Second Factor Derivatives

Going Where the Mind Cannot Have you ever wondered why childhood mathematics was limited to addition, subtraction, multiplication and division. You can be called ‘educated’ if you have mastered these skills, in almost every country in the world. But why isn’t Square Root, or r2 (a.k.a. Correlation), square variance, relative movement (a.k.a. beta), regression or logarithmic relationships not used so much in everyday parlance. Are these mathematical relationships less relevant to the real world? Pythagoras, Fibonacci and a few other geometricians showed us the existence of a few variables that appear regularly in our ‘random’ world. If at all there is a proof that there is (a) God, this is it….how can something so perfect, so symmetrical and so regular suddenly happen in such a chaotic, ‘big bang’ universe? So, e=mc2, a Nobel Prize is given (or not), and everyone goes home…. The Efficient Markets Theory says that all knowledge about a stock is instantaneously factored into its price, assuming perfectly competitive markets. This has since been mostly proved to be bunkum; almost every word of the sentence above has been proven wrong. The Random Walk Theory went a step further and claimed that stock prices followed a ‘random walk’. In its details, however, the book made 2 important points: one, that any ‘trading rule’ that outperformed the markets would be copied by everybody till it no longer works. This, of course, assumes perfect and uniformly transferred knowledge, which I know as a Professor is impossible…but never mind. However, even Burton Malkiel acknowledges one ‘trading rule’ that has been known to outperform the market over a hundred years, although he does still maintain that individuals cannot outperform the market. And that is, that Beta migrates and a portfolio of low Beta stocks will outperform the market over any long period, i.e. what the market forgets, the market later remembers, and this is a consistent cycle. Hence, what the market forgets, it cannot be invested in (by definition), so a good strategy to beat the market would be to invest in a portfolio of low Beta stocks. I have lots of disagreements with this rather simplistic theory. First, the role of human intervention and ‘special intelligence’. There are many ways to beat the market, which itself, is no benchmark. Over the long run, I would think that market returns should track GDP, liquidity, inflation and the profitability of businesses. But they don’t, giving us the feeling that Mr. Market would not make a very good portfolio manager. Just staying out of the market from Jan- Oct, 2008 would have made you 4 times richer than someone who did; what does it say about Mr. Market? The most devastating attack on these theories comes from the likes of Warren Buffet, Peter Lynch, George Soros, etc…..by their very existence!!! Classicists have no comment to offer, saying something like, “….but they too must die”. So here is my theory. The human mind is incapable of second factor (derivative) thinking. It takes an exceptional mind to look at a ticker, full of moving random numbers, and be able to calculate the ‘dispersion’ round the average, even as you calculate the moving average. Jesse Livermore could do it, in his famous ‘bucket shop trading’. It is somewhat similar to being able to calculate the moving odds in a game of Black Jack, which an American professor learnt to do, in order to beat the casino (and make $3.5 mn in a night). If you can do the above, you will get a sense of ‘beta migration’, i.e. in a bullish market, which are the stocks being ignored by the market? If you then see a perverse steadiness during the subsequent correction, you can tell that this stock is being ‘supported’ with an investment hypothesis, which has still to work out. But ‘smart money’ is in the stock, and the first indication of the ‘investment hypothesis’ showing results will result in a huge uptick, which will be confusingly understood as ‘beta migration’ by Mr. Malkiel. For example, Bharti Airtel is going through that phase just now. Why so? Because Mr. Malkiel deals only with market-level phenomena, not with individual stories. That is why he cannot understand the people who beat markets. Rather like sitting on the moon and observing that Mumbai is ‘going nowhere’. Oh, but Mukesh Dhirubhai Ambani is…….if you just look deeper!!! Since Mr. Malkiel does not understand Bharti, he will just take a ‘portfolio’ of low Beta stocks, which will comprise of HPCL, Balrampur Chini and Unitech/ DLF just now. They are different stocks with different investment hypotheses, displaying the same behaviour for different reasons. In case of HPCL, at some price point not very far from here (say, 270), ‘smart money’ will pile in and quietly sit there, waiting for oil prices to fall, or the Govt to tire with its OMC- raping. Or the Govt to wake up to the need to pay for new infrastructure in oil refining, or to pay attention to its off Balance Sheet Fiscal Deficit….whatever! They just buy HPCL at a discount of 50% to Book Value and go to sleep. In India, bad things happen for long, and then India surprises you.....just when you give up, something good will happen, when and where you least expect it. The upside is 150%, the downside is 20%.....an equation acceptable to ‘smart money’. But what is Unitech doing here, the crane among the storks? Its Beta has already migrated, and the stock has been an outperformer recently, giving 15% returns in a flat to reducing market. Its Beta was running at a whopping 6.39 in the run-up from 2004-2008; what is much more relevant is that during the downturn of 2008, its Beta ran consistently above market, i.e. it fell at TWICE the rate of the market. Remember, when something rises, the sky is the limit, but when something falls, the floor is the limit. To outperform the market during the upswing is no big deal, but to outperform the market during the downswing says something special. Three snapshots: market fell 22.09% from 8th Jan, ’08 to 22nd Jan, ’08, Unitech fell 33.22% over the same period for a Beta of 1.5; market fell a further 48.68% from 22nd Jan’08 to 27th Oct, ’08 in a once-in-a-century dive and Unitech outperformed it by falling 87.84% with a Beta of 1.8. Now hold your breath: market ROSE 2.34% over the period 27th Oct, ’08 to 9th Mar’09, but Unitech showed a NEGATIVE Beta by falling a further 41.85% for a negative Beta of 17.85. So a Beta Tracking strategy would have come to serious grief if it had chosen Unitech to practice its skills. Which brings me to the point about there being much more to it than a simple ‘single factor’ relationship to this complex question. What goes up must come down…. maybe…. but what goes down must come up is not necessarily true. The human element is obvious: a computer program that apes Mr. Malkiel’s view-from-the-moon strategy may ‘outperform’ the market over a hundred years, but Mr. Warren Buffet is sure to leave out Unitech from his portfolio intuitively. That would surely improve his track record over the long term. For example, I use 14 such filters to make sure that I don’t ever get caught in an over-priced stock. Yet, I don’t call myself a mathematician; the critical skill to me is that of a Behavioural Economist, who builds an ‘anticipator’ of ‘smart behaviour’ (like I have done for HPCL above) and then tracks it to check for reality.

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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 Dawn After

How Things Could Change For The Better There used to be much talk about ‘green shoots’ in 2009, although nobody uses that phrase any more. At a time when sovereigns accounting for about 3% of world GDP look all set to default, it is difficult to imagine just how things will ever come back to normal. Yet, to misuse NourielRuobini’s book title, ‘this time too, is NOT different’. The darkest hour (we might be approaching it now), will still be followed by a dawn. To get past these times, you need to have some picture of what the dawn will look like, which is why, contrarian as usual, I have decided to time this column just now. Remember: you read it here first!!! The cost of Solar (power) has just come level with the grid cost of thermal power, at least in California. Solar capacity used to cost Rs.42 cr per MW a decade back, and in a variant of Moore’s Law, is dropping 60% every 5 years. From Rs.16 cr per MW in 2008, it is now Rs.11 cr per MW in India. The latest American panels should now be launching at Rs.7 cr per MW, not very far from the ‘parity bar’ at Rs.5.4 cr per MW. For India, if you factor in the rising costs and availability issues for coking coal, together with the possibilities for Solar panels over the Thar Desert, ‘grid parity’ will be life-changing. The potential impact will rank along the lines of the IT revolution, followed by the Communications (Mobile Voice & Data) revolutions. First the cost of computing went to zero, then the cost of communications followed suit and now (maybe) the cost of energy will follow. While this will be a worldwide revolution, and I am sure India will lag behind in converting to Solar, I can see spinoff benefits for a variety of economic activity, which will boost poverty reduction. Principally, it will make water management cheap and easily accessible to the rural poor, allowing politicians to dole out their favourite gift: free power for farmers. At a different level, power reforms should see a fitful start, now that bankruptcy is staring both producers and distributors in the face. Amazingly, Tamil Nadu is looking at tariff hikes of 20-30%; reducing free power will create a further impetus for production. But if the real cost of power drops for technological reasons, there will be no dearth of demand, anywhere in the world. We have seen the same thing happen in the Communications Revolution. The development of Solar and other renewables technologies will still be incremental, and will not impact markets, except indirectly. There might be no Big Bang in Solar, and we might not see a Microsoft of Computing (or Apple of Mobile technology). (Solar) Power is an enabler, not a consumer good in itself, hence a producer will remain a Utility. Govts will interfere, preventing the kind of profits that, say, an Apple makes out of its leadership. Not so in Biotech. There are already more than 500 products awaiting FDA approvals, and they will impact big diseases like cancers, renal and liver disease, heart, diabetes and lifestyle disease. Over the next 3 years, they will be coming onto the market, impacting the pharmaceuticals industry in a way that cannot be imagined. The $40 bn of patents expiring, will not be noticed in the excitement that follows. For the equity markets, this (more than Solar) will create the next bubble. In currency and bond markets (the source of all the trouble just now), change will be equally dramatic, although it will be less noticeable, since it will be driven by attitudinal/ behavioural change. Govts will find it more difficult to be fiscally irresponsible, and the consequences of the current spate of bond market defaults will be remembered for a long time to come, at least in the developed world. Remember, Germany’s phobias about inflating away the debts of Greece come from the memory of their own hyperinflation of the 1920’s. Whichever way this current European imbroglio ends, you can rest assured: it will leave lasting memories of the consequences of fiscal imprudence, high Current Account Deficits and ‘hot money flows’. Anybody in Europe who is allowed to live life again, will keep these lessons in mind. That ensures a sharp jump in Govt discipline in the whole of Europe and its neighbours. Whether such learning will impact behaviour as far away as India (and I don’t mean geographically, but attitudinally), is something I cannot yet say, but Jayalalitha’s power sector reforms and Mamatadi’s “Ms. Populist” reaction to oil pricing, would suggest that the impact of Europe’s misfortunes will be far-reaching. Think of the impact of this. Govt deficits will be (relatively) under control, bringing back credibility to fiat currencies. This will take some of the shine off Gold and other precious metals. Commodities in general will get cheaper, not just through technological advances, but because of the absence of front-running flows that ‘anticipate’ Govt profligacy. The ‘dash from cash’ will slow down, and people will start trusting bond markets to preserve their wealth. Who knows, they might even start stuffing cash into their mattresses; it certainly feels softer than gold. Countries (especially in Asia) that were following Europe down the ‘welfare state’ route will tarry for a while. Not India, though, which continues to promise various ‘rights’ (to food, education and all the other things that it has no hope of ever providing). But overall, most countries will have better finances; this will be achieved, indirectly by vacating the towering heights of the economy (infrastructure, utilities and core manufacturing), all of which will be very good for jobs and income growth. So try and imagine a world where the cost of energy is zero, following up on zero- cost computing and communications. Incremental life expectancy comes very cheaply now, with major advances in disease control and rejuvenation. Govts don’t take their (fiscal) credibility for granted, and prefer to stay out of running businesses. Parts of the Indian economy in particular, where supply side inflation is both endemic and structural, will see an improvement in productivity. Even assuming that Indian agriculture stays the way it is, technology will still impact food production through biotech, energy management followed by superior water and logistics management. A doubling of food productivity is all that is needed now, not a very tall order on a very small base. What WILL NOT happen is also clear. There will be no structural reforms in agriculture, no corporatisation of agriculture at one end of the spectrum, nor any land reforms at the other end of the spectrum. Politicians need to keep agriculture free of any taxation, to hide their ill-gotten gains from the business of politics. This will push up the cost of real estate, but at the same time, ensure that leverage levels in India stay low. The world is going to get better. Event risks will remain, like nuclear terror and biological weapons. But they will be mitigated by a change in geopolitics through a tectonic change in, say, drone technology. The new drones being developed are microscopic, with nanotech-sized gnats sidling up to you and shooting you down, wherever you are. The power balance will shift back to America, which is where I would like the world’s geopolitical power to lie. I would have been much more worried if I saw power shift to China, Afghanistan or Iran, which seemed to be the alternatives this last decade. Lastly, private Americans have been paying down debt, even if their Govt hasn’t. Another 4-7 years more of this and they will be down to 1950 levels of indebtedness, which is where the last Baby Boomer generation started. And remember, this new generation of teenagers would have seen enough bad times to hold onto their character during good times, come 2020…

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The Way We Are

Summing Up The Last Decade The MFI will be ten next year. Unlike children, it still has time before it reaches puberty. Yet, it has seen more as a toddler than most people would have seen in an entire lifetime. For starters, it was born when the world had already changed, i.e. after 9/11. The IT Boom had just gone bust, the Sensex had dropped to 2800, and Mr. Greenspan was just embarking on the biggest (mis) policy of the century, something that would leave its stamp on a generation to come. A lot has changed during this period and yet, some things have not. The tone of my own columns has traced this change; I started with observations about human beings, trying to ‘be different’ by pointing out some home-grown observations about human irrationality (e.g. “How To Park Your Car”). This, I thought then, would be original stuff and I had limitless content, taking the broad principles and applying them to the many dimensions of economic life. The facts followed me in my journey. As India got integrated into the world economy, so did the Indian markets. The result was a classic ‘globalisation of irrationality’ that saw itself play out in mini-form in India. Most of the stuff that happened in India traces its roots to some global event or trend, until today we pass off anything that cannot be immediately explained, as ‘global cues’. Others will tell you how the facts evolved during this period. As usual, I will stick to the philosophy and the principles to be derived from it. Markets are supposed to forecast the future and ‘discount’ prospects. In the short run, they are reactive ‘voting’ machines while in the long run, they are discounting/ forecasting machines. They are also culling machines, routinely decimating the wealth of those who ‘react’, while at the same time creating impossible wealth for those who ‘forecast’ AND survive the mayhem wrought by the stampedes of those who react. This paragraph is particularly topical at this time of writing. For the Indian reader of MFI, and maybe for MFI itself, the journey (with the benefit of hindsight) should have been fairly simple and straightforward. Most of the bad news has emanated from the ‘global cues’, to which India has been exposed as an afterthought (and an aftershock). The irrationality that has to be survived is that of the global economy, which includes FII flows. The Indian economy has charted a fairly secular course through this last decade, cruising along in second gear. Yes, there are those who complain that it can do better, but it certainly is not part of the (global) problem. Nor has it contributed much to the debt woes of the world (thanks to some intelligent policing at the RBI). In this context, I must thank our stars that an Indian Mr. Greenspan never got close to the RBI Governor’s seat…we are rather satisfied with the Reddy-Rao axis!!! So you, my reader (and the MFI) would have done well (in hindsight) if you just stuck to your “I love India” bumper sticker. You just had to step back and survive the herds of exiting investors that periodically react to something happening somewhere else. If they heard a different drummer, it was not a beat meant for you. You just had to survive the stampeding herds and (you) would do well. I remember that from the scorched marketsof 2002-03, I picked up a purely domestic Indian play (on sugar), a well-known company (Balrampur Chini) that gave me 42 times my money over 3 years, on an investment of 3 years’ salary. My (financial) life was never the same after that. I mention this to bring home to you how, in exactly the kind of times that we are facing just now, it is possible to pick up a very good stock, believe in it, hold on to it with tenacity, and with (just a little bit of luck), reap life-changing rewards. This is not available to everyone, but to readers of this magazine, you have a chance. Would you believe that before the steel cycle turned up (with China) in the last decade, SAIL used to quote at Rs.5. It went up to 230 in a fairly predictable fashion. There are many such stories across India, which are available to you and me. That (apart from the fact that we have real jobs and maid- servants) is what makes us much more fortunate than those who live in the West. What has changed during this period is recounted every day in the papers, so I will spend little time on it. But mainly, it is the integration of markets, the way currency markets impact equities, commodity and bond markets affect everyone else in an interwoven mesh that really plays out Complexity Theory (remember the quote about the fluttering of the wings of a butterfly in Louisiana causing famine in China). These days, I find myself reading Der Speigel, a German newspaper, to figure out the intentions of the Freedom Party, which is a coalition partner to Angela Merkel. If they vote against the support to the EFSF, the Eurozone will collapse and that will affect my holdings in Tata Steel. How’s that for complexity?Most of you innocent buyers in Tata Steel would not even know of the EFSF, let alone who Angela Merkel is… It is no longer enough being a ‘fundamentalist’, because you might be waiting forever for the market to discover your stock. Especially when little known companies have to build ‘market reputation’ (which includes a reputation for Corporate Governance, a much-vaunted and rare attribute these days), you might find yourself going wrong with the punt of a lifetime. Technical analysis is a little better than astrology; if you read these chartists carefully, you will find they have a margin of error of 50%. If you want to play the price discovery process, it is far better to try and be ‘last man standing’. Read the “Art of War” by Sun Tzu, lots of statistical modelling (which is NOT the same as technical analysis) and Nassim Taleb to complete your education. The road to success hasn’t changed, although it looks very different these days. If you get your investing model right, there is a big market for your skills, which wasn’t so earlier. Just make sure that you don’t just study ‘what to buy’, but the price discovery process itself. When you do the latter, you will find yourself looking at complexity coming from Fx, bond and derivative markets, besides commodities and ‘flows’, a new variable these days. In Equity markets, at least, the old formula hasn’t changed. To take the example above, it doesn’t really matter whether Merkel stays in power or not. If I buy Tata Steel at a 35% discount to Book Value, I will be rewarded one day. The daily shenanigans of FIIs and markets will scare me, but longer-term trends will play out. Good managements will do better than bad managements, good business models will survive. The basics remain the same. The formula for the next decade is known: buy India, buy companies growing in the domestic space, with good business models, corporate governance, technology and a healthy Balance Sheet. And stop reading the (pink) papers thereafter; I promise you, that is NOT good for your financial (or mental) health.

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Je Ne Comprends Pas

Looking The Gift Horse In The Mouth Regular readers know that I mostly write philosophically, trying to derive principles that drive action, rather than recommending specific actions for our readers. Rarely, I speak about a specific company/ event/ trend, except to deal with a macro-trend. Today, here are some disconnected thoughts that slip through my mind as news/ events/ trends roll along in fast forward… • So S & P downgraded the US, and everyone panicked. It wasn’t really news, even from S & P; but I suppose once people start running, nobody knows why they are running. The same day, S & P UPGRADED Tata Steel, which then proceeded to drop like a brick, till it reached a whopping 20% discount to Book Value. The debt has come down to 2 timesconsolidated EBIDTA, well under control. Corus has mostly turned around and cost synergies (estimated at $400 mn) have started to flow. The closure of illegal mining in Bellary will indirectly benefit Tata Steel to maintain its 20% topline growth, both in India and globally. At Rs.130 EPS (including one-time Capital Gains), you are buying the co at 3.7 times earnings and 4 times EBIDTA. This is even better than Bharti, my last recommendation… • The company has a Return on Net Worth of 13%, but the stock is available at a 10% discount to its CURRENT Net Worth of Rs.490 per share; since you would mostly be investing with a horizon of 1 year, that would be a 25% discount to its expected Net Worth (of Rs.550 per share) 1 year hence. In short, you get a 21% post-tax (and 31% pre-tax) return if you hold the stock forever. This is the kind of once-in-a-lifetime investment that Charlie Munger and Warren Buffet talk about. If you have bought the stock at the right price, and it is compounding steadily, the right time to sell it is …..never. • Let us take a look at how this has come about, and what are the canards floating about in the market/ media/ analyst community that have beaten down the stock to such deep value. In these chaotic times, the media is full of misleading stories, sometimes orchestrated by the analyst community, who will change their tune the moment the stock has reached the right hands. I think this is a bigger, and more systematic scam that 2G, CWG and Bellary combined. It is just unfortunate that Anna and his Team don’t have the eyes to see it. • Don’t believe me?!For those of you who remember my columns while the Bharti story was unfolding, take a look at the sequence of events while the orchestrated beating down of the stock was taking place: o The first phase was when the tariff wars started and the stock was marked down on ahuge selloff by Mutual Funds from 457 to 320 (circa 1st – 14th Oct, 2009; look up the technical charts to follow my story). As a natural contrarian, this attracted my attention. o Tired bulls capitulated end-Nov, 2009 (near the expiry) and there was a short-covering rally by mid-Dec to 342. This ended Phase I of my story. o Now starts the co-ordinated‘story-spreading’. In Jan-Feb, 2010, the Zain story broke and an ‘analysts’ consensus’ was worked out, saying the acquisition was ‘value dilutive’ for Bharti, because it was a premium (about 20% per subscriber) to Bharti’s own beaten-down valuations. Look around now, and tell me where those concerns are. Bharti is up 60% from those days, even though the market is down 20%. Anyway, in the week 10-16th Feb, 2010, the stock was marked down from 315 to 271. Thereafter, it trundledalong over March and April, recovering as more information about Zain trickled in. In Feb, 2010, I wrote the first of my columns on Bharti, angry at the disinformation being spread about Bharti. o At just this time, I called up an analyst in a leading foreign brokerage who was covering Bharti. I challenged her downbeat view on the sector, finding that she agrees with all my counter-arguments about Bharti being a sector outperformer, and a relative value argument, etc. She agreed with everything, but maintained the ‘party line’. i.e. the stock is down from 271 with a target of 210. Recently, she has revised the price target to 504. I can’t believe that she did not know what she was doing; her ‘party line’ was to talk down the stock, put out ‘public research reports’ which are duly headlined by the leading pink papers (more money is made by this process than Mr. Kalmadi could ever imagine; in respectable Indian society, this is even called a ‘business’ and gets you Market Cap in Dollars). o But back to my story. After the Zain fracas died down, the 2G scam broke out, circalate April, 2010. It had a limited effect on the already beaten-down Bharti stock, except when a whopper of a story was headlined, obviously (surprise!!!) in the pink papers: the TRAI recommendations about the sector, especially one recommending a whopping Rs.14,000 crlicence renewal fee. These ‘recommendations’ were duly headlined as fact and repeated ad nauseam. I wrote an angry column ‘TRAI-ing to Fail’, which should be read now in the archives, to see how right I was: http://www.valueresearchonline.com/story/h2_storyView.asp?str=14788. The stock dropped below 260 and stayed there for 2 months, during which almost everyone I knew dropped out of Bharti. The stock they sold was picked up by some of the smartest investors in the country (including the promoters). o The point I am making: while the media (and analysts) were in a downgrade frenzy, why were smart, knowledgeable people, not reading those Research Reports (or pink newspapers). Or were they writing them? In trading parlance, we call this, ‘maalnikalvana’, and is in no way different from the manner in which you put a white bedsheet over yourself to make your sister shit in her pants…;). I survived all this, and exited Bharti at 360, happy at the predictable ‘behavioural map’ that I had figured out. After 360, the analysts returned to telling the truth; actually (oh sorry! But Bharti was really a good company, a sector outperformer and would consolidate both India and Africa. So what if the profits are down, the stock is still up, despite a beaten-down market!!!) o Something similar happened recently in DLF, which will give you a sense of déjà vu if you track the story with the technical charts. Thrice, there were prominent headlines in the pink papers on various issues with the company (bad accounting, hidden losses, high debt). Every time, it led to a selloff, the stock bottomed at 209 with huge volumes and backed up 10-15%...it was party time in a bear market. The big story now is the ‘penalty’ on DLF by the Competition Commission of a whopping Rs.630 cr (see the TRAI ‘recommendation’ above). Suitably headlined in the pink papers, it led to a selloff on a day when the broad market bottomed and some very smart investors bought 140 lac shares from some very relieved idiots. Watch this issue one year hence….!!! DLF is since not breaking new lows, despite being from a pariah(real estate) sector…! • But this story is about Tata Steel and I must return to it, first by making my main point: that there are serious, quiet and invisible ‘cosy’ relationships between analysts (especially from foreign brokerages, who put out ‘research’ when the market is delicately poised) and the pink papers, who give it a loud, terrifying voice that will blow you away if you don’t know your facts thoroughly. Recently, the market bottom for this cycle was made on a day when the leading pink paper chose to ‘poll’ some unnamed ‘Fund Managers’, and told you that the market was dropping 13%......not 17%, not 9%, not 12.36%. Just 13%.....the stock sold by its foolish readers was dully lapped up. Now watch this space 6 months hence!!! • The lesson for you, my dear readers…..you will die rich, if you just read these papers one week after they are delivered to your house, and then you watch what your foolish neighbours did when they listened to such false ‘advice’. In my case, I read these (pink papers) to find out what the fools are doing. And I don’t watch TV, which is seriously good for my financial health. • The canards floating around just now: o Tata Steel is a global company, and with Europe facing a double dip, its European operations will be badly affected. Europe accounts for 56% of Tata Steel’s turnover, and about 30% of its EBIDTA. It has high Operating Leverage, i.e. unit drop in selling prices will lead to high negative impact on its EBIDTA. But at 5 times EBIDTA, this belief will at best hold for the short term (even if it is true). At these valuations, just the 20% EBIDTA growth from the Indian operations, which are unaffected, will give you a decent return. o Steel prices are bearish, and Tata Steel will be affected. They have been bearish for some time now (CMIE has projected a 7% increase in domestic prices around Oct, 2011), and recent results showed that Indian turnover growth made up for the decline in prices. EBIDTA was flat, despite lower prices. Going forward, India will still see 10% growth in steel demand, and maybe some price improvement if the ban on iron ore mining and the problems of JSW prove to be good for its competitors. But this is to tell you that even in the short-term, Tata Steel’s EBIDTA will be more or less flat. But its stock price is down 20% below is CURRENT Book Value. At these levels, its current profits give you a 21% post-tax return; all you have to believe is that EBIDTA will not fall significantly. o In a high interest rate environment, this is an interest rate sensitive stock with high debt. It should be badly affected by a recessionary scenario. Wrong! The Corus debt has been reduced steadily, and consolidated debt is at 2 times EBIDTA now, a very stable ratio. Its spare debt capacity gives it the ability to make another aggressive acquisition; watch out. Even if it doesn’t invest, it is paying down Rs.10,000cr debt this year, or its expansion at Jamshedpur will come up with lower leverage than at SAIL or JSW. The company is the most under-geared in its sector, something it has in common with Bharti. o Other Positives. Its ‘global’ operations are genuinely global, with commercial operations in 53 countries. A shortfall in Sales in Europe, will be made up by faster diversion to other growing economies, especially in Africa. Corus is not the operation it used to be in 2008, when it brought down Tata Steel to 40% of its Book Value. Memories of that downfall have triggered the current selloff, and that is why it is an opportunity for you. Today’s Tata Steel is a different company: huge cost synergies have already been extracted, half the Corus debt is paid off and most importantly, Corus technology is now helping Tata Steel with its product development in India and other emerging markets; that will help it outperform its competition locally. And the local markets are both robust and growing. The fears about a European slowdown, even if they are true, don’t justify a 65% discount to its average historic valuations (of 2.3 times Book Value).At a 20% discount to today’s Book Value, you are getting a strong, deleveraged Balance Sheet and a robust P & L with little downside risk. If there are risks, they are in the price. The positives have not been factored in, and some of them are already on the Balance Sheet. Like Benjamin Graham was fond of doing, he wanted to pay only for current reality, not for future potential. You are getting just such an opportunity in Tata Steel right now. Disclaimer:the author has put his money where his mouth is. He has put his shirt (and his reputation) behind Tata Steel.

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Irregular Regulations

The need for a philosophy in Regulation Companies make Vision Statements that tell you (if they are honest) the broad direction that you can expect it to take. So an Apple Inc can be expected to focus on design, while a Samsung can be expected to focus on take-to-market. These Vision Statements usually come from deliberate Planning efforts, which is often called ‘Strategic Planning’. The outcome of these Planning exercises, is that there is an explicit statement of ‘strategy’, which is like a positioning statement for the co, a statement of aspiration for a ‘state of being’. Even countries have something like that. India has a Constitution and ‘Directive Principles of State Policy’, which give a deliberate structure to the direction of actions taken by the State. Have you ever wondered why the people who regulate these companies, don’t consider it necessary to let their subjects (and the general public) know where they are headed? Let’s take an example. When TRAI or IRDA are given their mandate over their respective industries, do they lay out a ‘Constitution’ that binds their own behavior and a Statement of Strategic Intent that lays out just what Utopia they are looking for. These statements can be changed from time to time, but they should be clear & transparent. It should be binding on the regulator to demonstrate, by every action of his, that he has kept in mind his objective while formulating a regulatory stance or taking some regulatory action. At a much wider level, you will discipline various arms of Govt from ‘playing to the gallery’ by pandering to media frenzy, which sets up these lynch mobs that destroy reputations. And you will bring some predictability and consistency to regulatory action. Let us take a very small example. The move to shift Currency Trading to an exchange-traded format, was part of the movement towards full Currency convertibility. It accelerated after the Fx Derivatives ‘scam’, in which a large number of small companies were (mis)sold complex OTC derivatives, with structures that increased risk rather than reducing them. During the 2008 crisis, most of these structures unraveled, causing huge losses and even bankruptcies among SMEs. Justifiably, the RBI took it upon itself to tighten the screws on this ‘business’ and put a stop to these bilateral transactions in exotic derivative structures. Through a slew of circulars and guidelines, it made life difficult for the foreign and private banks that were preying on the SMEs. Meanwhile, the door was thrown open for exchange- traded vanilla products, which became increasingly liquid, thanks to retail participation. As the currency exchanges gained volumes and market share, a minor argument ensued over who should regulate these currency exchanges. Were these formats more to do with ‘currency’ or did they have more to do with ‘exchanges’. Because traditionally, exchanges had been regulated by SEBI, while currencies, naturally, had more to do with the Central Bank. The matter was resolved in favour of SEBI, probably with reason. Meanwhile, things improved rapidly for those SMEs who understood both trading formats and international economics. The first good thing was that ‘underlying’ was no longer needed, everybody could trade and you could hedge, speculate, invest or trade, regardless of whether you were exporter, importer or neither. This promoted genuine price discovery with depth and liquidity appropriate to a money market. ‘Underlying’ is a FERA-era regulation, under which exporters/ importers have to prove that they have a ‘genuine’ trade transaction ‘underlying’ the hedging transaction they are undertaking with the banks. Otherwise, you were ‘speculating’, a bad word in Indira Gandhi’s time. Those days, foreign exchange was ‘precious’ and the buying of any foreign exchange was seen as a one-way bet against the Rupee. The regulation continues today, nobody knows why. Sometimes I think that the RBI very smartly uses this (regulation) as a tool to push corporates to trade on the currency exchanges, rather than deal bilaterally with the banks. Eventually, when enough corporates are forced onto the exchanges, the banks will follow, deepening the market. Meanwhile, regulations about ‘underlying’ are tightened, forcing mid-corporates out of the bank (trading) market. Needless to say, there is no question of any exotic derivatives being traded any more. Meanwhile, SEBI and the exchanges did a good job, pushing liquidity and promoting currency trading with good risk management practices and low impact costs. However, SEBI carried into this new product, its equity trading mindset and continues to regulate the currency markets as if it is still regulating an equity-like instrument. For example, it continues with ‘market concentration’ limits in currency markets, as if it was possible to ‘corner’ all the currency in the country. Believe it or not, the market concentration limit on a major currency like the Euro and the Yen is about € 5 mn, and ¥ 2 mn respectively. As background, it is understandable for SEBI to be obsessed by ‘market concentration’. Its very existence was triggered by the Harshad Mehta scam, which was all about cornering shares of companies (sometimes in collusion with the promoters of those companies) with money siphoned out from Banks through the securities trading market. Both segments of these (exchange-traded) markets ended up under SEBI regulation and led to the development of electronic exchanges. Then came the Ketan Parekh scam, which was almost exclusively about the ‘KP10’companies. This was nothing but cartelization, in collusion with company promoters. Thereafter, SEBI has been dealing with cartelization and market rigging, either through P-notes masquerading as ‘FII’ investment or through ‘persons acting in concert’ in high- promoter- stake companies. So it is understandable if it carries a paranoid mindset about ‘market concentration’ into its regulation of currency markets. However, the key underlying premise in ‘market concentration’ is a limitation on the ability to create supply. In some cases, companies were accused of putting out duplicate shares into a very ‘hot’ market, in effect short-selling their own stock with fake currency. But in currency markets, this pernicious activity is done by the regulator itself (and goes by the respectable name of Deficit Financing). So how can a poor trader ever be able to ‘corner’ a currency? In India, as in most countries of the world, the Central Bank routinely intervenes in Fx markets, creating money supply at one extreme end of the market. That takes the effect of ‘reducing volatility’ and is seen as honourable activity; but isn’t that what jobbers do? By the simple expedient of telling a PSU bank to monitor the exchange-traded markets, the Govt can ensure that price differences between the Bank market and the exchanges do not exceed a certain maximum. In any case, some banks are already doing that through their Prop Trading desks. In any case, can they (RBI and SEBI) see how they are working at cross purposes, simply because they have different objectives and hence, different mindsets. RBI, very justifiably, is clear that SMEs (and later maybe big corporates) must operate on the currency exchanges. Hence, it is gently but firmly pushing smaller corporates out of the Bank markets. It will probably now ask the Banks to shift their Prop Trading volumes onto the currency markets; I have not understood why it has not done so (maybe because enhancing liquidity in currency markets is not its objective). Finally, when there is enough depth and liquidity (currency markets’ turnover has already reached $7 bn, out of a total of about $50-60 bn, i.e. about 10%), it will close down the bilateral Bank/ OTC market. This has had the ‘unintended consequence’ of bringing in day traders from the Equity/ Commodity markets, who like the huge liquidity and low volatility of the currency markets, as compared to the equity markets. They particularly like the periodic RBI intervention, which cools down one-way movements and gives them an exit if they get something seriously wrong. When a currency trader hits her stop loss, she can at least find an exit. So HNIs and jobbers have started to populate the market. But what does SEBI do? It puts on its Equity regulators’ hat, and sets ‘market concentration’ limits that ensure that big jobbers (and later, bigger corporates and the banks) DON’T enter the market. What is the objective of this? It achieves precisely the opposite of the regulators’ original objective. Can you see how one (regulator) works against the other?

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The Alligators In The Moat

When Perception Does Not Equal Performance Investing is a complex business, not in the elucidation of the rules, or even their implementation, but in outlining/ knowing/ anticipating and providing for the exceptions to the rules. New writing by philosophers like NassimTaleb spends considerable time in pointing out the “black swans” that we mostly do not look out for, and how they can derail the best strategies. Counter-intuitively, a strategy that constantly looks out for the Black Swan, even without much idea of what it looks like, will be more successful. But we are here to sit in judgement on Warren Buffet’s prescription to ‘buy a business with a moat’. In an earlier, simpler world, it made sense to pick up a ‘simple’ business that was ‘simple’ because it was doing something very right, and was expected to keep doing it for a very long time. The customer paid for any mistakes, and the business ‘chose’ to ‘keep it simple, stupid’ by looking away from a whole lot of initiatives that had the possibility of going wrong. The obvious examples of Warren’s principle are Coke and American Express, and we look at both these examples in light of new experience. Coke, for example, had a long stretch of high Free Cash Flows, which were duly reinvested to finance further high-profit growth, till the return (after compounding for a long time) on the original capital looked unbelievable. But that was in a steady, domestic-oriented growth market, that grew as part of the American consumption story. Today, even Coke’s business is vastly more complex with threats, both technological/ behavioural and international, peppered all over their business case. You can, of course, punt/ pray that good management will ride out any potholes in the Coke story, but it might be a better idea to watch carefully…which is why ‘buy and hold’ is not such a bright idea any more. Coke now faces threats in India that it could not have ever imagined, and its famous ‘moat’ is now full of holes, exposing many sleeping alligators. The same goes for Amex, which once had the admonition, “don’t leave home without it”……well, it would seem that new Asia, which is where the growth is, is certainly leaving their homes without it. And America, which is the market that gave Amex its famous moat, is leaving it at home now… In the same breath that Warren laid out this principle, another Warren-lookalike, Tweedy Browne, gave this investing principle a grainy structure by talking about a “Competitive Advantage Period” (CAP). This was later used by Copeland and Currim when they laid out their principles of DCF analysis, in which they talked about the “terminal value” of a business, with a facile assumption of steady, uninterrupted and perpetual growth at a certain rate. Today, look at Coke/ Amex and tell me what their ‘terminal value’ is. Both have faced blind alleys in emerging markets, lost market share in home markets and faced falling ROCE. The moats they built, which looked so impregnable in the American market dominated by a Baby Boomer generation, fell by the wayside before Chindia’s Generation Y. The examples I have used are across markets, US vs Emerging Asia. That is only because I have chosen Warren’s own companies and the moats HE bought. The same, however, is equally true across time, where (much more spectacularly) the Competitive Advantage Period turns out to be much shorter than anticipated. In 20 years, Hindustan Lever has gone from a company that could do no wrong, to a pedestrian company that is actually rated as ‘risky’ by traders, because of its periodic bursts of underperformance. Somebody who paid 60 times earnings for this company in 1990, would not have earned as much as even the Sensex. The point is not whether HLL was a good investment; but that the ‘moat’ that you paid for, turned out to have a lot of alligators (called Nirma, P & G, Ghadi). Anticipating and monitoring these ‘alligators’ would have got you much better entry (and exit) points as a trader, than the static buying of ‘moats’. You know, there is no substitute for hard work… To repeat, moats ‘leak’, they decay over time and they have a lot of alligators, who have to be negotiated. Sometimes, if you can anticipate a “David” alligator in time (like CavinKare, who took on Goliath HLL), it makes more sense to invest in the alligator than in the moat. Today’s world has a lot of discontinuous threats, and it makes sense to invest in discontinuity as a phenomenon. I would modify Warren Buffet’s rule a bit: in the Indian context, look for a moat, but don’t pay for it. Sounds difficult? And yet, in these same columns, I told you about Bharti when it was trading at 255-320; in hindsight, it turned out to be a huge bear-market outperformer, rising 20%+ in a market that fell by the same margin. Right now, Tata Steel, one of the lowest-cost producers of steel in the world, is available at 5-6 times earnings, or 1.2 times Book Value 1-year Fwd. This, with a bear market RONW of 22%. Using the same logic, this same stock has gone to Rs.1000+, then down to Rs.150, so you have obviously had both kinds of buyers, those who paid for the moat (and got an alligator called Corus, instead) and those who didn’t. DLF, if you can stomach real estate, has Lease Rental income worth nearly Rs.2000 cr for a Market Cap of Rs.30,000cr (i.e. 15 times its rental income, or 6%). That is like buying property; the rest of the Operating Business is free. With Rs.414 per share in the Land Bank, they only need 50% premium over the land value to generate enough cash to retire the entire debt, leaving behind the rental income as profit. How is that for a moat that you didn’t pay for? Why do you think it just won’t fall below Rs.210 (till you, my dear readers, start buying, so be warned!!!)? The world has got just too complex for a simplistic, “buy and hold” strategy that allows you, the investor, to go to sleep. Hardly any business is able to outperform the cost of capital over a sufficiently long enough period of time, to recover the ‘cost of the moat’ paid by a lazy investor. Like I pointed out, it is the sellers of the moats who make the money, not the users. So what works? That would take much more than this column, this is just a counter-view to remind you of what doesn’t work (anymore). If you get into one of the Infra stocks sitting on a good concession (like Noida Toll Bridge), or GMR and the moat does not take too long in coming up, you might do well. The right time to ask yourself this question, is shortly after a huge fragmentation of the industry (like in steel, power and infrastructure just now, and telecom a while back). At this point, look for those who are still generating enough Free Cash Flow to repay debt, and ride the debt reduction programme. This was the common thing between Bharti a year back, Tata Steel just now, and DLF, maybe 1 year from now…once you start to see the debt mountain come off, start buying and you will hopefully see yourself sitting on a moat you haven’t paid for. Remember, debt repayment is deflationary, i.e. it reduces incremental returns and sends the stock into a long, slow decline. Timing the bottom is difficult and nerve-wracking, but the rewards are for the long-term. But buying Brittania before the fragmentation of the biscuit market, HLL before P & G came around, or Raymond before the waves of apparel retailers came on, is like buying a moat while the drawbridge is down. Moats are what moats do, not what they look like……a good moat would be pumping cash through a downturn, paying down debt and funding growth in an unattractive business. The latter may be the last giveaway indicator of a real moat…! Disclaimer:The author has large positions in Futures Contracts of Tata Steel and DLF.

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A Factory Called The Euro

The Logic of Carry Trades Think of it as a factory, or an SBU. The advantage over a physical factory is that our investment can be retrieved with very short notice; hence short-term (Working Capital) funds can be used to fund such activities. This would be a factory without any labour costs, any strikes and lockouts, no big Accounts and Admn Departments, no big offices (or even physical factories). Yet it produces a return in the same way that a factory does. It is superior to a factory, because you can vary the amount invested based on your appetite. If you need money for a house, just reduce your positions; you don’t have to sell your ‘factory’. Most important, is the process of growth. Like any factory, you make money after you start to do things right, relative to the market. However, in case of a factory, most businesses hit the rough when they set out to grow, i.e. set up the next factory. Here, they face a set of completely new variables, new skills and a whole new set of risks altogether. Since a company does not get many opportunities to set up a factory, it does not have much mistake-proofing built into its Project Management processes. And this is where many companies make grievous mistakes, leading to either a broken leg or even a broken neck. In fact, this is why the Capex cycle is synonymous with a Business Cycle. So what if I offered you a ‘business’ that is ‘frictionless’, i.e. it has no costs, no people, no strikes/ lockouts, no transport/ logistics breakdowns. There is no ‘project’ phase, during which the business has to go through trial runs, absorb spikes in material wastage, or find new customers for its additional production (or suffer extra warehousing and inventory-carrying charges while it waits for Business Development to deliver orders). Growth is also frictionless, i.e. there is no cost, no dislocation and no faltering in the business during the scale-up. Here is what you do. Look for a low-interest currency. Usually, interest rates are low where the savings rate is high, like in the JPY. But once in a while, you get low Interest Rates with low savings, like is being done by the US and European Central Banks just now.  The Economic Argument: the Forward Curve is related to the Interest Rate differential between any 2 currencies, after adjusting for the expected direction in Interest Rates over the foreseeable future. ‘Carry traders’ move money from one currency to another, betting on the fact that they will get higher Interest rates in the currency bought. Often, the relative levels of Inflation in the 2 currencies also impacts the Forward Curve, provided real interest rates remain the same or move in a narrow range. When this is not true, the Forward Curve gets disproportionately steep. Since real interest rates are a function of country risk, they reflect risk premia. If real interest rates are high, and risk premia are also high, it follows that the Equity Risk premium will be higher, reflecting in low Market P-E. That makes the country a better investment bet in Equities. In case of the Euro, for example, interest rates are low, despite a low savings rate because of Central Bank intervention AND the fact that a sluggish domestic economy has little room for any credit growth. This makes it a candidate for a ‘carry trading’/ funding currency, i.e. borrow in Euro at 1.25%, lend in the Rupee at 8%. At the end of the year, sell the Rupees and when you go to buy the Euro, it should have not appreciated much. An appreciating Euro will hurt Greek and Portuguese exports, widening their Current Account Deficit, thus bringing the Euro back to square one. Certainly, the Euro looks unlikely to appreciate 6.75% per year, ad infinitum.  The Traders’ Argument: volatility and volumes are good, even as the high-low band remains relatively small, and the number of one-way movements has been limited. If you use a technique of “rupee cost averaging”, you would be selling at all levels and buying back at all levels. This strategy presupposes that the sum total of all candlesticks is many times (>20) the actual risk of loss (a.k.a. maximum possible loss, i.e Value at Risk, VaR). Hence, you stand to lose, say, Rs.100, but you recover say, about Rs.500 from all the systematic trading that you do. It all looks (and sounds) very complicated, and the really interested reader might want to read this a few times over. But at its root, it is an Insurance company operation, i.e. there is a premium flow receivable every time you write a policy. Even though a lot of people are involved in finding the customer/ insurer, capturing the Insurance premiaand servicing claims, that is NOT the reason an insurance co makes money. You can do away with all this, and still make as much (if not more) money than the Insurance co; it is called (buying and selling) reinsurance, which is nothing but trading of income streams with probabilistic claims attached to it. At the net level, you are buying a series of positive and negative outflows for an NPV. Assume that over a period of time, these positive and negative flows cancel each other out, leaving a ‘net return’ that meets the cost of capital. But the return is lumpy, i.e. there are periods of high profitability followed by periods of sharp losses. Cut to the rest of the real world. The same thing happens in all markets. In the cyclical sugar industry, the turnover may be more or less equally spread over 4 years, but the profits come 60% in 1 year, 30% in another year, 20% in a 3rd year, and the 4th year carries a loss. This causes a huge variation in a traders’ income stream, but if he can avoid the sharp price corrections that take place at the top of the cycle, he can make big returns over the rest of the cycle. If you can sell a low-interest rate currency close to the top of its movement, you have actually ‘bought’ the high-interest (and savings deficit) currency. In the case above, you borrow from Euro at 1.25% and ‘lend’ to India at 8%, getting a 6.25% currency differential in the process. This ‘carry’ is nothing but the Forward Curve, visible over a year. In the Indian currency markets, it is the ‘rollover premia’, which you get, against which you have to provide for a ‘claim’, i.e. the probability that the Euro will appreciate. Now, through the economic arguments articulated above, we know that there is little logic for the euro to appreciate, so the probability of claim for a long period of time is low. Oh yes, there will be short spikes, which will have to be funded, but since they reverse quickly, your carrying cost is low. Look back at 2002, and you will see the $:: Re at Rs.42. If someone had sold it then, and carried a short for the last 9 years, he would have earned about Rs.21 in ‘carry’, And the $ is back at more or less the same level; so the strategy does work over the very long-term. For any individual who is willing to work hard and understand all this, you can build your own Insurance co, which will be far more profitable than almost any company in India. You are able to build a Pension Plan that outperforms almost any scheme sold to you by these big institutions. If you are a company, you get to outperform your industry by a mile. According to one of the Berkshire Annual Reports, this (reinsurance) strategy is the real reason for their ‘negative cost of capital’, and contributes more to their cumulative outperformance than their long-term Investment Return of 23%. The reason for this is simple: a negative cost of capital allows you to theoretically take unlimited leverage. The more your leverage, the more you earn. And the leverage is self-liquidating. If your effective cost of capital is MINUS 4%, the returns from this leverage will automatically take your leverage to zero in about 10-15 years. Do the math, and you will shock yourself. Companies that believe that low leverage is an unmitigated virtue, have obviously not understood this. That the Master of Capital Returns (Warren Buffet) is actually a fine practitioner of the art of leverage…even as he extolls the virtues of low leverage to those who don’t understand ‘negative cost of capital’.

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Core Competence

The Case Against Diversification What is the first piece of ‘investment wisdom’ that the self-appointed experts teach you? Hold many eggs in many baskets, because you don’t know which egg (or which basket) is bad. The argument for making a portfolio out of everything is repeated so often that its echo is often confused as the prevailing wisdom. Yet, when we talk about real businesses, we now make the exact opposite argument, i.e. focus on your Core Competence. The underlying assumption is that for a business to be competitive, it must have scale, intelligence/ knowledge/ data (about costs and revenues) and enough perspective/ wisdom/ philosophy/ know-why in all its business processes, to ensure that it outperforms competition. There are few activities that require perspective, as much as Investing. If markets are a mechanism for the “transfer of wealth from the foolish (many) to the intelligent (few)”, then the meaning of these words has to be carefully spelt out. Investing, then, is at least as much about having intelligence, as it is about having any money (to invest) in the first place. Thereafter, the principle of compounding tells us that Intelligence/ perspective plays a disproportionate role in deciding who wins the investment sweepstakes. Warren Buffet tells you to “buy a part of the business, and thereafter, to own your shares like you own a business”. He dwells on these aspects at length, and then goes on to tell you that “the best time to sell a good investment is never”. Indirectly, he is also bringing out the principles of Core Competence. For example, blind diversification for its own sake, is just that….blind!!! If you don’t know what you are doing, you are more likely to step into a puddle if you walk on many roads. As any blind person will tell you, the best way to ‘see’ where you are going, is to get a sense of a place by doing repeated passes down the same road. Jobbers often look like day traders, and have unfairly been given a bad name, all of them being painted with the same tarred brush. Some of the best jobbers will stick to the same stock for a lifetime, actually adhering to Warren Buffet’s advice of never actually leaving a stock, even as they buy and sell stock many times during a day. Not only do they add liquidity to the stock, they have local insights about the price discovery prevailing in a stock, its different ‘moods’ and its penchant for surprise, that outsiders will never have. This is perspective, something the stereotypical day trader does not have. Investors get paid to identify trends; they make money when they (correctly) anticipate a trend. Markets are a discounting mechanism, and the winners are those who forecast accurately, and then put their money behind a hypothesis. If any of these 3 are missing (i.e. the forecast, the money or the hypothesis), you don’t make money. The hangers-on, i.e. the pundits, sit on the sidelines and pass comment on the players. They are about as right as any cricket fan, about whether Sachin will carry India to victory or not. And their winning odds are similar. So ‘diversify’; they say, but against what? If you don’t articulate the risks you are facing, what are you diversifying against? The gullible investor is actually buying ‘Hope’ and as we all know, “Hope is not a strategy”. The cost of buying Hope is the actually the cost of buying randomness, and variability and unpredictability in investment returns. And most important, if you don’t know what you did right, then you have no hope of ever being able to repeat it. The pundits will tell you that your winners will make up for your losers, and that is the purpose of diversification. But if you don’t know (and don’t learn) how to tell one from the other, you have to live with the general belief that most stocks go up in the long run, often articulated as “market returns”. This, as we know, from recent experience, is not true over long stretches of time, and (you know from personal experience) is not the experience of most retail investors. However, this opinion (that markets go up in the long run) is prone to take widespread root in a late bull market, and shortly thereafter, is seen to be in the breach. Ironically, poor timing kills the people who claim to ignore market timing. Over the last 5 months, you could have been bought low Beta stocks (like Bharti, Power Grid Corpn), sold high Beta stocks (like Real Estate, Banks), bought the Dollar (against the Rupee) and sold the Euro (against the Rupee), bought Silver and sold Gold. Most of the positions would have worked out; to the uninitiated, this would look like diversification, but it is actually the same Investment Hypothesis, the same forecast. It may have been articulated over different instruments, but the underlying economic logic is unified. The same way, in 2007-08, you could have bought a low Beta stock like Hero Honda, sold a high Beta stock like DLF, bought the Dollar (against the Rupee), sold the Dollar (against JPY), bought Gold and sold the broad market. If you diversify blindly, you might get some legs right by accident, but you would be most likely to get enough legs wrong, to ensure that you destroy value. With the right economic arguments, you may choose to articulate it with one instrument or 10, that in itself is irrelevant. If your method of building your Investment Hypothesis is flawed, you have no hope….rather like the novice skydiver who took along 3 parachutes instead of one, but forgot to learn how to open them. Without the underlying knowledge, the ‘diversification’ is bound to lead to disaster. How about telling the novice to eschew skydiving till he learns enough about it? Novices should not be investing, they should be saving, generating capital, and if they MUST diversify, they can always buy 2-year Bank Fixed Deposits along with a 1-year Bank Fixed Deposit. If you know how to articulate an Investment Hypothesis, diversification is actually “di-worse-ification”, i.e. it means that you are investing in the probability that you are wrong. The way to manage that is through hard work and better diligence, not through diversification. If it turns out that you did a good job, you will actually reduce your Investment Returns, not your Risk. It is when you don’t know which way the trend is going (i.e. you don’t know Investing), that you say it through ‘diversification’…….I don’t know, and I am just hoping!!! Which brings me to the idea of ‘buy and hold’, another canard floating around the Investment markets. When we buy a stock, we are actually buying a business, whose returns over the long-term are linked to the fortunes of the business. Now, Business Risk is complex, has many aspects and there are many of them. Even the people running the business don’t have a full grip on all the risks in that business, and cannot tell you, for example, how much they will make (and why) in, say, 5 years. Why then, would ‘buy and hold’ be such a good idea? Just because you don’t know any better, and the pundits you trust don’t know either? How about trying to figure out the volatility (of price discovery) in a stock? It is difficult and complex, perhaps, but it saves you the effort of trying to understand the long term prospects of the sector, for example. It is much easier to buy a telecom stock when everybody is decided that “Telecom is an underperformer”, and then try to figure out the patterns in the stock, i.e. buy the stock when the rollover cost is negative and sell it when the rollover cost crosses 1% per month. Try figuring out the rest of the business….which way will 3G go, what effect will Cloud Computing have on Telecom, which African country is going up in flames, who is the new Minister in Telecom, what new social network is emerging among kids (and is it a threat to, or opportunity for, Telecom), and which new industry is going to come out of nowhere to suddenly replace existing technologies in Telecom? To those who say, ‘just buy a mediocre management in a great business, rather than good management in bad business’, make sure that you define ‘good business’ well. Is soft drinks a great business, and is Coke a great co? And if it is (a great company), is it also a great stock? Depends on when you catch it. Market timers might choose to look for an irrational seller, who gives away great value because of a weaker moment. Those who choose to ignore timing, are saying that the company’s business performance will be adequate to create value, i.e. the greatness of the business is a replacement for the lack of skill on the part of the investor. Because the company works hard, you (the investor) don’t have to…!!!

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An Accountant’s Budget

The Books Tally, But Little Else Does For a columnist who focuses more on philosophy than on analysis, this is an unusual column. The media seems not to have noticed the Govt’s accounting legerdemain, embedded in the Budget. It is a ‘paralysed’ Budget, with no major change in direction, although there are some pious platitudes in the fine print. And that is the saving grace, because in pursuance of those objectives, the Govt can kick off some major reforms during the course of the year, whenever it gets terrified enough to do so. Whether it will or not, has nothing to do with the thought process invested in the Budget (which seems to have been minimal), but will, as always, be a reaction to subsequent events (maybe the State elections coming up later this year). Figs in Rs. Cr. FY11 Budget Estimates FY11 Revised Estimates Delta % FY12 Budget Estimates Growth % Corporate Tax 301,300 296,400 (1.6%) 360,000 21.5% Income Tax 120,600 149,100 23.6% 172,000 15.4% Service Tax 68,000 69,400 2.1% 82,000 18.2% Customs 115,000 131,800 14.6% 151,700 15.1% Excise Duty 132,000 137,800 4.4% 164,100 19.1% Others Taxes 9800 2500 (74.7%) 2600 5.7% Gross Tax 746,700 786,900 5.4% 932,400 18.5% Source: Budget Papers Let us look at the illogic in the accounting numbers. GDP growth rate is projected at 9%, a slight improvement over last year. As the accountants say, “as per last”…! I can’t quarrel with that number yet, because you have to start somewhere. Inflation seems to be assumed at 5%, because the growth in nominal GDP is taken at 14% (the difference can only be Inflation). So tax revenue growth is assumed to be 18.5%, assuming a small uptick in tax compliance, I suppose. How did we do last year? On a nominal GDP growth of ~20.3% (8.3% real and 12% Inflation), tax revenues grew 25.9%. To assume that tax revenue growth will outstrip nominal GDP growth is only fair if you know the composition of Inflation. For example, last years’ tax revenue growth includes Customs Duty growth of 58.2% (in a year when the Current Account Deficit went to 4.1%). Is a repeat performance likely? The Inflation last year came from food prices, and agriculture does not contribute anything to taxes, so we cannot assume that high Inflation (especially if it comes from Food Inflation) leads to higher tax revenue growth. This year, the Budget Papers seem to have the facile assumption that Inflation will print in at 5%, no idea how. Implicitly, a fantastic monsoon is assumed, with somehow, low energy prices followed up with low commodity inflation. Given the background of erratic weather patterns, an inflamed Middle East and a resurgent US, I don’t see how global inflation will suddenly cool down to achieve anything close to such a number. And if Customs Duty growth does not help, how will you achieve such a steep tax revenue growth? Just because people will be nice to you….?! Remember: non-tax revenues like Telecom Licence Fees, which pushed revenues 89% last year, are expected to drop 43%, despite targets of Rs.16,000cr from FM Licences and Telecom Fees. I don’t think anybody is expecting a bonanza this year, unless some stiff fee is levied on the scam-tainted Telecom cos. The Tax:: GDP ratio is assumed at 10.4%, slightly below the peak rate achieved, i.e. 11.9% in 2007-08. That was a boom year for corporate profitability. And what is the market outlook for corporate profitability this year, if the Sensex is hitting YTD lows a day ahead of the Budget? It all depends on the composition of Inflation; if it is made up of a sudden increase in pricing power for manufacturers, then so be it. But if Inflation comes from high energy and even higher food prices, I don’t see the Tax :: GDP ratio going up. Quite the reverse: if Inflation starts to hurt, there will be a drop in tax compliance. So one of these things is going to fail you: either the GDP growth rate, or Inflation or tax revenue growth. The net result: the Fiscal deficit will not come in at 4.6%, unless you count the capital receipts coming from PSU divestment (Rs.40,000cr). This number has always failed us, and given the prevailing market sentiment, I don’t see how it is going to be achieved. Any shortfall will only add to the Fiscal Deficit. Let us now take a look at the expenditure side. This is where the Budget assumptions lose further credibility. Last year, Inflation ran at 10+%, and expenditure increased at 18.7%. This year, Inflation, by the Govt’s own projections is expected at an optimistic 5%, and the Govt is projecting expenditure growth of only 3.4%. With Plan expenditure still growing at 11.8%, the Govt actually expects non-Plan expenditure to contract by 0.7%, mainly because of lower provisioning for subsidies. Figs in Rs. Cr. Major Subsidies FY11 Budget Estimates FY11 Revised Estimates Delta % FY12 Budget Estimates Growth % Food 55,600 60,600 9.0% 60,600 0.0% Fertilisers 50,000 55,000 10.0% 50,000 (9.1%) Petroleum 3100 38,400 1135.1% 23,600 (38.4%) Interest Subsidies 4400 5200 18.3% 6900 31.5% Other Subsidies 3100 5000 58.2% 2500 (49.9%) Total Subsidies 116,200 164,200 41.2% 143,600 (12.5%) Source: Budget Papers Now make of this, what you will. In a year when the Food Security Bill is to be passed, Food Subsidiesare actually going to be constant. So obviously, you should not be surprised when Fertiliser Subsidy actually drops 9.1%, or Other Subsidies, which grew 58.2% last year, actually drop a whopping 49.9%. And either some very big policy change is round the corner in Petroleum, or this is plain obfuscation, because the bulk of the expenditure drop comes from this assumption. If you are going to acquire 65MT of foodgrains during the year, it will raise Food Subsidies by at least Rs.20,000cr; that alone will put you back at last years’ level. And if the oil gods are not kind to India (and I see no reason for them to be otherwise), I don’t see why the Fiscal Deficit will not come in higher. Which makes Inflation targeting, the main theme of the Budget, the first casualty. By no stretch of the imagination is this a path-breaking Budget that even sets a direction towards reforms, unless you believe the stuff about Petroleum Subsidies. If the Subsidy is actually withdrawn, oil prices at the pump will rise dramatically, and that itself will affect Inflation. How can you then assume such low Inflation? So what do you make of the other long-term promises, like Manufacturing to go to 25% of GDP. It seems like just a wish statement, with little substance or strategy embedded in the Budget. I had much hope that something would be done for investment in agriculture, other than sops. In particular, the nexus between clean energy, water management and agriculture would be recognised and we would get some hint of a Big Bang reform in that area, either a skeletal framework for the entry of corporates, or some new regulations to liberalise long-term land leases. There are some unimaginative sops to Clean Energy, LED Lighting and Solar, but no clear strategy emerges in this critical area. Quite simply, a Budget going nowhere, unless the Govt has some positive surprises in store for us later in the year. This Prime Minister has done it before, and I can’t seem to give up hoping. In particular, if the expenditure control is contained because of fundamental and structural reforms in an election year, we might just see a counter-intuitive movement of opinion from a scam-tainted Govt to a governance-focused, reform-oriented party and Govt. People WANT to believe. Mr. Singh has done it before and can do it again. Whether he will or not, only 2 people in this country will know….

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Hoist With Its Own Petard

An Update on the Telecom Sector In May, 2010, I did a columnhttp://www.valueresearchonline.com/story/h2_storyView.asp?str=14788, where I examined the recommendations of TRAI, and showed my readers how, it was impossible to achieve a fragmentation of the industry without resorting to unfair means. My column predated the breakout of the 2G Scam, which has hogged headlines for the last few months. It might be useful to read that article, to understand how the industry will evolve now. The TRAI Recommendations: it is now clear that they will be watered down, one by one. In May, 2010, TRAI had suggested that telcos pay market rates (based on 3G auction prices) for 2G spectrum at the time of licence renewal. At these prices, the licence renewal would have cost the big telcos Rs.20,000cr each; the new proposals floated by TRAI have already brought the bill down to half that amount. While this itself is a relief, it remains unfair and the telcos will protest it. The unfairness comes from the assumption that a price discovered in times of artificial scarcity (and post the 2G Scam, we know why), should be used to benchmark licence renewal fees and spectrum allocation in an environment that is now far easier. While the proposal for making spectrum tradeable is progressive, what they will find, after implementing the guideline, is that prices of spectrum will drop steeply, because on the selling side will be the numerous scam-tainted cos who have no customers, and on the buy side, is a set of very limited buyers with very limited purchasing power. The artificial scarcity of spectrum will have gone, and I won’t be surprised if prices even collapse. Remember, 3G spectral efficiency is 2.7X time 2G, so the spectrum needed for the same traffic will have dropped substantially. Already, one co seems to have realized that, because they have approached the Supreme Court with an offer to return the spectrum and the licences, if they can get back the Licence Fee they paid to the DoT. And the deafening silence of the DoT on this request, seems to indicate that they know this to be true. The proposal to cap spectrum seems to have been given a quiet burial. In any case, it would not have stood up to scrutiny in the courts, and is so blatantly seen as punishing the successful telcos, that it would have created a public backlash. As an aside, for those who are interested, it brings out the unfairness of the scam for the leading telcos. You fight a battle for the brand/customer and win fairly, based on superior customer service/ experience, etc. Then an artificial scarcity of your most important raw material (spectrum) is created, and that now-rare commodity is siphoned away to johnny-come-latelys, who are seeking a free ride into an industry that has already been opened up, and where latent customer demand is now unhooked. Shockingly, they discover that it takes much more than free spectrum to win the customer, and after entry, they find that the rest of the battle for the customer’s pocket is still way beyond their means. They bleed white, and chastened, they are happy to be given euthanasia. Really like the burglar, who picks the lock of the tijori/ Treasury, only to find that he has mistakenly stumbled into a snake pit… That leaves MNP, which came with a bang and went out with a whimper. The limited data coming from MNP is showing that the big telcos have superior networks, so there is no ‘hoarding’ of spectrum. The same coswhich are behind on rollout obligations, are anyway scam-tainted, have hoarded unnecessary spectrum and have kicked off the irrational pricing, are the biggest losers in MNP. The verification of subscriber bases has shown up these cos to be fudging numbers to corner spectrum again. If all this spectrum is taken over and released to those networks that have the subscribers, network quality will increase dramatically. That leaves only one more renegade proposal, which could hit this beleaguered industry. TRAI wants that every MHz above 6.2 MHz be priced at Rs.1769.75 cr. This is to put the bigger telcos at a cost disadvantage, simply because they have more customers and therefore, need more spectrum. This too, does not clear the test of fairness, and may not see the light of day. The Investment Hypothesis:After the collapse of Nazism, Germany has been defensive about its history for the last 60 years. That is human nature; the most diehard savers just now are no longer in Japan, but in the US and maybe, Greece. The cleanest, most careful policy that you will now see from this Govt, will be in the Telecom sector, trust me! If this is obvious to us, then we can move onto my next point. We will no longer see the hoarding of spectrum any more. Further, we will not see any policy from the Govt that pushes up the cost base of the entire industry, reducing it to a backdoor tax collection machine for the Govt. There will be some respect for the impregnably low tariffs achieved by this industry, and the fact that such a cost base fuels many other service and consumption industries. Now let us look at the competitive scenario. To repeat, MNP has come and gone, and the results have been predictable. The 3G launches have not seen aggressive behavior from anyone, nor are there any big expectations. Most big players will quietly use 3G to improve spectral efficiency, and absorb the licence costs within their existing profit streams. This is particularly true of Bharti, which will lead the price discounting, as it pays down the 3G and Zain debt. It is the only co that has been paying down debt, about $0.5 bn since my last update. The PSU telcos have too many problems of their own, with branding and service quality. They were never qualified for leadership, anyway. The battle really was between Bharti, Vodafone, Reliance and Idea. Reliance is now known to be facing Balance Sheet stress and is caught in a debt trap, operating above the acceptable Debt: EBIDTA ratio with big chunks of debt maturing by end of FY2012. It will have to place equity, which looks difficult, given that it has FCCBs which are not going to be converted. Even if it places Equity, it will be hugely dilutive, making it an unattractive investment even at these valuations. Bharti Again:Quietly, its EBIDTA run rate has gone back to its pre-Zain days. While the stock has stayed virtually at the same place, it has not suffered the washout that has plagued the broader market in the last 2 months. That is because there was very little expectation built into the price, given the overhang of the Zain valuations, the question marks over the turnaround + revenue/ profit growth at Zain, and the overhang of regulatory imposts embedded in the TRAI proposals. One by one, these concerns have been dealt with. Zain is back to revenue growth, the tariff wars have abated, EBIDTA is back at Rs.20,000 cr per annum (this time on a revenue base of ~Rs.60,000 cr), and the co’s Free Cashflows of Rs.10,000 cr are being used to pay down debt. While Reliance has Debt: Revenue = 1.5, with lower margins and much lesser Free Cashflow (Debt: FCF= 15 years), Bharti’s debt is at 1 time Revenue, and 5 years’ Free Cashflow. In about 2 years, the debt would have got very comfortable. At 6 times EBIDTA, the stock is among the cheapest Telecom stocks in the world, with an attractive positioning in the best growth markets of the world. It is perhaps the most competitive telco in the world, with its ‘minutes factory’ model, and is available at the valuations of a cyclical sugar/ textile co, which typically have Free Cashflow :: EBIDTA = 20% against 50-60% in case of Telecom. Using Warren Buffet’s principle, Bharti, therefore, is valued at about 60% of its Fair Value over 3 years, i.e. a Margin of Safety of 40%. Believe it or not, it falls into Charlie Munger’s set: if you buy a stock with a sufficient Margin of Safety, the best time to sell it is …..never!!! Using the Rule of 72, at 20% growth rate, Free Cashflow is doubling every 3 years. Remember, most of the Capex is over, and now the improvements in Network quality, tower population, solar panels for towers, etc have to be funded. Can you now imagine RCom being able to fund all that? In the next 2 years, we will see this industry consolidate, either by the fading away of some major players (the PSU telcos are prime candidates), or by their restructuring/ merger with other firms. The Joker in the pack?MukeshAmbani’s Reliance Industries, which could consolidate the industry, given what it already has (BWA) and an opportunistic acquisition or two, maybe even RCom. With the end of the regulatory overhang and the New Telecom Policy, one can expect that the end of the uncertainty over the Telecom sector will act as a trigger for a re-rating. You may not have to wait for the fundamentals to play out; just a clearing of the horizon may be enough.

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Retiring a 61-year old (Republic)

Is It Time For An Obituary? Table of Economic Governance: Is India Really Shining? Country Rating Govt Objective Japan China US India Full Employment × √ × × Low Inflation √ × × × Fiscal Deficit × × × × Current A/c Deficit √ √ × × GDP Growth Rate Below Potential Overheating Below Potential Overheating Above is my own perception, not researched ‘fact’ about where we stand on economic governance vis-à-vis major nations of the world. Looking at this, one would think that we share the bottom of the Table with the US, without, of course, having seen their (prior) economic success. So we have the unique distinction of being indigent like the rich, without of course, being anywhere close to rich. Japan does better than expected, because its problems are not completely of its own making. Their demographic problem is not strictly because of Governance, and its record on Employment is not really so bad. China comes closest to the pass mark, but it has to pay the price of driving fast when (world) traffic is slowing down. Originally, I started writing this article 2 months back, to argue that I saw no reason to be excited about India, and no reason to justify the huge premium our markets were commanding, regardless of underlying fundamentals. The markets woke up finally, and here we are, down 15% already and looking down the chasm to see whether we have got halfway to the bottom. Civil Society is duty-bound to give 3 fundamental freedoms: 1. Political freedom 2. Social freedom 3. Economic freedom Most definitions of Governance would cover any, some or all of these. Where countries differ is in what gets covered, in what sequence and with what depth. All this, of course, provided Personal Freedoms (i.e. right to life, property, security, rule of law, etc) are taken for granted; since we are discussing the major nations (and not Idi Amin’s Uganda), I am ignoring this, the most fundamental of Freedoms. If we take a snapshot of Asia, including the Middle East, we will find different amounts of emphasis on the different Freedoms, in different countries. Starting with India: post-Independence, we started in the sequence laid out above, with much higher levels of Political Freedom than even Social Freedom (the caste system and untouchability were big crosses to bear). When it comes to Economic Freedom, of course, we are still far behind the rest of Asia. What we take for granted, is the enormous amount of political freedom available in a country that does not allow you to decide what to produce and where,but you can make secessionist speeches in the heart of Delhi and get away with it, provided you strike the right political chords. China has been exactly the reverse: high on economic freedom, even perhaps social freedom but almost nowhere on political freedom. Outside commentators who predict implosions, would do well to remember that the build-up of revolutionary emotions is a function of the ‘expectations gap’. In Asia, if economic freedom is available, political freedom is not sought very aggressively. Singapore, Korea, Japan, Malaysia are all examples of this; India is considered lower down the pecking order, mainly because its economic management has failed its people. There are, of course, the ‘failed States’ like Pakistan, Afghanistan and to a lesser extent, Burma & Cambodia, which have failed on all 3. These may be ripe for revolution; the Middle East has many such cases, Yemen being one. The elites that dominate the polity of such nations have misappropriated both economic and political power, creating tensions between the haves and the dispossessed. These tensions are surfacing now, and we can see the contagion spreading across those States that have similar Governance standards, i.e. Tunisia, Egypt, Morocco, Yemen and maybe Saudi Arabia. There have been some whispers about India facing similar threats of revolution, because of its ‘pathetic governance’. I worry a little more than the others, because I care more about the effects of global warming, its impact on the Indian monsoon, and the fact that our pathetic efforts at Water and Agriculture Management will be our ‘fatal flaw’. Otherwise, judged on the metrics outlined above, we only need to improve our economic management, which is squarely in our hands. The major factors in India, is income inequality/ redistribution and structural reforms, especially in food and basic infrastructure. History, especially European history, teaches us that the Church has to move out of the political sphere (i.e. separate religion from politics), and the State out of the social and economic spheres(“business is the job of Business”). In a very perverse manner, that may even be typically Indian, a scam (a.k.a. evidence of misgovernance) breaks out at the precise point in time when the State moves out of an economic sub-sector, Telecom being a prime example. Other scams round the corner are the PPPs in Infrastructure, or Energy, where space is being vacated for Solar, etc. I tried to argue in a previous column that the net economic effect of corruption is marginal. It had a violent effect on some of my readers; while I stand by what I said, let me now make a fine distinction: the net (economic) effect of misgovernance is NOT marginal. It is not my case that India is not misgoverned, quite the opposite. It is just that I want to judge India’s journey as part of a historical process: to dwell on how far India has come, rather than how far it has to go. Casteism and regionalism are much less the forces they used to be. And barring a few festering cases like Kashmir, secessionism has died down (remember Khalistan, Hyderabad, Jamnagar, Tamil Nadu, even Assam?) and the integration of Indian nationality is complete. So you be the judge. The crimes of Indian (mis)governance are neither few nor small, but they seem mostly clustered around its economics. Given the ferment that the (Indian) system has tolerated, is it likely that our peculiar elephantine pace will evolve a ‘jugaad’ which absorbs the inherent (political) pressures of managing this continent called India? Or will Global Warming, a failed monsoon, gargantuan mismanagement in water and agriculture infrastructure, food prices and maybe famine achieve what Pakistan (and Richard Nixon) could not? Remember, revolution is always and everywhere a political phenomenon. Its final expression has to be through the voxpopuli. It bursts out only when the voxpopuliis throttled. If the final enabling condition for revolution is not met, how likely is it?

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Playing Chicken

Why It is Dangerous to Play For Low Stakes ‘Chicken’, by the way, is a game similar to ‘blink’, where children try and outstare each other. The first one to blink is the loser. One of the versions of this game was seen in an Aamir Khan movie, where he rushes at an oncoming train, jumping out of the way at the last minute. The guy who travels the longer distance is the winner; the other guy, hopefully, is dead. Now think a little deeper about this. 2 guys want to settle a duel, one has to die and the winner gets the girl (old filmy line). You have to take risk, and the winner gets a reward….sounds familiar?! So you have to run fast, but at the same time, you have to know your limitations. The latter is perhaps more important than the former. Insurance cos, day traders and derivative writers know this equation too well. They also know that your Risk is finite but immeasurable (i.e. the train runs over you), while the return is infinite (depending on how much you want the girl) but measurable. Think deeply about the previous sentence I haven’t got it wrong….how can something be infinite but measurable? Answer: Once you have figured out the equation within a certain range of probabilities, you can play the game again and again, till all your friends/ rivals are dead and you have all the girls in the colony…. The Toofan Mail comes at a particular time, at a particular speed and traverses a particular piece of track near your home over a certain number of seconds. You can get a Probability Distribution Function (PDF) over a large number of observations. Now practice your running, but set your ‘distance achievement’ targets with a Margin of Safety. This means also making sure that you are making a statistical bet, i.e. instead of betting for one specific girl, you bet on all the girls in the colony. This is called Diversification. This magazine talks too much about it. Make sure you stay alive. You can’t do much with a girl, if you are already dead. The Margin of Safety has to be set, with a certain target probability that you will get the girl, usually 95% (GE calls it 2 Sigma). Too high a Margin of Safety and you get no girls; too low a Margin of Safety and you won’t know what to do with them. Don’t ever try and get ALL the girls; you will be dead anyway. Satisfice, don’t maximise…. Let me now make the game a little more complicated for you. Suppose you can buy ‘insurance’, i.e. in case there is a loss, somebody else pays up for you. In other words, every time you ‘die’, you can put somebody else’s life on the table, for the sacrifice. Somewhat in the spirit of Yudhisthira betting Draupadi. So every time you win a girl, you stake her life against the train, not yours. This assumes, of course, that lives, like money, are fungible. Now, after winning a few women, you would want to reduce the Margin of Safety, to increase the probability that you will win the next girl too. This is called Compounding. If the train hits you, just sacrifice one of your previously won women. Let’s make the game really complicated, now. Suppose, the train is invisible behind thick fog, and you are playing this game under zero visibility. You are no longer able to accurately predict the distance you can run without getting hit, nor the probability that you will get hit. This is called Fat Tails in Probability Distributions, better known as Black Swans, after Nassim Taleb showed that they are sudden, unseen and not ever anticipated. Hyman Minsky pointed out that they usually happen, just when you are looking exactly the other way. So the train will hit you just when you are smiling at your waving girlfriend (or waving at your smiling girlfriend, as the case may be), like in the cartoon movies. Now let’s get this game even closer to real life. Suppose there was a loudspeaker, constantly announcing the time that a train is expected; but what you notice, after losing a few lives, is that the trains come in late or early, and the loudspeaker-wallah has no clue when the train is really coming in. He is just a fool with a loud voice, a.k.a. Media/ Investment Advisors. By the way, Indian Railways also has announcers like that, but they are harmless, because you KNOW that they have no clue. Together with the fog, you realise, if you are still alive, that the blind are leading the blind. And that you are better off alone, because at least you have a life at stake, and hence, will be looking to get out of the way the moment you see the train. But the loudspeaker guy neither knows nor cares about who dies and who lives, as long as he gets paid. He is just gathering people around, and collects from the advertisers. But this is where the game gets easier. If your rivals are too busy listening to the loudspeaker-wallah, and can’t/won’t do their own thinking, you just have to wait till they all get splotched by the train, and then you can collect your girl. You may not even have to run. From here on, it becomes more a game of brain rather than brawn. Actually, it was always that, except that it never looked explicitly like it. These days, all this is available as a video game. All you need is a computer (sometimes not even that) and access to an NSE trading terminal. The only problem is: the girl is not for having. She is just here to sell Wealth Management Services on behalf of your broker. But if you know how to play such a complex, real-world game, why would you waste it on girls? You should go set up an Insurance co, and become GeneralRe or Berkshire Hathaway. Or better still, you get into derivative writing and become a Master of the Universe. You are then allowed to do “God’s Work” at Goldman Sachs. To get still better at the game, you bribe the train driver to slow down at your turn, and accelerate at your rivals’ turn. You pretend to run, let your rivals run ahead, then shoot them in the back…anyway the train will then destroy the evidence. You get the loudspeaker-wallah to whisper ‘insider stories’ to your rivals; he is anyway too foolish to know the difference between a scoop and a plant. And now for the real advice. It helps to be a cat. You not only run faster, you have 9 lives and you produce 9 kittens every time you get the girl. You run on padded feet, and you always fall on your feet….so you get ahead without anybody knowing how far you have got! If you get big enough, you grow into a tiger… think about it! Even Govts play chicken: The ongoing debate between Paul Krugman and the ‘austerian’ economists (led by Bill Bonner, for example) goes something like this:  Krugman says that the US should try and spend its way out of trouble, ignoring the size of its already gargantuan Budget deficit. Spending MORE borrowed money will keep everybody happy, creating much-needed jobs which will create additional income, taxes and ‘multiplier effect’ to get the economy back on its tracks; in a little while after that, tax revenues will turn up, the Govt will post a surplus and pay everybody off…and of course, all will be well!  Predictably, the ‘austerian’ economists take the high moral ground, but they also have some hard-hatted realists on their side. One of the important stakeholders in this whole Budget deficit debate, are the bond markets, who will panic if they see huge deficits that refuse to go away. That will be apocalyptical for global markets, resulting in a meltdown similar to US 2008 and Euro 2010. Use the allegory outlined above, to understand how the destiny of the world’s greatest country is linked to the dynamics of this simple game. Learn to play it, recognise when others are playing it, and keep at a respectful distance, when you see a fool playing ‘chicken’.

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