The Model Model - Sanjeev Pandiya

All Indian have black and brown eyes. Aishwarya Rai has hazel eyes. Hence, Aishwarya Rai is not Indian.

The above is what in Logic is called a tautology. You can use 'logic' (which is mathematically sound) to come to some strange conclusions, simply by twisting a little part of the 'logical premise'.

Take a look at the first sentence again. If we assume that there are 5,000 people with eyes like Aishwarya's (wow!), then the first sentence is statistically sound, i.e. true for 99.99995 per cent of the Indian population. The use of the word "all" would then be justified, both by the English dictionary and by Statistics.

The subsequent sentence is also an absolute premise, statistically true. Hence, the conclusion logically follows.

I have a peculiar spin to this. So if you have hazel eyes, does that make you Aishwarya Rai? Well, to the extent that her hazel eyes have contributed to making her what she is, maybe yes, you would say. And if not, what else does it take to make/ get someone like that?

The Random Walk Theory says that "stock prices follow a random walk and markets are efficient", implying that it is therefore impossible to beat the market. Prices reflect all available information, thereby preventing anyone from consistently beating the market.

Well, if there are only 100 billionaires from the financial markets at any given point of time, then that is only 100/ 6.42 billion = some tiny percentage of the world population. Superimpose on the above tautology and you will be able to write a book that will become a bestseller, formulate a theory that could be 'universally' true and maybe even win a Nobel Prize for it…

Unless, of course, you ask Aishwarya Rai what she thinks of all this...! My guess is that she will be nonplussed. She will not be able to argue with any of the premises, but will obviously find the conclusion absurd.

Don't look at me like that! I am not pretending to be any Aishwarya Rai of any place, even the stock markets. I only write about these things. I am just the little guy who periodically points out that the king is wearing no clothes, something that is obvious to everyone, if they only stop looking at each other and focus on the king…!

No doubt market beaters are few in number, too busy actually beating the markets to be going around writing books about how to do it, and just not interested in Nobel Prizes. They may represent just a tiny fraction of the actual population operating in markets, but they represent fully 50 per cent of the behaviour patterns seen on markets. One behaviour pattern is that you can't beat markets (a.k.a Random Walkers), and the other behaviour is that you can. Which is why they are more important to markets than Aishwarya Rai is to Indian-ness.

Let us look at this concept called "market efficiency" where market prices are supposed to factor all available information. Everybody thinks "India is shining", hence everyone is buying stocks. I focus on everyone buying stocks, and I don't care whether Indian actually shines or not……

And if everyone is buying stocks, then the supply of (equity) paper will increase and capital (which is in excess supply) will eventually be misallocated, and India will someday stop shining when too much of this capital gets misallocated. I can see this in many stocks, sectors which are 'hot'.

There, I have gone and told you my secret. This new piece of information should now bring down the markets by 50% tomorrow morning and the government will put me in jail for high treason….what?! Say, power stocks are hot. But all this money is going into coal, even as the world gears up to sign the post-Kyoto protocol, where the rich nations will force us to take emission targets. If they don't, we will stupidly eschew new technology, while the world goes carbonless.

Much later, we will find that these new technologies leave us with expensive energy usage, while the world has moved to zero-cost power in wind, wave, tidal, geothermal, etc. Then, we will burn coal to produce aluminium, while they have a smelter in Iceland that imports bauxite from across the Atlantic and is still viable because it operates on free energy.

So now, both NTPC and Hindalco should drop like a stone tomorrow morning, no?!

But no...

This 'insight' is not enough. I not only have to be right about what I just said, but put my money where my mouth is, hold on to this belief for 5-10 years till the FIIs and sundry world travellers are done with India. I have to then pay margin calls while sundry operators manipulate stocks to squeeze the bears, with the excess liquidity easily available today. Not only do I have to believe something that is at odds with the 'market hypothesis', but I have to hang on till the market turns around to reflect (in stock prices) my 'new' hypothesis. In other words, I have to get a serious 'black eye' before I get a hazel one.

The tenacity of this belief system is really the key to beating the market. By definition, that has to be with the minority in the population. Otherwise, India would shine simply by printing Rupees and distributing it among the population; why do you need a stock market for that?

So which Mutual Fund will do that for you? This entire industry lives on misquoting that tautology I have outlined above. If you wear hazel contact lenses, you can be (or get, depending on your preference) Aishwarya Rai, say the dream-sellers. You can laze on the beaches, go to Singapore, retire at 40, send your child to the US, get yourself a facelift or whatever……just gimme your money!!!

What is wrong with all this? The underlying premise that you can't beat the market (which you probably can't, if you are still reading this dumb article) but we can…the implied promise that your money is going to outperform the markets if you give it to us, but will not if you just give it directly to the markets, is where you need to get careful.

Those of you who have the capacity to think about this will do so: efficiency is not about 'information' and it is known from other studies that insiders don't make a lot of extra money ALL the time, there is such a thing called 'insiders bias'. They know about inside information, but they (usually) don't know enough about human behaviour and its quirks, or relative valuation of markets….etc, etc ad infinitum.

So what practical use is this to you? Should you put your money under your mattresses, or should you look for someone who can beat the markets for you. Well, the problem is that if I know how to beat the markets, why would I need your money? So the guys who know how to beat markets, like I said above, are too busy doing it than talking (or writing) about it.

This is terrible, what have I done? So where does all this leave you, and what is the point of wasting precious trees on this garbage? Well, for starters, just understand why you will not be going to Singapore, that alone is worth the time you have wasted reading this. Read the rest of my articles on the behaviours needed to beat markets, learn to stand alone and look stupid for a long time, sometimes lose your shirt trying to hang on to what you think is right, get it right once in a while and hope for the best. In any case, isn't what you were doing when you gave your money to professional money managers?

Organisation Design And Profit - Sanjeev Pandiya

Ok, let's start with the clichés first. We all know that the profit motive is at the centre of capitalism, the raison d'être of an organisation. So profit is the purpose of an organisation and the shareholder (to serve whom the organisation exists) is the primary stakeholder.The organisation uses various resources to generate a profit. In economic terms, it uses land, labour, organisation and capital (LLOC) i.e. all the resources it uses can be classified in some way or the other into the above heads. If we take the 4 Ms: man, machine, materials and method, they are merely a re-statement of the above LLOC. Yet, most organisations I know tend to confuse this balance, i.e. they tend to focus excessively on one or the other of the above baskets. In some companies I have seen, I notice an excessive and almost myopic focus on labour i.e. doing things.

We have customers who tell us what to make from time to time. Through the TQM/ TPM/ six-sigma mindset that flows up and down the auto value chain, we all have this huge focus on the 4 Ms mentioned above. Most of the talk is about machine productivity, labour standards, (material) wastage, overall equipment uptime or line efficiency (OLE), inventory control etc. In other words maximising throughput per unit of capital employed. So either you reduce the capital employed for a given level of output (as in stagnating markets in the developed world where they use outsourcing and innovation to do this), or you maximise throughput for a given level of capital (as in developing countries, where demand is buoyant but capital is expensive and scarce). But the companies are only focused on doing things (i.e. labour) also called manufacturing in layman terms. Now compare this to a bank, as in, what does a bank do? Is there any physical transformation in its product? A bank captures 'profit' by ensuring that it raises funds cheaper than what it lends at (assuming it gets back all the money it lent out in the first place).

But this 'work' produces profit, which comes from managing capital, one of the four economic resources mentioned above. Let's look at organisation, often called management quality. The ability to capture and maintain a near-monopoly is the key skill for Microsoft's shareholders. Of course, the company's PR Department will argue that this skill comes under labour i.e. the ability to build the world's best software. But ask any user of Netscape and they will agree with my classification above. (Fortunately, this column is not read by people at Microsoft.) Or Berkshire Hathaway. A small group of wise men are brought and held together. They sit down around a coffee table and understand risk and opportunity better than anybody we know. Why and how do they stay together? I don't know, but this ability, which creates profit, must be put under the basket called organisation.

Under this head, I will also put the ability to handle risk and the other side of the coin, opportunity. A good insurance company, for example, (or a good derivative trading outfit, aka an investment bank) makes a profit because it charges more premium than it pays out. And it keeps enough risk capital on standby (either on or off its balance sheet) to make sure that it never goes bust, especially during those sudden cataclysmic crises that happen every so often these days.

Last, let's come to land. In Ricardian terms land used to mean anything whose supply was not controlled by human beings. The simplest example was land itself. In those days, if you owned land, you got to charge rent, from which came the term economic rent. These days, the concept covers every such situation where you earn profit merely because you are there. So if Tata Steel owns some fabulous mining leases in iron ore and coking coal, it can afford thrice the labour cost of its competitors. SAIL, which also has the same quality mines in iron ore, can afford four times the labour cost. This source of profit, a chunk of which is then lost to organised labour, is called land.

In the same spirit, Infosys 'mines' a seam of solid, mathematical/ logical skills to give itself nonpareil code-writing capability. This is a combination of land and labour, a good example of a case where an organisation starts with one source of profit, but goes on to build another one across the LLOC basket. Infosys started with a critical resource, code-writing skills, but has built skills to exploit another source of profit, business solutions, which is a skill layered over its generic capability. Yet, compared to a GE for example, I have not seen an Infosys use its balance sheet and its vast cash reserves to build a treasury. It is quite obvious that the company chooses to under-perform its profit potential. Perhaps it has weighed the profit potential (from treasury activities) against the risk and decided against exploiting it. I am told that early in its history, the company lost money in the markets. But to now get to the nub of my point. I don't think too many companies examine their organisation design, to see whether they are able to exploit all the sources of profit possible. Every external interface of the company creates an external stakeholder. Does the company examine each such interface to see how it is losing money or exploiting the relationship for profit?

For example, the company I used to work for earlier was one of the best-rated auto component companies, according to a CNBC poll. Yet, it was my personal opinion that we gave away 40-50% of our net profit by choosing to stay with a single-supplier of steel. One part of the management team argued that we cannot shift to multiple-suppliers without the customer's explicit approval. My counter-argument was that perhaps we, as management, were averse to building “strategic sourcing” skills that allowed us to scour the globe for alternate suppliers. How many vendor/ material-substitution proposals have we given to our customers in the past five years?

So we had chosen to stay 'ignorant' at the vendor interface, taking the prices we are given under the garb of customer interest. But in making this compromise, we have sacrificed shareholder interest.

And finally, I will establish the link with markets with yet another cliché. “Companies create wealth/value but markets measure them". I have often seen that markets don't value the various streams of profit differently i.e. the profits of an auto component company are measured on par with the profits of a bank/ insurance company. For a better understanding of the nature of profit, it is important to first analyse why (and how) the company makes money in the first place. For example, an auto component company makes profits from labour after losing whatever it does to its suppliers, bankers or even employees. It makes money (as in case of my company) after over-paying its suppliers, bankers etc. The residual profits are real and are less likely to be lost again. These profits are then redeployed into a set of real machines, plant, building, which will always have value, as long as the business has any role in society.

Compare this to a bank, which makes money during the boom because it borrows cheap and lends dear. The bank puts all its profits back into its balance sheet, leaving its past profits exposed to the same risk of default. Suddenly, after the recession hits, investors are left wondering how much of the past "profits" of the bank were real. The catch is that risk levels have stayed constant (or have increased) in the bank's balance sheet, while they have actually reduced in the autocomp co's balance sheet.

Yet, the market would value a typical bank at a P-E level higher than that of the typical autocomp co.

Let me summarise: profit is the objective of any organisation and it comes from the management of four key economic resources (LLOC). Most organisations are good at (managing) one or the other of the above (resources). Organisations need to grow in depth, i.e., learn to do things better, manage one resource. They need to grow in breadth i.e. know enough about managing other three resources better. What they know is wealth, what they don't is risk.

Mind of a Flawed Entrepreneur - Sanjeev Pandiya

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About a decade back, I left a leading finance company to join a large manufacturing corporate that had just bankrupted itself trying to digest what was then India's largest acquisition ever. The company was already defaulting on loans, even though its business was then generating decent ROCE. Manmohan Singh's “liquidity crunch” (of 1996) had left a huge hole in the company's means of finance, which had to be covered by asset sales and inter-corporate deposits (ICDs).

In one of my first discussions with the CEO, I was struck by how the company refused to see where it stood, and retained a false optimism that “something would change”. With operating margins at a comfortable 22 per cent on sales, the company was still defaulting on loans because at the margin, it was paying up to 27-32 per cent on its ICD portfolio. Yet, top management believed they would pull through.

I once said rhetorically, that if this company was a mutual fund, the top management would be sacked. A mutual fund manager cannot argue when stock prices fall, that the fund will pull through. He is not allowed to carry losses on his portfolio, arguing that they are long term investments and hence these losses are temporary in nature. When he takes a decision to invest, he has to 'mark-to-market' his portfolio and value his portfolio net of his losses.

Why are we so forgiving of corporate India? Is it simply because the CA institute does not want to (or have the intellectual wherewithal to) revalue corporate balance sheets, that CEOs are able to ignore the markets, pretend that they have made long term investments and get away with bad asset investments, a luxury denied to our mutual fund managers.

But finally all this money ends up in the hands of corporate India. Shouldn't good companies at least voluntarily disclose their estimate of net asset value based on estimated cash flows discounted at the cost of capital? Put it on your website even if you can't carry it in your annual report. It will sensitise CEOs to a whole range of issues that they tend to ignore. I will mention just a few.

When interest rates go up, the value of any cash flow will fall, so as we all know, bond prices fall. All that has changed is the 'discount factor'. I hope everyone understands why, otherwise don't bother with the rest of my article. When short-term interest rates are higher than long-term rates (as happened recently with call rates at 20 per cent and bank lending rates at 9.5 per cent), it is a signal that long rates too will harden. This process is triggered by central banks (like our RBI) to signal tighter money, so please slow down capex, especially long-term capex.

The knee-jerk corporate reaction is to rush further money into long-term assets. They divert working capital into long-term assets, further squeezing themselves dry. Then they go around desperately looking for short-term money, any money, paying through their nose to tide over a self-made liquidity crisis.

If only CEOs were a little more market-sensitive…what is the market trying to tell you under such situations? If short-term rates are high, then the cost of working capital will rise above the cost of long-term debt. At such times, the company should be liquidating long-term assets to stay liquid. Just now, which company do you see around you, that is doing anything remotely resembling this?

We are at the peak of the capex cycle. One by one, corporate India tries to wriggle out to find some arbitrage, like ECBs. And a good regulator like the RBI will follow through and plug each of these loopholes as they find them. Why won't CEOs listen?

Moreover, working capital financing gets renegotiated with every rollover. All the more reason to reduce your requirements but the majority of companies are doing the exact opposite. The typical argument given is the old one: growth is more important than cost.

My counter-question is: In a mad rush (also called bull market, a.k.a. boom cycle) the survivors are going to be those who know when (and how) to hold back. Retail investors know this feeling fully well…in a bull market, the surviving bulls are those who know when not to buy. At one point in a general bull market, the bull who says "growth at any cost" is the person who will be dead.

Across corporate India, you now have companies faced with the same predicament as retail investors. During the boom cycle, they have gone and committed capex. Now the debt market (and in some cases, commodity prices) is telling them that they cannot invest. The companies that don't listen are the ones who will be dead. If you aren't watching, you (as an investor in those companies) will be dead yourself.

I have often berated the media for triggering market volatility for the wrong reasons. The answer I get from editors is that the media is as much a part of society as investors or any other community, and hence prone to the same irrationalities. But this time, I was surprised to see wide publicity given to the ECB capping by the RBI, yet not a whisper on the markets. I cannot think of a more direct cause of general market bearishness than this announcement, yet nobody seemed to get it.

We seem to understand housing collapses, dollar movements, carry trades and whatnot, but nobody went through the list of pending ECBs and the pipeline to bring out a list of short-sells. Sectorally speaking, you would have found the entire list being made up of long-cycle sectors, which includes the current investor favourite, infrastructure.

Isn't it common-sensical to invest where the return (or opportunity cost) is higher? Then why do corporates invest in long-term assets when short-term rates are higher than long-term rates?

Ah, this very rational question above made you stop, didn't it? Let me explain why…..the word you are looking for is momentum. Humans will keep doing what got them success in the past, long after it stops getting them any further success any more. Like that coyote in the comics, who keeps running long after the ground has disappeared from under him, corporate India will suddenly look down from where they are and find that they are running on air, i.e., without working capital. Then the slide will start…! CEOs will go into denial and CFOs will go around whispering "but I told you so…". The ones who raise their voices will of course, no longer be CFO. CEOs will go into denial looking for hope (and their next CFO). They will look for ways to "pull through". Choose your sector/ companies and look for these clear behavioural cues to pick out the 10- baggers of the next boom cycle.

In fact, if you are intelligent and know any sector well, pick out 3-5 companies of any sector and ask the questions above. Put down your answers at both stages: the first stage is the start of the down cycle, which is just now, I think. At the bottom, look for the companies that are doing nothing, versus those that are in action mode, investing their limited cash at a time when the crowd has gone home.

For the last year and a half, I have been sitting with a quarter of my net worth in the bank. Yes, I have chosen to feel foolish, not buying real estate while it was trebling, or (not) buying DLF/ Omaxe while it was fashionable to do so.

For the last laugh, watch this space……!!!

Public Funds in Private Equity

An editor of a pink paper asked me my opinion of the $3 billion Chinese investment in Blackstone. There are many angles to this news story. The media has dwelt upon how this is a 'professional' (and therefore scientific) use of the nation's burgeoning forex reserves.

I only asked rhetorically: “What do you say when the world's worst investor hands over his money to someone who claims to be the world's best investor…….for a price which is embedded in the IPO pricing?” What is the probability that this is not a bum deal?

Ok, let me make my points, one at a time. The whole concept of private equity (as opposed to the public equity, i.e, listed stock markets) is opposed to the efficient markets hypothesis. The EMH, as it has come to be called, is based on the rather simplistic worldview that if you get millions of people to look at something, you will achieve the highest level of perspective, i.e., Mr. Market knows more than any single individual, or for that matter, any smaller group of individuals. In other words, it is a restatement of the underlying logic of 'democracy', that the wisdom of many is always superior to the wisdom of the few.

Somebody got a Nobel Prize for putting out this fallacy, that the price given by the market factors in all known information. Perhaps it does, but he forgot that people have different perspectives on the same information. In politics, this (EMH) is perhaps true, but for the wrong reasons. Democracy is the superior way of (political) management not because it provides the best (combined) perspective, but because it provides the checks and balances that are needed to obviate the misuse (or distortion) of a political process. Anybody who has ever watched video clips of our parliamentary proceedings will agree that perspective is not strength of democratic (or collective) choice.

In Economics, we have always known that EMH is almost never true. The “Laws of Group Think” (which is part of behavioral economics) postulates the exact opposite of the EMH, saying that “crowds (or groups) are always and systematically wrong”.

Private equity offers itself as an alternative option to public equity. PE firms do buyouts of publicly-held firms because they feel that the public (listed) value is understated. Then they go back and sell these firms to the same market they bought it from. No doubt, there is some real arbitrage available through management actions, but the larger value is extracted because of mispricing in the underlying (public) value of the stock. Value Investors know that this is a regular occurrence in public stock markets.

Coming to Blackstone then. The firm, by its very existence, size and reputation, puts out the claim that they are the world's premier purveyors of value, i.e., when they buy, the stock is undervalued. Implicitly, when they sell, the stock is overvalued. By implication then, when Blackstone decides to sell stock, one presumes that it would be at a value higher than the intrinsic value of the stock.

Using the principles of Classical Finance, a public issue of capital by a private equity firm makes no sense. If you have a large 'spread' (i.e. asset return minus the cost of capital), then you get a huge margin of safety. Since equity capital is nothing but a bulwark against risk, why would you need equity capital to finance an activity that has a huge 'spread'. You only raise equity, either when you need the bulwark against risk……..or you are getting equity at a mouth-watering price. Obviously, Blackstone insiders think their shares are over-priced.

Blackstone normally goes to the markets to buy stocks from the unsuspecting public, which they will sell back to the poor dolts after a cooling period. When would Blackstone go to sell shares to the hoi polloi, reversing their normal pattern of behaviour? And who is on the other side of the trade? Half the placement is to the Chinese Government, which is arguably the world's worst allocator of capital. Now let us see just how this is a bum deal.

The Chinese are capitalistically communist, or is it the other way round? They grew up believing that labour is the most important of the four factors of production, if only because it is the only factor that has feelings. Our Indian Communists also know that it is the only factor that votes, an even bigger convenience. That is why they do so well politically, but so disastrously in their economic policy.

In Economics, value is captured by the factor that is the most flexible, has the highest opportunity cost and the ability to capture such value. That factor, unfortunately, is capital, which slips away at the slightest hint of a sub-optimal return (ask Jyoti Basu).

Labour on the other hand, is inflexible, emotional and responds to power by acquiescence, ensuring that it captures less of the cake than it deserves. Any attempt to give labour higher negotiating power through administrative or political fiat will always result in the flight of capital, as we saw in Kolkata in the 70s.

China's 'growth strategy' has been to over-supply labour to manufacturing and drive down product prices, shrinking the producer surplus captured in ITS part of the value chain. Wherever China goeth, the value captured goes down to zero. Hence, blue- collar manufacturing, where the Chinese presence is most visible, has seen price erosion to the point of insanity. Western companies in general, and the Americans in particular, have been complementary to China, i.e., they have occupied the spaces that China has not, e.g., retailing, supply chain and logistics, construction, banking and white collar services. These sectors have captured disproportionate value, challenging the Chinese to move in. So first, China makes goods for the US, gives up its producer surplus to US consumers. Whatever little it saves from what it produces, now lies fallow in its forex reserves, which must either fund US borrowings (through T-bills and mortgages) or create inflationary liquidity in its domestic economy.

So these savings are now invested in Blackstone IPOs at inflated prices. The money, one presumes, will be reinvested back in China to buy undervalued assets from the private equity market (or the listed stock markets). At every stage, the Communists get short-changed, ceding value to savvier investors/ consumers from the West.

“So what?" argue the Chinese. You value humanity because you have so little of it. We have no shortage of people, hence they are valued less. So what if the savings of a small proportion of our people are blown up either in NPAs incurred by our domestic banks, or for that matter, if the nation's forex reserves are invested sub-optimally. It is, after all, 'savings' of our native population, which is meant for strategic purposes. I am sure our Indian leaders would love to think like that. Unfortunately, long before they get their domestic populations to pick up the tab for their decisions, the government would have been brought down. Democracy ensures financial discipline.

There is another reason why India cannot afford the luxury of sub-optimal investment decisions. Our forex reserves are funded by external liabilities; they are not generated by trade surpluses, as in the case of China. If our government puts it away in long-term investments that do not generate adequate returns in foreign currency, we will trigger a run on the rupee, just like in case of the 1997 Far Eastern Crisis. The Chinese government has only its own population to answer to, and they have been taught not to ask. Indians have the havala option!!!

About Eggs & Baskets by Sanjeev Pandiya

You cannot start on diversification without a clear understanding of the risks you are seeking to manage. That is why I spent some time commenting on the definition and nature of risk and the ways to measure risk management performance. In layman's terms, the usual term is return, the opposite of risk. Most investors are focused on return, realising risk only when it happens.

I defined risk as the probability of things going wrong. Once things have gone wrong, they cannot go right. Older investors will remember this feeling they have after their losses, of wanting to turn the clock back. It is the same feeling you get after losing a loved one, when you want to reach out and touch the person after she is gone.

Risk management, therefore, is a bit of an oxymoron. If risk is managed, it is not there, i.e., things go 'right'. The whole point is, that if risk is still there, risk cannot be 'managed'. Think about this for a long time, you might agree that this is a very significant observation.

Risk can only be anticipated, avoided/ obviated, measured (in an imperfect manner). The management of risk has two dimensions: curative and preventive. The curative part is really about surviving risk, which is not the subject of this article. The preventive part is all about 'diversification', almost the only way to manage risk as defined in financial markets. Both risk measurement and diversification (a.k.a. Portfolio Theory) lend themselves to mathematical and statistical analysis, giving classical finance its biases.

Value investors and behavioural economists tend to focus on a philosophy towards risk, which is softer and more nebulous than the normative approach in classical finance. I will try and lay out some of these elements for you.

Double or Quits?
Quite simply, never (either double or quit). You must remember that in Russian Roulette, you cannot keep playing. Even if you are right five times in a row, the sixth time you have to be wrong. And the only time you are wrong, you will be dead. In the same manner, you should never assume that you will always be right on the stock market. Mature investors always play the markets with their worst case scenario clearly laid out.

One takes a long time to figure this out. You take a long time to try out different trading strategies, then you get a high ratio of successful trades. This time you start to make good money. Now greed takes over and you start to believe that you will always get it right. This is the time when you are most prone to play the “double or quits” game. I know someone who got 814 trades right (successively) in a single run, then went on to lose everything in the next five trades (when Ketan Parekh went bankrupt). Please pay attention to this principle, especially if you already have a good right-to-wrong ratio.

Mind you, this is not to be confused with the philosophy of 'stop loss'. Short-term traders exit the market when the momentum turns against them, mainly because they are basically 'momentum' riders. Stop loss is the point at which you can't take any more loss, or you don't trust the momentum (reversal) any more.

Value investors do the opposite. They add to their positions as a scrip goes down, playing to be the 'last man standing', i.e. trying to buy the last falling share as sellers depart the stock. The more of these 'last' shares they can pick up, the better their returns, provided of course, they have bought a safe, steady business at a great price, and the business recovers subsequently.

Correlation & Diversification
Like buying a truck and car company together. That should be obvious to everyone, but how about a truck and a housing construction company together? In hindsight, you might realize that they are both linked to the interest rate cycle.

Sometimes people diversify into other assets that are themselves correlated with each other. In the above example, trucking and housing look different, but the underlying drivers of demand (in this case, credit availability) may be the same.

Diversify What You Do
Fewer people do this than you would imagine. In the stock market, most retail investors are usually only buying shares, never short-sold on the market. As a general principle, there is much to recommend this strategy…I feel that if you get a short-sold position wrong, your risk is unlimited. Imagine short-selling Infosys in 1998! But if you take a somewhat correlated portfolio, you can achieve a genuine reduction in risk levels. Recently, I was short on the Nifty, but was bought on a low-Beta portfolio comprising the likes of Reliance Energy, Tata Steel, Tata Power, Hero Honda and ITC. On the downside, the portfolio had a Beta of 0.3, but on the up, it outperformed the Nifty. Overall, when the market dropped 15 per cent, I lost a maximum of 5 per cent, but when the market came up, the portfolio outperformed the Nifty. I call this phenomenon Beta Migration. I was able to make money on both legs, by shorting the Nifty and by the increase in value of my bought portfolio.

Over short periods of time, this is mostly an art, not suitable for everyone. But over long periods of time (say, 5-10 years) it is a well-known principle that almost any portfolio constructed of low-Beta stocks will outperform a portfolio of high-Beta stocks. This should be obvious to any believer in human irrationality. High beta is usually achieved with high volatility, lots of froth, glaring media attention (remember the IT boom)…and we know how that went!

In this strategy, you should try to trade a correlated pair as part of your diversification strategy. Like buying the market leader and short- selling the market laggard. A caution here is that if you are buying at the bottom of the cycle, then the laggards gain more than the market leaders. In a bull market, buying the market leader and short-selling the laggard may be a good trading strategy. Make sure that you don't make a mistake in reading the market………for example, is this a bull market or a bear? I looked at the Interest rate cycle and thought it was the start of a bear market, but somebody argued that India is the only major country in the world with high and rising costs of capital. Across the world, the cost of capital will soon start to drop. That would suggest a very shallow bear market, if we see one at all. Even a normally 'bearish' person like me is not willing to take a stand.

Other Comments
Statistically one thing is clear - traditional means of diversification won't save you. Remember one common mistake: mindlessly diversifying into, say, 100-200 stocks, which then go unmonitored for entry and exit points. Since the investor no longer knows enough about these businesses, he is prone to fall prey to rumours. In effect, the act of 'diversifying' will actually increase the probability of losses rather than reduce it.

True diversification includes far more investment choices than just stocks and bonds. It includes other non-correlating asset classes that don't intrinsically involve either speculation or timing. I recommend keeping up to 15 per cent of your portfolio in cash, if you have devoted 60 per cent of your net worth to stocks, including derivatives. The rest can be in real estate and personal effects. Aggressive investors like the readers of this magazine must be having more than 50 per cent of their net worth in equities, especially if they are below 40.

With each investment be sure to invest no more than you can afford to lose, so you can sleep at night. And use rupee cost averaging - taking a fixed proportion of your personal savings each month to add to your investment holdings, so that volatility becomes an advantage over a long time horizon. Only then will diversification begin to make statistical sense.

Race to Beat the Market - Sanjeev Pandiya

I had argued earlier how risk is defined wrongly and that Beta is a flawed measure and “outperforming stocks don't really (outperform)”. What I implied is that Classical Finance takes these high-sounding, laudable objectives and produces good-looking, 'logical' (therefore rational) models that are supposed to achieve these objectives.

But long after the Nobel Prizes have been given away and people have gone home, it often turns out that the model sold to an unsuspecting public was a lemon. Last time, we talked about CAPM, but other big models like Dividend Irrelevance or Efficient Markets Hypothesis do not stand up to scrutiny either. This time, we will talk about “market outperformance”, a common measure by which money managers (particularly the Mutual Fund industry) measures and sells itself. Since I got almost no mail last time, I presume that either everybody agrees with me or more likely, nobody understood what I said. Which is just as well, because the strategy I laid out last time is delivering returns that no mutual fund manager can even dream of.

“Market underperformance' is seen by ordinary investors as a measure of risk. The other side of the coin, “market outperformance” is not seen as risk, but is clubbed as return. No money manager will treat 'statistical variance' of his performance as part of risk/ uncertainty. Tracking error measures the variability of a fund manager's performance with that of the major stock Index, say, the Sensex.

Beta here has no meaning. The Sensex return is like the cost of capital in the investor's mind. Both investor and money manager treat Beta as a measure of risk, when actually, it is merely an indicator of variability. Like I mentioned last time, risk is not the same as variability, which in turn, is not the same as volatility. You cannot be a good trader unless you understand the nuances of the difference between these terms.

Yet, investors routinely input Beta in calculating their cost of capital, allocating a higher cost of capital to stocks/ portfolios with higher variability, with strange results. No wonder DCF models fail to predict stock prices. Like Warren Buffet pointed out sarcastically, a stock cannot be 'riskier' at $40 than it was at $80. Classical Finance, which measures historical volatility and then equates it with risk, would tend to classify a stock as riskier at $40, just when it is cheaper. Value investors know that a cheaper stock gives higher returns, not necessarily with higher risk. Actually, the risk is lower.

However, the risk, as calculated by Classical Finance is higher, because it confuses risk with volatility/variability. But as I pointed out, this risk is different from real risk, which, as Buffet points out, is actually lower.

The resulting situation is almost comical. “Higher the risk, higher the return” is an old aphorism going around the markets. It seems logical, almost intuitively true………yet good value investors know that it is not so. The risk referred to here is actually not risk, but variability/ volatility. Value investors know that the highest returns actually come from 'low-risk' stocks. At this point, both variability and volatility are usually at historic lows. This is a typical aberration found commonly in markets…the Indian markets are no exception. Maybe the regular occurrence of such phenomena ensures that the “efficient markets hypothesis” is a failure.

Which investor, who manages his own money, ever compares his 'performance' against the Sensex? The actual cost of capital to an investor is his opportunity return, usually bank deposits. In other words, his real cost is inflation, not the pulls and pushes of the Sensex. This brings me back to the old argument in favour of absolute returns, rather than market outperformance.

Why is this subterfuge perpetuated? Because the mutual fund industry gets its fees from the size of funds managed, not from the returns generated. So they compete within the asset class, i.e. after the investor has put a certain share of his wallet into mutual funds, he diversifies his portfolio mindlessly, hoping that such diversification will somehow give him a better risk-adjusted return.

Regulators support this with flawed regulations. Fees based on returns are for hedge funds who need to focus on absolute return strategies in order to keep body and soul together. But the flawed logic of classical finance sees this as 'risky' and hence not for the small investor. So the poor guy lives with genuine risk, producing sub-inflationary returns on a mutual fund investment, while the smart, rich guys hire absolute return managers to take care of their portfolios.

Measurement of portfolio performance was a very good idea in its objective. It just went awry in its implementation. The application of various measurement techniques has vitiated the very purpose it was meant to achieve… the achievement of a proper, risk-adjusted return on the investor's capital.

It has perpetuated the idea that a money manager can be evaluated by a finite set of measurable, mathematically sound metrics that are standard across the entire set of managers. It assumes that the rules used to allocate your funds are repeatable, standardized and independent of their environment.

It tries to reduce to a logical evaluation, the study of process (of investment) that succeeds because of a very subjective skill. Just consider this: Your real cost in an investment is inflation and risk (i.e. variability of return and volatility of principal, not the Beta). Measuring investment performance against inflation ensures that you remain focused on absolute returns, while measuring risk ensures that you achieve genuine diversification, not the artificial, meaningless diversification achieved by trusting a larger number of strange 'mutually distrustful' faces.

Business of Bad Beta

In my career as a teacher, I have often come across the thought that the biggest problem with the concept of education is the very definition of the word (education).

When we teach our children, the typical middle-class Indian often confuses information with education. To me, education is all about building attitudes. The most beautiful thing about this is that it does not need a classroom.

For example, one of my first actions at the start of a course is to launch an attack on the concepts of Classical Finance. I find that Classical Finance is full of good-looking, logical (this word is often mistakenly confused with rational) and mathematical models that assume away reality. This obsession with logicality, in order to be 'rational' is probably the real reason why Classical Finance is often irrelevant in the pursuit of investing success. In capital asset pricing model (CAPM), for example, Harry Markowitz sets out to build the perfect portfolio. Very simply, he equated the volatility of a stock with the risk embedded in it.

CAPM allows investors to calculate the weights to give to each stock (given expected return, expected risk, and the correlation) in order to achieve the portfolio with the greatest return for a given level of risk. Investors can have mean-variance efficient portfolios, i.e., they will minimise the variance of portfolio return, given expected return, and maximise expected return given the variance.

CAPM rests on the concept of beta, the single factor that distinguishes between any two stocks in a portfolio universe. Everything else was assumed away. Beta, therefore, emerged as a surrogate measurement for risk. Meanwhile, I have a different understanding of risk. With my firm belief in the underlying irrationality of man, I define risk as the level of 'foolishness' in the stock. Foolishness, or 'feta' as I call it, is a measure of the amount of human misperception embedded in the behaviour of a stock. According to me, feta would be a better predictor of portfolio returns than the better-known beta. I pointed to some feta in a previous article about Tata-Corus.

No doubt, feta is much more difficult to measure with a nice, round number, which can be multiplied with the 'risk-free rate' to give you the cost of capital, the benchmark return against which all money managers must measure themselves. But that is precisely the point of this article. If you set the bar at a convenient but wrong height, you will never even start to figure out how well you did.

But enough of my own (irrationalist) version of CAPM. In the 'real' world of Classical Finance, many studies have found that beta is not a good indicator of risk. Portfolios constructed with the Markowitz model tend to underestimate the potential returns to low-beta stocks, at the same time massively overestimating returns from high-beta stocks.

Over the long run, there has been little relationship between the beta of a stock and its long-term returns. I have my own explanation for this. Beta, in some way, measures the relative enthusiasm in a stock (relative to an Index, or market, for example). Beta, therefore, is sometimes a measure for the linear underlying sentiment in a market, exuberant enthusiasm in a raging bull market or demented depression in a dying, bear market. Under such conditions, high-beta stocks will actually turn the most bearish in a downturn (like the real estate stocks in the recent February sell-off), while low-beta stocks will therefore outperform their erstwhile leaders, like Hero Honda, a laggard in the last two quarters, did not drop with the market during the recent crash.

Under certain conditions, beta is the manic-depressive face of Warren Buffet's 'Mr Market' - the fool who sells you his shares on the cheap, only to buy it from you at crazily inflated prices shortly thereafter. During such periods, it might make sense to weight your portfolio towards low -beta stocks. In 2001, I was short on IT stocks and bought sugar stocks. The former tanked 65 per cent on an average, while the latter went up 30 times in four years. I am looking for low-beta stocks again just now, as I expect another bear market. High beta? Take a look at Real Estate! In the US, studies over the 60s show that over a large universe of 600 stocks, stocks with the lowest beta have given the highest return, while those with the highest beta have given the lowest return. This is the complete inverse of the CAPM predictions. What is true of stocks has also been found to be true of portfolios, i.e., low-beta portfolios generate higher returns with lower risk than the mainline market indices.

For those who are interested in understanding this in detail, a recent portfolio constructed out of Reliance Energy, Tata Steel and Hero Honda has obtained a beta to the Nifty of 0.3. The return on investment is running at above 400 per cent, ignoring taxes. If one assumes that the downside risk on the Nifty is 30-40 per cent, and this track record is maintained, we have a risk to return ratio of 1:10. That is a fairly safe strategy in the worst of circumstances.

Ben Graham once argued that "Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability, yes; risk no. Real investment risk is measured not by the per cent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management".

CAPM assumes:

• No transaction costs (no commission, no bid-ask spread)
• Investors can take any position (long or short) in any stock in any size without affecting the market price
• No taxes (so investors are indifferent between dividends and capital gains)
• Investors are risk averse
• Investors share a common time horizon
• Investors view stocks only in mean-variance space (so they all use Markowitz's optimization model)
• Investors control risk through diversification
• All assets, including human capital, can be bought and sold freely in the market
• Investors can lend and borrow at the risk free rate

Let us take a few of the above assumptions to see how artificial they are. Any portfolio allocation that is based on relative volatility would have to be dynamic, with a large number of portfolio shifts. How can there be no transaction costs, or how can transaction costs be minimal?

Any institutional investor will tell you that it is impossible to enter or exit the market without disturbing the price discovery mechanism. Only individual investors can do that, and they don't use CAPM. In any case, individual investors cannot lend or borrow at the risk-free rate.

In a previous article on Tata-Corus, I showed you how different investors have different time horizons. The market has many blind spots, some of them constant and unchanging.

Ask any mutual fund manager whether he thinks of upside variability as risk. More likely, he will lump it with return. The entire mutual fund industry sells 'outperformance', i.e., the measure by which a fund has 'outperformed' the Sensex. They think of Sensex performance as their 'cost of capital'. The beta of stocks or of portfolios is perhaps too complex for the simple Indian investor.

Should these funds now be promising an expected loss of 20 per cent, outperforming a Sensex that might lose 30 per cent? If individual investors, like me, can construct 'absolute return' portfolios that produce a validated return over the long term, why can a sophisticated institution not develop a similar strategy? I think this makes out a case for allowing Indian hedge funds in some form or the other, but that should be discussed some other time.

Author - Sanjeev Pandiya

The Logic of the Stock Price - Sanjeev Pandiya

A stock price has many definitions. One of the most sophisticated definitions is that it values the forecasted free cash flows of a company. There are many financial models that try to capture this conceptual definition (e.g. EV/EBIDTA, EPSxP-E, Cash EPSxCash P-E).

The most popular among them is the discounted (free) cash flow (DCF) valuation. Mainly popularized by Mckinsey and some other strategic consultants, it sought to value 'free cash flows' (operating margins, net of investment in working capital and routine capex, after adjusting for the tax benefits of leverage) over the visible period (also called the explicit period). Mckinsey also imputed a terminal value, which assumes a steady growth rate going to infinity. This perpetually growing cash flow often created a terminal value, which accounted for up to 90 per cent of the enterprise value (EV) in a fast growing company There are problems with this model. It often arrives at valuations that are considered 'theoretical' by markets. My understanding is that the 'strategic' valuation that the DCF is prone to recommend (5 to 8 years) is simply too long for the market. The real reason why the market often undervalues a given cash flow is that it is simply too myopic.

That seems to have been the disconnect in the Tata-Corus deal. Phrases like 'winner's curse, 'arrogant acquisition' 'overpayment' and 'value destroying' have been used. The difference in perspective, I think, is purely over the visible forecasted period. Tata Steel's strategists are valuing the free cash flow over a longer competitive advantage period. This goes back to the Buffetian argument that the valuation of the stock should take into account not only the size and growth rate of a cash flow but also the competitive advantage period. This articulates a long-standing disagreement between the steel industry and the stock markets. The steel industry is a long gestation industry. The typical project (concept to free cash flow) is set up over most of the typical business (or interest rate/liquidity) cycle. Hence any steel company has to ride out a period of high liquidity and a cash crunch every time it sets up a greenfield capacity. Steelmen, therefore, are used to thinking in terms of a gestation period of 8 to 12 years. They simply have longer visibility than the financial markets.

On the flip side, they also know that an embedded player has a huge advantage. Sometimes you make extra money simply because you are sitting there. The Tatas have possibly projected a certain free cash flow grown at certain rate over a longer competitive advantage period than the markets are used to defining.

So who is right? Financial market players (my mental stereotype is of the Ketan Parekhs, Harshad Mehtas and the hedge funds of the world) or the steel industrialists? Are these market players any richer than the Tatas? Long-term investors don't necessarily do worse than spectacular wealth creators, found so commonly in the financial markets. You just have to decide what you want to be.

When Warren Buffet said, “Buy the business, not the scrip”, this was what he meant. Let me explain this in detail.

I don't think too many people, bar the most cynical, are arguing that the Tata-Corus deal is going to reduce the total free cash flow (FCF) of the combined entity. Yes, there is a certain view that if the steel cycle turns, the FCF being projected will drop, but will it turn negative? And if it doesn't, then the payback will happen. Only the rate at which the payback will happen might get extended. That would increase the number of years taken to digest the acquisition.

This is what a value investor should seek. Whenever Mr Market turns apoplectic, but you find long-term, 'strategic' players who want to 'buy the business, not the scrip' on your side; go ahead, jump. This is the Buffet model. Once you know where the market stands, you should stand apart from the market. At this point in time, the broader market is definitely morose about Tata Steel. Yet, nobody is arguing with Mr Ratan Tata on his claims of “long-term value”. The difference of opinion is only about the investment horizon.

Most of my regular readers would know that I am usually bearish, skeptical, 'negative'. This is especially true of the last couple of years, when I have been negative, even as I have myself joined the large mass of India's nouveau riche. Well, here is my recommendation - buy Tata Steel, and keep trading in the stock for five years (which is the payback period estimated by many analysts on current cash flows of the combined entity).

How do you trade? As you find the short-term (Mr. Market) marketmen get out, pace yourself and get in. Just like you buy a systematic investment plan (SIP), keep buying this stock on declines. Every time the stock recovers back to its previous high, sell what you bought at lower levels; then buy back the stock as it declines. This way, target to keep your average holding cost lower than the prevailing stock price. The stock will make a long, saucer-like pattern. Your average holding cost should track the falling price of the stock. As your average price drops, keep adding to your total holding. In other words, take your trading profits in the form of stock, not cash.

I will not speculate on how long the coming (down cycle?) will continue. The RBI has just hiked CRR rates again, clearly telling the country that they are determined to squeeze out liquidity till inflation slows down. As interest rates rise, the cost of capital in the markets will rise much more. That should bring temperance to the stock markets (and real estate, but that is a different story).

If you don't know how to trade, then you must buy and hold. That is a more difficult way to earn money, but Warren Buffet has proved that it can be equally profitable. For buy-and-hold investors, this would still count as a 'Buffet event', i.e., a sharp, apparently disastrous incident that looks spectacular, but does not impact the long-term prospects of the company. That is a cue for value investors to go bottom-fishing.

Hard Times Ahead? - Sanjeev Pandiya

Interest rates have 'plateaued' said a headline in a pink paper. The chairman of one of the leading banks in India was quoted as assuring the public at large that interest rates had peaked. Even as he said this, his bank was putting out term sheets to corporates that quoted only a floating rate. Some time back the bank was happily writing fixed rate loans. So whom do we believe… the papers or the actual actions of the bank?

Don't believe what the banks say. Corporate demand for credit (i.e. projects already announced) stands at roughly $900 billion for an economy roughly $800 billion in size.Assuming a net savings rate (net of government and public sector dissavings) of 25 per cent, we can expect an inflow of roughly $200 billion per year growing at 8 to 10 per cent (assuming some increase in the savings rate because of higher interest rates).

Now add retail and government demand for credit to the demand side of equation and foreign supply of savings (FDI and portfolio investment into debt) to supply side of the equation, to get some idea of the balance between the demand and supply of money. This would mean that the current set of outstanding projects would need roughly 7-8 years to fund with domestic savings, on the assumption that half the domestic savings find their way into the hands of growing corporates.

I don't have data to give you the details, but consider the following: corporate demand comes from a large variety of projects. The actual investment into these projects would have different gestation periods - from one year in an FMCG project to six to seven years in a steel project (may be more in a core infrastructure project). The demand for credit, therefore, would have an average tenure, which I think is roughly four to five years because a large number of industrial greenfield projects would be executed over more than five years.

Sometime during all this, the equation will go out of whack. In the short run, demand for credit at the margins by corporates (that are looking to raise money for projects that are half executed), will trigger a liquidity crisis. The flow of savings will not match perfectly the needs of the project. From a “liquid” situation, we are moving towards a tight situation where any supply shock will create a spike in rates, similar to the steep hike in call rates that we just saw immediately after the CRR hike by the Reserve Bank of India (RBI). These actions by the RBI are like short jabs on the brakes when a driver seeks to tell the car behind him that he is slowing down. You don't want to surprise the guy behind you but you do want him to slow down.

This is the big point. For the last three years we have had high GDP growth in a high liquidity situation, very similar to the flood of fuel into an engine just prior to accelerating the car. What you will now see is the momentum of the fast moving car trying to pull out fuel from the carburettor, even as the fuel is drying up. In the analogy above, fuel is the equivalent of liquidity (supply of money) while acceleration and momentum relate to GDP growth (which in turn creates the momentum of credit growth).

Have I made my point? The average tenure of flows into the projects will rise above the average tenure of domestic savings flow (creating a large and widening) “savings gap” which will have to be funded by overseas inflows.

Up to a point, portfolio flows will be responsive to the rise in interest rates, especially if liquidity in the US dollar goes up. If we see a recessionary outlook in the US, followed by a few rate cuts we will see rising liquidity coming from the US. As the cost of capital drops, this might result in higher overseas flows of both portfolio investments and the foreign direct investment (FDI).

On balance we have to compare relative momentum.

Quite obviously, real interest rates (nominal interest rates minus inflation) in India have already risen above their long-term averages. The momentum of credit growth is not slowing down, although I am expecting to see first signs of credit growth cracking. There was a recent news item that home loan growth has already started falling off. The same should start happening to corporate demand for credit, shortly.

There are bigger risks on the supply side. The RBI with its repo/reverse repo and CRR rate hikes is doing its bit to slow down the expansion in liquidity. There is some drawing room talk of India's forex reserve being brought back in case of a crunch.

I don't see that happening, even as the central bank is going around tightening liquidity.

The prevailing bias would suggest higher interest rates. My colleagues in the CFOs' community have started to talk about the nightmarish Manmohan Liquidity Crunches of 1991 and 1996. The first was driven by the bankruptcy of India on external account and the second was a crunching, mind-numbing braking of the economy to fight inflationary fears, prior to a national election.

At the current juncture, circumstances are much better. For one, India has large forex reserves with a negative carry. This (negative carry) will increase as nominal interest rates rise in India and they fall in the US. At any point in time, these funds can be brought back to lessen the liquidity crunch.

That brings us to overseas capital flows coming from portfolio investments/FDIs. The big 'supply shock' from these flows will come from rising risk aversion in the middle of a global slowdown. The premium demanded for moving money to India will increase sharply, the moment the profit slowdown shows up in the bottom lines of the companies.

It is dangerous for me to put numbers behind each of the above factors but I am willing to bet on the direction.

There is a clear consensus among all large financial players that interest rates are hardening and the medium term view is that liquidity will stay tight. Banks that gave us 10 year fixed rate loans at roughly 7 per cent a couple of years back are today not willing to write.

similar loans even at 11 per cent. The message is clear - only floating rate loans, relatively lower tenures and no premature termination clauses. It is clearly turning into a sellers market reminiscent of 1996-1998. All this mumbo jumbo recounted above is meant for practicing CFOs (who might find most of the above to be obvious).

For you dear reader, I'll keep it very short. Start preparing for coupon rates to become perhaps one-and-a-half times current levels. As the base changes you can immediately expect a drop in the market PE ratio. Adjust this PE for, say, 15 per cent profit growth and re-calculate the level of the market. Do the same for the expectation of real estate returns (refer to my previous articles to understand the equivalence between equity, real estate and debt market returns).

In short, over the next 3-5 years, returns in the debt market (current yield) will rise but bond prices of existing issued paper will fall. Average PE in the stock market will also fall, so you will get less price appreciation for the same profit growth. And God forbid, if there is a profit dip, the stock will get crucified. Liquidity in the real estate market will dry up. In some overpriced markets, there may be bubble bursts but in most of India where houses have been bought without borrowings, there will merely be no buyers. A panic seller who is forced to liquidate for any reason will have to sell at a huge discount.

So where do you go? My answer is: there is a time to make money and there is a time to save money. We are entering that phase of the liquidity cycle where cash will be precious. This is the time to turn virtuous.

Shape of Pyramid - Sanjeev Pandiya

One per cent of the world's population owns 40 per cent of its wealth. That on a base of 6.5 billion refers to 65 million people. The actual proportion of national wealth owned by the top one per cent varies and is measured by the Gini Coefficient, reported in the CIA Factbook.

Here is data on the US: The top one per cent owns roughly 38 per cent of all wealth, while the top five per cent owns roughly 60 per cent. The top 20 per cent owns 80 per cent of the wealth, down from 83 per cent in 1998. Average income disparity i.e. the skewness of income distribution has fallen continuously from 1929 (the year of the Great Depression) till 1970, but this (skewness) has doubled since then. The bottom 20 per cent has zero net worth i.e. no savings. Median wealth is at $62,000 (at the 50th percentile), which looks very good by Indian standards ($1100 by rough estimates) but their top one per cent have an average wealth of $ 12.5 million.

US GDP per capita is around $40,000-42,000 compared to India's $650. With nearly 70 times Indian income, their wealth ownership is sharply lower, only about 55 times. My numbers are approximate, because data taken is for varying years, but the ratio I want to calculate is important. Total US wealth is about $55- 60 trillion, but a third of that, roughly $11 trillion, is in foreign hands. More important, the flow of savings is completely dominated by foreigners, with US savings at one per cent (i.e. $125 billion on a total economy of $12.5 trillion). Foreigners bring in about $1.2 trillion, if you add up the current account deficit ($800 billion) and the fiscal deficit ($400-500 billion).

If you factor in indebtedness, you get a very different picture. The bottom 20 per cent has no net assets, i.e. net of debt. Half of them are bankrupt, facing legal proceedings for debt default. The rest are on social security. Blacks and single women (including single women with children) have the lowest levels of wealth i.e net income. Blacks have 60 per cent of average income, but only 18 per cent of average wealth. Single women with children have the highest bankruptcy ratios, now running at nearly 15 per cent.

Another significant trend thrown up is that of a non-household wealth. If you strip out house ownership, the top one per cent now owns over 50 per cent of all non-house wealth. They are predominantly concentrated in equity ownership, both listed and private. Ten per cent of the US population owns 85 per cent of the listed equities, 85 per cent of all financial securities and 90 per cent of business assets in the country. Compare this with the concentration of all kinds of wealth (38 per cent) and you know where you need to be if you want to get seriously rich. With per capita GDP of $42,000, US median wealth is at $62,000, i.e. a net worth of roughly 1.5 years' income. Much poorer India does far better. On a per capita GDP of roughly $650, we have net wealth of $1100 per capita, 1.7 years. But we know that from elsewhere our household savings rate is around 30 per cent.

Actually, this key ratio of net worth:income is much better. You need to factor in US indebtedness, low savings, foreign ownership of US assets and their very highly-valued stock markets (1.8 times GDP). If one factors in all these factors, the US ratio will drop and the Indian ratio will rise much more.

So let me make my points.

The US is one of the most unequal among the developed countries, except the UK. The Gini Coefficient (an index of income inequality) is at 45, against India's 32.5. It has been noticed that very high levels of inequality tends to slow down economic growth, because it distorts the allocation of resources away from basic public goods to luxuries.

When a nation is dominated by excessively rich people, tax collection as a proportion of wealth drops because the rich are better tax planners. Millionaires in the US have taxable incomes of just seven per cent of net worth, compared to more than nearly two to three those levels for the rest of the populace. Further, the quality of education (and public services) suffers because the rich are able to send their children to private schools, while the poor make do with public schooling, which is always starved of funds. We see this spectacularly in India.

Another important point is the role of innovative industries in exacerbating income inequality. Industries like IT and biotech tend to concentrate wealth in the hands of the educated elite. This kind of income inequality may be better than the feudal kind seen in, say, a Bihar, but it also distorts the allocation of resources to public goods, outlined above.

And the most important point is that markets accelerate income inequality, as the data shows above. Similar macro-economic data for India is not available, but we can all see anecdotal evidence around us. Those who have large proportions of their wealth in equities tend to do better over time. I have argued this at the micro-economic level in previous articles, where I pointed out that real estate returns are random and more uncertain over long periods of time. Equities outperform both in quantum and in predictability.

Equity returns measure entrepreneurship, the returns available to risk-seeking capital. High equity valuations are available to those countries that are relatively entrepreneurial and growth-oriented. The fruits of such growth get disproportionately distributed to the small risk-taking class. These are usually the educated elite, leading to results very similar to the innovation- drivers outlined above.

Qualitatively, this kind of wealth inequality is much better than the kind seen in, say, North Korea or Zimbabwe, which is feudal, power-driven and goes to the hegemonist. But still, thanks to a disproportionate control over the fruits of education, the educated elite in these democratic countries also tends to contribute their mite to the problem.It has been argued, very reasonably, that income inequality is the biggest spur to entrepreneurship and innovation. Without the potential for relative outperformance, nobody would have any incentive to do anything useful. This was the biggest reason for the death of communism. That is acceptable. But this is not an unmitigated virtue. Capitalism still bears the responsibility of ensuring that income inequality does not end up in wrong hands. We need to look at Nigeria/ Zimbabwe and the tinpot nations of Africa and the Middle East to see what excessive concentration of wealth can do.

Capitalism also needs to monitor who gets the wealth, and why? If the income inequality is happening Bihar style, with wealth being captured through political or muscle power, then you will have the vicious cycle of political power capturing wealth, then that economic power consolidating itself into further political power, creating and endless morass which perpetuates itself. The dons of Dhanbad started with crime, captured wealth, then political power, which created even further wealth.

So are the IT tycoons any better? They too perpetuate private monopolies, which just look better because they are white collar in nature. But the distortion in resource allocation is the same. The physical slavery of Dhanbad is not much better than the slavery foisted by dollar on the sweatshops of Asia…we make a container-load of garments, just to get back a CD with a computer programme. There are ethical and humanitarian dimensions to this problem, besides the usual economic and political arguments. The pursuit of innovation and entrepreneurship is of course a virtue but you need to question whether you are doing too much, if your Gini curve starts to look the same as Zimbabwe's.

I have argued for long that poverty in the US and London is far more debilitating than in Etah, UP, where everyone is poor. Poverty in the midst of riches creates far greater social problems than general, isolated poverty.