huge investments into Solar. This will cover both the energy deficit and reduce the blended cost of energy.

The floodgates of FDI should be thrown open. There is enough money waiting to come in, given the massive investments ($ 500 bn) already going into renewables globally. Given the context of the Durban agenda, it is now clear that China and India will also be launching aggressive emissions reduction programmes, instead of fighting for their “right to pollute”. This will clarify the way forward for industry; Solar is going to be the way to go…

The cheap money available in the US, should act as a spur to investments in India. The money coming in, should not be debt, but Equity. Investors can leverage themselves in the US, but should be invested in Equity here in India. This will insulate the country from currency risk (an especially topical issue at this time). There should be no dearth of investments, if the right enabling climate is created. Big companies like Reliance should be encouraged to launch super-ambitious investment plans; they have the debt capacity needed to even fund it off their Balance Sheet.

The gestation period for these projects can be brought down to 1 year, if some specific SEZ- type initiatives are taken, to ensure plug-and-play projects for smaller players. These can even be consolidated by the big Infrastructure cos (GMR has something like this in Chennai). The short point is that if there could be one single reason for an Indian resurgence, it would have to be the dropping cost of energy.

Worldwide, other trends are kicking in. US production of shale gas has gone up 700% this last decade, and is set to increase further. All this will affect the cost of coal, the dirtiest of the fuels. Oil, too, will eventually come under pressure, but only provided China and India perform disproportionately on the static energy front. The very fact that US and Europe are trying to shut off oil revenues for Iran (leading to higher oil prices for everyone) shows that they now care less about the price of oil than they did earlier. This will also have geopolitical implications.

The next is food, which is both dependent on the cost of energy and is far more complex. First, the cost of intermediation (the non-food cost of food) should be brought down. The value chain in food has a very large storage and logistics cost, which are soaked by traders and intermediaries. If these are handled by fragmented markets, costs will be high. Integrated (or organised) supply chains will do a far better job of reducing cost. I don’t know whether a protected Indian retailing industry is better, or foreigners will really bring in technology and good practices (our experience with Banking would suggest that it doesn’t make much difference eventually, but the entry of foreigners would act as a catalyst).

But food and agriculture needs some serious structural reform. Look at how the inflation problem is going to get intractable. If this (food inflation) continues, it will push up inflationary expectations at the lowest level, fuelling wage inflation. This will set off a spiral. The old and the weak will be the worst affected. Since food inflation shifts pricing power to big farmers and traders, both of whom are almost entirely outside the tax net (the former officially and the latter unofficially), it will ensure that, over time, the tax :: GDP ratio will drop, increasing the Govt’s Fiscal Deficit. There will be a cost push on a variety of industries, which will set off another inflationary spiral. All in all, not a pretty long-term picture.

Productivity can only improve if we bring in serious (corporate) investments into agriculture. I know this sounds completely (politically) impractical, but we need to liberate (land) leasing laws, to allow long-term leases, which allow corporates to get into Corporate Farming. This is in everyone’s interest; the tiller, the absentee landlord and the customer (read: the population of India). It would allow serious investments into wasteland development, water management and soil rejuvenation. New technologies, especially those that use low-cost energy (Solar again?) for water and logistics management, will drive up agricultural productivity. Just ask Brazil how they transformed agriculture within a decade.

These two components make up core inflation. If you look at any manufacturing Cost Sheet in India, you will find that the cost of energy and wages make up at least 30% of total Value Added. Managing these 2 costs will decide the company’s Internal Inflation Rate, i.e. the actual Inflation in the co’s input costs, which might be sharply different from the average reported across the entire economy.

For example, right now, a textile exporter would be seeing very low inflation in input costs (with cotton prices sluggish because of reduced offtake from the spinners), even as he sees increase in Dollar realisations from Sales. On the other hand, power producers would be seeing sharp increases in the cost of fuel (especially coal), even as price realisations stay sluggish.

This would be a good way to evaluate the prospects of companies. Each company has to focus on its Internal Inflation Rate, and focus on the components of its Inflation. This should be set off against ‘beneficial inflation’, i.e. the price increases it gets from the markets it faces. Setting this equation would give it some sense of its future profitability, and its future strategy (to manage its profitability).

India’s savings are currently invested in a lop-sided manner. It is the (energy)- consuming industries that are investing incrementally, not the energy- producing ones. The same goes for food. We have the savings flow to fund our deficits domestically; those that interest foreigners should be left open to them, while we drive our domestic savings into investments in Corporate Farming cos, for example. It is not very difficult; we have the tea companies as a shining example, and internationally, there is the Brazilian model in sugar, to learn from.

The old argument that markets are self-correcting mechanisms does not hold just now. There is a clear price signal coming from the raging food inflation, yet the market is unable to respond. We don’t even know whether the current food inflation is because of falling productivity, that comes from a lack of adequate investments and a complete stagnation in technology. We do know that some of this is because most Indian agriculture continues at the subsistence level, with no scale, absolutely no technology investments in mechanisation, energy usage and input management. All of this would need organised effort, as much into knowledge and management, as into physical assets. At the moment, that is well beyond the capability of the India agriculturist; but politics will ensure that reform here will be left pending till the crisis is well over our heads. 

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The Power Of Compounding

I got a study of real returns in English stocks going back 300 years. What it shows is that the idea of getting wealth by being “in the market” is a fraud. Most of the 20-year investment periods produced real returns of less than 2%. Only one time - the stretch of 1980-1999 - gave investors more than 8%...with the next best more than 100 years earlier, and that still not returning more than 4%.

In other words, the last 20 years of the 20th century (1980-2000) were a freak - an outlier...a “fat tail,” as statisticians call it. Of all the two-decade periods since 1700, it was the only one when an investor could have made serious money on appreciating equity values alone. Yet this anomaly misled an entire generation. Today, most investors under the age of 60 believe they need no longer work hard, save their money, or invent something new; it is enough just to “buy and hold” and they will get wealthy.

Yet even in the 21st century, you still can't get something for nothing.

So what CAN you do...in the real world...where real returns rarely exceed 4%?

The secret is “compounding,”l. It means taking advantage of the relatively modest gains, but doing so over a very long period of time.

There is an extraordinary study by Value Research, showing the advantage of beginning early. Assume an investor opens a Systematic Investment Plan (SIP) at age 19. For the next seven years, he puts, say, Rs. 200,000 each year in the account. But he stops after seven years and puts not another Rupee in the account after the age of 26.

At that time, his friend gets the idea and begins putting his money into his own SIP. He puts in the same amount as his friend. But he continues for the next 39 years - until both are 65 years old. The first has put only Rs.14,00,000 into his account. The second has put in Rs.80,00,000.

Who has more money? Incredibly, no matter what rate of return you use, it is the first man - the one who has contributed less - who comes out ahead.

Neither man is getting something for nothing. Both are being paid for the use of their money. But the man who started first is paid more. His account always has more money in it, and he is paid more for giving it up for a longer period.

Lesson: Aim for the highest, safest yield you can find. Begin as soon as possible.

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The Road Less Travelled

How Not To Think What Others Are (Thinking) -- Contrarian Thinking

The population of the world is divided along many dimensions. There are physical dimensions, like fat people/ thin people, brown/ white people, etc. Then there are psychographics, ie some like it hot and some like it cold, etc. Among the many other dimensions, one of the most important is the “behavioural dimension”, ie, the predilection to behave in a certain repeatable/ predictable fashion. The economic aspects of this kind of behaviour are of great interest to marketmen.

Until now, Classical Finance studied human beings as static and uni-dimensional objects, whose aggregated behaviour was reducable to mathematical formulae. If that was not so, it was not worth studying, said the professors.

Practitioners, however, found their way round the professors. A new pseudo-science emerged, which found believers among practitioners, although it has still to gain wide acceptance among academics. “Believe if you want to, don’t if you don’t want to, but it works”, said some of the best traders in the world. But this “research” cannot be called so, because it does not meet the rigorous standards of a ‘science’, said the academics.

Stanley Danko put out a surmise that went somewhat like this: the world is divided into people with two distinct categories of mind-sets, the ‘majority’ mind-set and the ‘contrarian’ mind-set. The Majority set is clearly the dominant figure, with 97% belonging to this club (he quoted a more exact number, but I don’t want to get mathematical). Only 3% are the Contrarians.

The twist in the hitherto predictable tale is more than 80% of the millionaires came from the latter (Contrarian) community. Danko, came up with some other surprising findings, which were severely attacked for their lack of “rigour”. But they made intuitive sense, and can be verified anecdotally by observing people around you.

The “millionaire mindset” is happy to be dowdy and unfashionable. Most American millionaires don’t live in fashionable areas. They live wherever they started out from. A spectacular example is Warren Buffet, who still lives and eats at the same place he started out from, way back in the fifties. They choose convenience and functionality in everything they do, not “status”. It is the millionaire wannabes that buy all the aspirational products that denote millionaire-hood, not the millionaires themselves.

They don’t change cars for the sake of (change), they often buy second-hand, low-depreciation cars, they mostly stay married to the same woman and their children are often brought up with the same “middle-class” values that got them there.

So where does all the garishness of American consumerism come from? From the high-income earners, NOT the millionaires. Income does not create wealth, the (millionaire) mindset does. The majority mindset pursues high-income, thinking that income creates wealth. The contrarian pursues a simple, unfashionable lifestyle, creating wealth by saving and investing whatever little income he gets. Understanding this subtle difference would be very good for all of us.

Contrarians distinguish themselves with a keen sense of balance. To use a driving paradigm, it is often said that all good drivers may not be good investors, but all good investors are good drivers. That is because good investors are able to balance out 2 very important ‘linearities’ evident in the majority of the population. One, they are able to understand the need to have an objective different from the crowd. For example, most ordinary people get into a car to go fast, so they then go fast........the logical linearity. Good investors know that you enter markets to get a high return, but after you enter the markets, you should focus on managing risk/ downside....the return will take care of itself. Similarly, you get into a car to drive fast, but after you are in the car, you focus on maximizing safety. In this manner, good investors avoid the linearity that is a characteristic of most “majority mindsets”.

The second linearity is called “self-attribution bias”, ie the tendency to attribute all successes to yourself, and to simultaneously externalize all failures to bad luck, the other car-drivers/ market. The ability to behave in a manner that assumes and incorporates the (anticipated) mistakes of others, is an ability unique to good investors. In driving, the majority of drivers (about 85%) believe they are good drivers, something we know (at least in Delhi) is simply not true. This is simply over-confidence, seen very commonly in bull markets. In fact, in mature bull markets of the kind we see right now, this behavioural characteristic is very common........that all investment success is internalized (“it was MY stock-picking that did it”) rather than the more humble “I was lucky to make money”.

The difficulty in classifying people on the basis of behavioural orientation (like contrarianism) is that human behaviour is neither constant under all conditions, nor scientifically measurable. A fat man is fat under all earthly conditions, and measurably so. So patterns can be attributed to “fatness”, which can be scientifically validated. But ‘research’ into contrarianism must stay anecdotal, and only those who find these patterns intuitively acceptable, will be influenced.

However, there is an emerging well-spring of information on this unique pattern of behaviour that is now finding its way into serious academia. The first, most interested readers are traders in financial markets, who are the first to admit to “groupthink” and its damaging consequences. Locating and rooting out “groupthink” is not yet a priority in corporate boardrooms, probably because the damage because of it (groupthink) cannot yet be traced back. In another example of “self-attribution” bias, most corporates are able to externalize their misfortune to chance, the previous management or the Government. There is little introspection to locate the problem within, which is a known characteristic of crowd behaviour.

Crowds, especially large crowds, are monolithic, unthinking, linear and incapable of introspection. They are intolerant of contrarians, and reject any thoughts that fly in the face of “common wisdom”. Contrarians have learnt, under pain of death, to live a dual existence........a public “yes man” who keeps checking back on his contrarians thoughts to see if has missed out on something.

Here is a little exercise that you can do, to assure yourself that these (2 mindsets) exist. Next time, you are in a long linear car park, check the ratio of cars parked with their noses in (towards the kerb) and the cars parked with their noses out (towards the road). Take many readings of this ratio, and calculate the average.

I think 2 psychological patterns drive this number. One is the tendency to postpone pain (pain aversion), by which humans generally choose the option that postpones any pain. That is why we postpone a visit to the dentist, and in stocks, why we sell our winners and keep our losers. It is easier to park your car with the nose facing inwards, even though it increases the inconvenience and risk of taking your car out backwards.

Two is the tendency to herd. As more and more cars are parked with their nose facing inwards, the new cars coming in will tend to do the same. The paradigm built by the ‘system’ creates “culture”, which promotes linearity, even if it is irrational. So it becomes a sort of ‘rule’ to park with your nose facing inwards. I know that this is so, because (in my housing society) I have often parked all my 3 cars together with their nose facing outwards, and then checked to see what the others do. I find that the cars around my cars are often parked with their nose facing outwards, but generally, the others are parked with their nose facing inwards.

Over the last 8 years, I have taken hundreds of readings of this ratio across maybe 10 cities in 8 countries, but always found the ratio to vary around 3 out of every 100 (there are of course, outliers at times). I wonder if this can be called “research”. 

The existence of linearity in the Majority Mindset takes on differing hues, ie, it varies. Beyond a point, it gives rise to a ‘double-feedback’, which is the source of such great volatility in markets. It happens rarely, but is remembered because it creates tsunami-like destruction of wealth among the populace. Maybe we have one building up just now.

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Is The Banking System In a Debt Bubble?

I have heard it discussed in the media that India has tremendous potential for growth, because of positive demographics (meaning a young population), substantial debt capacity (meaning a consuming population with low debt) and substantial untapped consumption growth from the first 2 factors.

Let us examine this a little more in detail. While at first glance, the first 2 factors are factually correct, it is the logical inference, with which I have a quarrel.

To suggest that the debt capacity of the Indian population should be calculated as a proportion as a GDP, is misleading. This has happened because it is common practice in the US, to calculate debt as a proportion of total GDP. For example, total US debt is running at 3.6 times GDP, with net external indebtedness at a shade above 25% of GDP. By comparison, India’s ratios look low, and hence the conclusion that there is substantial scope for debt-led consumption before we enter a debt bubble. For example, it is often mentioned that the US mortgage market is over 80% of their GDP, while India’s is less than 5%. This is often used to justify the case that we are far away from a retail (finance) bubble.

But look at the story on the ground. Measuring an economy’s debt capacity as a proportion of GDP is like measuring my personal debt capacity as a percentage of my income. If I have high income (say, Rs.10 lakhs per annum), I would need, say, Rs.250,000 to ‘maintain’ myself, I, take care of basic needs like food, clothing, education & housing. My actual ability to service debt now comes from my ‘revenue surplus’, in this case, Rs.750,000 or 75%.

But if I had a low income of, say, Rs.100,000 per annum, my ‘revenue surplus’ would be only, say, Rs.10,000 or 10%. That is because basic needs (or ‘fixed expenses’) take away a larger chunk of a poor man’s income, than for a rich man.

It is the same with economies. For the Indian economy, with 35% of the population below the Poverty Line, and with an equal number at subsistence level, the ‘middle class’ is less than 10% of the economy. And within that, the consuming class (defined as the credit-card happy, BPO-employed ‘young consumer’) would be even smaller.

The so-called ‘growth’ of the Indian economy, and in particular, the growth of its debt capacity, has been concentrated around the middle class, which is in the service sector. This sector is largely focused on export of services, and gets its value from selling services to the West.

How large is this sector, and is it large enough to support the trebling of consumer credit in the last few years (from Rs.59000 crore in ____ to Rs.160,000 crore in ____). Who is taking all these houses on finance, fuelling the housing boom? Where is he getting his income from, and how secure are his income flows, to ensure that this build-up of credit will not end in grief for the banking sector?

Let us take a closer look at this build-up of retail credit. 80% of incremental retail credit is in housing finance, a sector where asset quality is dependent on the market value of the asset financed. Appraisal of a prospective borrower takes on 2 dimensions, a look at the client’s income and cashflows, and a view on the future value of the underlying asset.

So far, the latter issue has been a no-brainer. Housing prices have seen little cyclicality, because of the fact that very few houses had loans outstanding against them. Supply (of houses) has always been short, creating a perpetual scarcity, and hence, a perpetually rising price trend, at least in nominal terms. For the retail investor, housing has always been a good investment, because prices always rose, taxation was lower because of Capital Gains, and anyway, half the returns came in cash.

However, we should not lose sight of the fact that prices are a function of supply and demand. In asset markets, they are a function of incremental supply and incremental demand. At the margins, the price of a share or a house is determined by the no of houses coming on the market, vs the amount of incremental money being invested into housing stock.

What is the probability that more houses will start to come on to the market? Suppose there are 100 houses in a village, all of them without leverage. The probability that any of them will get sold is, say, 1%. Then suddenly, 20 new houses get bought, all of them on leverage. It is very likely that after this, say, 5 houses will come on to the market. So a 20% increase in housing stock (all funded with leverage) will create a 500% increase in the number of houses coming up for sale. This is not a mathematical relationship, but an observed behavioural trend. Whenever a stock of assets is built up on leverage, it increases disproportionately the ‘propensity to sell’ of the population as whole. This creates disproportionate increase in incremental supply, which exceeds incremental demand at some point, causing a downward spiral in prices.

We will now look at what happens to the incremental demand. If there are only 200 people in the village mentioned above, and 100 of them had houses, and now 20 more have borrowed, what is the likelihood that more people will borrow for new housing. Demand for credit has a way of exhausting itself, just like a drinker who has had 6 pegs of whisky is less and less capable of having (and holding down) the next peg.

Like I explained above, for a given ‘revenue surplus’, every increase in debt outstanding will reduce the borrower’s incremental debt capacity. However, markets being what they are, the supply of debt continues unabated, regardless of the dwindling debt capacity of the debtors. This causes a debt bubble, with rising NPAs and dwindling quality of credit.

“Professional institutions” are always focused on maximizing revenues and profits, and hence, contrarian thoughts like the one above can never be institutionalized in large

banks. Even though I know that at least some senior Risk Managers at the top of the big banks do agree with me, they express helplessness in being able to control or reverse the trend. This is the Principle of Institutional Stupidity, which I mentioned in an earlier article.

The opportunity for a savvy trader………… wait till the trend is mature, and then go short on the leading lenders. You will get 2 clear reasons why you will make good profits:

i. Once a trend of rising disbursements, profits and good recoveries has been established for a period of 3-4 years, the market will give the bank a ‘confident’ valuation that factors in the continuance of the above. For example, look at the valuations of ‘holy cow’ HDFC (and the bank). The linearity of assumptions about its continued good performance, will keep rising, even as the probability that it will be able to maintain the momentum of its performance, keeps falling. You will get a very nice, fat, over-valuation (like the Infosys P-E of 200 in 2000) to short-sell from.

ii. As the base keeps rising, the ability of the banks to find ever-rising volumes of good business, good recoveries and fat margins, will keep dropping. Quietly, asset quality will drop, but it won’t show up in the numbers, because the business volumes keep rising. And then….boom…..business will slow down, and it will all come apart together.

The “fat valuation” banks are therefore, very attractive short- sells. Their top managers know it, so watch out for big insider selling. I think some of it has already happened.

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Kicking & Screaming .

Why Our Thinking On Global Warming Is Wrong

Any Bombay Club industrialist would have told you (if you had bothered to ask). A good business model is one where the cost of capital is already subsidised by someone else. Dhirubhai set up his great empire by effectively reducing the Cost of Capital of his projects to near zero. The Birlas will tell you that good Project Management is the key differentiator in all commodity businesses.

Our Govt needs to understand this. An economy is nothing but a collection of economic activity, most of which is business, especially big business. Some businesses/ individuals save, and some borrow; if the real cost of debt is above inflation, value is transferred from the borrowers to the savers. This is traditional economic theory; you don’t need me to tell you this.

The critical thing about Clean Energy is not that the capital cost (of solar, etc) is high, but that its Variable Cost is NIL. If the Capital Cost is charged to someone else’s revenue, then it is a ‘frictionless’ business, i.e. a business with only profits, no costs.

Read that again. Right now, Solar energy is viable, even at Rs.12-13 cr per MW vs. coal at Rs. 5 cr per MW. Against coal’s Variable Cost of Rs. 1.2 per unit, Solar would be near zero, say, Rs.0.05 per unit. The only real cost in the DCF is the Interest Cost on the Capital Cost differential, and the Cost of Equity (a.k.a. payback period), which is typically 5 years in India. I have ignored depreciation, because a thermal plant will also depreciate at the same rate.

If you have $ 8 trn to invest into an (American) black hole, wouldn’t you be relieved that some of it is going into a capital asset with an assured return of both Interest and Dividend, over whatever period. So I can understand that the OECD countries are secretly happy at this new opportunity. It is like how an earthquake in a mature economy like Japan is good (economic) news, because the reconstruction will generate jobs and economic activity; savings was anyway never a problem in Japan.

Savings is not a problem in another place, called India. Channelising it into productive resources, especially those routed through Govt initiatives, takes some thinking. At about 37% savings: GDP ratio, we were headed into another Japan-like situation, as we mature into a slow-growing economy. Yes, I know, that is very far away, but it would have happened some day, wouldn’t it?

So is that what we are crying about, that we are a capital-short economy, despite a whopping Savings rate; and the Govt, especially, is always short of funds, because of an abysmal tax: GDP ratio. Isn’t there a way round it, just that nobody wants to look at such dramatic solutions?

What we are really looking at, is just a way to fund the Capital Subsidy needed to bring Solar on par with Thermal. This cannot come from a bankrupt Govt, which anyway has to turn to deficit financing, every time it suffers some small shock. That is because we have over-stretched finances, coming from all those distortions in energy and food subsidies. We actually pay our people to misuse energy, while the world is learning to use energy efficiently. We can simultaneously talk of reducing carbon intensity of GDP, while refusing to free energy prices. As if this were not enough, we can actually talk about water conservation, even as we fight to keep water free and subsidised. How can something be precious and free at the same time? Ask the Govt…..or the Opposition Left/ BJP!!! As the song says, it happens only in India!!!

So cut to the mechanism to fund Capital Subsidies for Solar. If we are all agreed that an appropriate tax: GDP ratio is closer to 25%, then there is some $100-120 bn (10-12% of GDP) lying outside the system. Of this, 3% of GDP, say $ 30 bn of taxes, is lost from agriculture, which is a holy cow. Which politician is willing to tax himself? So that leaves 7-10% of GDP, waiting to be harnessed through a market mechanism, that funds such a (Solar) Capital Subsidy outside the Govt ambit.

Set up an apex body like IDFC, exclusively for Clean Energy initiatives. This will be a holding co, that funds debt and capital needs of various Solar generating cos. A set of rules is designed, and a model is worked out, a hybrid of debt, mezzanine funding and pure Equity in a ratio that keeps the cost of capital (and the average tenure of maturity) within a reasonable norm. The difference (in cost and tenure) of this Liability Profile and that of the markets, will be borne by the IDFC-like body.

So draw up 2 DCF statements: one, for a normal Thermal Power plant. Put in the 3:1 debt: equity norm, price the debt at, say, 10%, work out the tariffs at Rs. 2.2 per unit, and a Variable Cost of Rs. 1.2 per unit. You will get a certain IRR, say, 15%.

Now make another DCF. The cost of debt is 8%, but there is a Pref Cap/ Subordinated debt at, say, 12%, giving you a blended cost of the same 10% (assuming a 1:1 mix). Take equity as the balancing figure, but come to a blended cost of capital that is the same 11% WACC that is used by the wider market. The important thing is that if the Payback of the Solar project takes longer, the ‘rollover risk’ is guaranteed by the Clean Energy corporation, which, being a Govt body, passes through a Govt guarantee to the investors.

Now here is the catch. The Govt only contributes a notional amount to the Equity of this Corpn, which is a Class A share, 100% held with the Govt. The entire Operating Corpus of the Corpn is raised from the public, in the form of bonds, and the subscription to the bond attracts a tax break from current income to the extent of 100% of the amount invested. That is like giving a 35% subsidy to the investor; although since mostly black money will flow into this, the imputed credit that the investor will give (in his mind) will be closer to 15%. So that is like pricing the bond at Rs.85, not Rs.100 per bond, even as the coupon rates and market prices are determined by market forces. Needless to say, it will be a “no questions asked” scheme.

So why will all taxpayers not opt for this bond, is the $300 bn question? Because if I know human behaviour, the cost of capital of black money is very low. Look at black money lending markets anywhere; in Jaipur, it is a low 2-3%, while bank deposits yield 6% for the same tenures. Honest people who pay taxes, will seek higher yields; those with a mindset of evading or not paying taxes at all cost, will choose the bond route. The bonds will have a steep ‘yield curve’ depressed by the sale of the bonds immediately after subscription; these sales will be pressed by those who want to strip out the tax benefit. Normal clean money will flow into the bond as it gets closer to maturity, and an arbitrage market will emerge to bridge the difference.

Remember, these are Govt bonds, so banks can start making a market in these. The spin-off benefit, your $200 bn capital subsidy needed to build 20,000 MW capacity will be funded painlessly. In fact, the momentum built by such a market can be used to finance any long – gestation project that is good for the country, and otherwise needs public money to be funded. The River Linking Project, Water Desalination Projects and various water recycling/ micro irrigation projects come to mind…

I know all this is a little complicated, but if it catches someone’s eye in Govt, I would love to flesh it out for them. I think Clean Energy (and Water Recycling) are the only way forward for a country that is otherwise facing sure calamity because of Global Warming effects.

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The Principle of Institutional Stupidity

Also known as “Why people are more stupid in groups than as individuals”

Around the turn of this century, I used to be a trader. At the same time, the world was given to a singular bout of extreme stupidity, the after-effects of which have still to wear off. This was a very bad time to be a trader, but I survived, mainly thanks to my incorrigibly contrarian outlook on the markets (ie, I was short on IT, at a time when everybody thought it, or rather, IT was rendering the Business Cycle extinct).

Around this time, I went to a (foreign) bank, and wanted a loan against my shares, to meet my margin requirements. Now, my portfolio was entirely “old economy” (a funny word, much in use in the last century). Since 95% of trading volume was in IT stocks, liquidity on my portfolio was poor, and the bank told me that it was not going to finance “illiquid” stocks.

The stocks were Balrampur Chini (since then, up 600% from Rs.75), Paper Products (up 240% from levels of Rs.75), Bata and SRF (which are hovering around the same levels after a few spikes up and down). With the exception of Bata, the Bank turned away ALL the scrips.

The scrips I wanted to short (DSQ mainly, now down >95%) were being happily financed by the Bank, because of its huge “liquidity”. The only scrip from my portfolio, which the Bank was willing to finance (Bata) has been the biggest under-performer in my portfolio.

With the benefit of hindsight, we can say very clearly that there is almost a one-to-one relationship between the Bank’s willingness to fund a share then, and the scrip’s subsequent under- performance. One would think that this is a statistical coincidence, but think about it some more……!

The Bank’s search for “liquidity” during bullish times, coincides with my search for “foolishness” during the same bullish times. The same fools who dominate trading during bullish times, are the ones thronging the corridors of the Bank, looking to increase leverage, so that they can all go bust at the end of the bull market.

So there is a near certainty that most the bank’s “customers” are going belly-up, precisely because they are the bank’s customers. The bank lives off their dead bodies, calling in the loans at the end of the bull market and selling their stock at the bottom……….in fact, Bank selling creates the bottom of the market (as we saw in 2001 after the Ketan Parekh scam).

The Bank turns away long- term survivors of the market (like me!), and picks up (nay, it creates) the future dead ducks. It relies on its ability to sell stock at the bottom, and this is called a “business”………..!!! You would think that all those fancy foreign-trained MBAs in those hallowed granite corridors would have better sense about how to build a business………..but no, you would be wrong.

Sometimes, a stock has low liquidity because it is under-valued, and in “strong hands”, who are not selling till the stock is a multi-bagger. A good securities analyst would be able to figure out “the strength of the consensus” and see absence of liquidity as a positive bullish sign…………….but such a securities analyst cannot find a job in a foreign bank.

You’d think a Bank would understand that the liquidity it supplies to the stock, promotes “foolishness” and therefore, if it has enough of a lending portfolio, it is the de facto supplier of foolishness to the market. What it is seeking to track (ie, downside risk) is actually impacted mostly by its own lending actions (or that of the Banking system).

If it is so obvious to an individual, why does a big Bank not “get it”?

Because of the “Principle of Institutional Stupidity”.

The term was first used by Peter Lynch, who pointed out that structural flaws in the way organizations are built, ensure that they do not operate at a high level of intelligence, even the basic level of intelligence that we use as individuals. You will see this same principle in operation every time you have to interact with a big co.

Between 75- 85% of Mutual Funds do not beat the market in any given year. Their long-term track records are even worse, if you factor in “survivorship bias” (the fact that we evaluate only the surviving Mutual Funds in any comparative study, not including the schemes that are closed down).

The level of foolishness is directly proportional to the number of people who have to evolve a “consensus”. An individual (at least, an intelligent one) is able to make complex trade-offs, which 2 individuals will never be able to agree on. And if you have a Committee, your chances of understanding anything fall further…….if you are a co, especially a big, arrogant and successful co, you don’t have a chance. And God forbid, if you are the whole market………..even HE cannot help you!

Thank God I am an individual……….!!!

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Frying The Fish and Feeding The Sharks

There is a lot of talk in the markets about the recent Budget provisions on Capital Gains and Turnover Tax. I think I have something to say, which I have not seen in the recent articles on the Budget.

The Economics establishment in this country is dominated by ‘classical economists’ who deal with static models of taxation, ie, models that do not anticipate human behaviour, but take it as unchanging and constant. This is a flawed view.

Sometimes, the observer does something that itself changes the behaviour of what he is observing. That is when you have “shot from a cock-eyed gun”, and the bullet comes back to shoot you in the foot. The Govt of India is a past master at this fine art (of shooting itself in the foot). It often ignores the role of its tax policy, in the generation of the taxable income itself.

Let is now take a look at this new set of provisions on the Capital Markets.

Markets are made up of many kinds of participants, and many kinds of independent behaviour. Without going too deep into the details, I will point to 3 kinds of participants and their behaviour:

1. Retail: this is the poor fool who gets taken to the cleaners every few months. He is the day trader, or at best, the short-term trader, with very short views on the market.

Since he never earns any money anyway, he is never taxable. He is the fellow who loses all the money that ends up in the hands of the intelligent few, as taxable income. When the Govt was charging Short – term and Long- Term Capital Gains, those big, intelligent ‘sharks’ of the sea were the ones who were paying up.

2. Institutions: these are the big, lumbering ‘whales’ of the market (some of them are ‘sharks’, but mostly, they are vegetarian and too busy trying to ‘beat the market’ to do any significant damage to the small investor)

3. Smart Guys: these are the intelligent kings of the jungle. They are Nature’s way of ensuring that there is not too much stupidity in the markets. They are the snakes who ensure that there are not too many rats around.

These are the fellows who sell at the big spikes you see in most technical charts. They are big, because they have grown fat on all those poor fish who have been getting cleaned out over the years. They have fangs, because they have a deep understanding of the market, of the real value of the stock, and of human irrationality…………..they hunt in packs, and can break the back of any rally in the market.

They are sure of themselves, they have the media under their control, and they can turn public sentiment at the switch of a cellphone button.

Now let us examine what Tax Policy does to each segment of market behaviour. For all the hoo-hah about the Turnover Tax, it really hurts only the day trader, and his turnover. That hurts the stock brokers, a powerful lobby group, which is why the media is full of stuff about them. Frankly, I would ignore this issue, because it does not affect price discovery in any significant way.

Long Term Capital Gains should have gone a long time back. It is a good policy, because it rewards the real investor, who seeks to get his gains from business transformation. Although these are often the rich, they should still be rewarded, because tax policy seeks to reward Savings behaviour, and returns from Savings should be looked upon kindly, if you want to promote Savings and Capital Formation.

Most of these big, intelligent investors (the Warren Buffets of India) stay out of the short-term markets partly because of tax policy (35% Short Term Capital Gains Tax Vs. 10% Long-Term Capital Gains Tax). According to research, this kind of behaviour makes ~65% of the profits made on the stock market, even though it accounts for just ~1% of the trades. These sharks do not come out very often, and that is good for the market, because it helps to build up ‘sentiment’ (which is nothing but the poor fish congregating in shoals so that they are easier to catch).

Another ~13% of the trades make the rest of the money, and all this money ends up as Short-term Capital gains. This goes to the ‘intelligent fools’ (like the readers of this magazine) and to the elephants of the market (ie, the institutions).

So the Turnover Tax does not catch such people, but the Long Term Capital Gains Tax did. This is where the real profits of the market are, but the Govt has chosen to tax the poor and exempt the rich.

The most retrograde provision is the drop in Short-Term Capital Gains Tax. This will bring out the sharks more often, because of another peculiar economic phenomenon called the Fallacy of Composition. In very short, this is a complicated way of saying that “what is good for the goose is not good for the geese”. I will explain…..!

Most of those sharks did not come out to hunt, because the Govt was taking 35% of their prey if they came out before a year. That was allowing the fish to multiply, giving the market some direction, allowing sentiment to build up.

There is a term in financial markets…”profit potential” of a market. In simple terms, it refers to the fish who have congregated in a shoal (and refers to the amount of prey in the sea). A shark only wants to feed off the prey available, he does not increase his size beyond that.

The only thing the shark fears is another shark. Now, with just a 10% tax rate on Capital Gains, he fears another shark will come out and take his prey away, ie, he will ‘farm’ the poor fish early in the rally.

So while he is happy that the Govt has dropped the tax rate, he now worries that other sharks will come in and sell early in the rally, simply because ‘they have made enough money’. This is the Fallacy of Composition, where even as he celebrates the drop in his tax liability, he worries that his income itself will come down. So that will drive him to sell early.

Remember, this guy (shark) is good for the food chain. But now, with quick extinguishment of rallies, the market will turn more volatile as these guys will come to sell more often, and at shorter spikes. As the market turns volatile, Risk goes up (ah! Now the classical economists can understand….!), and with it, so does the Cost of Capital in the economy. Price discovery is hampered, and stocks will not reach full valuation, because long before that, the poor fool (retail investor) who is mostly responsible for the “linear thinking” that drives big, long rallies, will have given up and gone home.

You want to verify what I am saying………..let someone in Govt do a Research Project. Take a list of the big taxpayers of last year under this head, and classify them under “Behavioural Heads” as above. Now take a list of taxpayers this year, and observe how their composition has changed. You will find the poor fools (Turnover Tax) are paying more tax, than the “sharks”. So the Govt HAS gone and taxed the poor and exempted the rich.

When I grow up, I want to be a shark……………!!!

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