Category: blog

Heuristics help open doors, but are bad for investments

May 14, 2021

Letter # 41, 14 May 2021

“He was unprecedented for a European business leader – a Scandinavian who combined old world manners and language skills with American pragmatism and an orientation for action,” writes Phil Rosenzweig in his book The Halo Effect. The press could not get enough of Percy Barnevik, the CEO of ABB, in the mid-1990s as its revenue almost doubled, profit tripled and market cap breached the USD40bn mark between 1988 and 1996.

It started with Sweden’s ASEA and Switzerland’s Brown Boveri merging in 1988; they integrated at break-neck speed, saving millions of dollars in costs. Plants were closed, jobs were cut and overheads slashed, while acquisitions rose. By 1994, ABB had consolidated in Western Europe & North America, and expanded in Emerging Markets, with Percy at the helm.

In early 1990s, magazines like Long Range Planning, Forbes and Business Week gushed over Percy’s management style; academics at management schools praised his persona and Korean Management Association named him ‘world’s best honoured top manager’ – he was getting an award for getting the most awards!

And then came the downfall, starting 1998. The spree of acquisitions, the unrelated expansion (into financing arm, etc.) and the litigations (asbestos) hurt ABB. The size of the problem grew so large that ABB had to sell its petrochem business, its finance division and take unprecedented loans. By 2003, the company was a mere shadow of its previous self, as Jurgen Dormann, ABB’s Chairman remembered, “we had a lack of focus as Percy went on an acquisition spree. The company wasn’t disciplined enough.” Then, managers recalled poor coordination among countries and dysfunctional competition. The board joined the chorus on how Percy had ‘monopolized the flow of information’. By now, the once superstar had to give up more than 60% of his pension pay and his legacy was in tatters.

It’s a nice story—leaders are important, but judging whether a leader is great from the fact that a company has been successful is breaking down a complex problem into bite-size theories. To me, that begs a larger question, given that we are aware that some relationships of cause and effect are complex in nature, why do we have the urge to break them down into heuristics?

And, it is not just about distant corporations and CEOs; our financial markets too are inundated with investment theories that sound simple, but with little effort, we know them to be totally wrong. Over the past few letters, I have written how frameworks that sound simple (buy growth companies with high RoE, don’t buy PSU, don’t buy commodity companies) do not actually work in real life. They are largely a hoax, meant to make the financial guru to sound intelligent and for marketing guys to be able to sell you a product.

Today, let us look at one more of such truisms, “Times are uncertain; stay invested with the leaders in each sector; your portfolio will emerge stronger from the crises.” Over the years, chances are high, that you might have come across someone making similar claim.

The table below summarizes the leading company by revenue (in fiscal 2011) in different sectors. Now imagine one created an equal weight portfolio, investing the same sum in all companies that were leaders a decade ago. This portfolio would have returned ~16% CAGR, a superior return compared to 10% CAGR in Nifty.

However, had one created a similar equal-weight portfolio of contenders, the returns would have been a staggering 22%. To put things in perspective, the ‘contender’ portfolio would have been up 6.6x over the previous decade versus the ‘leader’ portfolio, which would have been up 3.5x. The leader portfolio underperformed the contender portfolio by a staggering 47% in a decade.

We discussed last week ⁽¹⁾ how reducing an investment framework to narratives (that sound intelligent) does not hold the test of numbers over time. The result above debunks a similar myth that has been doing the rounds in the world of investments for quite some time now.

As to the broader question of why the urge to break down a complex relationship into bite-size theories that aren’t true, Elliot Aronson, an American psychologist, has a beautiful answer in his book The Social Animal. He observed that “people are not rational begins so much as rationalizing beings. We want explanations. We want the world around us to make sense.”

Experts appearing on CNBC will sound a lot more intelligent if they explain half a point drop in a stock with something that sounds plausible (albeit inaccurate) rather than suggesting that on any given day, stock price fluctuations are more easily explained away with a Brownian motion. That need for the world around us to make sense compels us to form heuristics; it makes our lives easier. It gives us the confidence that we will be able to open a door to a room that we have not previously entered. In life, heuristics serve a useful purpose.

When it comes to investments, however, each situation is different from another. And, while broad rules do apply, boiling down a framework to these rules (buy the leaders, buy high growth high ROE companies, don’t buy PSU etc.) does not work. People who propagate them do a great disservice to the overall investment clan.

At the end, one might have a question—investing in the contender portfolio will help generate superior returns in the next decade, right? Sadly, if one did the same in the FMCG sector in the past decade (buying Nestle instead of the leader Hindustan Unilever), one would have underperformed by a whopping 45%. While trying to debunk the notion that formulas do not work, I am not about to introduce a formula that I think works. Investing is simple, but condensing it down to heuristics is a recipe for disaster.

Notes:
(1) Numbers matter, not the narrative – Buoyant Capital
This letter was originally published here: https://www.cnbctv18.com/market/heuristics-help-open-doors-but-are-bad-for-investments-9299131.htm

Disclaimers:
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.

Numbers matter, not the narrative

May 7, 2021

Letter # 40, 7 May 2021

Let’s start with a fun exercise. Based on the past 20-years’ stock returns, match the following companies to the following returns (without looking them up):

Companies: (a) Hindustan Unilever, (b) Nestle, (c) Colgate, (d) Infosys, (e) JSW Steel and (f) Vedanta.

Stock returns (CAGR): (a) 35%, (b) 25%, (c) 21%, (d) 19%, (e) 18% and (f) 15%.

Let me share a couple of interesting stories, before we come to the results.

Philip Tetlock, a professor of psychology, in his book Expert Political Judgment writes that he spent 15 years (1988 – 2003) studying the decision-making process of 284 experts. He defined experts as people who appeared on television, were quoted in newspaper & magazine articles, advised governments & businesses, or participated in punditry roundtables. All of them were asked about the state of the world; all gave their prediction of what would happen next. Collectively, they made over 27,450 forecasts. Tetlock kept a track of each one and calculated the results. How accurate were the forecasts? No better than dart-throwing chimpanzees!

You might think that people may not be great at making predictions, but when it comes to facts, they know their stuff, right?

Hans Rosling, a renowned medical doctor and public educator, in his book Factfulness asks 12 (multiple choice) fact questions about the world (how many girls finish primary education, how much population lives in low-income countries, etc.) to a variety of people (12,000 people in 14 countries in 2017). On average, they scored just two correct answers of 12. No one got a perfect score and a stunning 15% scored zero.

Respondents included medical students, teachers, scientists, investment bankers, journalists, senior political decision makers. The most appalling results came from Nobel laureates and medical researchers. These were not just wrong results, but they were systematically wrong. The test results were not random, they were worse than random. Chimpanzees (who have no knowledge at all) would have done a better job. He writes, “every group of people I ask thinks the world is more frightening, more violent and more hopeless–in short, more dramatic–than it really is.”

How is it that well-educated people with access to all the data would score worse than chimpanzees in their knowledge of facts or their forecasts? Rosling writes that only ‘actively wrong knowledge’ can make us score so badly. We build a narrative of the world view based on what we hear in the news, what we see on television and who we interact with; this makes us form a world view that is different from reality.

However, Daniel Kahneman, in his book Thinking fast and slow, has a more nuanced answer. He writes that our cognitive processes are divided in two modes of thinking: (a) thinking – traditionally referred to as intuition (system 1); and (b) reason – described as slow and rule governed (system 2). Whereas system 1 operates automatically, quickly, and effortlessly with no sense of voluntary control, operations of system 2 require concentration. And, although we like to think of ourselves as having sturdy system 2 ability, in fact much of our thinking occurs in system 1.

Now, answers to the quiz. Ranking from highest to lowest stock returns: (a) Vedanta – 35% CAGR, (b) JSW Steel – 25% CAGR, (c) Nestle – 21%, (d) Colgate 19%, (e) Infosys – 18% and (f) Hindustan Unilever – 15%.

You might think that 2002-08 was a super-cycle–a once in a century event, which skews returns. Here are the returns for the past five years–JSW Steel 42%, Vedanta 32%, Nestle 25%, Hindustan Unilever 24%, Infosys 20% and Colgate 14%.

These numbers may appear counter intuitive; after all, how can a capital-intensive commodity business outperform a consumer staples or an information technology business over a 20-years’ time frame? The people who Tetlock tracked and Rosling spoke to might appear distant, but haven’t we, over the past few years, been fed a certain narrative (companies with higher revenue growth with strong return ratios outperform in ALL market conditions or don’t buy commodity companies or don’t buy PSU stocks) that needs to be seriously questioned after these results?

Well narrative aside, numbers have always told a different story, i.e., if we were willing to listen. In the future, at some point of time the returns of commodity businesses will likely look sub-par, but therein lies the important lesson. I am reproducing the table (updated for latest data) that I had written about in the December 2020 letter ⁽¹⁾. Over different market cycles, different sectors tend to drive (or lag) indices and the narrative that there could be ‘one investment strategy that can beat the markets at all times’ is largely a hoax.

However, if numbers spoke that loudly, why would a lot more investment managers not include cyclicals as part of their investment framework? Because we have the recency bias and until recently (a year back or so), commodities did not look like an investible asset class. The narrative of a framework that included cyclicals was very difficult to sell to people who would invest in funds.

Morgan Housel summarises it well when he writes, “few people make financial decisions purely with a spreadsheet. Most make them at the dinner table or in a company meeting. Places where personal history, your own unique view of the world, ego, pride, marketing and odd incentives are scrambled together into a narrative that works for you”. Marketing experts that sell financial products are aware that building a simple narrative has a stronger chance of generating a sale. Paraphrasing Kahneman – we might think we are deploying reason (system 2) while making a decision, but in fact, much of our thinking happens through intuition (system 1), which is gullible to narrative. For system 1, narrative matters more than numbers, which guarantees a sale; but for generating superior long-term investment returns, the numbers will always matter more!

Notes:
(1) Jailing short sellers, capital returns and long-run cycles – Buoyant Capital

Give it time and you will see

April 30, 2021

Letter # 39, 30 April 2021

Have a look at the figure below. Given the times we currently live in, you might think it illustrates the rising Covid cases in India. It does not; but let us park that for a minute; I shall come back to it. First, let me tell you a story about two gentlemen.

The first one, let us say Mr. A, studied to be an investment banker and got a job at a decent bank. He globe-trotted his way till the age of 30, by when he got bored and decided to start investing full time. He had saved USD1mn, which became his seed capital. Over the course of the next 30 years, he did fantastically well, generating 20% CAGR till he turned 60. By then, his corpus ballooned to USD237mn and he decided to give up investing full time to rekindle with his childhood passion of playing golf. Mr. A did well (20% CAGR is not common and a quarter of a billion is a lot of money). But then, it would have been just another story, nothing that would inspire generations to come.

Now consider Mr. B. He started investing at the age of 11 and is still investing full time as he becomes a nonagenarian. He has compounded his wealth at the same rate as Mr. A (20% CAGR), but for a longer period. He holds annual shareholders’ meetings, which are attended by shareholders from across the globe–to gain from his wisdom, but more importantly, to pay homage to one of the best investors of our generation. He hosts a charity lunch once every year, for which someone paid USD4.6m last year. Compared to Mr. A’s USD237mn net worth, Mr. B is now worth a staggering USD84.5bn!

By now, you would have guessed that Mr. B is indeed Mr. Warren Buffett. But would it be surprising if I told you that Mr. A is also Warren Buffett with a slight nuance—he just decided to retire early at the age of 60. The chart above is the age wise graph of his wealth accumulation. Of the USD84.5bn in wealth, he generated a whopping 95.5% (or USD80.7bn) after he turned 60. One might think that the rate at which wealth compounded after he turned 60 has increased dramatically; it has NOT! (age 30 to 60: CAGR of 32%, age 60 to 90: CAGR of 11%). This might sound counter intuitive, but that is simply how compounding works.

Of the thousands of books and articles that deeply analyse Buffett’s investment style, hardly any book mentions what’s far more important is that he has done it for way longer than anyone else. And come to think of it, Buffett hasn’t had the highest returns track record; many of my fellow asset managers in the alternatives space report far superior returns. Jim Simons, who ran Ren Tech’s Medallion Fund returned more than 66% CAGR over a 30-year life span ⁽¹⁾. And yet, Jim’s net worth in not even a third of Buffett’s! The latter’s skills are possibly many, but his secret is one… TIME*.

A lot of people on hearing this, come back with something like, “I agree! I want to get invested for the long term, but markets are at their peak right now. I will look for a more opportune time to get invested.” A lot of us think that ‘getting in at the bottom of the market and getting out at top’ is the key to successful investing. While that has its benefits for wealth creation, it is not an essential criterion (see data below).

We have analysed data of BSE Index since 1979 (close to 13,500 days). Had one chosen any random day to invest, there is a 92% probability that they would have generated a positive return over a 5-year period. Now, I am not suggesting that because it has happened in the past, it will always happen; but historical odds are staggeringly in favour of getting invested.

A corollary to this is true as well. If one had invested on January 1, 1990, their cumulative returns till date would have been 6242% (or 14.2% CAGR). However, if they had missed just the best 10 days in that time, the returns would have been only 2205% (lower by 65%). Miss 30 best days and returns fall to just 512% (lower by a whopping 92%).

The learnings are simple, but counter intuitive. As investors, we focus a lot more on generating maximum returns for any given period, and a lot less on how we can keep doing it for a long time without getting burnt out. The highest returns mindset forces our attention on the smallest of the news items that we can consume (from social media, Whatsapp, news channels, etc.); after all, we wish to be the quickest to execute the trade before the market gets the chance to digest the news. In my opinion, that is as often noise as often as it is a signal; intelligently deciphering it to benefit consistently has proved futile. Second, we obsess endlessly about timing the market. We want to get in at the lowest possible price and get out at the highest possible price. Every now again, one gets it right, which creates a false sense of comfort that they can keep doing it. But since it is not humanly possible, it eventually leads to the feeling of either: (a) having missed out; or (b) having messed up. That is far worse than the few times one was right in timing the market.

Third, some take inordinate risks that can put them out of markets in the event of an adverse outcome. Last week, we discussed how things that haven’t happened before, happen all the time (no typos in that sentence). If you are that leveraged, where you potentially risk ruin in case of an adverse outcome, staying in the game long enough will prove highly challenging.

Lastly, we should be willing to learn and adapt. Strategies that have done well in the past five years are not the strategies that will continue to do well now or in the next five years. Strait-jacketing an investment thesis ⁽²⁾ (I will only buy high RoE and fast growth businesses, never buy PSU stocks, never buy commodity stocks etc.) does not take lessons from history and will likely result in resentment on several occasions.

Like nature, investment strategies should learn to adapt. There can be boundaries that we, as investors, will never cross, but willingness to learn and adapt will likely enhance our time horizons. In the end, that’s what matters more than anything else, right?

Notes:
(1) Renaissance Technologies – Wikipedia
(2) We have endlessly written about those; you will find them at blog – Buoyant Capital
* This story is adapted from Morgan Housel’s book, The Psychology of Money
The letter was originally published here: Give it time and you will see – cnbctv18.com

Pessimism sells, but does it also pay?

April 23, 2021

Letter # 38, 23 April 2021

In late 2008, the Dow Jones Industrial Average was down close to 40% from its recent high as the global financial crisis engulfed the entire world. A crisis of this magnitude was unprecedented, and everyone was uncertain as to what would happen next. That’s when an article appeared, ⁽¹ ‘As if things weren’t bad enough…’

“Around the end of June 2010, the US will break into six pieces. California will form the nucleus of ‘The Californian Republic’ and will be part of China. Texas will be the heart of ‘The Texas Republic’, a cluster of states that will go to Mexico. Washington and New York will be part of ‘Atlantic America’ that may join the European Union. Canada will grab a group of Northern states and Hawaii will be a protectorate of Japan or China, and Alaska will be subsumed into Russia.”*

No, this is not some looney blogpost or a newsletter that no one reads; it is on the front page of the Wall Street Journal–widely considered one of the most prestigious financial newspapers around the world, with circulation of 2.8mn copies and 37 Pulitzer Prizes.

2008 appears to be a long time ago, but the feeling of pessimism surrounding the article seems as pervasive even today. A perusal of several social media or news articles indicates an impending doom of the second Covid wave in India. There is no denying that the on-ground situation in India is acute, but the news reports almost conclude that there is no end in sight. Consider this Bloomberg article ⁽²⁾ which lists everything problematic, without even mentioning how the situation is improving at the margin. Or this article ⁽³⁾ which lists how the absolute number of Covid cases in India is the highest now, disregarding the size of India’s population and density.

One often wonders, why the exaggerated pessimism? Morgan Housel deals with this subject beautifully in his book The Psychology of Money. He says that optimism is the best bet for most people because the world tends to get better most of the time, but pessimism holds a special place in our hearts. Pessimism sounds smarter, it is intellectually captivating, and it is paid more attention than optimism, which is often viewed as being oblivious to risk.

Historically, the odds that an outcome will be in our favour over time are greater despite there being setbacks along the way. Optimism is focusing on the higher odds; pessimism is focusing on those setbacks.

However, sounding pessimistic grabs attention faster. As Morgan puts is, “if a smart person tells me that a stock pick that’s going to rise 10-fold next year, I will immediately write him off as nonsense; but, if someone who is full of nonsense tells me that a stock that I own is about to collapse because of accounting fraud, I will clear my calendar and listen to his every word.”

Now imagine someone writing this in the late 1940s after Japan was gutted in World War II and the future appeared bleak. “Look today it looks bad, but it won’t be like this forever. Within our lifetime, our economy will grow 15x pre-war levels. Our life expectancy will double. Our stock markets will rock. Unemployment won’t cross 6% for decades. We will become world leaders in electronic innovation. We will become so rich that we will own a decent chunk of Manhattan, and yes, America will be among our closest allies.” Sound ludicrous, right? But that is exactly how it panned out*.

It is easier to create a pessimistic narrative when the panic is fresh in our memories. At the peak of the Covid crisis in India in March 2020, some prominent industrialists and politicians sounded intelligent by arguing how “India flattened the wrong curve” ⁽⁴⁾by imposing the national lockdown and how “central leadership screwed up by not giving states the control to fight the pandemic ⁽⁵⁾.” In the second wave of covid, we find out how neither of those narratives was accurate.

In a 2008 letter to shareholders, this is what Warren Buffett wrote, ⁽⁶⁾ “amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21 1⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

When we are on the river of life, it is more than likely that we will hit a few rocks. That’s not being pessimistic, that is being accurate. From memory, I recall Ayrton Senna, the Formula one car racing champion, saying something like this in an interview, ^{(7) “}I attempt that my car never goes into a tailspin. But when it does, I can either look at the wall I might crash against or the road where I am supposed to drag my car back to. Focusing on the road improves the chance of my car not crashing by a factor of 10. And in my line of work, that is difference between life and death.”

Pessimism helps sell book and newspaper, and it may even make you sound intelligent; but over the long term, does it really pay to be pessimistic all the time? During the previous crisis, Warren Buffett was focusing on the road instead of the wall; all of us might do a lot better with our investments if we did the same, the current covid predicament notwithstanding.

Notes:
(1) As if Things Weren’t Bad Enough, Russian Professor Predicts End of U.S. – WSJ
(2) India’s Covid Tragedy as Seen on Twitter, Instagram and Facebook – Bloomberg
(3) Covid: India sees world’s highest daily cases amid oxygen shortage – BBC News
(4) Coronavirus Lockdown Flattened The Wrong Curve: Industrialist Rajiv Bajaj To Rahul Gandhi On Lockdown (ndtv.com)
(5) Modi’s Need for Control Impairs India’s Coronavirus Recovery – Bloomberg
(6) printmgr file (berkshirehathaway.com)
(7) I fail to find a reference of this anywhere on internet. There is a strong possibility I maybe wrongly attributing this to Ayrton Senna
* Story adapted from the book: The Psychology of Money by Morgan Housel
This letter was originally published here: Pessimism sells, but does it also pay? – cnbctv18.com

Because it has never happened before – tail risks and convex portfolios

April 16, 2021

Letter # 37, 16 April 2021

In a series of interviews last week, Prashant Kishor—one of India’s finest political strategists (in my opinion)—reiterated, multiple times, a commitment which sounded bizarre. Prashant’s company, I-PAC ^{(1) / (1b)}, is currently working with All India Trinamool Congress (AITC) for the ongoing assembly elections in West Bengal in a primary fight against the Bharatiya Janta Party (BJP). He claimed that BJP will struggle to cross 99 seats (in a 294-constituency assembly), and if it does cross, he will quit this space ⁽²⁾ (which he later clarified to mean that he would stop being a political aide to any other political party and shut down I-PAC ⁽³⁾).

The claim is bizarre, predominantly on account of the disproportionate risk he seems to have taken; and not, at the very least, because he does not have the data or the on-ground reports or the absolute expertise to read the election. In the 2016 West Bengal assembly elections, AITC had won 211 seats and BJP had secured just three (with a vote share at 10%). By the 2019 Lok Sabha elections, BJP’s vote share in West Bengal had jumped to 41%. If BJP were to translate its 2019 parliamentary constituency win into the 2021 assembly constituency win, it would stand to win 127 seats. In addition, with a mere 3.5% vote swing, some 36 seats could swing from AITC to BJP.

Now, I-PAC has been years in the making and has already helped national (BJP and INC) as well as a few regional parties (JDU, YSRCP, AITC, DMK). In its field of operation, it is by far at pole position. Politicians making unsubstantiated claims may be par for the course, but for a professional, as astute as Prashant (who even chooses his words carefully), the upside from making this unsolicited bet is flummoxing. Until, in one of the interviews ⁽³⁾, he clarified the basis of his conclusion, “we have studied data for the last 30-40 years and have seen elections in most polarizing atmospheres. We have found that 50-55% is the limit beyond which it is not possible to polarize a community; it has never happened.” ⁽³⁾

To simplify, Prashant is staking everything he has painstakingly built over the past decade, inter-alia, on the assumption that because it hasn’t happened before, it will not happen now. Whether he wins or not is not as much of consequence, as the realisation that even seasoned professionals can end up taking disproportionate risks based on erroneously calculated odds. And, if you think this hasn’t happened before, read on.

In 1991, John Meriwether, then the head of bond arbitrage desk of Solomon Brothers, resigned and founded Long-Term Capital Management (LTCM) in 1994. Members of LTCM’s board of directors included Myron Scholes and Robert Merton–who shared the Nobel Prize in Economic sciences for ‘a new method to determine the value of derivatives.’ John’s desk was responsible for 80-100% of Solomon’s total earnings between the late 1980s and early 1990s ⁽⁴⁾, and the other two gentlemen literally wrote the book on how to value derivatives. Clearly, LTCM was run by an exceptionally sharp bunch.

The idea behind the hedge fund was simple–exploit small pricing inefficiencies in bond markets and leverage the trade to generate a superior rate of return on equity. Among its core strategy was to purchase the old benchmark, say issued 3 months ago (which no longer had a premium attached to fresh issues), and to sell the newly issued benchmark, which traded at a premium. Over time, valuations of the two bonds would converge. Assuming this generates 50bps arbitrage, you leverage the position 25 to 1 and earn 12.5% return on equity (50bps * 25x leverage). LTCM generated annualised return of 21% (after fees) in its first year, 43% in second and 41% in its third year. The going, so far, was good.

By the end of 1997, LTCM broadened its strategies by including new approaches in markets outside of fixed income. Many of these strategies were not market neutral as they were dependent on directional movement in interest rates or stock prices (not traditional convergence trades). By 1998, LTCM had accumulated extremely large positions in merger arbitrage and S&P 500 options. The assumption was, because things have historically converged, they will in the future as well.

At the beginning of 1998, LTCM had equity of USD4.7bn and had borrowed over USD125bn, a debt-to-equity of over 25x. The markets, then, were just recovering from the 1997 Asian Financial Crisis when the Russian government had defaulted on its domestic local currency bonds. It hadn’t happened before; countries have access to the printing press, why would it default on local bonds instead of just printing more money. But it did, and in the ensuing flight to quality, prices that ‘should have’ converged went farther apart. By end of September 1998, LTCM had lost USD4.3bn, leaving it with debt-to-equity ratio of a staggering 250 to 1. Fourteen institutions had to bail it out under supervision of the Federal Reserve and the fund was dissolved in early 2000.

At the end, we must acknowledge that with investments, as with life itself, events that have not happened before, may happen. Prior to last year, markets had never fallen 25% in one month (and yet they did in March 2020). And, markets had never recovered to form new high in one straight line (which again they did by December 2020). These are tail risk events, ones that have an exceptionally low probability of occurrence, but when they do occur, they have a disproportionate impact.

As investors, all of us regularly draw conclusions from historical events. As the availability of data and the depth of our analysis increase, so does our confidence in decision making. And when rising confidence meets success, for every subsequent bet, we tend to increase the stakes. This can be a virtuous circle, only so long as we do not raise the stakes so high that when a tail risk event strikes, its impact delivers a devastating blow on our portfolios which we cannot recover from.

Nassim Taleb, in his book Antifragile, calls it making your portfolio convex–something that gains from disorder (including tail risks), whereas Mohnish Pabrai, in his book Dhandho Investor, elegantly puts his investment philosophy as, “heads, I win; tails, I don’t lose much.”

Even seasoned professionals can fall in this trap when the going is good. Being prepared that life will, intermittently, keep serving events that have never happened before, is the battle half won.

Notes:
(1) The un-politics of Prashant Kishor | India News,The Indian Express;
(1b) IPAC is widely reported as Prashant’s company, but it is difficult to find in what capacity he is related to it from its website.
(2) https://twitter.com/PrashantKishor/status/1340882902628749317?s=20
(3) Prashant Kishor Speaks To Rajdeep Sardesai Over His Explosive Chatroom Audio Leak On Bengal Polls – YouTube
(4) Long-Term Capital Management – Wikipedia

The letter was originally published here: Because it has never happened before—tail risks and convex portfolios – cnbctv18.com

Changing how it is always done – exchange, agriculture and AMC

April 9, 2021

Letter # 36, 9 April 2021

“The NSE will only result in fragmenting the existing market, which will lead to less competition and greater volatility,” said the then president of the Bombay Stock Exchange (BSE) in September 1991 ⁽¹⁾. In June 1991, a committee headed by Mr. Pherwani had recommended, among other things, that a new stock exchange be promoted as a ‘model exchange’ which would provide access to investors from across the country on an equal footing ⁽²⁾. BSE, at the time, was the largest exchange accounting for 70% of all transactions in India, but had multiple issues—fake certificates, broker defaults, counterparty risks, low liquidity, delayed settlements, antiquated trading platform and frequent closures.

At the root of the problem was the exchange’s bundled structure (ownership, management and trading), controlled by the broker coterie, that created unusually high entry barriers and thwarted all attempts of automating the exchange fearing that the transparency would end their dominance ⁽³⁾.

The NSE was set up in 1992, but BSE continued to believe that brokers, and not technology, is central to operations of the exchange. Even the protests around the creation of a new exchange were rather muted, as most participants had expected NSE to fail. Under the leadership of Mr. Nadkarni and Dr. Patil, NSE linked trading terminals across India using the V-SAT technology and introduced electronic matching system ⁽⁴⁾. Trading at NSE took off in 1994 (amid high suspicion), but was slow to begin. However, once it started processing weekly settlements (unheard of at that time) with relative ease, volumes started rising. Within just a year of launch, NSE had beaten the champion at its game and started reporting a higher turnover than BSE. BSE’s own members now started taking NSE memberships. Technology had changed the game and incumbents did not see that coming.

Fast forward a few decades to now, and we find another resistance to adoption of technology. Last week, India’s Food and Public Distribution minister Piyush Goyal wrote a letter to the Punjab government asking it to finally (after years of cajoling) implement central guidelines for e-payment of minimum support price directly into farmers’ accounts for the upcoming rabi season ⁽⁵⁾.

The Public Finance Management System (PFMS) was launched in 2009 as a platform to track funds released under Plan expenditure of central government. By 2012, the central government started direct payment of MSP to farmers, and by 2013, the PFMS was put in use for all direct benefit transfers (DBT) from the central government. By 2017, PFMS was made mandatory for all central government schemes. Andhra Pradesh, Bihar, Rajasthan, Telangana and Haryana integrated land records (with some exceptions for Haryana), set up own procurement portals and started e-transferring the money to farmers. Punjab, on the other hand, continued to pay farmers through middlemen (arhathiya) who facilitate the transaction in marketplace (mandis). Given that Punjab was among the first few states to ensure bank accounts for all households under the Pradhan Mantri Jan Dhan Yojana, it is apparently the fear of moving to a new system and control of a few vested interests that seems to be holding the process back ⁽⁶⁾.

Coming closer home, technology appears all set to disrupt the asset management industry as well. The mutual fund industry has done a fabulous job of expanding the equity culture in India over the past two decades. With targeted marketing and strong distribution, assets under management have increased multiple folds and the mutual fund industry has taken the product to India’s masses (with 85m retail investors with average ticket size of just INR69,000 per account ⁽⁸⁾). However, a cursory glance ⁽⁷⁾ indicates that seven of the 10 largest asset management companies in India have banking parentage. Wide-spread banking reach and brand equity of the parent enable them to create a distribution network that reaches far into India’s hinterland. On occasions, that has also implied that the distribution (marketing and sales) has taken precedence at the cost of product (ability to generate superior returns in a consistent fashion). In most categories, alternative asset managers (AIF and PMS) seem to be displaying a superior product slate (better risk-adjusted returns), but lack the distribution (hinterland roots and ubiquitous brand) and a higher ticket size has so far prevented their large-scale asset accretion (relative to mutual funds). With democratization of data and information availability easing, on incremental basis, a superior product could start having a much stronger ‘pull’ compared to a weakening distribution ‘push’. A level-playing field on taxation could just accelerate the process much faster.

In conclusion, the pace of technology-driven change often surprises us with its speed and leaves a lot of ‘once immensely powerful’ systems in its wake. NSE transformed the game with weekly settlements and today, the system happily settles trades on the same day effortlessly. Similarly, technology changed how corruption was tackled with DBT. Changes are now upon us in the asset management industry. A lot more alternative managers will come about, and the industry, which has grown multi-fold over the past few years might come to be the mainstay in some categories (wealth above certain threshold). Moats around the mutual fund industry (viz. brand and taxation) might prove inadequate in face of technology and data democratization that could change how distribution is handled in India going forward.

Notes:
(1) Ego clash – Economy News – Issue Date: Sep 30, 1991 (indiatoday.in)
(2) High_Powered_Study_Group_On_Establish_Of_New_Stock_Exchanges.pdf (mstatic.in)
(3) Sucheta Dalal on the NSE. (goodnewsindia.com)
(4) RH Patil: The man who revolutionized Indian stock market – The Economic Times (indiatimes.com)
(5) Ensure e-payment of MSP directly into farmers’ accounts: Piyush Goyal to Amarinder Singh | India News,The Indian Express
(6) Amarinder Vs Goyal On Direct Payments To Farmers: In No Possible Scenario Do The Arhatiyas Gain Anything (swarajyamag.com)
(7) 10 Biggest AMCs in India – Asset Management Companies List 2020! (tradebrains.in)
(8) FolioandTicketSize.pdf (amfiindia.com)

This letter was originally published here: Changing how it is always done – exchange, agriculture, and AMC – cnbctv18.com

Changing perceptions could bring outsized returns

April 6, 2021

Letter # 35, 26 March 2021

Had I started the sentence with, “past performance is not a guide to future,” you would have invariably presumed the ending to be, “please read scheme-related documents (or disclosure document in case of PMS) carefully before investing.” No, I do not intend to start the letter with a disclaimer. However, the stories I am about to share highlight how outsized returns (for investments, but more importantly, for nations) are generated when perceptions, formed by past actions, change.

In the last week of February 2021, the Director Generals of Military Operations (DGMO) of India and Pakistan, in a joint statement, agreed to strict observance of all agreements, understandings and ceasefires along the Line of Control (LoC) and all other sectors. The reaction to this on the Indian side was, at best a ‘yawn’, “nothing new, mate; we shall be back to square one within a few days.”

And, that is where the question of ‘past performance’ comes in. A ceasefire understanding between India and Pakistan was reached way back in November 2003, which paved the way for the Vajpayee-Musharraf meeting in Islamabad alongside the SAARC summit. This kickstarted the peace process from 2004 to 2008, before the whole thing was blown apart by the 26/11 Mumbai terror attacks by Pakistani terrorists. Then, in December 2013 again, DGMOs of both the countries met and agreed to ‘maintain the sanctity and ceasefire on the line of control.’ But, from 2014 onwards, tensions across the LoC rose and the agreement was in tatters.

Then, in 2018, for the third time, an agreement was reached by the two DGMOs to “fully implement the Ceasefire Understanding of 2003 in letter and spirit forthwith and to ensure that henceforth, the ceasefire will not be violated by both sides.” Alas, this too did not survive a couple of months and a record number of violation incidents were reported in 2020.

So, you might as well ask, “will this agreement be different?” I do not profess to know the answer. Frankly, I doubt if anyone knows; we will simply have to wait and see. But the 2021 agreement was followed up with a conciliatory speech by Pakistan’s Army Chief Bajwa. But, it is not just that; for Pakistan, it is simply getting too expensive to keep the rhetoric on.

Pakistan’s finances were far from stable even before the COVID-19 hit. With aggressive curbs on imports and massive devaluation of the currency, it was able to reduce its current account deficit, but economic growth fell from 5.6 percent in 2018 to 3.3 percent in 2019 and was expected to plunge to 2.4 percent in 2020 without the COVID-19 impact.

In 2019, it had already foregone an increase in defence budget and cut expenditure on health, education and other social services. In general, Pakistan is battling mammoth twin deficits, deteriorating forex reserves, weak currency, soaring sovereign debts and for the 13th time in three decades, it formally requested an IMF loan. Its public debt had reached close to 90 percent of GDP in 2020 and it was seeking bailouts from China and Saudi Arabia. Meanwhile, inflation had reached 15 percent in January 2020. Post-COVID-19, the situation has only turned for the worse.

Besides, geopolitically, it has to contend with a resilient India on the East, its dwindling importance for the US in Afghanistan and an overbearing China in the North. No surprise then that peace might suddenly start sounding a lot better option.

At the same time, India’s ability to fight a war on two and a half fronts is less than ideal as well. Its defence spending over the previous decade has barely kept pace with inflation and as we had pointed out here, rising naval spending are focused on expanding the commercial footprint. Given that India’s current dispensation, in its federal budget, appears to be finally focussing on economic expansion, a stable and peaceful border might not be a bad bargain.

India will most likely follow a ‘trust, but verify’ doctrine that the US followed towards the end of the cold war with the then USSR. But if Pakistan’s future actions are different from its past, the change in perception can drive higher rewards, both for Pakistan and India.

And, talking of changing perceptions bringing higher rewards for countries, let us talk about how it can drive stronger returns for investments. Before the onset of the global financial crisis (GFC) in 2007, sectors that had delivered superior returns were asset-heavy and capital spending driven (real estate, power, energy, telecom, capital goods). Businesses that are now considered ‘compounding stories’ (FMCG, information technology, healthcare) were among the worst performers back then.

The GFC and the subsequent meltdown in equity markets have exposed the froth in the best performing sectors prior to GFC. Since 2007 and before coroanvirus, the market’s attention had entirely shifted from capex stories towards consumption ones. FMCG, IT, durables, healthcare and automotive became the best performing sectors and realty, power, telecom and capital goods lagged the index’s performance.

In the post-GFC world, things were different; consumption stories benefited immensely from a change in perception (see table below). Yes, these businesses did report strong growth in earnings, but the stock price performance in most cases was way ahead of the increase in profitability. On a market-capitalisation weighted average basis, these stocks, over the decade, were 10 baggers versus 3x increase in earnings.

The price of any stock has two components: (a) earnings; and (b) price to earnings multiple. While earnings growth could be relatively simple to forecast, the price to earnings multiple expands when the perception of business changes. Of course, there are technical factors as to what the justified valuations should be (price to earnings, EV to EBITDA or discounted cash flow), but the number of assumptions that go into those models makes PE ratio as much a ‘perception issue’ as much as it is a ‘technical issue’.

In conclusion, we saw how changing perceptions resulted in some sectors that were big outperformers during 2002-07 turn underperformers in the next cycle. Similarly, we also saw how investments in some businesses benefited disproportionately in the next cycle with changing perceptions. As investors, part of our job is obviously to gauge how earnings are likely to change over the next three to five years. However, if we get the change in perception right as well, the alpha generation (and investment returns) can be outsized.

Originally published here: Changing perceptions could bring outsized returns – cnbctv18.com

Chemicals and Commodities: Knowing how China operates can help

March 26, 2021

Letter # 34, 19 March 2021

“The rarest pistol in the world, Larry. A point 45 Luger,” said Gekko. “Only six of them were ever made.” Sir Larry Wildman scoffs off a congratulation before coming straight to the point with, “but rarer still is your interest in Anacott Steel.”

And we all know that ‘Blue horseshoe loves Anacott Steel’, right! The classic 1987 movie, Wall Street, directed by Oliver Stone which all of us must have watched several times.

The scene depicted a typical fight between two corporate raiders, quite a regular feature during the 1980s in the US. Towards the end of that scene when Larry leaves, Gekko’s protégé Bud Fox recites passages from the ‘Art of War’ that he has been reading up to fend-off competition.

Sun Tzu was a Chinese general and military strategist and his book is very well read and quoted. When practiced in the movies, it can be fun. But when it comes to real life, the costs involved are simply too large. China has often put its political objectives ahead of other considerations (economic and environmental) before taking ‘business decisions’, and when dealing with other countries. India has benefited due to this in the chemicals space but had to pay a decent price in the metals industry. Investments in these businesses can gain from a clearer perspective on how China operates.

Last Friday, the leaders of four Quad countries—India, the US, Japan and Australia—held their first virtual summit. Among other things on the agenda, Nikkei newspaper reported on Thursday, was an expectation of working together to secure rare earth metals.

The news article itself was inconspicuous and chances are that you might not have heard of rare earth companies (India has just one and it is not listed— Indian Rare Earths Ltd). But, without rare earths, a typical modern life will fall apart, literally!

The rare earth elements (or rare earth metals) are a set of 17 nearly indistinguishable metals. Despite the name, rare earths are not so much ‘rare to find’, as much as they are ‘rare to process’. A rare earth Cerium is the 25th most abundant element, more abundant than copper. But unlike bulk metals, they don’t occur in concentrates but are rather scattered, and it makes commercially mining these on large scale result in deforestation, contamination of land and water, human rights violation and a few elements are also radioactive.

Difficult and as polluting mining them is, not doing it is not an option—they permeate our everyday life. They are a critical element in digital technologies (vibration motors, electrical componentry, LED screens, speakers, etc.), Automotive (electric motors, AC compressor, braking systems, coolant system, etc), military (guidance and control system, communication and radar technology, electric motors) as well as clean energy (especially wind turbines). Essentially, without them, we cannot operate mobile phones, cars, electric vehicles, wind turbines, bombs, missiles, drones or radars.

Now that we know how important they are, let us look at where they naturally occur. USGS estimates total global reserves of rare earth at c120 million tons, of which 37 percent are in China, 18 percent each in Vietnam and Brazil, 7 percent in India and 4 percent in Australia. Here is the fun part: with 37 percent of rare earth reserves, China, in 2010, accounted for 97 percent of global mine production (120k out of 124k) of rare earths.

Given the environmental implications, the world was happy to let China do the heavy lifting. The former did not know, just yet, how rude a shock it was in for. On one Tuesday in September 2010, the then Chinese Premier Wen Jiabao called for Japan to release a captain who was detained after his vessel collided with two Japanese coast guard vessels as he tried to fish in waters controlled by Japan, but long claimed by China. Wen threatened unspecified further actions if Japan did not comply.

Later, the commerce ministry declined to comment on China’s trade policy on rare earths, saying only that Wen’s comments remained the Chinese government’s position. Until that time, Japan had been a major buyer of Chinese rare earths, using them for a wide range of industrial applications. Alarm bells started ringing loud and clear for the need to diversify the source of a material that virtually controls everyday lives. Things have improved over the previous decade and China now contributes only 58 percent to global rare earth mining.

That was not the first time that China had put national interest above environment and economics. By 2000, it was ready to start building infrastructure for the next generation and needed millions of tons in bulk materials (metals and cement). USGS estimated that China, in 2000, had just 2.8 percent of global bauxite reserves—a key material to make aluminium. Over the next fifteen years, global aluminium consumption more than doubled and China’s accounted for 80 percent of that—spectacular numbers. Despite that, the price of aluminium rose just 59 percent in those years, only marginally beating inflation.

Given such strong consumption growth, prices should have skyrocketed, but they didn’t, primarily on account of China’s make versus import decision. With hardly any bauxite and despite having to import coal to generate power (a key cost in aluminium), China’s aluminium production (at 10 percent of world in 2000) jumped to 50 percent by 2015. In addition, it decided to produce more than required and export the surplus, often at prices where global companies (including Chinese companies) lost money. Why, you might ask! Because the money that Chinese companies lost by selling aluminium was minuscule compared to the cost that China would have incurred had it imported aluminium from other countries (at 2-3x the price).

Over the past seven years, a similar story has developed in the chemicals space as well. In 2013, China passed measures for environment protection and set targets to reduce emissions and followed that up with shutdowns in many provinces. In addition, trade wars between China and the US, which started in 2018, forced a lot of western hemisphere consumers to start looking at India. India did well to develop a niche in complex chemistry (multi-step synthesis) and specialised in specific unit operations like fluorination. Indian chemical companies have benefited immensely—profits have risen three folds over the past seven years and analysts expect them to double over the next two. Stock prices have already skyrocketed, rising more than 20-30x over the past seven years.

In conclusion, I will say that we have historically been trained to evaluate capital-intensive businesses with a keen eye on unit economics. Geographies with the highest raw material resources tend to be among the lowest-cost producers and they acquire scale to become the largest producers and exporters of that commodity. Knowing that ‘economics’ is not the only operative condition whenever China is involved will help us analyse these businesses better in the future.

The letter was originally published here: Chemicals and Commodities: Knowing how China operates can help – cnbctv18.com

Simplifying a complicated relationship

March 12, 2021

How US treasury yields, exchange rates and FIIs impact your portfolio

Letter # 33, 12 March 2021

It’s the middle of World War II, in New York City in 1943, and Steve Rogers is rejected for military recruitment due to his small stature. He keeps trying and finally lands himself into the Strategic Scientific Reserve as part of the ‘super-soldier’ experiment, which turns him into a superhero. He then joins forces with Bucky Barnes and Peggy Carter to lead the fight against HYDRA—a Nazi-backed organisation.

If you guessed what I am talking about, you are a fellow fan of Captain America! If you didn’t and are wondering why I am handing out a crash course into a movie that released in 2011 (based on the Marvel Comics character), let me tell you that the story I am about to share today also started with the invocation of war-time spirits.

During World War II, the US launched the Series E savings bond to help finance the war effort. The advertisement campaign appealed to patriotism, urging people to buy bonds with a negative interest rate. The government managed to raise a staggering $186 billion (over $3 trillion in today’s money) from 85 million US citizens—a resounding success.

Fast forward a few decades and this repeats in 2020, but things are done a little differently now. To fight the corona pandemic, governments the world over have announced massive fiscal loosening measures and central banks have relaunched Quantitative Easing (QE), thereby lowering interest rates. Savers are expected to do their part by accepting much lower yields than before and inflation, which is way higher than before. The US 10-year treasury note (US10Y), which was tracking close to 2 percent in November 2019, started sliding and settled close to 0.5 percent by August 2020.

As the fears around the pandemic eased, US10Y started rising–initially to a percent by January 2021 and later more as the reflation argument started surfacing; bond markets were now on an edge. Then on February 25, 2021, something unusual happened. At a regular auction of US treasuries, an unusually large proportion of bonds remained in the hands of primary dealers as opposed to long-term investors. That spooked markets and yields rose–of not just 7-year, but also US10Y, which rose 16bps that day. By March 8, 2021, the US10Y had risen 58bps from its lows in February.

You might say, what do you expect? Fundamentals matter, right? The latest $1.9 trillion stimulus means that the fiscal deficit in the US will reach unprecedented peace-time levels. Over the past two decades, global debt has jumped by $150 trillion compared to a mere $45 trillion rise in global GDP. That is an incremental debt-to-GDP of 3.4x (in 2000, that number was just 1.8x). Governments cannot go on borrowing without consequences; after all, money borrowed today should generate sufficiently high return versus its cost; it’s unproductive otherwise.

And, you are right. But you see, US treasury yields have implications—not just for bond investors in the US, but also on the US dollar and US equity markets as well as on all Emerging Markets (EM). All other things being equal, historically, a rise in treasury yield has been accompanied by a stronger US dollar, weaker US equity markets and sharply lower EMs. Consider the following examples:

Taper tantrum in 2013 (between February and July): The US10Y rose by c80bps, the USD appreciated by 5.4 percent and the MSCI EM index fell 8 percent in constant currency terms.
Trump tantrum in 2016 (between August-16 and January-17): The US10Y rose by c87bps, the USD appreciated by c6.9 percent and MSCI EM fell by c5 percent.
Recent rout in 2021 (between 27th Feb-21 and 8th Mar-21): The US10Y rose by 58bps, the USD has risen from 90.1 to 92.3 and global equity markets have been jittery.

Many of you would know that the US dollar wasn’t always the ‘be all, end all’ that it now is. Prior to the First World War, the pecking order of the US dollar was much behind Sterling, Mark, Franc, Guilder and Lira. Despite the size and strength of its economy, the US had no central bank, and its currency was a hodge-podge of bond-backed notes by commercial banks. Post the Federal Reserve (Fed) formation in 1913 and during the First World War, the prominence of the US dollar increased dramatically as the Fed did well to create a market for trade credits, smoothened interest rate spikes, reduced financial volatility and solidified management of the gold standard. Europe was floundering at the time and by 1920, the US dollar had become one of the world’s major international currencies.

Now that the Fed and US dollar assume so much prominence, their actions are analysed at great lengths. To manage the monetary system, Fed’s reaction function is theoretically two-fold—verbal and balance sheet use. Participants were hoping that Chair Powell’s comments on March 4, 2021, will placate markets. But they were interpreted as being insufficiently forceful as the yield kept climbing higher. All eyes now are on March 17, 2021, FOMC meet; especially on how they choose to use the balance sheet (buy more across the curve, extend the duration, or do an operation twist) which will determine if, and how, fast the yields get contained.

To put things into perspective, between 2002 and 2008, the dollar index fell 40 percent (from 120 to 72) and EMs returned 205 percent over that time. And, between 2008 and 2017, the dollar index rose from 72 to 102 (up 40 percent) and EMs returned a cumulative negative 12 percent (see chart). In the meantime, India’s relative positioning among EMs has improved and FIIs have accelerated their investments in India ($30 billion poured into Indian equity markets over the past year versus the previous best of $16 billion in 2012). If US10Y tapers off and the US dollar depreciates, going by historical precedent, it is quite plausible that foreign investors will keep pouring money into EMs and India as well.

For portfolio decisions, one should consider a few things–on the one hand, liquidity has become overwhelmingly important and we should track it with equal zeal as we track fundamentals. On the other, some classical signs of over-heated markets are starting to emerge, viz., an elevated number of issuances each week, blockbuster listings, stratospheric levels of oversubscriptions to even some questionable offerings.

So how does one approach investments? For us, the absolute price-to-earnings multiple of the index, in and of itself, means little. What is expensive can stay expensive for long. It is better to approach investments through a holistic portfolio approach, one where you stay invested, but it is about time that the quality of the portfolio improves rather than worsens by buying the latest fad. And, by improvement, I mean: (1) buying businesses with cash flows that offer inflation-hedge; (2) buying businesses with physical assets on the ground and reasonable debt rather than those with invisible ideas; and (3) buying businesses with predictable cash flows rather than growth cash flows.

The blog was originally published here: https://www.cnbctv18.com/views/simplifying-a-complicated-relationship-how-us-treasury-yields-exchange-rates-and-fiis-impact-your-portfolio-8577421.htm

Live free or die hard!

March 5, 2021

Letter # 32, 5 March 2021

A ‘Fire Sale’ is an all-out cyber warfare attack that mounts a three-stage systematic attack on a nation’s computer infrastructure. Hackers called it Fire Sale because “Everything must go”.
Stage 1: Shutting down all transportation systems such as traffic lights, railroad lines, subway system and airport systems. Stage 2: Disable financial systems, including Wall Street, banks and financial records. Stage 3: Turn off public utility systems such as electricity, gas lines, telecommunications and satellite systems.

If you recognized the dialogue, you are a fellow fan who grew up watching Bruce Willis play John McClane (the dialogue is from the 2007 movie Die hard 4.0). For those who haven’t seen the movie (oh, you should), the central thesis of the movie was—steal data through the anarchy created via the Fire Sale. As much as the movie was fun, it sounded, in equal measure, ludicrous. Now, after 14 years of release, it no longer is.

Technology is continually changing the rules of engagement across the globe. This week, we look at how warfare between countries, as well as between telecom companies in India, has evolved.

A few weeks ago, we had written about how China plans decades and centuries in advance and the reason why we believe it engaged in a protracted standoff with India (read it here). On October 12, 2020 (around the time when the border tensions were at peak), a grid failure resulted in a massive power outage in Mumbai, bringing the Maximum city (including its buildings, trains and hospitals) to a grinding halt. Two days later, the state’s Energy Minister Nitin Raut told the media that sabotage cannot be ruled out ⁽¹⁾.

This week, Recorded Future—a Somerville, Mass.-based company, that studies the use of internet by state actors—made a startling revelation ⁽²⁾. Stuart Solomon, Recorded Future’s COO, said that the Chinese state-sponsored group, which the firm named Red Echo, “has been seen to systematically utilize advanced cyber-intrusion techniques to quietly gain a foothold in nearly a dozen critical nodes across the Indian power generation and transmission infrastructure ⁽³⁾.” The report further says that 10 distinct Indian power sector organizations, including 4 of the 5 Regional Load Despatch Centres (RLDC) responsible for operation of the power grid through balancing electricity supply and demand, have been identified as targets in a concerted campaign against India’s critical infrastructure. Other targets identified included 2 Indian seaports.

And, it does not end here. Earlier this week, Reuters also quoted cyber intelligence firm Cyfirma that Chinese state-backed hacking groups had targeted the IT systems of two Indian vaccine manufacturers (Serum Institute and Bharat Biotech) ⁽⁴⁾. “The real motivation here is actually exfiltrating intellectual property and getting competitive advantage over Indian pharmaceutical companies,” said Cyfirma Chief Executive Kumar Ritesh, formerly a top cyber official with British foreign intelligence agency MI6 (as literal an equivalent of ‘Q’ in a James Bond movie as I have ever come across in real life).

Whereas most countries have a military doctrine for fighting wars (conventional and nuclear), how different countries choose to react to these new tactics is still developing. Moving on from countries to companies then. The recently concluded airwaves auctions brought back memories of how the war in the telecom sector has changed over the past two decades.

By 2010, the Indian telecom market was growing fast, but was already overcrowded. Reliance Jio still decided to enter it, albeit by stealth. It first acquired a broadband wireless spectrum (BWA) licence, which later got converted into a unified licence. By 2016, the original licence (internet service provider) also got converted to allow voice telephony and Jio launched its services.

If you were listening, corporate India hadn’t heard a louder battle cry in a while. Having already invested USD32bn, Jio wanted majority (if not all) of the Indian telecom customers. It went for the kill.

First, it launched its much superior services free for three months and extended it by three more months. The difference between ‘ten dollars’ and ‘one dollar’ is large, but the difference between ‘one dollar’ and ‘free’ is HUGE. Competition was ready for a price war, but not to compete with ‘free’. Along with the shockwaves, it sent the average per user revenue (ARPU) tumbling— it halved over the next two years. Second, it created capacity to serve an even larger customer base by signing a spectrum sharing arrangement with Reliance Communication for the 800MHz spectrum. The net result—mergers, shutdowns and bankruptcies. A 13-players’ market in 2014 became a 4-players’ market ⁽⁵⁾, with Jio emerging as the largest company with 35% of subscriber market share. That was a straight-out war.

Although India now is effectively a 4-players’ market, three companies account for over 92% of revenue—Reliance Jio (Jio), Bharti Airtel (Airtel) and Vodafone Idea (VI). Around 2019, things had started looking rosy—a consolidated industry, players raising prices in late 2019, APRU rising 20% plus since lows. Despite the price hike, the industry was generating return ratios that were far lower than its cost of capital and investors assumed that with the wars now behind, greener pastures lie ahead. Jio had other plans, as it moved from an all-out war to salami slicing tactics.

In September 2020, Jio launched post-paid plans at an aggressive price point and followed it with a bundled Jio phone launch last week. For its part, Airtel added 10-20MHz of additional spectrum in the 2,300 band (in category B & C circles) last week. It is essentially telling Jio that I am here to stay.

The intended target, then, is… VI. It still has close to 25% of customers and is a large No.3 player (at least by subscriber market share). Fighting the massive wars have left it with a negative net worth (USD4bn) and continues to report quarterly losses. If Jio and Airtel delay another price increase, say by a year, they deprive VI of billions in earnings. Jio and Airtel get hurt in the process as well, but it becomes an existential crisis for VI. The company will have to dilute equity massively to survive (and that assumes that capital is somehow available).

In the end, what doesn’t kill you makes you stronger. In the long rum, a 2-players’ market is certainly far more profitable (well, for those two players) than a 3-players’. As the tactics for cross border warfare change, telecom wars in India have also changed tactics. It is now up to VI to roll up its sleeves and defend its territory—time to ‘Live Free or Die Hard’!

Notes:
(1) October 12 blackout was a sabotage (indiatimes.com)
(2) Chinese Group RedEcho Targets the Indian Power Sector Amid Heightened Border Tensions (recordedfuture.com)
(3) China Appears to Warn India: Push Too Hard and the Lights Could Go Out – The New York Times (nytimes.com)
(4) Chinese hackers target Indian vaccine makers SII, Bharat Biotech, says security firm | Reuters
(5) List of telecom companies in India – Wikipedia