Vijay Kumar Gaba: Taiwan

Wednesday, November 23, 2022

Mind the flocks of black swans lurking around the corner

The toughest job in the present day environment is risk management. Of course, it has never been an easy job; but when we consider the proportion of moving parts, fragility of systems, disregard for conventions, total lack of mutual trust and disillusionment with the status quo, managing risk appears the toughest job. I can now appreciate the risk managers’ plight during the first half of 20^th century; when similar conditions were prevailing.

To illustrate my point, let me highlight the following instances which may not appear ominous to a common man, but could give cold sweat to risk managers.

Interest rates have risen in most parts of the world in the past one year. In many cases the rise in rates has been rather steep, especially the developed economies. Most of these economies were struggling with deflation pressures for the better part of the past two decades. Obviously the rates were low (close to zero and negative in many cases). Many businesses were built assuming this to be a lasting phenomenon; or at least many investors valued businesses assuming this to be a lasting phenomenon. The pandemic however annulled this assumption. It now appears that we shall not have near zero rates for longer, even if inflationary pressures ease in the next couple of years. A large number of the businesses built on “lower for longer” assumptions are facing existential risk.

How would a risk manager handle this risk? If an investor changes the assumption of “lower for longer”, the basic case for investment in such ventures may collapse. An exodus that may thus result would only result in immediate collapse of such a venture. If the management guides change in assumptions about finance cost, cash losses and poor visibility of fresh capital, the valuations will collapse anyways.

· The news flow in the past few days includes the following headlines:

“Iran fires missiles at Kurdish militias in eastern Iraq” (see here). This was to follow up 73 ballistic missiles fired by Iran in September 2022 (see here).
“Texas to send military armored personnel carriers to the border to escalate enforcement. The move comes days after Texas Gov. Greg Abbott invoked an 'invasion' clause to step up border enforcement.” This is part of the border reinforcement in the past 2 decades in which billions of dollars have been spent. State funding for border security has grown from $110 million in 2008-2009 to nearly $3 billion for the 2022-2023 budget cycle. (see here)
“Ukraine nuclear plant shelled, U.N. warns: 'You're playing with fire!” (see here)
“South hits back as North Korea fires most missiles in a day.” (see here)

Besides, news flow on Sino-Indian border tensions and China’s aggressive posturing on Taiwan has been consistent. A risk manager who is aware of the energy crisis of the 1970s; has been struggling to manage the fall outs of Russian invasion of Ukraine; and is aware of hardliners winning elections in Italy, Israel, Brazil etc. would find it hard to ignore these geopolitical threats.

“Mumbai sees temperature dip, IMD issues cold wave warning for parts of Maharashtra.” (see here) This could be a worrying signal for risk managers worrying about inflation; supply of grapes, onions, pomegranates; public health etc.

Besides, in the mountains it started snowing earlier this year. Late rains have ensured late sowing for Rabi crops. If winter sets in early and nascent crops are hit by frost, we may have poor Rabi yield.

I recently met with a company which earns substantial revenue from UN tenders. The management highlighted the substantial cut in funding of the UN as a key risk to their operations. They did not mind discussing the probability of the UN becoming redundant or even getting dissolved in the next 10-12 years.

The point I am trying to make is that in the present times investors should better avoid overconfidence in any investment idea. The black swans could emerge in flocks from nowhere. It is therefore a good idea to keep portfolios well diversified and liquid. Exposure to exotic, unproven, experimental, innovative, expensively valued businesses must be kept to bare minimum – ideally not more than what you could easily afford to write down fully.

Wednesday, March 2, 2022

Su karva nu? (What to do?)

As I indicated last week (see here) to me markets are not looking good, at least for now. And it is definitely not only due to the latest episode of Russia-Ukraine conflict. This conflict has only added to the caution. My primary problem is the lack of adequate growth drivers for the Indian economy.

There is a virtual stagflation in the domestic economy, constraining private consumption. The exports have helped in the past couple of years to some extent. However, the higher probability of slowing growth in the western countries due to tightening monetary policies and the spectre of a prolonged geopolitical conflict in Europe and probable reorganization of the global order (political realignment, trade blocks, currency preferences, energy mix etc.) clouds the exports’ growth in FY23.

Another key driver of growth in the past few years has been public expenditure. The government made decent cash payments to the poor and farmers to support private consumption. It also accelerated the expenditure on capacity building, to compensate for the slower private investment. From the FY23BE it is clear that the government’s capacity to support the growth is now limited by fiscal constraints.

What does this mean for the equity markets?

In my view, the following ten themes have been the primary drivers of the performance of Indian equities in past five years:

1. Larger well organized businesses gaining market share at the expense of smaller poorly organized businesses. Demonetization, GST and Covid-19 have aided this trend materially. This trend has been seen across sectors and geographies.

2. Import substitution and make for exports. Many sectors like chemicals, pharmaceutical (API), electronics, food processing etc. have built decent capacities to produce locally, the goods that were largely imported. Some global corporations have increased their domestic capacity to address the export markets from India. Many Indian manufacturers have also built material capacity to address the export markets. The government has aided this trend by providing fiscal and monetary incentives.

3. Implementation of Insolvency and Bankruptcy and some ancillary provisions, gave impetus to the resolution of bad assets and material improvement in the asset quality of the financial lenders.

4. Persistently negative real rates, stagflationary environment, business stress for smaller proprietary businesses and significant losses in some debt portfolios, motivated a large section of household investors to invest in equities for augmenting their incomes and even protecting the savings.

5. Increase in rural income due to cash payouts by the government, higher MSP for crops, better access to markets etc.

6. Increasing popularity of digital technology, driving efficiency for traditional businesses and facilitating numerous new businesses (Etailers, FinTech, B2B & B2C platforms, incubators, etc.) that command significantly higher valuation than their traditional counterparts.

7. Overcapacity in infrastructure like Roads & power, where traditionally India has remained deficient, resulting in higher productivity and better cost efficiencies for businesses.

8. Aspirational spending of the Indian middle class outpacing the essential spending, resulting in higher discretionary spending.

9. Climate change efforts prompting higher interest in clean energy and electric mobility.

10. Cut in corporate tax rates leading to higher PAT for numerous companies.

To decide what to next, an investor will have to make assess how the current and evolving economic, financial and geopolitical situation will:

· Impact these drivers of Indian equity markets?

· Impact the earnings forecasts for FY23 and FY24, which basically hinge upon the operation of these drivers?

The assessment will also have to factor whether the impacts as assessed above, will have an endurable impact or it will be just a passing reflection.

In my view, it will just be a passing reflection and these drivers of the Indian equity market shall endure in the medium term (3 to4 years). Therefore, I would mostly be ignoring the near term turbulence and stay put. I would:

· Follow a rather simple investment style to achieve my investment goals. It is highly likely that this path is boring, long and apparently less rewarding, but in my view this is the only way sustainable returns could be obtained over a longer period of time.

· Avoid taking contrarian views.

· Take a straight road, invest in businesses that are likely to do well (sustainable revenue growth and profitability), generate strong cash flows; have sustainable gearing; timely adapt to the emerging technology and market trends, and most important have consistently enhanced shareholder value. These businesses need not necessarily be in the “hot sectors” and these businesses may necessarily not be large enough to find place in benchmark indices.

Of course there is nothing proprietary about these thoughts. Many people have often repeated it. Nonetheless, I feel, like religious rituals and chants, these also need to be practiced and chanted regularly.