Category: blog

Fully invested bears, anyone?

September 24, 2021

Letter # 58, 24^th September 2021

It’s easy to miss the events that occur in far-off lands, but a few offer an interesting perspective. Yesterday, Algeria closed its airspace to Morocco, a month after it broke off all diplomatic ties with its neighbour. While it is difficult to spot the two small North African nations on a map, their story is fascinating. One that leaves you gasping with… “but, why?”

On paper, the African nations appear promising. Oil reserves (Algeria), vast natural resources (including a large coastline) and new-found independence. Circa 1960s, they held the potential to usher North Africa into prosperity in the post-independence era. Well, they did not.

It started when the French conquered Algeria in 1830s. Like a good neighbour, Morocco catalysed a rebellion against the occupation. But a decade later, France responded by attacking the Moroccan army and annexed parts of its territory to France.

By the 1950s, however, precious metals were discovered in the annexed parts and France transferred the area to Algeria. Years later, France offered to return it to Morocco, if the latter was willing to jointly develop the minerals with France. Morocco rejected this advance as by then Algeria was in final swing of its independence movement. Provisional government of Algeria offered a better deal.

But, on gaining independence, Algeria was in no mood to comply. The trust was broken, relationships were soiled and “Sand Wars” broke out. The final nail came in 1975 when Spain conceded its territorial occupation of Western Sahara to Morocco (a region to its South). Western Sahara had a large coastline and offered access to the Atlantic Ocean by bypassing the Gibraltar Strait. For Algeria, that was the key to its aspiration of regional dominance. A proxy conflict ensued which lasted for two decades. A cease fire was announced in 1991, but the score was far from settled.

Over the past decade, the two countries combined have spent over USD110bn on defence (combined GDP is cUSD300bn). Morocco runs amongst the most sophisticated military with arsenal of F16 jets, M1 Abrams battle tanks, M109 howitzers and observation satellites. Algeria matches it with its own fleet of SU 34 jets, Navy frigates and kilo-class submarines. A close observation would reveal the country of origin of this equipment (for respective countries).

The two countries do not face a national threat, apart from each other. Yet, they spend all that money on defence, year after year, just trying to out manoeuvre each other; precious money that could have been spent on education, infrastructure building and general economic development. All this, while Algeria’s GDP is contracting, and austerity measures are in place for more than the past five years ⁽¹⁾.

In his book, The Wisdom of Crowds, James Surowiecki argues that under the right circumstances, groups are remarkably intelligent and are often smarter than the smartest people in them. He begins by telling the story of Francis Galton, the English Victorian-era polymath. In one of the poultry contests in 1907, some 787 people paid six pence for the opportunity to guess the weight of a rather large ox. A few guessers were farmers and butchers (maybe classified as experts), but a far greater number had no specialized knowledge of farm animals. Based on that, he anticipated his 787 participants would come up with a dumb answer.

The ox weighed 1,198 pounds. Galton took all guesses and plotted a distribution curve. He found that the median guess was within 0.8% of the correct weight and mean guess was within 0.1% (average guess was 1,197 pounds). The crowd, as a collective, just knew! They knew it better than the “so-called” experts could guess. How?

Surowiecki writes that two critical variables are necessary for a collective to make superior decisions–diversity and independence. One, if a collective can tabulate decisions from a diverse group of individuals who have different ideas or opinions on how to solve a problem, the results will be superior. Two, independence does not mean participants remain in isolation, but each member is free from influence of other members.

A geopolitical history of the two African nations reveals how the collective wisdom of crowds has always been missing. The politics of Morocco takes place in the framework of parliamentary constitutional monarchy. It hold elections, but the King makes strategic decisions. In July 2020, Morocco’s King Mohammed VI celebrated 21 years on the throne. Prior to him, late King Hassan II ruled from 1961 to 1999 and the list of dynasts date back to 788 AD.

Algeria, on the other hand, is a constitutional semi-presidential republic. However, many political observers call Algeria a “controlled democracy”— a state where the military and “a select group” of unelected civilians make major decisions, such as who should be president ⁽²⁾. When talking of countries, one cannot distil the failure point to one (or even a few) variables. Nevertheless, it is fair to say that the wisdom of crowds has been long missing, and the lack of accountability does explain the situation in part.

Now let us consider Galton’s idea for stock markets–a system that is incentive-based and one that can aggregate investor decisions. If the “smart collective” always comes to the right conclusion, how come we end up with booms and busts? Why does the “diverse group” not come to the right prediction for the market as it did in Galton’s country fair?

Surowiecki argues that with markets, condition No. 2 (independence) is often not met and more so in modern times. Decisions of market participants are not always independent, but often coalesced into one opinion. People make decisions based on actions of others rather than their own private information. The age of social media accentuates this process.

And, it adds up. Prior to March 2020, the market had never fallen 35% in one month and never before had it recovered in one straight line; and yet it did. Earlier, two cohorts existed: (a) “Trend followers” (momentum strategies) who bought more when prices rose (and vice-versa); and
(b) “Fundamentalists” who bought based on underlying value. They used to balance each other out and historical market corrections (or recovery) were not as pronounced.

Increasingly, that difference has blurred. Whereas momentum strategies continue, fundamental investors have devised ways of valuing businesses that did not exist before. Thought process moves to relative–B is cheaper compared to A, hence one must buy B. Regardless of whether B deserves to be valued at current absolute valuations. PE multiples are just a state of mind, they say, right?

When everyone starts operating looking at others, it eventually results in market rallies (and corrections) assuming extreme proportions. The last straw is when fundamentalists throw in the proverbial towel and convert into what one finds regularly now… “a fully invested bear”. Now that this is out of the way and as US and Indian markets hit their all-time highs, do you think it is a good time to start getting invested in equities for the next decade?

Notes:
(1) ALGERIA: Shift Towards Austerity (readcube.com)
(2) https://www.economist.com/middle-east-and-africa/2012/05/12/still-waiting-for-real-democracy

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

No such thing as a free meal, or… free make-up, apparently!

September 17, 2021

Letter # 57, 17^th September 2021

Malcolm Gladwell has an interesting start to his book, Outliers. He argues that “I did it by myself” kind of explanations to success don’t usually work. Most of them are invariably beneficiaries of hidden advantages, extraordinary opportunities and cultural legacies that enable them to learn, work hard and make sense of the world in ways others cannot.

Take hockey teams in Canada for example. Here, 40% of the national players are born in the first quarter of a calendar and only 10% in the last. What gives? No, it isn’t astrology. It’s simply that the eligibility cut-off for age-class hockey is January 1. So, someone who is born on January 2 would compete with younger kids, sometimes almost a year younger. At that level, 12 months can make a huge difference. As levels advance, it then leads to a self-fulfilling prophecy–you start getting more games, better facilities and the benefit compounds in your favour by the time you reach the national stage.

I was reminded of Outliers earlier this week as many brokerages presented their views on the upcoming (and quite hot, might I add) IPO of the home-grown online Beauty and Personal Care (BPC) champion Nykaa. As Spark Capital succinctly put it (and I paraphrase) over the last decade, a lot of factors have aligned to create a conducive runway for growth for Nykaa i.e., the rapid penetration of smart phones, affordability of data, adoption of digital commerce, evolution of logistics ecosystem and Covid-led digital adoption. Nevertheless, Nykaa got multiple things right–the category and channel (there weren’t many players in online BPC space), solved the right consumer problem (counterfeits and lack of foreign brands sans distribution) and did so without burning a lot of cash.

The consensus opinion from most reports appears to be along these lines: (a) it is a great business; (b) in a nascent industry with a massive runway; (c) it has cracked it in a way that competition never would be able to… and that too; (d) without burning cash.

Consequently, it deserves to be valued quite close to stratosphere. Nykaa last raised capital in May 2020 at the valuation of USD1.2bn. One year later, by March 2021, news reports ⁽¹⁾ had started pegging IPO valuation at USD3.5bn. By June 2021 ⁽²⁾ that rose to USD4.5bn. Most recently, one brokerage report suggested a one-year forward target of cUSD9bn.

I think that as Nykaa’s business model has benefitted from the ecosystem that evolved, its valuations have benefitted from the gush of liquidity fuelled through by historically low interest rates. And, whereas reams of pages are being dedicated to the business model, a discourse on how secondary market shareholders should value such businesses seems missing (publishing absolute valuations may not be permitted under law, the methodology to value it still is).

The venture capital model runs on probability rather than cash flows. A 10% probability of 50x returns over five years implies 33% CAGR… that math is easy. For secondary markets: (a) cash flows; and (b) its timing, take precedence. In developed economies, investments in new-age, hyper growth, cash burning businesses are treated akin to an investment in an ultra-high duration bond (a cash flow stream that will probably generate high cash flow after a long period). So long as interest rates stay very low, secondary investors happily match their ultra long-term liabilities with investments in equity of such businesses. The moment interest rates rise above a certain threshold, these equity investments become untenable to fund. And, without continuous funding, the ‘probability’ of future cash flows dwindles.

I employ similar model that a brokerage might have used to arrive at the USD9bn valuation, albeit with 2 minor changes–one, I increase cost of capital by 2%, and two, I lower terminal growth by 2% (both are quite conceivable and within the realms of possibility). With these changes, the valuation falls to USD5bn, down 44% from the suggested USD9bn. Also, important to point out that the terminal growth rate kicks in after assuming that the annual FCF increases from negative USD10mn currently to over USD2bn over the next two decades (yes, two decades is the explicit forecast period).

“Look at the mess the US economy and the Fed balance sheet is in,” you might say. “Why would the interest rates ever rise?” The short answer is, because economic activity is rising due to liquidity, not necessarily due to productivity gains. Also, a large part of supply disruptions may be permanent. And… it has happened before!

Richard Nixon was inaugurated in 1969 and despite widespread belief of being ‘fiscally conservative’, he turned out to be one with “liberal ideas”. He continued to fund the war, increased social welfare spending, ran large budget deficits and supported income policy.

In 1971, he broke away from the gold standard, which devalued the USD. He fired the then Fed chair McChesney and installed Burns, and leaned heavily on him to keep rates low. “We will take the inflation, if necessary, but we can’t take unemployment,” said Nixon, recalls Burns in his book Secret of the temple.

Initially, the Fed in the 1970s kept seeing inflation as driven by high crude oil prices (and therefore “transitory”, which also saw mankind invent the term ‘core inflation’). Eventually, US had both–high inflation and high unemployment. By 1973, inflation doubled to 8.8%, on its way to 12% later in the decade. It eventually took a new fed chair Volcker in 1979 to raise interest rates to double digits, which put the economy in recession.

Milton Friedman, later, eloquently said it in his book Money Mischief, “inflation is always and everywhere a monetary phenomenon.” To summarize, something will eventually give in and interest rates will rise. May not be now, not next quarter, but soon enough. And once that cycle starts playing out, a lot of business models will become questionable. With that, valuations of all such businesses will be questioned.

Nykaa has created a phenomenal business out of hardly any investment. Even if evolution of the ecosystem benefitted the company, one must credit it for getting almost everything right. Regardless of that, the question of valuation is still one for secondary investors. Nykaa will do phenomenally well if it were to grow annual FCF from negative USD10mn to over USD2bn over the next two decades (as that broking house seems to believe). Even if that happens, minuscule changes in assumptions lead to dramatically lower valuations.

Given the frenzy surrounding the IPO market in general and Nykaa in particular, ours would likely come off as a minority opinion. I am aware of that. Nevertheless, over the short term, following central banks helps make money; over the long term, macros need to fall in order. And, whereas macros for Nykaa might turn out to be just fine, those of several economies leave a lot to be desired. Sadly, that has an equal (if not higher) bearing on the valuation of these businesses than the macros of these companies themselves.

After reading this, while scratching your head, if your question for me is, “dude… I just want to make money on listing pop; will I?” I would do you one better and ask this in return, “if there is a huge runway ahead and the company isn’t burning cash, why the IPO in the first place?”

Notes:
(1) nykaa ipo: ETtech IPO Watch | How Nykaa’s valuation, cap table have evolved over the years – The Economic Times (indiatimes.com)
(2) Nykaa looks to list at $4.5 billion valuation (livemint.com)
This letter was originally published here: No Such Thing As A Free Meal, Or … Free Make-Up, Apparently! (cnbctv18.com)

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.

Same story: structural when chemicals, cyclical when aluminium?

September 3, 2021

Letter # 56, 3^rd September 2021

If I asked you to name the best performing stock in your portfolio over the past five years, what are the chances that you would pick one from the chemicals space? Called by whatever name – commodity, speciality, CRAMS, high performance etc.–on an average, over the past decade, these companies have catapulted 50x. Their historical earnings during the same period have jumped 5x, implying meaningful expansion in valuations.

And the story, you would say, is straight forward, right? Chemicals is a polluting industry; China did whatever it had to do over the past 2 decades and is now incrementally focussed on environment. Plus, post-Covid, the world is tired of the supply chain hassle and wants ‘China plus one’ procurement. Indian companies are well placed in simple as well as complex (or multi-step) chemistry. Plus, managements speak decent English to converse with buyers, labour cost is low, law of the land holds, currency is broadly stable and companies are free to pollute their way to growth. A minuscule move away from China would double revenues of Indian companies. Natural destination… right to win… blah, blah. I will hold these businesses for the next 50 years and valuations don’t matter!

It’s all good and we are in the same boat as the next person; as in, our best performers are chemical companies as well. But what if I were to tell you that the exact same story is playing out in aluminium, and whereas all of us see the chemicals story as “structural”, we view the aluminium price move as “cyclical”. That is to mean that good chemical companies deserve a 30x PE multiple, but metal companies are something of a fad and hence deserve a single digit PE multiple and are generally not worthy of a place in our portfolios for the long term. If you are happy to consider a nuanced take on a complex topic, allow me the opportunity to present my case below.

Aluminium is a reasonably new metal. Unlike steel’s history of thousands of years, aluminium’s history dates back only to early 19^th century, when it was considered ‘holier than thou’ (Napoleon III, the first president of the French Republic, served his state dinners on aluminium plates while the rank and file were served on plates made from gold. Yes, you read that right!).

In the late 1800s, Oberlin College student Charles Hall and French engineer Paul Heroult, separately and simultaneously, developed an inexpensive electrolysis process to extract aluminium from ore. Large amount of electricity was required to power this process, and consequently, production moved to regions where power was cheap. In 1970, NAFTA and USSR accounted for 58% of global aluminium production. By 1998, aluminium production had doubled from 1970 levels, but these countries still accounted for 40% plus of global production. Here is where things started to change.

At the turn of the new millennium, aluminium was THE shiny new metal; it weighed a third of steel, was corrosion resistant, completely recyclable and had good electrical conductivity. It was the metal of the future and all countries creating infrastructure were looking at aluminium with a lot of hope. Sadly, one of those countries was China.

Broadly speaking, to make one ton of aluminium, you need two tons of alumina, four tons of bauxite and 15,000 kwh of electricity. Whereas aluminium smelters and alumina refineries can be built, bauxite and coal (traditionally the fuel for electricity) occur naturally. Historically, therefore, the largest aluminium producing countries were the ones that had access to cheap electricity and bauxite.

That was about to change. In the run-up to 2020, the global aluminium smelting capacity would nearly triple. What was more striking was that China accounted for more than 80% of the incremental capacity. That’s HUGE. For a country that imports bauxite (by my estimate, 40% of bauxite that China requires is imported) as well as coal to generate power only to export aluminium while its domestic companies incurred losses was baffling. I had previously discussed why I believe China expanded the way it did; you can read about it here ⁽²⁾.

Now the thing we conveniently forget is that aluminium is also a highly polluting industry–to make one ton of aluminium, the refinery process (2 tons of alumina) produces around 9kg of air emissions (mainly SO2), 1kg of water emission and over 2000kg of solid waste (red mud). Plus, the anode making produces 2.5kg of air emission, 0.3kg of water emission and 25kg of solid waste. Lastly, aluminium smelting itself produces 23kg of air emission, half a kg of water emission and 34kg of solid waste (landfill) ⁽³⁾.

Last year, China accounted for over 56% of global aluminium production with a carbon footprint that is much larger than rest of the world (given huge transportation for bauxite and coal, plus largely coal-fired power plants). As the Chinese government started clamping down on aluminium production⁽⁴⁾ to curtail emissions, aluminium prices hit a decade-high this week.

Discussions, even now, revolve around how sustainable these prices are and a large section of investors choose to ignore this sector. Since 2000, however, whereas absolute aluminium prices are up 65%, adjusted for global inflation, they are down 25%. The three listed aluminium companies in India generated a single digit ROCE last year, and two of them are integrated with captive bauxite, and the third one has the lowest conversion cost.

If chemical businesses have rallied for the better part of the past decade, inter-alia on the news that China is serious about reducing emissions, then a similar analogy extends to these aluminium smelting companies as well. Indian companies combined have the production capacity of over 4mt and they trade at single digit PEs. Over the past two months, aluminium prices have moved higher by USD300/t, resulting in an annualized increase in EBITDA by over USD1bn combined.

As many global brokerage houses start pegging next year aluminium prices at over USD3,000/t, which of the below do you think is the right question to ask? (a) should aluminium companies be a part of your portfolio; or rather (b) which aluminium company would you prefer to own?

Notes:
(1) Aluminium and aluminum are interchangeably used in this article and might appeal differently to your sensibilities depending on which side of the pond you are. I am sure my purist colleagues would be kind enough to excuse this liberty at my end.
(2) https://www.buoyantcap.com/capitalist-but-on-my-terms/
(2b) https://www.buoyantcap.com/chemicals-and-commodities-knowing-how-china-operates-can-help/
(3) 46194971.pdf (oecd.org)
(4) METALS Aluminium prices lifted to 10-year high by China concerns | Reuters
This letter was originally published here: View: Should Aluminium Companies Be Part Of Your Portfolio? (cnbctv18.com)

Disrupting the disruptors

August 27, 2021

Letter # 55, 27^th August 2021

Let us start with a question: In your opinion, when an industry undergoes seismic changes, do incumbents sense them and respond quickly? Or do things become clear only in hindsight?

In the mid-1800s, Instagram wasn’t yet a rage, but everyone still loved clicking photographs. Cameras were then built using photographic glass plates as supports for negatives and were considered superior to film because they were stable and unlikely to bend or distort. But, there was a problem–cameras were huge and not portable.

That was about to change by 1888. “You press the button; we do the rest” was the slogan with which Kodak’s first fully portable camera was launched. George Eastman’s (Kodak’s founder) guiding principles were simple–mass production at low cost, international distribution, extensive advertising and customer focus. Kodak single-handedly disrupted photography by transforming it from complex activity to a social practice that became part of everyone’s life.

Kodak had a good run until the 1970s, when Japanese film companies (Sony and Fuji) started aggressively pushing into the US market. Kodak lost market share in the run up through 1990s. The sale of analogue camera and films still accounted for 64% of photographic products in 2002, but the world was changing. But by 2005, the consumer film business was disappearing 25% per annum. For 120 years, Kodak had done everything by itself (at one time, it even raised its own cattle and used the bones for making photographic gelatine). In the new digital world, Kodak could no longer do that. By 2011, its stock price fell below USD2 per share and it filed for bankruptcy on 19^th Jan 2012.

The funny part is, the first electronic camera was invented by Steve Sasson, an engineer with Eastman Kodak in 1975. But it was filmless photography and Kodak generated majority of its profits from selling films. Management’s reaction was “that’s cute, but don’t tell anyone about it.”

While Japanese companies Fuji (films) and Nikon (digital cameras) were disrupting Kodak, another US company was busy dethroning a Japanese giant, this time, in the field of music. Akio Morita, Sony’s co-founder, had the vision to marry digital technology with media content in early 1980s. But engineers (and not the media division) ran Sony. The idea that consumers can download music and keep listening to it without it resulting in incremental sales for Sony did not sit well with them. Even when they came around, they introduced proprietary files that were incompatible with the fast-growing mp3 market. By the time they were forced into co-operating, Sony had lost its foothold in two crucial product categories–television and portable music devices.

The company that owned the Walkman brand (was synonymous with portable music devices) was nowhere to be found by the time Apple’s iTunes became the industry standard. Sony’s market valuation by 2012 was down 87% from its 2003 highs (when iTunes was introduced) and down 97% from the 2000 highs.

These days, cameras and music are no longer getting disrupted; instead, the movie exhibition business is. Pay per view and OTT services are trying their level best to change the way movies are viewed world-wide.

In India, however, we have a little history. The introduction of colour television and VCR technology in late 1980s marked the beginning of the piracy culture in India. By early 1990s, many entertainment channels were launched and an average India viewer was eager to consume a lot more. However, the country spent a large part of 1990s living borderline on the cusp of illegality with the movie business. Pirated compact disks were sold by the roadside or on peer-to-peer sites (like BitTorrent or Kazaa) without any part of that income accruing to the formal economy of India.

Yes, it was shoddy. Yes, the quality was supremely bad. But it was cheap and it offered instant gratification. Towards the turn of the new millennium, Indian viewers were tired with this system and wanted better.

That’s when the current exhibition chains set up shops. They didn’t just exhibit a movie in high quality, they sold the entire ‘movie-going experience.’ Spend time with your family, enjoy the movie in good seats and air-conditioned halls, shop in the malls after the movie and end the day with dinner in the next-door restaurant. An entire ecosystem emerged–malls with exhibition houses as anchor tenants, restaurants and shopping markets, which became the mainstay with many families in India.

In the year ended March 2020 (a year with marginal covid impact), over 100mn people saw movies at PVR, India’s largest movie exhibition company. An average visitor paid INR204 for a ticket, consumed food & beverage of INR108 and paid INR20 in convenience charges (the convenience to book tickets on internet). For a family of four, that amounts to INR1,325 per movie. That’s a sizeable amount considering India’s current average income, but nevertheless, it establishes the fact that in just over 2 decades, exhibition houses have managed to disrupt the way movies were traditionally watched in India.

The challenge now is at their doors. Since the onset of covid, in the seventeen odd months that the cinemas were shut, production houses and movie watchers have altered their habits. Traditionally, cinemas enjoyed a three-month window of exclusivity before films moved to other formats. Great box office numbers were good for everyone – cinemas, studios and movie stars. But things are different now. Warner Bros released its entire 2021 slate of films, including Godzilla vs Kong, on its HBO Max streaming service the same day as theatrical release. Disney did the same with Black Widow.

Now that multiplexes are about to open, will viewers go to the cinemas to watch a movie? Well, you tell me. Now that Amazon prime and Netflix deliver the same content at a fraction of the cost to your houses, how valuable is the ‘movie watching experience’ for you? A vast majority of the market believes that exhibition houses are here to stay. PVR’s share price is only 35% lower than its pre-covid highs and analysts that cover the stock overwhelmingly rate the company as a Buy (26 Buy and Hold ratings vs. 5 Sell ratings).

Historically, whenever seismic changes have occurred in an industry, the incumbent player believed that the world is unlikely to change beyond a point. The fact that change was imminent became apparent only in hindsight. The fate of exhibition industry lies in the balance; and we shall let time decide.

This letter was originally published here: As Multiplexes Open, Would They Make For Good Investments? (cnbctv18.com)

Losing the plot

August 20, 2021

Letter # 54, 20^th August 2021

It’s the crucial day five and India is in their fourth over of the day (86^th of the inning). Ollie Robinson has the new Dukes in his hand and is charging towards Pant who is batting on 22 off 45. Pant edges one to the keeper and India are 194 for seven. By the 90^th over, Robinson traps Sharma on the crease with a slower ball and India are down to 209 for eight. In walks Bumrah. A shaky lead of 182 and with two wickets to take, England is now favourite to win. By the time India declares their innings, they are at 298 for eight with a mammoth lead of 271 runs (Shami and Bumrah scored an unbeaten 56 and 34, respectively).

What happened there? How could the entire Indian top order collapse for a little over 200 runs and the ninth wicket partnership goes on to score an unbeaten 89! Former English bowler Steve Harmison had an interesting take on that.

He says ⁽¹⁾, “they didn’t have any slips, no catchers in any position while bowling at numbers 9 and 10. A good ball to Virat Kohli is a good ball to Shami and Bumrah. England just seemed to get one eye off trying to get Bumrah out by bowling bouncers at him.” Why, might you ask? “The inexperienced characters were trying to sort of stand up for Jimmy Anderson (Bumrah kept bowling bouncers at Anderson in the first innings and they were returning the favour). Sometimes, you just have to step back and take a couple of deep breaths.”

Essentially, to avenge the bouncers bowled to Anderson, the English team ended up giving 89 runs to the ninth wicket, gave away the highest runs ever and second 50 to Shami and lost all 10 wickets and the match with just 60 overs to play on the last day.

How rookie of them, one might wonder. Such a blinding glimpse of the obvious, right? But it happens often than we think, and it happens closer to home all the time.

Long Term Capital Management (LTCM) was started in 1993 by the renowned Solomon Brothers bond trader, John Meriwether with two Nobel Prize winning economists on the board of directors. The strategy was simple: (a) Identify a minuscule opportunity of arbitrage in bond markets’ and (b) Leverage to the hilt, which generates a significant return on equity even with a minuscule return on investments. At its peak, LTCM had USD5bn in equity and USD124bn in debt. When the going was good, returns were great–21% in year one, 43% in year two and 41% in year three prior to 1998. Then, they lost USD4.6bn in less than four months due to: (a) Asian and Russian financial crisis creating unprecedented situations in the bond market; but also (b) having a false assumption that arbs work equally well with equities (short volume, risk arb and equity relative value) as they do with debt.

Well, that was decades ago; let’s talk about the more recent implosion of Bill Hwang’s Archegos Capital late March this year. Archegos was structured as a family office, investing just Bill’s money. While US rules prevent individual investors from buying securities with more than 50% of money borrowed on margin, no such rules apply to hedge funds or family offices. By late March, Archegos’s leverage had increased 5 to 1. Also, Archegos used swaps where it got the upside and downside in stock performance without owning the equity directly (the name of the bank would show up in shareholder register). While even the banks that funded him were not aware of the complete picture, on March 26^th, with a staggering USD100bn portfolio defaulting, Bill Hwang became synonymous with LTCM. Such high leverage, what were you thinking, right?

Even if we directly don’t identify with these stories, there are lessons to be learnt from them. Equity markets have steadily risen since March 2020 and buying the dip along the way has always appeared to be a great decision in hindsight. It is during times like these, and unknowingly, the anchoring bias sets in. When markets correct, we anchor our decisions to latest prices. When a stock falls from INR800 to INR600 during a correction, we are tempted to average, without consciously thinking if INR600 is a good price in and of itself. That leads to sub-optimal decisions. What then should we be ideally doing?

At Buoyant, we always return to these two actions when we make decisions like these. One, we do a sort of ‘zero-based budgeting’. Let’s forget at what price the stock has recently quoted at, and rather assume that we had the opportunity to buy out the business entirely. If one were to run a discounted cash flow model on it, what assumptions would I have to make to justify the price today? If those assumptions look broadly achievable, we go ahead and buy more.

Second, and more importantly, to retest our thesis, we actively reach out (with utmost respect) to people who have a negative view on the stock than we own, even if they have gone wrong for the entire bull run. Shutting oneself to alternative view points and drinking our own cool aid is among the worst things investors can possibly do.

When the going has been good (in cricket, asset management or individual stock decisions), it is easy to lose the plot when the situation reverses. We risk losing the entire test match, returns of an entire lifetime or might find ourselves buying sub-standard businesses at slightly lower price just because it recently quoted at a price which now looks high. Being aware is a battle half won.

Notes:
(1) England lost the plot by trying to get back at Bumrah over bouncer barrage to Anderson: Steve Harmison (sportskeeda.com)
This letter was originally published here: What Not To Do During A Market Correction (cnbctv18.com)

Mistakes

August 13, 2021

Letter # 53, 13^th August 2021

Over the past two years, did you take a few investing decisions that you now regret? Did you panic during Covid and sold a part of your portfolio? Or, bought only a little during recovery, waiting for a ‘better price’ to buy the balance and missed the rally entirely? Or started investing, but didn’t size equities high enough for those stellar returns to move the needle enough?

While the list could go on, by the end of this letter, it is my hope that you would not consider those as mistakes, for two reasons: (a) “investments” are a different field from a few other areas where being ‘right at all times” is critical; and (b) for everything that is meaningful in life, not failing enough is often a bigger failure.

First, let me borrow a story from Morgan Housel’s book ‘The Psychology of Money’. Consider what would have happened if you had invested USD1 every month from 1900 to 2019. You invest USD1 every month, no matter what. Don’t bother listening to economists or analysts–just invest. Let’s call an investor who does that Sue. But then, investing during recession is scary. So, perhaps, you don’t invest when the economy is in recession, sell everything when that happens, accumulate the cash and invest when recession ends. We will call that investor Jim. And, perhaps, you are even more conservative. You wait a few months for the recession to end and sell everything within 6 months of the beginning of recession. We shall call that investor Tom.

Given how the benefits of SIP have been engrained in our minds by the mutual fund industry, it would be intuitive to figure out that Sue wins, but can you gauge, by how much? Sue ends up with USD435k, Jim with USD257k, and Tom with USD235k. Of the 1,428 months between 1990 and 2019, 300 were marked by recession. So, in order to be richer by 85%, all that one needed to do is keep their cool for 22% of the time!

Instead, most financial advice these days is about “today”. What should you do ‘right now’; what stocks should you buy ‘right away’? There are fields where you must be perfect every single time, like flying an aircraft. There are also fields where you must be pretty good nearly all the time, like running a Michelin 3-star restaurant. But finance is not one of those fields. Robert Mercer, the co-CEO of RenTec, said this, “we are right 50.75% of the time… but we are 100% right 50.75% of the time. You can make billions that way.” And, Jim Simons, founder of RenTec, did manage to make a quarter of a trillion dollars by precisely doing that.

Second, we often don’t differentiate between: (a) the frequency; and (b) the impact of the outcome. Of the 100 decisions that one takes, one could be wrong in 90, but could still generate stellar returns. The latter depends on how big the wins are. The venture capital industry is a prime example. Nearly everything that is important in life is driven by ‘tail events’ – a small number of events that drive majority of the impact.

Many large companies acknowledge this. One might intuitively think that the CEO of a company facing a major product setback ought to apologize to shareholders. But this is what Jeff Bezos said shortly after the disastrous launch of Fire phone, “if you think that’s a big failure, we are working on much bigger failures right now. Some of them are going to make the Fire phone look like a tiny little blip.” Amazon Prime and Web Services make so much money for Amazon, that it is ok to lose a few hundred million on a failed phone. But come to think of it, Web Services, when started, had a similar probability of failing.

If we take a giant step back, this becomes even more evident. Evolution has forged the entirely of the sentient life on this planet using one tool, and one tool alone – MISTAKE. The Cambrian explosion happened around 541mn years ago. Before that, organisms were relatively simple. The rate of diversification increased dramatically after the explosion. Post the explosion (The Palaeozoic era) first creatures with central nervous system emerged, but the Permian Triassic extinction wiped off 96% of marine species (oops, mistake. The extinction took just 50mn years. Let’s start again, shall we?).

During the Mesozoic era that followed, non-primate mammals evolved (like dinosaurs). But if they survived, how would humans get to the top of the food chain (which isn’t a big problem for nature, except that, who would invent ESG investing then!). Anyway, the KT extinction killed all the dinosaurs, and it took just 150mn years to settle down before the current Cenozoic era began.

A series of trials and errors just to bring us to a system where Amazon can be happy to have lost millions on a phone that didn’t work, and Netflix cancels several big budget films because their ‘hit ratio was way too high and they were not taking enough risks.’

Where does this bring us? In the journey of investing, all of us will likely make many mistakes. But consider this data point. The rolling median CAGR that one would have generated over a 3, 5 and 7-year period (between 1990 and today) is 9%, 10% and 11%, respectively. You could have chosen any random day to get invested and the probability that you would generate a positive return over 7-year period would have been close to 95% (assuming you had the worst luck, the loss would have been 6% CAGR, and assuming you had amazing luck, the highest returns would have been 28% CAGR).

With that in the backdrop, the bigger question is, what, in your opinion, is a bigger mistake–fearing that we might err in our decisions (which sector, which stock, whether now or wait for correction) every now and again or not getting meaningful exposure to equity even when markets look like they are trading at highs?

Historical context to China’s crackdown; where does India fit?

July 30, 2021

Letter # 52, 30^th July 2021

We could be accused of indulging our vanity, but still we are going to say this: it gives us immense pleasure to announce this 52^nd weekly letter, marking the first anniversary of us publishing every Friday. It has been an enriching experience–a lot of learnings along the way and fruitful interactions with many of you post the publication (the brickbats and bouquets are appreciated in equal measure) make us look forward to the weekends. Onto this week then!

The last week saw a sharp contrast between established tech companies reporting record profits and new age tech businesses losing billions of dollars following the crackdown by China. But July 2021 also marked the 100^th year of the founding of the Communist Party of China (CPC) and a brief peek into their past might surprise a few–starting with the fact that it wasn’t the de-facto heir to modern China. Rising decibel level of China’s activity in the Taiwan strait amidst US navy leadership continued belief that China will take control of Taiwan soon, makes for interesting times. More on that in a bit, now a brief history of how the CPC got here.

Following the collapse of the Qing dynasty (1644 – 1912), it was chaos in China. By 1923, the Kuomintang (KMT) emerged as the principal party in China. Buoyed by Soviet Union’s support, KMT agreed to cooperate with the Chinese Communist Party (CCP) to form the First United Front. But, after the death of KMT’s founder in 1925, it split into left and right wings; the left wing aligned with the CCP. By 1927, CCP and KMT were in an all-out war, pretty much till 1949 (with a brief armistice during the second Sino-Japanese war, 1937-1945). The two Chinese parties fought the Japan war differently—while the KMT preferred conventional warfare, the CPC opted for guerrilla tactics.

The end of war saw CCP’s ambitions take wider wings. Based on the terms dictated by the US, Japan was asked to unconditionally surrender to KMT (and not to CCP). In the eyes of the US, KMT, and not CCP, was the heir apparent to modern China. Despite over USD4bn in post-war aid from the US, the war had left KMT significantly weaker. CCP’s membership, meanwhile, was rising dramatically – and it went for the kill. Mao Zedong proclaimed the founding of People Republic of China on 1^st October 1949. By then, the CCP had suffered 1.3mn combat casualties, but the same number for KMT was over 7.5mn! CCP systematically pushed out the KMT government from its capital in Nanjing to Guangzhou, then to Chengdu, and later across to the strait to Taiwan by December 1949.

Since then, the CPC has kept an iron grip on China. As Richard McGregor writes in his book, The Party: “the Party has made sure it keeps a lock-hold on the state; the three pillars of its survival strategy are–control of personnel, propaganda and the People’s Liberation Army.” The Party has a central committee (300 members), which reports into the politburo (about 25 members), which then reports into the sanctum sanctorum – the standing committee (5-11 members; currently 7). Since 1949, there have been five heads of the Party, Mao Zedong (1949 – 1976), Deng Xiaoping (1976 – 1990), Jiang Zemen (1990 – 2002), Hu Jintao (2002 -2012) and Xi Jinping (since 2013).

China adopted the Soviet model of Red Army, but under Deng, it judged that the arms race had brought down Communism in Moscow and that is how Hu’s confidant, Zheng Bijian, describes the ‘peaceful rise’ of China. Under the radar, until you gain the size. Operative word being: ‘UNTIL’.

Now that China has the size, it is time to let ambitions fly. Adm. Phil Davidson (US Indo-Pacific command, 2018-2021) ⁽¹⁾, and his successor Adm. John Aquilino (since March 2021) ⁽²⁾ have separately testified that “we have seen aggressive actions [by China] earlier than we had anticipated, whether be on Indian borders or in Hong Kong or against the Uyghurs.” Aquilino believes that China considers establishing full control over Taiwan as its ‘number one priority’.

Life appears to have come a full circle – Japan surrendered to the same KMT that is now relegated to being the opposition of a much smaller Taiwan–a country the US believes will be attacked by China within the next six years.

In the early 1980s, China had devised the ‘one country, two systems’ approach to regain control over Hong Kong and Macau; Taiwan unification was next in line. Geopolitical analyst Shrivan Neftchi in his Caspian Reports says, “Beijing has used economic isolation and political interference to coerce reunification.” Eventually, China cut ties with Taiwan in 2016 after election of pro-independence forces and increased military activity in the Taiwan strait.

China, with USD250bn defence budget, significantly outspends Taiwan’s USD11bn, but given that Japan and US will back Taiwan in a war, the playing field is levelled. An all-out war, therefore, may not be the solution. What is possible, however, is that China begins a hybrid warfare – stop short of shooting and subdue the foe through fear and exhaustion, says Shrivan, which can be decisive if performed well. China’s Airforce breaches Taiwan airspace routinely. Last year, Taiwan had scrambled its air force nearly 3,000 times against China, costing it over USD900mn. And the tempo is rising. The number of Chinese vessels entering Taiwan controlled waters stood at 2 in 2017; by 2020, it had risen to nearly 4,000!

China can keep salami-slicing Taiwan and not go for an all-out war until it is desperate for approval back home. As Richard writes, “state sovereignty, territorial integrity and economic development are all priorities of the state, but all are subordinate to the need to keep the Party in power.” The crackdown on education sector is essentially China playing to the galleries (domestic middle class) by keeping education, healthcare and real estate costs down, while pandering to the communist agenda (serving middle class at the expense of billionaire founders and venture capitalists).

Geopolitically, India is not new to China’s tactics, and recent skirmishes at its borders suggest that India is up for the task. But financially, India might need to up its game if it intends to benefit from the massive business that ‘China plus one’ strategy brings.

PLI is a step in the right direction here, but the size of many Indian businesses is still a fraction of China and Indian corporates are wary of taking on more debt to fund growth. While extending a significant helping hand to corporates would help India seize the moment, the political pliability of it is questionable. Tactical deal-making with new partners (say for Indian textiles industry with Europe, for the GSP+ status) could help as well.

From the markets’ standpoint, it would be a stretch to believe that investors that lost money in the Chinese crackdown would automatically shift that exposure to India. India still does not have the size and an even stricter capital convertibility. The ‘Rupee risk’ investment will have to compete for that international investors’ pie and the best strategy to ensure that it comes to India is by strengthening the core (helping business grow, signing on more trade deals, bolstering the economy), rather than looking for quick fixes.

Notes:
(1) Davidson: China Could Try to Take Control of Taiwan In ‘Next Six Years’ – USNI News
(2) Chinese threat to Taiwan ‘closer to us than most think,’ top U.S. admiral says | CTV News
The story was originally published here: Historical Context To China’S Crackdown; Where Does India Fit? (cnbctv18.com)

“Davids” beat “Goliaths” more often than we know

July 23, 2021

Letter # 51, 23^rd July 2021

Equity markets have a way of surprising us. Yes, they did fall more than they arithmetically should have during covid. But there is another undercurrent that is often missed– the 2-plus years’ underperformance of small-cap stocks ended with the market’s bottoming. Since April 2020 till as of writing this letter, while the Sensex has jumped 79%, the BSE Small-cap Index has catapulted 175%. If that sounds like a lot, let me tell you that by historical standards, it’s NOT. But, more on that when we return from this brief detour; one that involves the story of David and Goliath.

While the biblical account of this story is rather well known, I shall still briefly summarize it. As per the Book of Samuel, Israelites were in a standoff for over 40 days with Philistines at the valley of Elah. They eventually decided to settle it based on the outcome of a single fight (less bloodshed that way). Goliath (appearing for Philistines) was a six-footed giant and came bearing heavy armour and many weapons; he was expecting a hand-to-hand combat. David (appearing for Israelites) had a rather small frame and came to the fight with no armour and just a stick, a few stones and a sling. As soon as the fight began, instead of engaging in a close encounter, David hurled a stone at the only part of Goliath’s body not covered with armour (the centre of his forehead), instantly killing him.

While this is interesting, Malcom Gladwell in his book David and Goliath has a more nuanced take on how this story translates into today’s life. He explores two ideas: one, that all what we consider valuable in our world arises out of these lopsided conflicts because the act of facing overwhelming odds produces greatness and beauty. And second, we consistently misread such conflicts. What appear as weaknesses often translate into great sources of strengths; and in that, the fact of being an underdog transforms people in ways we often fail to appreciate. It is a fascinating read, which provides a template of sorts for defeating giants. Let me share a story from the book.

The story of Vivek Ranadive, an MIT graduate who grew up playing cricket, but had to later coach his daughter (12-year old) Anjali’s team at basketball. Initially, he thought that basketball is a mindless game. Team A scores and immediately retreats to its side of the court and team B dribbles the ball from its side of court to A’s side. The length of court is 90 feet, but majority of the game is played in just 24 feet! Only occasionally, teams played ‘full court press’, i.e., contest their opponent’s attempts to advance the ball.

It was rare, but Ranadive had a problem–his girls weren’t tall, couldn’t shoot, weren’t adept at dribbling and there wasn’t a lot of time to teach these skills. He knew that if they played in the conventional way, they were sure to lose. But then Ranadive wasn’t the one to give up easily (he went to study at the MIT in the 1970s–during that time, RBI had to approve the use of forex for studies of individual students. If he could get RBI to bend, how difficult could this be).

Ranadive’s strategy was built around two deadlines that must be met. First, when a team scores, a player from the other team takes the ball outside the play area and has five seconds to pass it on to a teammate in the court. If the team can’t make it in five seconds, the other team gains possession of the ball. Normally it is not a problem since the other team always retreats to its side of the court. The second deadline was to advance the ball across mid-point to the other team’s side within 10 seconds.

Ranadive’s girls decided to play it man-to-man defence (shadow your opponent) and made sure the other team was unable to pass the ball from outside the court. Eventually, the other team missed both its deadlines. This is still ‘little league’ of basketball and 12-year old girls, known to play a certain way, didn’t know how to cope with this unorthodox strategy. Ranadive made sure that his girls were better trained; they had to survive the ‘full court press’ for the entire game. With this little innovation, Anjali’s team managed to reach the nationals despite their known inabilities. They changed the traditional rules of how the game was played, just like David changed the rules of engagement.

Malcom also mentions the story of Lawrence of Arabia’s conquest of Aqaba and how they took on the Turks from the direction where they least expected. I think India’s final assault on Tiger hill during the Kargil war was also based on similar strategy.

Now coming back to markets. Before the onset of the Covid-triggered market fall (and during the time when small caps were underperforming i.e., December 2017 to March 2020), a section of investors (professional and otherwise) had formed this opinion that “large companies will keep getting larger and at the expense of smaller companies.” That meant that the investible universe in India had come to be narrowly defined as a few companies, beyond which investments were considered pariah. That made sense, right? After all, look at small-cap stocks getting decimated for more than 2 years now. It didn’t matter that history stated otherwise, and therefore, these investors were arguably not ready for what was coming.

See the exhibit below; the relative 100ppt outperformance since April 2020 by small caps is the lowest on record since the inception of these indices in April 2003.

Five distinct upcycles are apparent since these indices were formed; and the small-cap index has beaten the Sensex every time. Of course, the opposite is true in downcycles, but it is the net result that should count, right? Any guesses on what that is?

Over the past five years, traditional way of doing business has been disrupted. Banking AQR in 2015, Demonetisation in 2016, GST in 2017, NBFC crisis in 2018 and Covid pandemic in 2020, among others, have made it rather difficult for a lot of smaller companies to compete with larger ones. However, the resilience of Indian entrepreneurship has managed to find ways to stay relevant and be counted when the time comes. The net result: Since April 2003, the BSE Small-cap Index is up close to 30x compared to Sensex rising just 18x. In India, the “Davids” certainly have been beating the “Goliaths” more often than we know.

This letter was originally published here: Smallcaps Vs Sensex: “Davids” Beat “Goliaths” More Often Than We Know (cnbctv18.com)

Inflation might not have the answers, learnings lay elsewhere

July 16, 2021

Letter # 50, 16^th July 2021

Hey mate, your team lost to mine at our favourite sport last night ⁽¹⁾; time for you to treat everyone to dinner. How about Saturday?

Umm… I owe dinner, I agree. But can’t we do it on Friday? You see, I am on a tight leash here.

What? Are you suggesting that you can afford a meal on Friday, but not on Saturday?

Precisely! Prices on Saturday are twice that of Friday.

Oh, how about Sunday? People go to work on Monday; not that many go out dining on a Sunday and restaurants know that, correct?

Not really. Cheque on Sunday is twice that of Saturday. And, on Monday, it is twice that of Sunday.

Come on mate. You have got to be kidding me.

Midway, you might have caught on that I was referring to what could have been an actual conversation in Zimbabwe, circa 2009. At the height of hyperinflation in 2009, it was so difficult to measure inflation that the Zimbabwean government stopped filling out official statistics. Hanke and Kwok ⁽²⁾ estimate the peak month of inflation stood at 79.6 billion percent per month or 89.7 sextillion percent year-on-year in November 2008. Or, put another way… prices were rising roughly 131% every day!

That might appear a while ago, but the debate rages on. Data published earlier this week showed that US consumer prices rose by 5.4% in June 2021, at a faster pace than 2008. Data published this Wednesday also showed that UK inflation hit 2.5% in the same period, its highest level since 2018.

The same day, Fed chair Jay Powell fended off a barrage of questions from the US Congress as he sought to ease concerns over the Federal Reserve’s response to surging US inflation. “I know that people are very worried about inflation. We hear that loud and clear from everybody,” said Powell. But added that, “we do believe that these things will come down of their own accord as the economy reopens – it would be a mistake to act prematurely.” The 10-year Treasury note traded 6 basis points lower post the testimony and equity markets rallied.

While newspapers and social media feeds are inundated with posts consisting of views from people on either side of the aisle (those who believe inflation is transitory or otherwise), Ha Joon Chang has quite a different take on this in his book Bad Samaritans.

He writes that during the 1960s and 1970s, Brazil’s average inflation rate was 42% per year. Despite that, Brazil was one of the fastest-growing economies in the world for those two decades (per capital income rose 4.5% p.a.). Even Korea, during its “miracle years”, was growing per capita income at 7% per year, while continuing to have inflation at the rate closer to 20% p.a.

Chang, of course, doesn’t argue that all inflation is good: Argentina’s 20,000% inflation during the 1990s, Germany in the early 1920s and Zimbabwe’s above are unquestionably bad. It hampers long-range planning, thereby making investment decisions difficult to execute, which in turn impacts jobs and economic growth. But, in moderation, inflation could be a good thing–something that neo-monetary policy experts completely dismiss.

The post-apartheid Africa National Congress regime in 1994 announced that it would pursue an IMF-styled macro-economic policy (so as not to scare away investors) and kept real interest rates high (10-12%), which kept inflation rate low (6.3%). But, this was achieved at a huge cost on jobs and growth. Chang concludes that when rich countries get into recession, they usually relax monetary policy and increase budget deficits. When the same thing happens to developing countries, the “Bad Samaritans”, through the IMF, force them to raise interest levels and balance their budgets (stark contrast of Korea in 1997 vs. Sweden in the early 1990s).

Now, let’s bring attention back home; do we know whether India’s inflation (CPI at 6.3%, WPI at 12.9%) is transitory or not? What we do know is that India sits on an all-time-high food grain stock (food and beverage form 46% weight in CPI), that housing (10% weight) inflation is absent and pick up in vaccination and supply-side easing could bring in incremental supplies. While rising commodity prices (incl. oil) and bad monsoons pose risk to this, beyond that, we don’t really know.

But the fun part is, we don’t need to have a great handle on inflation; learnings might lay elsewhere. Historically (since we have data – 1991), equity markets have been ok with inflation rates up to 8%, a bit worried till 12% and nervous beyond 12%. But more importantly, during extreme times, central banks have historically been reasonably tolerant of inflation. Between 1940 and 1952 (World War 2 periphery), US inflation reached double digits on three separate occasions (1942, 1947 and 1952). Debt to GDP crossed 100% in 1947 and infrastructure to GDP stood at a mammoth 1.6%. However, during all these periods, US bond yields hardly changed.

While the jury is still out on whether Covid zone qualifies as “extreme times”, the reluctance of central banks to act (raise interest rates) in the face of record borrowings by governments and rising inflation does provide an opportunity to get invested appropriately, i.e., in companies that own hard assets, preferably ones that have moderate levels of debt. Ever wondered why those infrastructure, real estate and commodity stocks in your portfolio have been having a stellar run lately.

Notes:
(1) I could have used the example of Italy and England, but I fear that it might be too soon to joke about it!
(2) cato123448v26n2_2up.q
(3) The letter was originally published here: Inflation Might Not Have The Answers, Learnings Lay Elsewhere (cnbctv18.com)

Capitalist… but on my terms!

July 9, 2021

Letter # 49, 9^th July 2021

July 2 was a typical Friday evening for most companies, save one. The Cyberspace Administration of China (CAC) warned Didi Chuxing (Didi; China’s answer to ride-hailing app Uber and Lyft) that in one hour it would publicly be ordered to stop signing new users ⁽¹⁾. Didi was subsequently also asked to remove its app from app stores in China as it had violated laws on collection and use of personal data. By Tuesday, CAC announced that it would tighten regulations over companies listing abroad, especially, over cross-border transfers of sensitive information. Prior to this, CAC had never invoked the ‘cyber security review process’ introduced just over a year ago.

FT states that according to procedure, companies should volunteer for a review of their procurement and supply chain if their operations are of critical importance to national infrastructure. If Didi ‘voluntarily’ submitted for clearance, it would come as a surprise that it chose not to wait for the clearance before proceeding with the USD4.4bn IPO, which got listed just a couple of days before the crackdown. Didi’s ADR is since down more than 27% from highs and now trades below its IPO price i.e., over USD20bn in lost shareholder value in less than one week.

Chances are that you have already read all about it. While CAC’s action could have surprised a few, it would not have surprised Nian Guang Jiu. Richard McGregor writes about Nian and the way China operates in his book, The Party: The secret world of China’s communist rulers.

Nian was first jailed in 1963 for engaging in illegal speculation, i.e., running a private food stall in his hometown Wuhu in Anhui. During the Cultural Revolution, a few years later, his capitalist rap sheet alone was enough to put him behind bars again.

When freed in the late 1970s, Nian opened a shop selling roasted sunflower seeds. He did not have a good education while growing up and was nicknamed the ‘fool’. He chose to name his product Idiot Seeds. Within a few years, Nian had a thriving business with more than 100 employees.

This success got the Anhui party chiefs petrified, who thought that they might be committing political error by allowing Idiot Seeds to flourish. They sent a report to Beijing asking whether they should shut the shop down, which eventually landed on Deng Xiaoping’s ⁽²⁾ desk in 1984. Soon after, Deng replied that, “in keeping with wild economic experimentation he was encouraging at the time, closing a business might make people think the open-door policy had changed.” Nian’s Anhui Fool Group (no typo) survived. But, by 2008 when Richard met him, he had morphed from a subversive capitalist into a state-sponsored business celebrity, parroting official propaganda.

Richard writes that after coming to power in 1949, the Party closed private businesses and confiscated their assets. The suspicion harboured towards entrepreneurs lingered long after Deng’s market reforms in the late 1970s. When Jiang Zemin ⁽²⁾ allowed entrepreneurs to join the Party in 2001, it created a rare public split among the Party’s leadership.

The Party’s distrust of private sector was never about money, nor the flagrant contradiction between individual wealth and Marxist pantheons. Everyone agreed on the need to turn profits. The real issue for the Party was the threat that foreign and local private sector might become its political rival. The unprecedented partnership between a Communist party and capitalist business holds; it remains an uneasy, unstable and unholy alliance, but an alliance, nonetheless, writes Richard. The book published more than a decade ago makes a lot of sense in the current context.

And, there are more stories. China National Petroleum Corp (PetroChina) is best described as the ExxonMobil of China. Paul Schapiro of Goldman Sachs wrote this around the time when PetroChina was gearing up for listing: “The best way to describe PetroChina was that it was the Ministry of Petroleum.” But, as it was getting repackaged to be sold off to foreign shareholders, PetroChina shed close to 1mn jobs and the Ministry of Petroleum disappeared altogether, leaving the company with little direct oversight from the government. When capitalism is the need of the hour, communism can clearly wait! That and oh yes, there was a subtle difference–PetroChina was getting listed in the mainland and in Hong Kong, not in the US.

As Richard Baum, another China scholar, puts it, “state sovereignty, territorial integrity and economic development are all priorities of the state; but all are subordinate to the need to keep the Party in power.” If the Party fears that foreign or local private sector might become a political threat, they will be reined in. And, if the Party fears that Chinese entities wanting to list in the US would have to share audit files with US regulators, then the whole process of US listing could be stifled.

You can very well be a capitalist operating in my country, BUT it must be on my terms is the thinly-veiled message. Or as Richard so succinctly puts it, “the Party is like God. He is everywhere. You just cannot see him.”

In comparison, another IPO will likely list this month, but in India. What started as Foodiebay in 2008, later rebranded as Zomato, would likely list for over USD10bn! A truly home-grown company with orders per month approaching 55mn and transacting users likely to cross over 14mn, started just as restaurant listing business, and entered food delivery as late as in 2016. But now, of its USD394m consolidated revenue, 82% comes from food delivery, 14% from dining out and the balance is contributed by classifieds and loyalty programme.

The second largest shareholder in Zomato, at 16.5% pre-money, is Ant Financial. Ant Financial (or Ant Group as it is now known) is an affiliate company of China’s Alibaba Group. India, just a year ago, had an acrimonious altercation with China at its north-eastern border, which resulted in public outcry calling for banning China manufactured products in India.

Whereas India has done nothing to stifle the IPO of a company that has a large holding from a Chinese company, readers would recall that it is the same Ant Financial whose IPO (in China and Hong Kong exchanges) was suspended in November last year citing ‘possible failure to meet disclosure requirements.’ Reasons could have been different then, but the message was the same: You can be a capitalist operating in my country, but IT MUST BE ON MY TERMS!

This behaviour has several implications for India, both business wise and for equity markets. Superior operating efficiencies have enabled China to become the manufacturing hub of the world; it’s difficult to entirely replace it. But, increasingly, businesses have started to realise how China operates and are looking to diversify; hence, the ‘China plus one’ strategy. Industries (like chemicals and textiles) in India are already benefitting from this. India benefits by having a superior and predictable regulatory environment. Increasingly, the Government of India is realising the benefits of lending a helping hand to several industries (hence the PLI schemes).

What has started with ‘China plus one’ for business procurement, will likely soon extend to the financial realm as well. Though the size of Indian businesses is much smaller compared to Chinese businesses, domestic demand in India is still high. Financial investment from foreign players (via FDI, FPI, etc.) should dramatically increase in India over time.

Notes:
(1) Didi caught as China and US battle over data | Financial Times (ft.com)
(2) CPC leadership history: 1949 to 1976 – Mao Zedong, 1976 to 1990 – Dang Xiaoping, 1990 to 2002 – Jiang Zemin, 2002 to 2012 – Hu Jintao, 2013 to now – Xi Jinping