Order Vs Chaos

  When The Omelette Is  (Occasionally) Better Than The Egg

Some time back, I had this discussion with a gentleman who heads one of India’s premier Industry Associations in manufacturing, and is a frequent visitor to that most revered of rivals, China. He remarked that ‘they’ were clearly ahead of us, with a long-term Vision and Strategy to play to. The monolithic Chinese Govt could “make things happen”.

I have heard this often, and often thought about how this is a limited truth. Limited because it is true under specific circumstances, for a period and for a limited purpose.

Communism ‘failed’ because it believed that a monolithic ‘planning’ process was superior to the chaos and confusion that prevailed in ‘capitalist markets’. Over 70 years of experience, the world realized that in most cases, Capitalism was less wasteful than Communism, despite its apparent chaos and confusion.

Another thing the world discovered is that beyond a certain size, organizations (in this case, countries) failed because they became simply unmanageable through top-down fiat. A far better way to manage size was to break down this organization and get the component units to be controlled closer to the frontline. The sum of the parts would be more efficient than the whole…….that was the logic of the Ma Bell break-up, and maybe, Soviet Russia.

China’s “strategy” and its single-minded pursuit of “progress” can be seen in many places…geo-politics, population policy, technology, even the more recent pursuit of natural resources. Its progress always shows good-looking ‘order’, as opposed to India’s mostly “do-nothing” approach to progress. But this is not an unmitigated blessing…witness the impact of China’s one-child policy on their future geo-political position. There were lots of things that the “strategists” did not think of……the ageing of the middle generation, the future tax base, social security issues, even the future of the consumer products industry.

Compare this with India’s ‘population policy’. For the most part, its distinguishing feature has been simply that it is not there. Yet, there is a ‘trend’ that India has achieved…not superior to China, but nobody knows whether the long-term impact of this (non) policy is going to be ‘inferior’ either. The trend has grown in response to local developments, from Kerala to Bihar. Each state has seen a local “population trend” develop, some of which may contradict each other, but is individually logical. No China-style Govt “strategy” could have evolved this. 

In the same manner, India’s IT/ BPO service sector grew out of a dysfunctional educational system, that created competitive students by giving them loads of adversity to cut their teeth on. Anybody who made it through its “survival-of-the-fittest” filters, could make good under any first-past-the-post system. That is what gave our IITs their cutting edge. In other words, chaos created excellence.

Take the current search for oil. As usual, China’s determined Govt is doing a far better job of tying up the world’s oil reserves for itself. India is behind, at least as far as Govt performance is concerned. But who is to say that Indian entrepreneurship will not turn this disadvantage around…India, faced with an oil crunch, may actually do more work on alternate energy, converting to more sustainable energy. This would be in tune with the way the world is headed. As technology and usage move towards cleaner, sustainable fuels, China may find itself bogged down with “legacy” assets and a vested interest in hydrocarbon usage, which could prevent the modernization of its transportation systems and its industrial fuel usage. India may find itself forced to adopt newer technologies faster, which gives it a longer-term advantage.

Consider the telecom story. Poor performance of the public sector Telcos, created low tele-density, leaving large “empty spaces” for the Mobile cos to capture. This gave them large potential markets, a huge unmet need……which led to immediate scale economies. Middle India converted to Mobile telephony at blinding speed, faster than the West. The earlier chaotic Fixed Line system gave way to (arguably) the best, most competitive, most sophisticated Mobile telephony network in the world. Who knows, the current chaos over GSM vs CDMA might lead to something good, in ways that we cannot yet imagine?

It is a heretical thought, but I wonder whether Indian cos would be a little inferior if they were born in, say, the US. Somebody once told me that the best doctors in India could be found in Govt hospitals, because they had seen the largest number of cases (and hence, honed their diagnostic skills), worked with no equipment (and hence, diagnosed ailments without medical aids) and made the highest number of ‘mistakes’ (ie, professional negligence)………foreign doctors did not get such “exposure” and were left behind in the skills and ability area.

It is difficult to extend this logic to manufacturing, but I shall try. At the autocomp co where I work, I notice that our customers would rather deal with us than with our Chinese competitors…we have to actually turn away enquiries because we cannot scale up any more. That is because the “mandated” manufacturing sector in China, is less sensitive to resource-efficiency than us Indians. This applies not just to capital, but to materials as well…..it could be the basis for global OE s to build their supply chains here.

In those manufacturing sectors where China has “legacy” assets, it is most ‘competitive’ because there is no cost to the capital employed. But where new assets have to be funded, it comes mostly from its famed FDI-machine. Outside these 2 quadrants, it would appear that the Chinese lose out, ie, if they have to build up businesses from the ground up, without the support of either zero-cost capital or foreign technology/management, they are not as competitive.

This is where India scores. The adversity embedded in our economy, hones the skills of our entrepreneurs, giving us the famous Indian “jugaad”. We learn to use all resources efficiently, giving us a clear head-start in those industries where new investments need to be made, and  FDI is not coming in, for various reasons.

A ‘dysfunctional’ political system imposes costs on its economy. This is like an excessive tax, which is an economic term for the “adversity makes you strong” argument that I have given above. This tax is nothing but a pound of flesh taken away from the other factors of production, which must learn to make do with less. Living with this Shylock-effect actually gives the Indian entrepreneur a motive to increase the efficiency (in other words, get more from less) of resources.

Don’t get me wrong. I am not apologizing for the inefficiency of the Indian Govt. Nor am I suggesting that this is the right way to approach Governance. I am merely arguing that all is not right with molly-coddling. Chinese Govt support to its industry may actually be weakening its industrial culture, rendering them unable to stand on their own feet.

On the other hand, Indian Govt “dis-support’ might actually be making Indian industry stronger. Too much of either (support or dis-support) will be counter-productive, for sure. But a little bit of adversity, may, in a perverse sort of way, be good for us. 

A good example of this is the sugar industry in France. With massive subsidies, French sugar is still uncompetitive. India, with some of the lowest sugar prices in the world, also has one of the lowest conversion costs in the world. The huge adversity inherent in the sugar industry in India, has actually resulted in producing some 5 players with the best operating and financial efficiencies in the world. 

To summarise, I am merely arguing that we stop saying that foreign support for their industry is an unmitigated advantage they enjoy. Or that the fact that we (Indians) have inferior governance, is a disadvantage that we labour upon. To use a sporting allegory, if every Govt had to feed its team to compete in the Olympics, it is very likely that over-indulgent Govts (like China) are over-feeding their teams. They are more likely to produce “fatsos”. A negligent Govt like ours will likely produce leaner, meaner sportsmen.

I must acknowledge here that the above allegory destroys my case. In the real (sports) world, over-indulgent China produces the best, leanest sportsmen in the world; while negligent India just produces “fatso” cricketers who are seen more in Pepsi ads than on the crease.  

Indian Business is going to be different. I live in hope, don’t you?!

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A Market Mechanism For “Taxes”

While doing some research on the Special Economic Zone (SEZ) policy, I came upon this observation. The basic irritant in the face-off between India and China is the “subsidy” that the Chinese system gives to its industries……low-cost or free capital, that either come from legacy “Communist” assets, the State-Owned Enterprises (SOEs). Or the explicit subsidies that China gives to its industry, which are discretionary (ie, by administrative whim) and non-transparent. India finds it impossible to build a rule-based system that can take on such an adversary, who apparently follows no rules.

Take the SEZ policy. China created these “bubbles” with taxpayer funds, that are a world of their own. The entire environment in these zones is built to please the incoming investor; existing reality can be completely wished away. India finds it difficult to build these “bubbles”, and its SEZs are bogged down by the surroundings they are situated in. SEZs in India have not taken off because politicians find it difficult to pander to the industrial investor, who may have the money, but does not have any votes……….in this trade-off, the vote-bankwallah always wins. China has no such problem.

So India handed over the SEZ to private promoters. It seemed like a good idea at first, to at least get the Govt out of SEZ infrastructure. Hopefully now, promises would be kept, infrastructure would actually work, and investors would be pleased.

However, 2 problems got in the way. One, private investments seek self-sustenance, ie, they must deliver a Return on Investment. Two, the feeder units to the SEZs (water, power and other services) had no incentive to deliver better quality at low cost, because they got no concessions if they were located outside. This led to a spate of broken promises, as a result of which many SEZs got themselves a bad name.

The Chinese again have no problem. Not only was the SEZ constructed with Govt money (which sought no return), but so also was the support infrastructure………the whole shinbang was a zero-cost support to the incoming investor.

Now here is my very hazy draft structure to take on the Chinese threat.

Suppose India’s SEZ companies were given a special status, say, as “infrastructure cos”. These companies would be entitled to issue a special category of long-term (5,10,15, 20-year) bonds, whose coupon would be market-determined. Capital adequacy and repayment risk would be monitored by a market mechanism (say, the Rating Agencies).

The kicker: these bonds would qualify for Section 88-type tax (deduction) benefit. Simultaneously, the PPF rate is dropped to the GOI Bonds level. The immediate consequence: PPF money would flow into these cos.

Now, to sweeten this further. The Govt issues an edict saying no-questions-asked on the source of the subscriptions, a kind of backdoor Voluntary Disclosure Scheme (VDIS). Maybe 20% of the black money in the country would flow into these bonds (provided the Govt’s promise about continuity of such a policy is credible).

Look at what it will achieve. Effectively, it disintermediates the Govt out of the “administer tax-allocate funds-invest in assets-build infrastructure” loop, which is very inefficient right now. Less than 10% of the taxes we pay, ends up building any kind of assets, leave alone world-class infrastructure of the kind that will keep international investors happy. All infrastructure funding is coming from the fiscal deficit, which would reduce to the extent that these SEZ cos take the burden (of infrastructure funding) off the Govt.

These bonds would get traded on the secondary market, and prices would correct to the point where the yield on the bonds would be below market prices of mainstream bonds (the yield curve would get very flat, even inverted, because investors would want to delay receipt of principal). This would encourage issue of more long-term bonds, with commensurate back-to-back investment.

The “subsidy” provided by long-term investors would be the “tax rate”, which would be market-determined. Since most of this money is anyway outside the tax net, the existing tax base is not cannibalized. I believe the implicit tax rate would settle around 15-20%. Given the much lower cost of collection, lesser leakages, this “tax” system would be much more “asset-efficient”, ie, much more assets would be built per unit of “tax”. 

And if you add the tax collections from the incremental investments into the SEZ, the tax-efficiency of this policy would be even higher. The key assumption here is that under the current tax regime, whoever can evade taxes, is doing so. This market-based structure would harness much of that money.                

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Acceptable Risk: Is it Worth the Reward

Risk is often understood in markets in a very limited context. In fact, classical finance treats risk as synonymous with volatility. That is NOT because it is so, but simply because Volatility is statistically measurable and capable of being mathematically manipulated, while most other elements of risk are not.

In the risk-return trade-off, return is eminently measurable and managers have a good time in doing so. In any historical analysis, therefore, the return is remembered and recorded for posterity, but the risk is forgotten. So a Fund Manager may have used very high-risk strategies (that are bound to fail disastrously in the long run), hoping that his wins will be remembered (as they often are), but the risk he took will be forgotten. I have seen this spectacularly in multinational finance companies, where managers have taken break-neck risks, front-ending the returns, knowing that they would have moved on, by the time the chickens come home to roost (as they eventually will).

This flawed understanding of the nature of risk leads to peculiar, and repeated patterns of behaviour among investors. For example, whenever you hand over your money to somebody else, rest assured that his attitude to risk would be less conservative than yours. Especially in case of Institutional investors. Remember: everybody’s money is nobody’s money.

Investors, especially institutional investors in competitive markets, know that they are ALWAYS judged by the return they produce, NOT by the risk they took. That is why every bull market is ended by a scam or a bankruptcy brought upon by an institution taking excessive risk to produce ever-higher returns. It is an unwinnable race against expectations, which must inevitably come to grief. Rare is the Warren Buffet or George Soros, who returns investor funds because he refuses to stay in such a race.

Investors worry about losing money only when they have already lost it. That is when risk (or the possibility of losing money, which is its real definition) moves to the forefront of their “hierarchy of considerations”. Till such time, they are only focused on returns.

So what is an appropriate response to risk? Diversification is one, both at the level of the individual scrip and at the level of the asset class. This is where traders make their biggest mistake. Day-traders, for example, never have any Tier II capital, which is ever adequate to take care of Margin Calls in a crisis.

This ability (to be Last Man Standing) itself would be a differentiator for a day trader. After all, this more than any other business, is subject to the Rule of Last Man Standing. Returns in this business are always above-average, but only as long as the investor is getting them. During a market reversal, the key differentiator is to be able to stay in the market when everyone is exiting. This is why Buffet calls his (insurance) business a “Super Cat” business, ie, he is only a temporary trustee of the market’s wealth, holding it till the market chooses to take it back during a “super-catastrophe”. So the key, implies Buffet, is not the many winning trades he makes (in the re-insurance market), but his ability to survive the “Super Cat”. He could get a smaller return on his trades, and still have a very high return, provided he was able to reduce the probability of losing his shirt in the Super Cat. The problem in such businesses is that there are not enough “Super Cats” in one man’s lifetime, to get any real sense of how much (Tier II) capital is enough. 

Institutional investors must take on Tier II and Tier III capital on their books (and pay for it), reducing their returns. The low-tier capital must be parked in low-return avenues, while the major part of the earnings comes from the Tier I capital deployed in the high-risk avenues. Overall, on a weighted-capital basis, the return is not outstanding.

Individual investors (and corporates) have no such disability. By their very nature, they have potential access to capital (spare debt capacity, for example) which is not currently used in their mainline activities. This can serve as the Tier II capital.

A high-risk trading strategy could be outstandingly successful in such a scenario, delivering hundreds of per cent in returns on a small amount of Tier I capital invested in the business. The key, of course, is not to let the tail wag the horse, and invest ALL your capital into such a strategy. The ability to draw into your Tier II capital is the key to success, not the elements of the trading strategy itself. No business can fail if it has access to unlimited capital, in a manner of speaking.   

Properly understood and implemented, this kind of Treasury strategy has helped build very good companies among manufacturing companies. The key is honing the ability to access capital in doses that are way out of proportion to the operational needs of the company’s mainline business.

The actual asset-side investments may be in equities, bonds, commodities, forex, derivatives, even real estate. This apparent high-return asset actually derives its strength from the liability side.

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The Flawed Business of Focus

Missing the Opportunities in the Woods

A couple of months back, I was sitting with one of the biggest commodity industrialists of the country, when he remarked, “We are a very ‘focused’ group. We don’t get into businesses or activities we don’t know”. My response then came as a bit of a shock to him: “Then the problem is with you (or your knowledge), not with the business.” The context was a discussion of the full range of Treasury activities that a company should invest in.

The background to the conversation holds the key to the point of this piece. The company was just another (commodity) player, with good financial (management) skills, conservative management and excellent Project Management skills. In the recent commodity boom across a broad spectrum of products this company has been one of the most “fortunate”. It has grown by leaps and bounds, not only in its domestic operations, but also in exports (to China, but naturally) and in its international operations (through some acquisitions in third countries).

This has triggered off a growth spree. What used to be a single-plant operation with a simple processing operation (buy inputs from one place, process, sell mostly to Indian customers) is now a multi-input, multi-location, multi-currency/ country, operation that is run by the same intellectual core of 4-6 people, who used to run the previous single-plant operation.

The increase in complexity is enormous. Barely 4 years ago, the company bought all its inputs from India, and sold its final produce in the domestic market. Now, a sudden but temporary adverse movement in an ASEAN currency like the (Malaysian) ringgit, will leave a gaping hole in the company’s cashflow.

Take the steel sector. Suddenly, steel companies are importing Coking Coal, Nickel, Chromium in quantities (and values) that are equal to their entire turnover a few years back. The consequent risk due to commodity price volatility is equal to their entire bottomlines today. In other words, if there is a series of adverse movements in a currency (like the Rupiah), a commodity (Nickel/ Chromium/ Coking Coal), a labour/ political problem in a country of production/ export, you could suddenly see the entire bottomline (or even a chunk of the Net Worth) of a company go up in smoke, with not a ripple worth reporting in the respective economies/ markets where the company is operating.

The point I am making is this: that as Indian companies “globalise”, they take on risks that they were not paying attention to earlier (and in many cases, where they have limited skills even now). Along with risk, they are sometimes presented with opportunities from outside their “sector”.

To take the steel example above, a globalising steel company is faced, willy nilly, by new threats from volatility of the currency, the commodity…… besides the normal fluctuations in interest rates and other input costs. In managing these threats, it is sometimes presented with opportunities as well. That is when it finds its traditional definition of “focus” challenged. What I heard this industrialist say, is that he would eschew opportunities that were outside the scope of his “business” and therefore not part of his focus.

Risks do not seek an invitation before impacting your business. A growing company that is also globalising, needs to build skills in understanding the various risks that will enter its business domain. From the SARS virus, to the ripple effect of the tsunami, to more everyday concerns like volatile currency/ commodity price volatility, all this and more will be par for the course for the international risk manager.

The flip side of this coin is opportunity. In building these skills, why does the company then turn around and say, “but our business is steel, we will only make money out of steel”. What if the next big trend is not coming in your sector. Does your Chief Economist/ Treasury Head sit back and say, “I will not make this money, because my business is steel.”

The point I am making may seem obvious, but you would be surprised at how many entrepreneurs fall for the flawed argument. Like the “Devil quoting the scriptures”, companies hide behind this definition of “focus” to keep their skill-sets narrow, ie, to avoid wading into risk, to seek opportunity.

A little story I heard about Delphi might help make my point. In the middle of the Brazilian (Real) crisis of 2002, the company moved nearly half a billion dollars into the bankrupt economy, betting on a turnaround. Its escape hatch: even if the economy stayed under, Delphi would find a use for the Real, by converting its liquid holdings into long-term investments.

Delphi did not sit back and say, “we are an auto company”. Incidental to that (auto) business, they had to build skills in understanding the currencies and the countries they were operating in. Consequent to such an understanding, they could take a view that the Brazilian crisis would (in time) blow over, a local assessment that proved superior to the broader market’s view on the country/currency.

This was a punt that worked. There are punts that don’t work. In every case, there is a fine balance that a company needs to define for itself. That is, to understand and handle the risks that it faces as part of its business, a company must build skills to survive. Increasingly, good companies define their “businesses” in terms of these critical skill-sets, rather than the product-market spaces (steel, aluminum, auto, FMCG, whatever) that these companies operate in.

Is Delphi a currency speculator? No, it just took advantage of a local insight, which gave it access to superior information (and consequent) assessment. It also took advantage of a fortuitous situation it found itself in - the ability to convert a liquid holding into a long-term “investment” that would reduce the holding cost of the “view” the company had taken.

The actual source of the profit came from superior risk-assessment skills, which should usually be used defensively, ie, to neutralize operating or financial risk. Sometimes, however, it can be converted to opportunity.

For investors and analysts though, this makes it more difficult to understand a company’s “core earnings”. Often the market will turn up its nose at a company’s “quality of earnings”, until the company is able to prove the sustainability of such cashflows. That does not lower the strategic importance of such skill-sets. In an increasingly dangerous, integrated and volatile world, such skills (and with it, the corporate attitude) could actually be the differentiators that build great companies. 

Yet another argument against sticking to a defined “focus area” is that often it is subject to a known irrationality, often called Mental Accounting. This is nothing but our tendency to think in “buckets”. For example, if you make a loss in nickel buying (against a standard ‘bottom’ target price of nickel), you want to recover that loss from Nickel trading. Why?

I am reminded of an American professor who would fool his natural “loss aversion” by deciding to “donate”, say, $2000 to a distant charity. Then, every time he lost money to life’s little irritants (a New York cabbie on a rainy night, maybe), he would deduct his “loss” from the amount he was to pay his charity. Somehow, he says, it makes him feel better. Try it!

In line with this I argued that the company should debit a special account with all its (notional) “losses” and to calculate its Nickel cost as if it has obtained its Nickel at the lowest possible cost. Then hand over the deficit to its Risk Function, with the mandate to neutralize the deficit with “whatever means possible”. The Risk Manager could then use the company’s large cash surpluses, its substantial debt capacity and its well-rated Balance Sheet to capitalize on opportunity wherever it happens. But this would require that the company define its business a lot more broadly than “steel”. What’s more, such a definition of “business” would perforce be fuzzy, with periodic shouts of “focus” going up every time the Risk Manager miscalculates.

Knowing large companies, this is a difficult, even if superior, existence.

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Don’t Sweat. Not Yet At Least

Has the run-up in the stock markets exhausted itself? The pundits seem to think so. Mostly, the arguments in favour of bearishness come from the fact that the minds of these worthies have got ‘anchored’ to a nominal figure, like the Sensex number.

“Anchoring” is one of the flaws in our thinking, wherein the mind fixates on an initial number, no matter how arbitrary it is. The situation is very similar to the pattern seen in our purchasing habits, where the shopkeeper quotes a high figure, say, Rs.1000 for a purse. This is just an initial negotiating point, which tends to become our reference point for future negotiations. So we negotiate for a discount from that initial number, even though it may have no link to the actual value of the goods being purchased. So a purse that is worth Rs.100, gets sold for Rs.800, with the buyer happy to get a “bargain” from the initially quoted figure of Rs.1000.

We see this flawed thinking among those who argue that the “Sensex is too high”. Any index is a derivative, whose value is derived from the value of its underlying assets. Mostly, the argument against this has constituted of “value”, ie, the calculation of P-Es and expected growth rates in profitability. This constitutes the “fundamentals-based” argument in favour of Indian markets.

There is a technical argument too. It is made up of the “big trend” towards a revaluation of currencies across the world, which will lead to a re-balancing of currency portfolios among international money managers (FIIs).

In 2004, the US Dollar, depreciated further against major currencies such as the Euro, the Swiss Franc, and the Yen. The US Dollar lost even more in value against some of the more exotic currencies, such as the Polish Zloty (+23.9%) and the South African Rand (+18.1%).

The other best-performing currencies against the US Dollar were: Colombian Peso (+18.1%), Hungarian Florint (+15.7%), Iceland's Krona (+15.6%), South Korean Won (+15.6%), Czech Koruna (+14.9%), Slovakian Koruna (+14.8%), and Romanian Leu (+11.3%), while the Swiss Franc appreciated by 9.10% and the Euro by 8.02%.

Marc Faber points out that in Euro terms the Dow Jones declined last year by 4.5% and the S&P 500 was up by just 0.9%. By comparison, German bunds were up by 10% in Euros and 19% in US Dollar terms. So, when pundits forecast an S&P 500 level of 1,350 or higher by the end of 2005, they need to specify at which level of exchange rates the US Dollar will find itself. After all, in an inflationary environment (asset inflation), domestic asset prices can be boosted by an expansionary monetary policy, but at the corresponding expense of a weakening exchange rate.

Alternatively, US monetary conditions could tighten and reduce asset inflation in stock/bond/housing markets, at the same time boosting the value of the dollar, especially with reference to the Euro.

The strong appreciation of the Euro and other European currencies over the last two and a half years has led to a very significant overvaluation of the Euro against the Asian currencies, which, since the beginning of 2000, have hardly moved against the US Dollar.

Whereas since January 2000 the Swiss Franc, the Euro, and the Pound Sterling have risen by 35%, 29%, and 14%, respectively, against the US Dollar, over the same period the Japanese Yen is up by just 3%, the Singapore dollar by 2.5%, and the Taiwanese dollar is down by 3%. The Euro in turn has performed strongly against the Japanese Yen and the Singapore dollar, which has led to a relatively low valuation of Asian assets expressed in Euro terms (despite their appreciation in US Dollar terms). The Singapore stock market has almost recovered in US Dollar terms to its year-end 1999 level, whereas in Euro terms it is still significantly below that level.

Largely due to currency movements, Asian asset values (equities and real estate) seem to be relatively inexpensive compared to the rest of the world.

Since all asset prices have risen strongly over the last two years, it needs to be remembered that rising commodity and real estate prices lead to inflation in consumer prices and so to dwindling demand. Rising interest rates follow inflation, which then depress bond and equity prices. This is what we see happening in US markets.

But India and maybe Asia, seem to be much lower in the inflationary cycle. A re-balancing of currency portfolios would see a drop in Euro allocations, largely because of the technical reasons outlined by Faber above. Fundamentally too, the Euro zone does not have the growth momentum that Asia (particularly India and China) has.  

Portfolio flows would then gravitate to Asian currencies, with the Rupee (among others) as a major beneficiary. Given the underlying fundamentals of 6-7% expected growth, >15% growth in profitability and a Market P-E around 15, a lot of money would flow in, wanting to take advantage of relatively higher interest rates. This would create a bullish cycle, which would be self-fulfilling. Portfolio flows would ultimately serve to keep interest rates low, pushing corporate profits up and hence stock values. That would mean that a 15% increase in Sensex would seem reasonable, after it has reached a base Market P-E of 15.

From a trader’s perspective, it would therefore make sense to stay on the buy side till the Sensex goes up to a current P-E of 17-18 (15% over a Sensex P-E of 15). Assuming a small 3-5% appreciation in Rupee over the short-term, a foreign portfolio manager would find it profitable to get a 10% return from Indian markets. If he gets, say, 5% Dividend Yield from a stock, no capital appreciation and 5% currency appreciation, he should be quite happy.

Assuming that he gets a widely available 2% Dividend Yield and the currency return, he needs little trading incentive to invest in Indian equities. Although he might want to stay in Large Caps, and make quick exits whenever the situation demands.

So it would be fair to expect that, based on the above “currency play argument”, foreign flows into India will continue, with short and increasingly sharp fits and starts. That would increase volatility, with a mean value around a current Sensex P-E of 15-18.

The above argument is a theoretical one. The flaw in it is “single factor thinking”, ie, the tendency on the part of many analysts, to take a single factor and study it threadbare. The increased focus on this single factor, leads the analyst to ignore the impact of myriad other factors. Among them would be political factors, demand slowdown, corporate indebtedness/ credit cycle, etc.  

But to those who fear a sudden and sharp reversal of foreign flows, simply because of the increased dependence of Indian markets on them, there should be some comfort. In the current scenario, we are still not in (relative) bubble territory, as far as the international portfolio manager is concerned.   

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How To Park Your Car

 & Use The Same Wisdom For Bigger Rewards

Delhi’s cars and its drivers have been discussed in many places, but car parking has not received the same attention. I will focus on Delhi alone, simply because its populace is specially endowed with all the elements of “foolishness” that is so much a part of any bull market. So the parallels between good car parking and good investing are brought home very starkly, every day I take out my car in Delhi.

The trade-off in parking and investing are similar. You get a small benefit (ie. your car parked) at a certain cost (in terms of time, effort and money). The time you spend in parking and walking to your destination, the effort in doing so, and of course, the parking fee or the absence of it. In the same manner, you invest time (ie, the investment horizon),

effort (ie, research) and of course, money into your investments.

When I pass by a Banquet or Wedding Hall, for example, I am struck by the number of people who have taken special trouble to park right at the gate of the Banquet Hall. This is the most inconvenient place, with a huge crowd jostling around your car, scratching/ bumping against it. Yet the maximum number of cars are parked in this region. You would think they would want the comfort of parking at a distance…..but no, you would then not be a Delhite. For the small benefit of a shorter walk, they pay a huge cost in terms of the heightened risk to their car, and the inconvenience of driving out.  

An outsider would also be excused for thinking that the density of cars should fall uniformly, with increasing distance from the Banquet Hall. In other words, if there are 50 cars in a radius of 10m, there would be 30 cars at a radius of 30m, 10 cars at 50m and so on. But no…..and this is the big point……the gradient of this pattern is not uniform. That is, the density of cars has a steep gradient that accelerates as the distance increases. At 100m from the Banquet Hall, you might have no parking fee, lots of space to park and so on, but I find that almost invariably, mine is the ONLY car parked so far away. 

We see the same pattern in markets. In Option pricing, cost drops disproportionately as the Strike Price moves off the Spot Price. The rate of change of cost is disproportionate to the rate of change in Strike Price. In cash markets, this pattern is not so obvious, but P-E on forward earnings moves in a similar fashion. A jump in profitability, however large, is not discounted by the market if it is sufficiently far away.

For example, in 2000, a Balrampur Chini in the down-and-out sugar sector was available to me at ~3 times forward earnings, simply because there was no short and specific time horizon the market could impute, to the revival of the sugar industry. So a co with a 10-year average RONW of 20% was available at a P-E of 3. This year, profits are up ~240% and the P-E is up 133% (at 7), giving a return of 560% (ignoring dividends) over 4 years.  The stock might well double from these levels, as it delivers RONW of 40% this year and then maybe the next. That would mean a 10- bagger for me in 5 years.

Warren Buffet gave this kind of investing a name…….cigarette stub investing, he called it. Benjamin Graham called it “deep value”.  They implied that Value happens, and a good investor should look for it. Value is assumed to occur regularly, but randomly. If you keep looking hard, you can at best hope to find a couple of ten-baggers in a lifetime, to make you rich.               

The Car Parking metaphor is meant to point out that sometimes, “deep value” occurs in a patterned way. Growth stocks are born because of a business transformation (like IT, BPO or Biotech), but there are equally good investments to be made in old, boring

industries, with much lower risk and much higher predictability.

This patterned occurrence of “deep value” will happen in all those cases, where the ‘cost’ of investing (like the ‘cost’ of parking your car) is higher than the market is willing to pay. This ‘cost’ is measurable in terms of time (ie, the investment horizon being too long), energy (ie, too much independent research required) and money (ie, perceived risk of total loss). For the investor who is willing to do all this when the market is not, there

may be disproportionate rewards. The point I am making is that the occurrence of “deep value” is embedded in patterns of human behaviour, and often, it happens in a non-random, patterned fashion.

Let me give you a (somewhat) heretical hypothesis, and we will see how many have the courage to invest there. The jute industry may revive sometime in the future, with the economy gravitating to recyclable packaging. Another possibility is the emergence of

Geotextiles, an industry with a domestic potential of Rs.6000 cr. Now, there are listed jute mills available at 2 times earnings, doing an RONW>15%, even 20%.

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