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

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

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.

Changing perceptions could bring outsized returns

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

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.

Chemicals and Commodities: Knowing how China operates can help

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

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.

Simplifying a complicated relationship

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

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.

Live free or die hard!

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 resultmergers, 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

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.

If you can censor the king…

Letter # 31,  26 February 2021

…well then, you are the king! If President Trump (1) ever dreams of returning to the White House in 2024, he must now take an additional route—one that goes via the Silicon Valley. Before he can get “selected” at the caucuses, “elected” at the primaries, “endorsed” at the GOP national convention, “voted” in general elections and “elected” by the electoral college, he must first be “approved” by Twitter and Facebook to use their platforms so that he can reach his 89mn followers.

By the morning of January 9, 2021 (a Saturday), Apple had listed ‘Parler’ as the number one free app for iPhones. By nightfall, Parler was struggling for its life. Google was first to remove the app from its Play store and Apple promptly followed suit. By evening, Amazon told Parler that it will boot the company from its web hosting services by Sunday. Parler, a social media network that pitches itself as a ‘free speech’ alternative to tech biggies, did eventually manage to survive, but only after going dark for a month and having changed its data-storage provider and its chief executive officer.

Earlier this week, Australia passed a law that mandates digital platforms (like Google and Facebook) to pay local media outlets for their news. The debate that started earlier this year i.e., a tech company’s right to censor versus individual’s right to freedom of expression, has now expanded to the role of state in business, with tech companies still in the mix.

Officially known as the News Media and Digital Platforms Mandatory Bargaining Code, the idea is to ensure that news media businesses, that generate the content are “fairly remunerated”. Now, what is ‘fair remuneration’, one might ask. If the parties come to an independent commercial agreement, fine. Otherwise, a government-appointed arbitrator will decide on the final price. That’s right – the epitome of capitalism (the Silicon Valley giants), by Australia’s book have become so powerful that it believes that a law is required to protect its smaller enterprises and that a government appointed body will decide the fair pricing.

While that’s happening in Australia, India’s historical experiments with such price fixations have resulted in extremely adverse outcomes. India regulators used to regularly fix prices for many commodities, viz., power, fertilizers, etc. That gave rise to huge inefficiencies and mounting losses. Ha-Joon Chang, on the other hand, has quite a different perspective on this debate in his book 23 things they don’t tell you about capitalism. He cites Korea’s example on how successfully government can bolster private enterprises.

Around 1965, Korea was one of the poorest countries, relying on natural resource-based exports and labour-intensive manufactured exports. The country, with abundant labour and very little capital, should not have been building capital-intensive products like steel, especially if it did not have the necessary raw materials–iron ore and coking coal (they had to be imported from Australia, Canada and US, all 5,000 miles away). Yet Korea set up POSCO in 1968 and appointed a former army general with minimal business experience to run it. With no economics, no raw material, no technology and no talent, the World Bank advised potential donors not to support the project, and they pulled out of negotiation in 1969. The Korean government persuaded the Japanese government to channel a chunk of reparation payments into the steel-mill project, provide machines and technical advice. POSCO started production in 1973, and by the mid-1980s it was considered among the most cost-efficient producers of low-trade steel in the world. By 1990s, it was among the world’s leading steel companies and among the most profitable in early 2000s.

Throughout 1960s and 1970s, the Korean government pushed many private sector firms into industries that they would not have entered of their own accord. In the 1960s, the LG Group was banned from entering the much desired textile industry and was forced to enter the electric cable industry. In the 1970s, Chung Ju-Yung, founder of the Hyundai Group, was compelled to start a ship-building company.

Given India’s track record discussed above, one might be tempted to believe it runs a very lousy state-owned enterprise (SOE). But what if I told you that the largest (and most revered) private financial institutions today (which form over 25% of Nifty) started as something entirely different.

Industrial Credit and Investment Corporation of India (ICICI) was formed in 1955 at the initiative of the World Bank, the Government of India and representatives of the Indian industry with the primary objective of creating a developmental financial institution to provide project financing to Indian businesses. On October 17, 1977, ICICI incorporated HDFC as a public limited company to provide housing finance to mainly low- and middle-income individuals and companies. Hasmukhbhai Parekh played a pivotal role in its formation. In 1994, HDFC Bank was incorporated as a subsidiary of HDFC and ICICI Bank as a subsidiary of ICICI (later reverse merged in 2002). Similarly, Axis Bank was founded in 1993 as UTI Bank, which was promoted by UTI, LIC, GIC Re and four other insurance companies.

These four now private entities (HDFC, HDFC Bank, ICICI Bank and Axis Bank), which cumulatively contribute over 25% to India’s main index (Nifty), started off as semi state-owned enterprise.

Now that India is embarking on a massive disinvestment drive, this debate finds an increasing number of people on either side of the argument. For us, the Indian government has done well to seed corporations in important areas of activity (and support them on sparse occasions). However, its record of continuing to operate them has, more often that not, been patchy at best, and has promoted huge inefficiencies (and created deeper problems) at worst. At the risk of creating private corporations that become too big to fail, it would behoove the government to follow the path that the PM has laid out for his government today–one where the ‘government has no business to be in business.’

Notes:
(1) Although the official website of the United States of America, states that the correct way to address a former president is to use “The Honorable John Doe” and the correct salutation is “Mr Doe”, most etiquette sources maintain that living former US Presidents continue to be addresses as Mr. President. Forms of Address: How to Address the President | HuffPost Life

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.

Decades in planning, if not centuries!

Letter # 30,  19 February 2021

While we try to get our heads around Sun Tzu, they already know enough to quote Chanakya. A few days back, India’s defence minister announced that India and China have agreed to disengage on the Pangong lake and both sides will cease forward deployment of troops in a ‘phased, coordinated and verifiable manner.’ (1) Videos released by the Indian Army later show the disengagement in action, after 10 months of tense standoff and nine Corps Commander-level talks.

There are multiple theories that explain the sudden breakthrough: one, India gained the upper hand when its troops undertook an operation in the Chushul sector (the night of 29th Aug) and occupied multiple heights along the LAC which overlook Chinese fixtures at Spanggur Gap and Spanggur Tso (2). Another school of thought suggests that the upcoming 100th anniversary of the Communist Party of China in July 2021 could have forced China into a faster disengagement (3).

Whereas that might explain why the standoff diffused, I am yet to come across something that explains why China chose to engage in a protracted standoff over a mountainous land with no vegetation or mineral resources in the first place. It only becomes clear when one: (a) reads how deeply and coherently China is aware of India’s military doctrine; and (b) knows how well China reads India’s defence budget, and its priority of allocation. On 8th Feb 2021, China Aerospace Studies Institute released the English translation of its 2013 Science of Military strategy that lends tremendous insight. (4)

The document breaks India’s military strategy over four time periods: (a) 1947 to 1960: Focus on building the economy while building defence just on the western frontier (Pakistan). (b) 1960 to 1972: Focus on building and modernizing armed forces after reeling from the loss in 1962 China war, which culminates into a win in the 1971 Pakistan war (attack West, defend North). (c) Post 1970s to end of century: Maintain land control and expand in the seas (this is where it gets tricky; we shall come to that later). and lastly (4) By 21st century: With the economy booming, establish passive deterrence for China while pursuing aggressive and punitive deterrence for other countries.

The PLA thinks that India takes a “Indo-centric” view of South East Asia, rooted in the belief that ‘India is at the heart of the region and that Pakistan and China are its main obstacles.’ Here is where they quote “the historically famous strategist – Chanakya” ‘who treated neighbors as enemies and that dealt with those who were far away and attacked those who were near’ (to imply that India “deals” with erstwhile USSR and USA, while conflicting with Pak and China).

It sheds some light as to why the PLA thinks that India might want a conflict with China; but if they believed that India’s military doctrine towards China has always been one of ‘persuasive (and not punitive) deterrence’, why would China engage into a protracted standoff rather than diffuse the situation faster? This is where it gets interesting.

A one-line answer is: because protracted stand-off in norther frontier leads to higher military spending and the relatively fixed defence budget leaves little allocation for Naval spending. For, you see, with enough funding, India can theoretically block 80% of all China’s hydrocarbon imports! Yes, you read that right.

It started with India setting up a Theatre Command (all assets of Army, Navy and the Air Force vests under the operational command of a three-star General) for the Andaman and Nicobar Islands (ANI) in 2001. That started the militarization of the ANI which has now turned into refitting of the airfields and docking facilities to accommodate larger vehicles. The plan, off late, has been to station additional aircrafts, warships, missiles and soldiers in the vicinity. India claims this is to protect trade (90% by value passes through this route) and for security.

ANI is a group of 572 islands, with the northern-most tip just 300km away from Myanmar and the southern-most tip a little over 200km away from Indonesia. End to end, ANI spans across over 800km and even though it accounts for just 0.2% of India’s land mass, it accounts for over 33% of its exclusive economic zone in the sea.

This means that every merchant vessel going through the Malacca strait MUST navigate through either side of the ANI. With right militarization, India could gain the ability to block the western entry point to the Malacca strait.

This could be ground-breaking and can potentially change the world order. The Malacca strait is the busiest maritime route in the world. Of the 120,000 ships that sail through the Indian ocean every year, about 70,000 vessels pass through this strait. And, for China, 80% of its hydrocarbon imports go via this route. The vital strategic value of the ANI is certainly not lost on New Delhi.

But India has limited financial resources and ability to spend on defence. Its 15-year navy modernization plan will require funding support of USD123bn or an annualized spend of USD8.5b (5). Over the years, India has not been able to allocate even half the annualized budgeted spends, which has left the navy grossly under-funded, years in counting.

An additional knock on the door from the northern neighbours cut into the already strained Indian fiscal resources. For China, it is a game of depleting the adversary while hardly breaking a sweat itself. Here is a country that plans for decades, if not centuries.

Moving on from countries that plan for decades to companies that do the same. A lot has already been written about Amazon and Google, and how they are years and decades ahead of the curve, in terms of their thought process as well as actions.

In India, however, one company that has thought and executed “long term” is Max Life (we have investments in its listed parent- Max Financial, or MAXF). At the start of the millennium, the life insurance industry had just been opened-up to the private sector and a mad rush to expand fast by adding branches and recruiting agents ensued.

Founded in 2001 in partnership with New York Life, MAXF was one of the (if not the) weakest brands to enter the life insurance business. Other insurers incorporated during the same period (2001-05) either had large banks backing them (HDFC, ICICI, SBI and Kotak) or large industrial houses (Bajaj, Reliance, Birla). Relative to competition, Max Life approached the space differently—build the business slowly with a razor-sharp focus on training the agents. Their pareto was going to be granular as well, meaning, lesser dependence on a few “superstar agents”.

The idea was to build the right talent, and if MAXF got that part right, the business would eventually follow. It ran an ad campaign which drew attention to insurance mis-selling (pervasive at the time). When the regulator eventually clamped down on this, MAXF came out on top. Relative to peers, its agents serviced far fewer customers on average, but it ensured that clients were satisfied. The idea was to build a durable business—a long, slow and expensive journey, but one that was built to last.

The net result? When the regulator clamped down with introduction of ULIP guidelines, MAXF’s market share jumped from 5.5% to 7.5% (in 2010-11). Another round of tightening came around 2013-14 when highest NAV guaranteed products were banned and MAXF’s share increased from 8.5% to 10.3% in 2013. Its VNB margin (akin to EBITDA margin) at 25% and its ROEV (akin to ROE) over 20% are now best in class in the industry. The proof of the pudding lay in the fact that the HDFC group, during its discussion to acquire MAXF (which did not eventually go through), was for the first time in the group’s history willing to pay a non-compete fee to the promoter.

In the end, countries that plan for decades generally end up coming out on top. Companies that are willing to do so and take the pain in the short term, end up becoming stronger to withstand the test of time. Often, they make for an extremely rewarding investment.

 

Notes:
(1) India and China to pull back troops in a phased, coordinated manner: Rajnath Singh in Lok Sabha | India News – Times of India (indiatimes.com)
(2) Explained: In India-China border standoff in Ladakh, why Chushul sector is critical | Explained News,The Indian Express
(3) Has India spoilt the party for China ahead of CCP’s 100th anniversary? What Xi won’t say (theprint.in)
(4) 2021-02-08 Chinese Military Thoughts- In their own words Science of Military Strategy 2013.pdf (af.edu)
(5) Indian Navy’s modernization plans in jeopardy (defensenews.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.

Join the dots!

Letter # 29,  12 February 2021

The thing about relationships is that one often forgets how it started. And, Aung San Suu Kyi, the state counsellor of Myanmar, shares a similar relationship with the Tatmadaw (Myanmar’s military)–a tumultuous, sad, but one that is stranger than fiction. Amidst this, India finds itself in a difficult position, for you see, part of its USD5tn economy dream is at stake.

At the start of this month, the democratically elected members of Myanmar’s ruling party, the National League for Democracy, were detained by the military in a coup d’état. Two days later, President Myint was charged for breaking pandemic restrictions during campaigning (basically, arrested for not wearing a mask) and Suu Kyi was charged for illegally importing six intercom devices for her security team (yeah, really!) and remanded to two-weeks’ custody.

A little bit of history is in order. Myanmar declared independence from Britain in 1948. From then till much of 1990, military ruled the country. By 1990, Suu Kyi, the daughter of Aung San (the country’s modern founder) had become a pro-democracy voice. The military was under the illusion that it enjoyed popularity and allowed free elections in 1990, but Suu Kyi’s party swept them. The military refused to cede power and put her under house arrest.

Another 22 years passed and the military, having drafted a new constitution in 2008, developed the roadmap to hold free elections again by 2015. Here is the fun part–two unique conditions are put under this constitution: (a) the military will retain 25% of seats of the combined house (lower and upper); and (b) a person married to a foreign citizen cannot become the president of Myanmar (thereby disqualifying Suu Kyi automatically; hence, her obscure title in the government).

Suu Kyi’s party still swept the 2015 election, winning 370 of the 476 seats. This is where things start to go awry. In the run-up to the 2020 election, media reported that if successful in 2020, the NLD would eventually cut down the seats reserved for military to just 5% over the next 10 years (1). Come 2020, the NLD wins 396 seats (higher than 2015). The military, citing irregularity in the election (that was certified by the Union Election Commission), orchestrates a coup. The political system in some countries appears as mean reverting as the global commodity markets these days!

Had the story ended here, I arguably, wouldn’t have been writing about it. But this seemingly less-often talked, far-off country, has decent implications on India’s economic growth, especially in the East and North East regions. To recover from the loss of a strategic partner, the USSR, India’s then Prime Minister P V Narasimha Rao launched the ‘Look East Policy’ in 1992. With this, India initially started working with ASEAN and other regional forums, and started to tilt towards the United States.

When the new government took office in 2014, India introduced version 2.0 to that policy ‘Act East’ with higher focus on culture, commerce, connectivity and capacity building. The emphasis was on reaching out to the North East in a better fashion. Currently, it is connected only through a very narrow Siliguri corridor (often called the Chicken’s Neck). We tried asking Bangladesh for a transit pass multiple times, but they haven’t obliged so far. So, we decided to take the go-around sometime in 2013.

As part of that, the Sittwe port is being constructed on the western side of Myanmar, which will connect Bengal ports via the Bay of Bengal. Plus, building a road under the Kaladan Multi-Modal Transit Transport (KMTT) project will link Mizoram to Myanmar. The endgame–reduce transit travel from 1,880km via Siliguri to 950km, with the option to expand volumes over the next decade. A master stroke!

Why is this important, one might wonder. States within the coastal region in India account for roughly 40% of population, but 50% of Gross State Domestic Product (GSDP). On the other hand, states that the KMTT project influences constitute 11% of population, but account for only 8% of GSDP (2). With better access to coastal transportation, these states alone can result in a 5-6% growth in India’s GDP (assuming similar multiplier effect as coastal regions) over the next few years.

But this story has a few interesting takeaways regarding investments as well. First, as Anthony Bolton says, “people don’t change.” Suu Kyi would have done better to read him. When markets are hot, investors too, tend to forget this and start investing in companies where promoters have recorded history of fleecing minority shareholders. That is unlikely to end well!

Second, structural change is hard. For a society used to military rule (and more importantly, a military that is used to power), the transition to democracy is hard. This makes the Indian government’s change in stance towards privatization, admiration for wealth creators and the generic bold shift in fiscal budget, that much more interesting.

Lastly, consolidation of power takes a long time, especially if you are not the incumbent (as Suu Kyi government finds out the hard way). Attempt to alter the status quo after just one election was probably too soon, and the same goes for industries and businesses. It’s akin to people arguing that new entrants can disrupt the leader easily (happened in case of toothpaste in late 1990s and is happening in case of the paints industry now).

To end, let’s take a moment to reflect on how easy it is to fall for the ‘fish taking water for granted’ syndrome. In India, we have a swift and democratic change of power at the Center and states. We are afforded a reasonable freedom of expression, the opportunity for education, social upbringing and for capitalism to thrive. It certainly makes the democracy in India something to celebrate, every now and again!

Notes:
(1) India’s option in Myanmar post-military takeover: Primacy of strategic interests (indiatimes.com)
(2) statewisedata.pdf (esopb.gov.in)

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.

Yes, we can

Letter # 28,  5 February 2021

If the stroke of pen can take away billions, it can make billions too. Today, we contrast how changes in legislation have cost almost USD10bn to a few Canadian companies versus how Indian state governments are learning from each other to make their billions.

Depending on which side of the political spectrum one is, this story can look either like Erin Brockovich – part two at one end, to total oppression of capitalism at the other. Politics aside, it surely makes for a fascinating story. So, here it is:

Sometime in 2008, a Canadian energy giant TC Energy (formerly TransCanda) decided to transport the planet’s dirtiest fossil fuel to the market. To do so, it had to build a pipeline of about 1,700 kms from Hardisty (Alberta) in Canada to Steele City (Nebraska) in the US. This pipeline was phase IV of an existing Keystone pipeline and was named Keystone XL (or KXL, with XL standing for export limited). Canada was already sending close to 500k barrels of oil per day to the US; with KXL, that would have increased by another 800k. Thousands of kilometers of pipeline runs across Canada and the US, but you see, this was different–this one would have carried the tar sands.

Beneath the forests of northern Alberta in Canada lies a sludge like, sticky deposit called tar sands. These contain bitumen, a gooey-type petroleum, that can be converted into fuel. Well, it’s not easy to convert these into oil, but you do remember the days when oil was above USD100 per barrel, right? These investments were planned around that time. Anyhow, the idea was to transport these remote, land-locked tar sands to Mid-West and Gulf coast refineries in the US.

Given that tar sands are thicker, more acidic and corrosive than lighter versions of crude, the protests to the project (emanating from fears of spills) started almost as soon as the plan was set in motion. In August 2011, silent protests outside the White House resulted in the arrest of more than 1,200 people. That peaked in 2014 with more than 2mn comments urging the rejection of the KXL pipeline was submitted to the US State Department during the 30-day public comment period.

That was probably just enough for the outgoing US President in his second term. So, in 2015, President Obama temporarily delayed the permits for KXL approval. “America is now a global leader when it comes to taking serious action to fight climate change,” President Obama said. “And, frankly, approving this project would have undercut that global leadership.”

The new president wouldn’t have any of that. On the fourth day in office, President Trump signed an executive order to allow Keystone XL to move forward. On March 28, 2017, his administration approved a cross-border permit for the pipeline. And, construction began in full swing. TC Energy and the Alberta county had invested close to USD8bn so far in the run-up to the US presidential election.

And then, comes the new president –President Biden. Having run the campaign on vowing to curtail fracking and stop the permit for the “environmentally unfriendly” KXL pipeline, it did not come as a surprise that he reversed the approval for on January 20, 2021–his day 1 in office.

Biden delivered on day 1 what the Obama administration had started. Yes, we can (but after re-election!). While environment groups in Canada have applauded the decision (1), Alberta’s premiere Jason Kenny called the decision a ‘gut punch’. In the process, USD10bn were lost, but in the overall scheme of things, it “no biggie”!

Onto greener pastures now. Not all political stories end in billions of losses. Some leave us with gains and a high (you will get my drift in the next few paragraphs).

The Indian state of Uttar Pradesh has a few unique characteristics. It is not only India’s most-populous state, but also the most populous country sub-divisions in the world. The assembly elections in 2017 threw an interesting winner, the ruling incumbent at the center, the Bhartiya Janata Party (or BJP) who won 78% seats (just five years ago, it had won 12% of the seats). Stranger still was the choice of Chief Minister; the BJP decided to appoint Yogi Adityanath, still in his 40s when he took office.

The Wikipedia bio of Yogi Adityanath lists him as an Indian Hindu monk and politician (2). As soon as he took office, some old and seasoned hands (3) suggested that India would embark on a national prohibition drive that is easily understood by the public and which can be painted as a major reform. And boy, would they be surprised if they saw what has transpired since!

In order to break the liquor bootleg cartels and large trades in the organized liquor retail markets, Yogi government aggressively cut excise duty on liquor (4). This brought liquor smuggling to historic low levels, leading to the unorganized market moving to organized. The results were stark–excise collection on liquor grew 21% in 2018, 38% in 2019 and 25% in 2020.

And he is not stopping here. Liquor in UP is now available in tetra packs, even as the entire supply chain, including the state government’s departments, is being digitized. Cheaper “official” liquor is reducing the number deaths due to spurious liquor and generating employment within the state. In absolute terms, excise collection from liquor in Uttar Pradesh is slated to jump from USD1.9bn in 2017 to a staggering USD4.6bn in 2022, while slashing costs for the end consumer.

Finance ministries of other state governments are studying the model with great interest. If the taxation around alcohol comes down and to more predictable levels, the valuation multiple for a lot of liquor stocks in India can dramatically increase. From being a business with huge government interference, they could transform to truly consumer discretionary businesses and valuation rerating would follow.

Notes:
(1) Alberta leader says Biden’s move to cancel Keystone pipeline a ‘gut punch’ | Environment | The Guardian
(2) Yogi Adityanath – Wikipedia
(3) Stanley Pignal on Twitter: “Nationwide prohibition in India is the next demonetisation (ie big, surprise policy move that is easily understood by public, painted as major reform). https://t.co/uJhax0HIOS” / Twitter
(4) Yogi government to cut excise duty to curb liquor smuggling | Business Standard News (business-standard.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.

Catch up, Monday?

Letter # 27,  29 January 2021

Hey, been a while mate; catch up, Monday?

No, can’t do. Gotta listen to the budget speech, crunch the numbers and put the report out.

Blimey! You kidding me? What’s there to do? 28% of receipts is GST. Don’t you have a separate council there? And, another 28% is corporation tax, the glide path for which is already announced, no?

Yeah, but there’s more.

Really? Like the excise and custom duties at 16%, half of which is different types of tax on fuel. Those aren’t really tinkered with in the budget, right?

Yes, right.

Right. So, you are really going to see what they do with income taxes then. The last standing bastion. Put in Covid cess if you like, ‘coz unlike the West, it’s not like you really need a second stimulus.

No mate, the rating agencies put India a notch above junk (with “negative” outlook by two of the three). We didn’t really stimulate the economy during the lockdown, but it doesn’t mean we didn’t spend (F21 likely scenario–tax revenue down 7-8% and non-tax down 25-27%, and expenditure up 6-7%). We could still manage with federal fiscal deficit at c7% (state + Center at 12-13% of GDP) and public debt of 85-90% of GDP. You know right, that those numbers for the US are 15% (FD) and 130% (debt to GDP), and they still got their AAA (or AA+ for S&P).

But, come to think of it, that’s not really riling me up a lot; most industrialists will still give a ‘ten on ten given the circumstances’ to the budget. And yes, we will plan to borrow almost INR11tn this year at the gross level (in F21, we did INR13tn), and despite that, we do not think the RBI will raise interest rates anytime during 2021.

Oh right, that reminds me, you’ve also got the monetary policy on 5th Feb–a policy packed week. Start Monday with the budget and end Friday with monetary policy. What do you expect there?

The RBI hasn’t really looked at the supply-side boost to inflation that had stayed above its 6% upper band and gone ahead and cut rates, almost 250bps (135bps before pandemic and 115bps after). Inflation appears to have peaked in October 2020 and should trend down below 5% for 2021 driven by lower food inflation primarily (down from 9% in 2020 to something like 5%). We have had bumper crops you see and wheat/rice stockpiles are like 3x normal.

No rate cut then, pretty much like the Fed then, huh?

Umm… not so fast. The rates at the shorter end of the curve have fallen much below 4% (the policy rate). The RBI will dry out current liquidity (INR7.5tn) to more a sustainable level (INR2-3tn) by end March 2021. First, it will allow the 1% cut in CRR announced in March 2020 for one year to lapse. Also, tax-related payments will come due too. You see, the RBI has tolerated supply-side inflation so far, it may not be as tolerant of the demand-side one once the economy expands again in 2021 and may want to target liquidity at more sustainable levels.

Oh, the recovery!! We got a K-shaped one, did you too?

Oh yeah. Companies with strong balance sheets have gotten stronger and people with excess liquidity have deployed in markets and gotten richer, while the unorganised sector has all but disappeared. And yeah, looks like real estate is turning around as well. But then, that’s the problem for the fiscal budget to sort out. Back to square one! See, that’s why I can’t see u Monday!

A’rite then! excited and looking forward to Monday?

Super excited, against the odds, can you imagine! The current dispensation has presented seven budgets so far and on six of them, markets have sold off post the budget speech.

Not that seven is a statistically significant sample size anyway, right! But then, all of us have the optimism bias; like whenever something good has to happen, it happens to me and when something bad happens, it happens to others, that sort of thing. SAP and Qualtrics did a global poll (1) and discovered that Indian respondents are exceptional when it comes to their optimism with regards to job prospects, use of technology, pay rise, ability to find the next job easily and everything in between that you could imagine. So, lets see how this one goes.

Alright then, sounds like you have a packed week. Catch up, Monday – umm, the next one?

 Notes:
(1) Indians Among World’s Most Optimistic People in Terms of Technology | Analytics Insight

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