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If risks and rewards are not located at the same place it indicates that the system is broken. In a fundamentally sound system, higher risks yield higher rewards while lower risks yield lower returns. Stability and resilience of earnings or profits is characteristic of lower risks. High risk earnings tend to be volatile. However, when a sector gets stable high earnings without as much volatility we must conclude that system is broken. This is typical of financial system.
The risks are being accumulated at government agencies while rewards will be released privately. It is one of the reason why Too-big-to-fail was a hazard. In simple words, TBTF held governments hostage forcing a transfer of risks and penalties to the public system.
Firms routinely exercise strategies and tactics to shift risk out of the firms domain while retaining the rewards within the firms' domain. This, to my mind, is the goal of the bargaining power struggle well characterized by Michael Porter. Porter also suggested, as I interpret, that the system will stabilize at the point of fairness.
A fair firm is one that has returns in line with the risk it takes. It is able to take such risks because of knowledge and understanding of the process. However, through regulation and other intervention, it is possible to tip the bargaining power dynamics one way or other. I believe that is exactly what led to current crisis.
A crisis-detection system should use this property to flag potential crisis.
There has been some talk lately about Emerging Markets, mainly China, saving the world through growth. I do not think that is possible. The size of developed markets is simply too large for emerging market growth to register any meaningful impact.
US, Western Europe and Japan together account for almost $40 trillion of world GDP of ~$55 trillion. US is about ~$14 trillion, Europe is ~ $17 trillion, Japan is ~ 5 trillion. BRIC countries account for $8 trillion. A meaningful part of BRIC's domestic GDP is dependent on growth in developed world. A slowdown in these countries will impact this part of GDP. BRIC countries may be able to cannibalize domestic GDP from developed world but overall we will be net losers.
An analogy I like is that of Titanic. The developed world economies are like titanic while emerging markets are like small yachts.Yachts cannot save all the passengers from the Titanic. So we should work to keep titanic afloat.
Co-dependent growth is the best way out. But such growth is not possible unless we put our houses in order.
After I shared the list of ideas (download from Scribd) I discussed in my book "Subverting Capitalism & Democracy" (buy on amazon) I have received my first feedback. Ellen Di Resta, an innovation consultant and a dear friend, liked my proposition that Government and Markets are competing systems. Understanding the implied competition is critical to understanding role of governments and markets.
I believe that both government and markets are will of the people. People express their opinion through votes and through prices. Today, voting is limited - at the most about 50% people vote. while almost everyone, including the poor, are connected to the markets. It appears that markets are better equipped to solve or do as people want. However, there are differences.
Firstly in the way we pay for services of governments and markets. Markets use efficient mechanisms (pay-per-use) while government uses unfair mechanisms (everyone pays - as taxes).
Secondly, markets are exclusive. They are open to those who bring value to exchange. The influence on market is proportional to the value you bring to the market. Government, on the other hand, is inclusive, more just. Everyone has the "right" to participate. Everyone participates equally.
I argue that since people participate in both, they often confuse their roles. This allows, I believe, expanding governments, weaker regulations and general dissatisfaction with the government about taxes. I believe we need to fix this to get to a better system.
We should interpret the responsibility of government in this context.
Sovereign balance sheets are under intense media scrutiny. Sadly, the scrutiny lacks actual analysis. What makes a debt-to-GDP of 120% for a country more palatable than debt-to-GDP of 80% for the other? The answer is growth. So where is growth going to come from?
From the first principles approach, we know growth is derived from two sides. First, an increase in the penetration of current activity to cover more population leads to growth. Second, inventing new activities leads to growth.
Developing countries are growing using the first method. They have population where goods and services are yet to reach and mature. The risks involved in such growth are well understood.
Developed countries essentially rely on second approach to growth. The technology boom created one innovation driven growth wave in late 80’s and early 90’s. Internet created next one in late 90’s and early 2000. So where will the developed countries get the next source of growth? The answer is still not clear.
First, the tech-led triggered after more than 3 decades of scientific research. Modern computers and the Internet were inventions of 60’s and 70’s before they became a true mass-invention capable of driving GDP growth. At the moment only alternative energy seems to be on such a take-off point. In my limited understanding both nanotech and biotech will take more time and won’t be mass-inventions for another few decades.
Finally, it means that investors should be better off targeting “penetration-led” growth in the interim.
Stephen King of HSBC has come out with a new book. According to the reviews, it forecasts the decline of the west in the context of the current crisis. I was of a similar opinion.
The decline of west is not specifically a decline but more like mean reversion. Asia was a significant player in the global context for mos of the past 2000 years. The recent 500 years have pushed the west ahead. With this background, coupled with the current weakness in the households and governments, there is a compelling case for a relative decline or more correctly a stagnation of the west.
Yet the infrastructure in west is fundamentally very sound and hence it is hard to make a definitive conclusion. A more reasonable approach seems to be one suggested by John Hempton. He refers to what I call a "browning" of the west. It implies a population growth through migration, predominantly from Asian region.
If and how will the western world react to this new trend remains to be seen. One predictable response should be a wave of protectionism against people movement. Possible job protection and corresponding labour harsher labour laws is likely. Yet even this is not certain. Europe has shown surprising resilience in protecting and upholding democracy and capitalism. It is possible they might stand up to negative developments again.
There is a great deal of talk about pressurizing China to appreciate its currency. The talk is bunk. The idea behind Chinese currency appreciation is not simply about China but it is about an exchange rate regime change. Asking China to let its currency appreciate in isolation will achieve nothing.
The old regime, dominated by US Dollar and other western currencies, was installed through higher savings and purchasing power (ability and intent). The intent to consume remains strong in the western economies. But the ability is seriously impaired due to lack of savings. So the old regime is falling unless we do something about it.
On the other side, a new regime is yet to emerge. China and eastern countries have higher savings rate (ability to spend), but seem to be lacking the intent. It is believed that the savings rate is excessive and may translate into consumption. Michael Pettis, professor from Peking University, believes this savings rate cannot rapidly translate into consumption. The savings are earmarked for social security, pension and education. Thus the demand that we expect from China or other eastern countries will not be that high. In other words, to be a strong consumer for the world, China will need much higher savings and purchasing power.
A rising currency can reinforce purchasing power for any economy. Importing capital goods becomes cheaper. Importing key raw materials becomes easier. There are lot of cost efficiencies that are generated. However, it exposes the economy to competition from overseas. It means employment is threatened. If economy has large population at lower incomes then it reduces consumption at national level. This is a good move for an economy where income pyramid is fatter in middle. It is natural that China would feel threatened by such a move.
There is other way to sustain the economy in appreciating currency environment. This stems from Porter’s competitive advantage of nations. Economies should start building sustaining competitive advantages. Low labour cost is not a sustainable advantage; rather it is a self-cancelling strategy over long term. The answers lie in Germany, in all likelihood.
In sum, it is time to establish a new regime based on fundamentals rather than managed currencies. In such a regime, those with purchasing power will have stronger currencies than those without. There has to be global agreement on this regime to make it effective. Without it, we are going to wander aimlessly as far as exchange rate scenario is concerned.
The reserve bank of India (RBI) announced its annual monetary policy yesterday. The RBI increased repo, reverse repo and CRR by 25 basis points. The reasons were as follows:
Inflationary concerns are dominant. The RBI is keenly watching the change in the structure of inflation. Rising food prices triggered inflation last year (weak monsoon effect). However, it quickly moved to non-food price increase. This, coupled with abundant liquidity has given inflation a substantial resilience. It is imperative to highlight that food prices have eased since January.
The Indian economic recovery is yet to get proper traction. The direction is right but credit off-take (bank and non bank) and other indicators are still wobbly.
The policy rates in India are about 100-150bps below the normal rates. So this is a process of normalization.
Global factors continue to remain weak due to impending sovereign crises and playing out of asset deflation. The potential impact of sovereign crises is not fully clear and it is better to be circumspect than sorry.
The step change moves and cautious certain trajectory reminds one of Greenspan era policy changes. We know how that ended in bubbles. However, there are two reasons, intended or unintended, that makes the move a good choice.
There is still a lot of uncertainty in Indian economy. The way to counter uncertainty is by introducing certainty in controllable variables. The RBI has indicated a clear direction towards normalization and given us exactly this.
The RBI is also facing challenge of managing exchange rate regime. Any changes to relative exchange rates, interest rates will trigger a capital inflow into India affecting Indian domestic and export competitiveness. While it is not correct to promote export competitiveness through weak currency, the global exchange rate regime does not allow RBI that flexibility. With many countries following weak-currency approach, RBI will risk exposing domestic industry to unfair competition.
Thus, moving steadily while constantly watching the global scenario will serve the RBI and Indian economy better. The RBI has shown prudence, intelligence and resolve in combating the crises. Overall, this policy reinforces the RBI’s credibility.
My book "Subverting Capitalism & Democracy" is now available on amazon (kindle version and paperback version). I am not yet sure why kindle and paperback version are shown as two different books but I think it will be sorted out soon. Here is a brief introduction:
Subverting Capitalism and Democracy
What caused the current financial crisis? A lot of answers have been proposed. But do we know the root causes? This book looks at the causes behind the causes we know. The micro-faults that subverted capitalism and democracy are still overlooked.
Today, finance dominates our socio-economic hierarchy. Sadly, we know less about finance and economics than we like to believe. We must relook at the basic concepts of finance and economics. We need to know how large pools of money create systemic weakness. We need to ask why the media and the regulators were sleeping at the switch.
We have to go beyond lobbying, beyond “intellectual capture”, beyond exotic financial instruments and ask the next level of questions. Only then we will reach the root causes. Now is the time to set the system right. I hope this book will extend the discussion towards a solution.
Now that it has shipped I can see a million mistakes in it, a billion ways I could have made it better. But what the hell! I look forward to your feedback to make second version a better one.
Indian IT companies are not fully cognizant of the challenges facing them. There are many forces at work here:
The terms of exchange rate contribution will be adverse. Going forward, I expect the INR to appreciate closer to 35 (INRUSD). The only variable is exactly when. At the moment, financial analysts have lulled the managements into thinking that these levels are not possible in near future. I am not so sure.
Exchange rate will trigger further competitive pressures from global IT majors.
The need for cost cutting and efficiency is driving demand for IT companies. This may not remain as strong as expected. There should be some pressure on margins in this area.
Overall I would be keen to have in-depth session with top managements of Indian IT majors.
I do not see why not. I think households should be allowed to walk away from non-recourse mortgages and no one has any business trying to create social pressure into paying more. Banks and financial institutions have played this as an economic game, no emotions. So why blame individuals when they make economic decisions.
Second, writing debt off is also used as a trick. You write off the debt but hold on the portfolio. Whatever the household pays back is then directly added to the profits. It might seem idiotic, but I have seen banks do it with ill intention.
Third, The written off portfolio is, in some cases, sold to "recovery agents". These agents follow up and try and recover as much from this as possible. In principle this is not wrong. But with inflated loans and deflated incomes this can be harsh.
These steps will impede recovery of consumption in developed countries.
He predicts another year of range-bound behaviour with higher highs and lower lows. I am not sure about the duration but I agree with higher highs and lower lows theory. Further I believe the cycles (high to low) will be much compressed this time around.
Investment Strategy
Katesenelson's investment strategy suggestions are must read for all investors. I would just add that one needs to pick winners/survivors in this crises. This is type of crisis that separates really dynamic companies from sitting ducks. So extra due-diligence is the order of the day.
Vitaliy Katsenelson's recommendation for investment strategy:
In range-bound markets, as P/Es compress they turn against investors; thus investment strategy in this very different and difficult environment needs to be adjusted for the new investment reality:
Become an active value investor. Traditional buy-and-forget-to-sell (hold) strategy is not dead but is in a coma waiting for the next secular bull market to return; and it’s still far, far away. Sell is not just another four-letter word; sell discipline needs to be kicked into higher gear.
Margin of safety needs to be increased. Typically, value investors seek for margin of safety to protect them from overestimating the “E”. In this environment it needs to be beefed up to accommodate the impact of constantly declining P/Es.
Don’t fall into the relative valuation trap. Many stocks will appear cheap based on past valuations, but past secular bull market valuations will not be in vogue for a long time, thus absolute valuation tools such as discounted cash-flow analysis should carry more weight.
Though timing the market is alluring, don’t – it is very difficult to do it consistently. Value individual stocks instead. Buy them when they are undervalued and sell them when they become fairly valued.
Increased margin of safety and stricter sell discipline will lead one to have a higher cash position at times. Don’t invest for the sake of being invested, because this will force you to own stocks of marginal quality or ones that don’t meet your heightened required margin of safety. Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high. However, the opportunity cost of cash is a lot lower during a range-bound market.
There is a lot of talk about return of the USD, specially after Jim Rogers declared that he is long USD. Jim Roger put out a counter trade argument. Simply put, there were too many people betting against the dollar. So no way it will go down right away. There is one more argument!
Exporter push developing country central banks to the wall!
While USD weakness is well known, the developing country central banks are under increasing pressure to manage the exchange rates at current or pre-crisis levels. Entire exporter lobby staff is on just this one task. The thing they don't understand is that US demand is not coming back to pre-Sub-Prime Crisis levels.
I expected this lobbying. But I also expected large exporters to start geographical diversification. This would suggest that exporters are buying time while preparing for new world realities. But there is still no sign of it. I believe, exporters are still in denial!
Currency tango - It still takes two for it!
Central bankers, on the other hand, do not want to be the first developing country to let their currency appreciate. So it will be a game of who blinks first. The usual strategy is such a poker game is to suggest that one will defend the peg no matter what! That is what China has done.
But I would venture they will be the first to act, and they will act decisively. But till that time we are in for holding breath under-water! It is unlikely that anything substantial will happen in 2010 on this front, may be during fall of 2010. One can only guess the impact once currency revaluation sets in. Lord have mercy!
One of my hobbies is to poke holes in stock ideas of analysts. Recently, these talking heads have put out strong buy ratings on Indian tech companies, the likes of Infosys, Wipro, TCS and even Satyam (post scandal). Here is what I need to know before I can be certain of such a trade.
Winning contracts in currency uncertain environment
Indian IT companies have been winning technology contracts from top companies, most recently Walmart. Now imagine a US company that knows USD will depreciate. So how would this impact my sourcing strategy? I, personally, would accelerate all the supplier contracts in today's dollars. Iron-clad them in legal fine-print to mitigate risks from demand collapse and currency fluctuations. The longer such a contract the better it is! Now the question for me is, sitting on other side of this agreement, how have IT companies managed this risks?
The currency risk
This is the most potent business killer, if ever one exists, in Indian IT companies. A lot of analysts have sensitivity analysis ranging from INRUSD of Rs 30/ USD to Rs 50/USD. A few smart investors have already stressed the financials till INR 20/USD and seen the impact. Even smarter investors know that the impact is non-linear in nature. Such currency volatility needs business model innovation (as above) rather than simple currency hedges. The volatility implied in such scenarios may actually test counter-parties in hedged transactions.
Survival Necessities for coming years
Given our current situations, IT companies will have to prepare differently to survive.
Multi-location operations will be an advantage: This implies having robust processes to create and manage scaling issues well. Companies like ones mentioned above are operating in various countries thus helping them react better.
Flexi-sizing will be key: If the currency valuations reach new normalcy, it will be important to relocate manpower to cheaper locations. Companies will have to be quick to rapidly expand, move or lay-off employees. While, all the companies above have what it takes to do it, we should realise it is not an easy process.
A bit more fat! The crisis is upon us and the IT companies are cash rich. The key is to keep higher than normal cash reserves and not fall into the acquisition trap at this early stage.
The best time for investment is not now!
Once the currency crisis hits, there will be more clarity on winners and losers. At that point valuations will be saner and those that survive will definitely give better results. Till such time, I would keep a safe distance between myself and IT stocks.
The way to interpret equity valuation has changed in the context of current crisis. The day CNBC talking heads realize this will mark a new beginnings in the history of mankind.
At some stages, we find same cash-flows being looked upon more kindly (higher valuations). This does not mean that analyst should rework forecasts tampering with cash-flows to retrofit the price and valuation equations. Yet, that is precisely what I am noticing currently. That is bad analysis!
It is the liquidity stupid!
There is ample liquidity in global system at the moment. This money moves across borders, based on whatever reason it deems fit, and lands into a sector or stocks. So the traditional logic of valuation is stretched a bit. Though we don't throw it out of the door. Therefore, watch the global macro in a more meaningful way.
A simple investment strategy
Given the current environment, the best way to manage investments is going back to basics.
We have to find financially robust companies that generate positive cash flows and have lesser leverage.
We then look for managements that have a vision for growth. We are looking for cash-flow accretive growth. So companies with plans to buy market share are out. Growth should be profitable growth.
Thereafter we watch these companies for opportunities to buy. Any correction is opportunity to accumulate.
Exit when the market peaks! Exit is very critical otherwise all profits are paper profits.
Notes and disclaimers
Equity investment is filled with risks so beware. The ideas above are for investors and not for speculators.
Do not construe this as advice to buy at any time. (Timing is critical). These views, though fundamentally sound, are echoed by very few people. So mostly, you will hear very different ideas.
A lot of telecom analyst base their growth forecast on tele-density figures. Tele-density refers to ratio of number of connections to population. It is usually expressed as a percentage. Tele-density determines the upper limit to subscriber growth.
MOU refers to minutes of usage or talk-time of subscribers. “Minutes of Usage” multiplied by Average Revenue per Minute (ARPM) to arrive at Average Revenue per User (ARPU). ARPM has shown a declining trend with respect to time. MOU, therefore, represents growth potential of current subscribers.
The growth potential of any telecom company is a function these two variables. Yet, the concept of teledensity and MOU have not been understood well. A few innovations in the past few years have added new life to both these variables in ways analysts have failed to grasp.
Era of bandwidth Node
The interpretation of teledensity as a cap is remnant of telephone as a voice call device era. This old era represented voice-based communication. We also discovered ways to send data over telephone lines. But this was inefficient. We were sending data over voice networks.
The era has changed and a new era is here. Today, telecom is essentially a provider of bandwidth node at a given location. The question of what to do with this bandwidth is entirely left to market forces. Market forces have deciphered one use of the node through “smart phone technology. Today our networks are essentially dual-mode networks. On the smart-phone or any 3G phone, we have access to a data network AND a voice network. We are no longer sending data over voice network.
So the correct way to look at MOU is in fact, to look at overall consumption of bandwidth. There is no doubt this is only going to go up!
Smart phones boosting data usage
The smart in smart phone is actually in usage of bandwidth tap. The smart phones have, through use of apps, created new uses of data. Further, the presence of 3G implies we are going to listen to move songs and watch more videos on the smart phone. Both these applications are bandwidth-hogging applications.
Overall data requirement of phone user has definitely gone up. And most of the time, data is served by a telecom company. Sometimes, it is your telephone cable connected to a wi-fi modem, other times it is your phones 3G network. As new apps spread, we will have increasing data requirements. So MOU, in terms of overall usage of telecom service will go up. Also, the more connected people are more are voice calls likely!
The upper limit on teledensity
Tele-density has another story. First, there is natural requirement for multiple phone connections per person. In developed countries the number is 2. So we can expect a natural phone penetration limit to twice the population. Further, simply put, there is a potential to connect all the laptops that are in use in the market currently. So the factor of 2 seems pretty understated. Thereafter, anything that is mobile and generates data is a target for embedding a phone connection.
Telecom can definitely cannibalize 50% of the GPS applications. Cars can share location data, engine performance and others. Trucks and delivery vehicles are already using telecom based location services.
Further, it does not take much imagination to foresee new applications. A door viewer that can send photo of visitors is pretty common. Telecom-equipped nanny cams are definitely well accepted. TV set-top boxes can have embedded connections transmitting viewing habits. Buses in Switzerland are already transmitting data about arrival times.
In sum, we can say that older paradigms of Tele-density need to be massively revamped.
It will happen within 5 years
The classical rebuke to these arguments is visibility. Analysts do not foresee such changes happening in near term. I think otherwise. All it needs is right pricing and little bit of imagination. The iPhone, is revolutionary in that sense. It has socialized the imagination part while retaining the basic bandwidth pipe control to itself! I am betting, we will see tremendous explosion in bandwidth consumption in next 5 years and most of this will enrich the telecom companies. That is why I have invested in Bharti Airtel (Bloomberg: Bharti IN).
There is a difference between the recovery rally and the main rally that preceded it. People have started talking about sustainable recovery in equity markets. Still, things are not as they seem. Investors should brace for a rough ride ahead. The rally seems to comprise four phases.
Four Phases of market movement
First phase of secular insanity. In this phase all stocks go up. People ignore the fundamental warning signs. Even companies with questionable managements got sky high valuations. His phase ended with the great crash of 2008. Possibly, what Rob Shiller calls "irrational exuberance" appears to be this stage.
Phase two is essentially over-excitement of the rationalists. Looking at cheap valuations and signs of strength in company performance the rationalists over-extended themselves. Midway, the irrational investors rejoin the party. The phase ends when the cynics join in. We are currently at this stage. I am watching the converstion of cynics. Even this phase ends with a crash. The dimension of the fall now will determine the long term damage to the economy.
Phase three is a placid languishing of the markets at near bottom levels. There is lack of trust and overall cynicism about any future prospects. This is the true bottom. Sweat, sacrifice and prudence regain their respect in this phase.
The hard work in phase three results in growth and proserity that is our final phase. The economy gains traction and with it, a new hope emerges.
Is the crash coming?
President Obama attempted to jump phase three into phase four. For a while it seemed possible. But I do not see the tough choices being made, or vision to take down broken structures. Sadly, we will see our third phase. The time is just about right.
