China’s Belt and Road Initiative: Pax Sinica Redux or Economic Black Hole?

Contributed by: Ishwar Chidambaram, CFA, CIPM

“… (We must) hide our capabilities and bide our time, never try to take the lead…”

-Deng Xiaoping, Paramount Leader of the People’s Republic of China (1978-1989)

On May 14, 2017, Deng Xiaoping would have been spinning in his grave at China’s flagrant disregard for his sage dictum, when the heads of state of 29 nations converged on Beijing for the inaugural Belt and Road Forum. The 2-day extravaganza, touted as the biggest diplomatic event of the year, was designed to promote China’s leadership of Eurasia under the Belt and Road initiative, an ambitious plan to realize President Xi Jinping’s strategic vision. This vision calls for constructing a land economic belt to Central Asia and Europe, and a Maritime Silk Route to connect the Pacific Rim with the Indian Ocean and Africa. China has pledged more than $100 billion under this initiative, popularly known as One Belt, One Road (OBOR).

Prominent attendees to the Forum included Russian President Vladimir Putin, Turkish President Erdogan, seven ASEAN leaders, the Prime Ministers of Pakistan and Sri Lanka, and heads of the United Nations, IMF and World Bank. Bucking the rising tide of protectionism in the Western world, 130 nations on 5 continents flocked to the event.  Prima facie, this would appear to affirm China’s position as a beacon of globalization, in an era where the Trump administration has slashed foreign aid and erected trade barriers in the name of “America First”. OBOR might also be expected to consolidate the position and perpetuate the legacy of Chinese President Xi Jinping, arguably the nation’s most powerful leader since the revered Deng Xiaoping. In his speech at the Forum, President Xi announced that total trade between China and other OBOR countries has already surpassed $3 trillion from 2014 to 2016. China’s investments in those nations have exceeded $50 billion, with a target of $4 trillion. It has set up 56 Special Economic Zones in 20 countries, which have collectively generated $1.1 billion in tax revenues and created 180,000 jobs. But the project is not without risks, as outlined below, and has drawn criticism from various quarters.

Critics of the project contend that the entire scheme is poorly conceived and simply an ego trip for the powers that be in Beijing. They point out that China is merely exporting overseas its domestic model of debt-driven development. They contend that this model is unsustainable in the long run, and that any escalation of credit risk could lead to spiralling bad debts, which would severely burden the fragile economies of peripheral nations. In fact, the UN has itself expressed concerns over economic, financial, social and environmental risks of OBOR. A recently concluded UN Economic and Social Commission for Asia and the Pacific Study (UNESCAP) has warned of financial risks in countries in south and central Asia where China’s announced investment value under OBOR is high compared to the relative size of the economy of the recipient country. The $15 billion China-Uzbekistan investment deal signed in late 2013 is roughly equivalent to a quarter of Uzbekistan’s GDP. Similarly, the $37 billion China-Kazakhstan cooperation agreement signed in late 2014 and early 2015 and the $46 billion China-Pakistan agreement in April 2015 each represent over a fifth of GDP level in Kazakhstan and Pakistan, according to the UN study. “External account indicators for some of these economies are relatively weak”, as per the report, which also expresses concerns over upheavals on the social and environmental fronts in the region.

Another concern is ratings firm Moody’s recent downgrade of China’s long-term local and foreign currency issuer ratings by one notch to an A1 rating from AA3. Moody’s cited expectations that the financial strength of the world’s second biggest economy would “erode in future, with economy-wide debt continuing to rise even as potential growth slows”. The downgrade is yet another signal to the international community that all is not well with the Dragon, even as it has embarked upon its expansive OBOR initiative, targeting global dominance. Some Western nations have also expressed reservations about the Forum, as they see it as an attempt to hard sell China’s soft power, with complete Sinification being the ultimate objective. Already there are grim assessments to the effect that weaker economies like Pakistan would be fully subjugated and reduced to an economic colony by China.  Western countries are also bothered by the perceived lack of openness and transparency in awarding contracts. According to one US investment research firm, it is also open to question “how much political sovereignty is sacrificed, and what is the risk to completion of projects in the event of a disorderly slowdown in the domestic Chinese economy”. Nevertheless, this has failed to dent enthusiasm for the Forum.

Peering into history, commerce along the ancient Silk Road was pivotal to the emergence and flourishing of the ancient civilizations in East Asia. The Chinese, in particular, were the greatest beneficiaries of that free trade, which led directly to the establishment of the first Pax Sinica (Chinese peace), when China maintained the dominant influence in Asia due to the combined might of its soft and hard power. In its current avatar, the Belt and Road initiative is widely regarded as China’s tour de force, heralding its emergence as a superpower on the world stage and shifting the planet’s economic centre of gravity towards Eurasia. It envisages extensive investments (as much as $ 1 trillion by some estimates) in infrastructure, such as roads, railways, airports, seaports, transnational electric grids, oil pipelines and fibre optic lines of communication. If successful, it would represent the culmination of China’s ascendance, and transform the face of Eurasia beyond recognition.  

The initiative showcases China’s global ambition on an epic scale. The motivations behind this proposal are ubiquitous, with economics being chief among them. China needs to find and develop the untapped markets in its hinterland to export its excess capacity in cement, steel and industrial materials. The Dragon has a burgeoning war chest of over $3 trillion in foreign exchange reserves, most of which is parked in low-interest-yielding US Treasury securities, and which need to be redeployed to more profitable alternatives. Another imperative is to quell the unrest in China’s troubled western provinces of Tibet and Xinjiang, by strengthening the fragile economies of Central Asia, thereby creating a more stable environment. And last, but not least, the Maritime Silk Route could possibly bolster China’s territorial claims in the South China Sea, a region long coveted by Beijing.

The Initiative has already begun to attract significant financing. In 2015, The People’s Bank of China transferred over $80 billion to three state-owned banks mandated to provide funds for OBOR projects. A new Silk Road Fund worth almost $40 billion was promoted by China’s sovereign wealth fund. The most significant milestone was the inception of the Asian Infrastructure Investment Bank (AIIB) by the Chinese government, with $100 billion in initial capital. Like a freight train pulling away from the station, the OBOR project is slowly gathering momentum. Now China’s omnipotent state resources are mobilising, with over two-thirds of China’s provinces incorporating OBOR in their development objectives.

Despite these efforts at coherence, the initiative is beset with teething troubles, especially in South and East Asia, with disputes over a railway line through Thailand and clamour for renegotiating projects in Sri Lanka and Myanmar. There is also a profound dearth of feasible projects for the enormous sums of money allocated. Moreover, OBOR lacks a strong central leadership, with its present leader- Mr. Zhang Gaoli- perceived to be out of favour in Beijing. Even more critically, there exists a vast cacophony of internally competing bureaucratic voices within China- the ministry of commerce, the foreign ministry, the planning commission and China’s provinces, to name but a few- each competing for their share of the lucrative OBOR pie. These will need to be reconciled for the OBOR orchestra to hit all the right notes and play a fluent symphony. Whether it results in a second Pax Sinica or collapses into an economic black hole-only time will tell; but one thing is certain: win or lose, the Dragon means business. Every chain is only as strong as its weakest link, however, and the Belt and Road Initiative is no exception.



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Sensex @ 30,000…What Next?

Contributed by: Shivani Chopra, CFA

As the CFA Institute celebrates its 70th Anniversary this year, it remembers the seminal event that shaped the geographical reach of CFA Society network. Even today these events deliver value to the members by providing forums to learn and discuss issues of common interest. We witnessed another such event on 13th May 2017 when the Delhi Chapter of CFA Society India had the privilege of hosting Mr. Navneet Munot, CFA who delivered a very interesting talk on the current topic. An acknowledged expert on the topic, Navneet is the Chief Investment Officer of SBI Mutual Fund and Board of Director, Indian Association of Investment Professionals (IAIP).

The list of variables affecting equity markets is interwoven in a complex web and the list itself is pretty lengthy. Navneet tried to discuss most of these factors currently affecting Indian stock market. He started the discussion by highlighting the structural reforms happened in India recently. These include Bankruptcy code, GST code, Aadhar Bill, Real estate regulatory bill, etc. Demonetisation of high value currencies has significantly expanded the tax payer base by adding 94 lakh new income tax payers. As finance is becoming more digital, it is leading to Financialization of assets. The household savings are entering the financial sector more rapidly and for longer term now. The situation in India can be compared to 401K movement in US. A reform with a simple motive – “Save more to have a better retirement”.

Digitization, Technology, Urbanisation and Rural revival

Navneet then discussed the growth drivers for India. Some of the growth drivers are correctly priced while others are not. Digitization will be one of the most important growth drivers. Infact, India is leading the digitization drive in the world as its migrating from data poor to data rich country. Many government programs are being tracked on live basis. Another growth driver closely linked to digitization is technology. The best way to change our country’s ‘DNA’ is through use of technology. We have a great potential to become one of most literate countries in the world as today being able to use technology is equivalent to literacy. Technology will continue to do wonders for the corporates as well. Jio is a brilliant example. It used Aadhar card information to expand its subscriber base to such high levels. Banks are considering the downsizing of their existing branches and may not be opening new branches at all. A point that was repeatedly stressed was that we as a country are massively underinvesting in technology. We need to invest much more in technology if we want to see the right results. Urbanisation and Rural revival was the next factor talked over. The government focus is on digital connectivity, rural electrification, crop insurance, road connectivity, financial connectivity, etc.

Leverage, Global Economy and Exports

Navneet went on to share some facts relating to leverage, reliance on global economy and exports .India is one of the least leveraged countries. During the last business cycle in 2007, the analysts predicted a 10%+ growth for extended period but this expectation busted due to policy inactions. India story today is strengthened by the regulatory and policy measures taken. Borrowing costs have come down and there is easier availability of credit in the retail sector. The private capex cycle will take some time to improve but the government capex looks good. Affordable housing schemes are fast gaining popularity. These schemes depend on idle land bank, tax incentives, latent demand, lower rates and easier credit. Real Estate Regulatory Act (RERA) is going to change the industry for good. The speaker expects the volumes to go up in the next few years in contrast to the prices that had gone up in the last few years. He also spoke about the importance of global trade. Though it is perceived that India is a domestically driven economy, the truth is that global economy also matters a lot to us. The continued pick up in India’s exports is a healthy sign. India has never lost its market share even in tough times. Our country is least affected by global trade volatility because of a well-diversified basket. Growing exports coupled with robust FII and FDI flows have led to the appreciation of the rupee. After the demonetization, the excess liquidity in the banks kept RBI intervention low as absorbing excess dollars could have added even more to the rupee liquidity.

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What Next ?

All the factors discussed above will have an important bearing on the Indian stock market. Things have just started to fall in the right place, be it liquidity or political stability. We have a reform oriented government and supply side economy is building up. Other than the twin balance sheet problem, macroeconomic situation is looking very bright. Taking clues from the past Sensex performance, there have been two set of periods when the market was down for two consecutive years (1995-96 and 2000-2001). After that we have not really seen any period and so logically the third year after two almost flat years should be good. Below are the contributors which will help sustain 30K level –

  • Earnings Quality and controlled costs – Navneet’s biggest worry is the earnings sustainability. The NIFTY PAT is expected to post a double digit growth but it is coming from only a few select sectors like Banks, Oil and gas, etc. In this cycle, wages and other key costs will remain controlled. So in future when revenues will improve, this level of 30K will sustain
  • Better leadership at state levels – We can see some major action happening in a few states. E.g. Uttar Pradesh (UP) which has historically been a drag can actually drive the growth agenda for India. A state with 16.5% of country’s population has ranked very poorly in terms of per capita income, literacy level, poverty ratio, etc. In terms of social conflict, UP can either be a biggest demographic dividend or demographic disaster.
  • New set of winners- India might be heading towards NICE era – Non Inflationary Continued Expansion but with a new set of winners. As the rising tide doesn’t always lift all the boats, likewise not all the corporates will do well. A few may even go out of business. With the help of technology and emergence of social media platforms, costs like advertising are very low today. This will help companies with new business models thrive at a faster pace. Active stock picking remains the key.
  • Liquidity- The biggest contributor is increase in liquidity. The retail participation is at all time high but the numbers are just a tip of the iceberg. Increased supply from IPOs, divestments and QIPs can absorb this liquidity. The need of the hour is to issue mega IPOs to revive the IPO market. Private PSUs have a good scope to go public as well.

There are risks to be considered too. Navneet mentioned a few important ones like geopolitical, GST implementation, twin balance sheet problem (over leveraged corporate balance sheet and NPAs in banking sector), disruptive forces faced the business, etc

The talk ended with attendees actively asking equity market related questions, all of which were answered very patiently by our eminent speaker, Mr Navneet Munot.


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Millennials and Financial Services

Contributed by: Rajni Dhameja, CFA

The Panel:

  • Navneet Munot, CFA, Chief Investment Officer, SBI Mutual Fund
  • Partha Iyengar, Co-Founder and Managing Partner, Life & Money
  • Amit Kumar, Partner and Director, The Boston Consulting Group
  • Kalpen Parekh, Joint President, DSP BlackRock AMC
  • Rajiv Sabharwal, Partner, True North  
  • The Moderator: Uday Dhoot, CFA, Founder,

Millennials seek life balance and they aspire to get the financial freedom at the earlier age. This coupled with their present focused mind, pose a challenge for the financial advisors. To achieve the financial freedom at an earlier stage of life, it is important to start saving early and invest for long term. But Millennials have low disposable income as they are in the initial stage of their career and their present focused mind gravitates them towards spending more rather than saving more.

Financial advisors have to tailor the presentation of the advice to leverage upon the behavioral traits of the millennials. The tendency to spend more is attributable to one core factor of convenience. Spending is convenient, but the investment is not. Today financial companies are talking among themselves rather than engaging in a meaningful conversation with the end investor. They talk in terms of numbers and jargons which make the investment process really complicated for the generation Y hence they get gravitated in the opposite direction.

To address this issue, financial services industry needs to engage in dialogue with Generation Y in a language which this generation can identify with. For instance, talking in terms of goals rather than in returns. For instance, to enjoy an exotic vacation after four years, you need to invest so much amount in so and so asset. Further, rather than giving them advice, the financial planner should act as a choice architect. For instance, to achieve the financial freedom, these many combinations of asset allocation are available. Each presented with relative merits and demerits. Such an approach leaves a satisfaction in their mind that they made the informed decision as they tend to listen less to others.

The purpose orientation of Generation Y should be brought about in the financial advice. For instance, an ESG compliant portfolio contributes to the larger good over and above achieving the financial advice. The investment process needs to be made easier the way spending has been made easier with few clicks on the phone. It will help to bring about the change in their habit of low investing. The question for financial services industry is how to manage the small margins of advisory fees with the investor class who otherwise is habitual of free offers and services in their spending habits.


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Mind of Millennial

Contributed by: Rajni Dhameja, CFA

The Panel:

  • Sachin Kalbag, Resident Editor, Mumbai, The Hindu
  • Mandar Mhatre, Entrepreneur and Investor
  • Talvinder Singh, Product Head, Flagship, OYO Rooms
  • Sameer Somal, CFO, Blue Ocean Global Technology
  • Ravi Subramanian, Executive Director, Sriram City Union Finance
  • Sonia Gandhi, CFA: The Moderator, Board of Director, IAIP

Millennials, also known as Generation Y, is the name given to a generation born between 1982 and 2004. To be more generic, millennials is a generation which is exposed to technology from a young age, exposed to confused parenting and have information overload.

Millennials world over share the similar traits. They follow the YOLO (you only live once) principle. They focus on now rather than future. They have a fear of missing on hence they want to experience most of the things instantly. It is a generation which grew up using smartphones hence they are very much comfortable with the technology. They seek the information from various sources and are aware of many things. It helps them to take the informed decisions. The generation Y is characterized by impatience. It can act as an asset and liability both depending on the situation. They are believed to have the entitlement mentality. On the flip side, they are insecure about the future. They focus too much on their convenience.

Panelists shared the point of view that this is the generation which does not have a fear of failure. They are ready to try out the things different from what their parents did. There are two types of millennials and the aspiration levels differ between the two. The urban or the millennial who had easy access to things and the others who did not have easy access to things. The aspiration level for have not’s are completely different than the aspiration level of the former.

Millennial have this constant quest for purpose. They try to find out the meaning and purpose in everything they do and this gets reflected in most of the choices they make. They had to learn quite a few things at significant speed to match with the information overload at their disposal. Due to this, they are better suited to tap few opportunities contrary to an earlier generation.

Some surveys on millennial reveal about their reading habits and wellness choices. They prefer to read the print version of books rather than e-books as reading is the way of de-stressing and disconnecting for them. They are very much focused on their health and wellness as they believe that healthy lifestyle is pivotal in their overall happiness and wellbeing. Brands are finding it difficult to gauge the minds of millennial today, so according to the panel, anything which has simplicity, serves the purpose and convenient to execute will definitely find the success to win the heart and mind of millennial.


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The Elephant & the Dragon: Changing Dynamics that affect Asia & Beyond

Contributed by: Ishwar Chidambaram, CFA

On 6th May 2017, CFA Society India- Mumbai Chapter hosted a talk by Mr. Xu Sitao, Chief Economist and Partner of Deloitte China. Mr. Xu said that most people view China as an important source of global demand. This view is correct, as you need to study Chinese investment and demand cycles in order to analyze commodity prices, which cannot be forecast using technical analysis alone. Further, if one neglects China, then one cannot correctly forecast global interest rates. For example the Reserve Bank of Australia cut rates twice last year because, in their opinion, China was headed for recession (hard landing) which would weaken commodities prices. Another example was the Fed’s reluctance in the past to cut interest rates, fearing a Chinese hard landing. These examples reflect China’s emergence as a center of gravity on the world stage.

Mr. Xu praised China’s government for making the economic miracle possible. In 1978-79, per capita GDP in China was only $200, below that of India. Prior to that, there was stagnation for more than a decade. Now, China is the second biggest economy at about $12 Trillion, behind only the US ($18.56 Trillion). Within the next 15 years, China will surely overtake the US as the world’s largest economy, even as China’s growth rate stabilizes. Credit for this is largely due to Deng Xiaoping, who ruled China from 1977 to 1989. After 1989, he was still in charge behind the scenes. From 1949 to 1976, China under Chairman Mao then was no different from North Korea. From 1961 to 1964 roughly 30 million people died from starvation, largely a man-made disaster. During the Cultural Revolution, another 5 million perished. India too had failures during this period like the Emergency, but the scale of human suffering witnessed in China was unprecedented anywhere else. He said these were failures of socialism and top-down planning, and that any reform needs to be driven from the bottom-up in order to succeed.

Returning to the subject of Deng Xiaoping, Mr. Xu emphasized that it is essential for national leaders to be pragmatic. He cited former Premier Deng’s famous aphorism, “It doesn’t matter if a cat is black or white, so long as it catches mice!” Mr. Xu suggested term limits and age limits for national leaders. Another unique feature of Chinese politics is that a leader does not directly choose his own successor. For example, the current premier, Xi Jinping was chosen by former premier Jiang Zemin. These checks and balances are a prerequisite for impartial governance. After the 1989 student uprising at Tiananmen, China slipped into a recession, as it was blacklisted worldwide. In 2001, China entered the WTO and the entire country became a Special Economic Zone (SEZ). From 2003 to 2012, China experienced a lost decade, as corruption mushroomed and new reforms dried up under a perpetual stimulus. China’s forte is scalability, as it is extremely good at ramping up to higher trajectories of development. The current premier, Xi Jinping, comes from a very privileged family and is a relative unknown in China.

In 1978 China’s economy was small, largely rural and agrarian. Today urban population is more than 65%. Urban consumption is a powerful driver. Only 4% of Chinese own passports. China is opening politically and economically. China is the largest trading partner across the comity of nations. Now China is emerging as the biggest source of foreign direct investment, and a leading provider of international liquidity.

Bilateral trade between Asian giants India and China currently stands at only 20% of the bilateral trade between China and South Korea. China is driving demand from both rich and poor countries. Mr. Xu is skeptical about the possibility of another commodities bull market, given consolidation in China’s industrial sector. The term “savings glut”- coined by former US Fed Chair Ben Bernanke- in relation to China’s excessive savings, has propelled global interest rates lower. India should pay attention to China’s impact on interest rates. China’s One Belt, One Road (OBOR) initiative was launched in 2013. This development strategy and framework, proposed by Chinese paramount leader Xi Jinping, focuses on connectivity and cooperation among countries primarily between China and the rest of Eurasia, and consists of two main components, the land-based “Silk Road Economic Belt” (SREB) and oceangoing “Maritime Silk Road” (MSR). The strategy underlines China’s push to take a bigger role in global affairs, and its need for priority capacity cooperation in areas such as steel manufacturing. The timing of this initiative coincided with former President Obama’s Pivot to Asia. Mr. Xu also mentioned the Asian Infrastructure Investment Bank, first proposed by China in October 2013, which is a development bank dedicated to lending for projects regarding infrastructure. Incidentally, India is the second largest equity holder in AIIB.

Protectionism is the biggest challenge confronting China. The solution is for China to open its markets further. The second challenge is the evolving trajectory of US-China relations, which have entered a difficult phase, with US viewing China as a competitor. The third challenge is costs, including currency costs and labor costs (both of which have gone up 7-8 times) as well as environmental costs. Finally, a burgeoning middle class and its growing expectations are another challenge. The final challenge is leadership and the system of alternate succession in China. This is particularly significant given the 19th Party Congress scheduled for October 2017.

China has printed plenty of money resulting in explosive credit growth. China’s debt to GDP ratio is expected to reach 400% as per Goldman Sachs. Mr. Xu is not as pessimistic, and believes China is in much better shape compared to nations like Italy and Australia. You will never see a bank run in China. In this respect, China is like Japan. Best solution for China is to slow the economic growth rate to more sustainable levels of about 3-4%. Another solution is to implement structural reform by selling state-owned assets via privatization. But this is unlikely to happen for now, given the impending Party Congress.

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China’s currency was historically pegged to the US Dollar. Now the yuan seems to be slightly overvalued. Comparing foreign exchange reserves, while India has around $300 Billion worth of reserves, China’s tally is close to 9 times that number. Thus, China can pay for 20 months’ worth of imports. They have too much of reserves. Based on this, China’s currency ought to appreciate, but that will not happen due to cultural issues, Party Congress, etc.

By the end of 2017 China will ease restrictions. When that prospect materializes, Mr. Xu expects the yuan to depreciate. This will need to be accounted for while forecasting exchange rates across the world. The demographic dividend is more favorable in India than in China. Now even though the one-child policy has been scrapped, China is behind the curve in achieving more favorable demographics. The China-India relationship continues to underwhelm expectations. Both nations would need to understand each other’s strengths and weaknesses. China’s strength is its huge momentum. India’s strength is its favorable and sustainable demographic dividend. Corruption in China is much worse than in India.

China’s economy today is extremely open, despite the restrictions. The restrictions will be phased out after the Party Congress. On the point of reserves, one needs to view reserves in relation to imports. China can cover 20 months, while Japan can cover 40 months of imports. This is excessive. Depreciating the currency should be done before the onset of a crisis. Policy makers must reduce the size of asset bubbles before they burst. More capital outflows (but not capital flight to safety) out of China are perfectly fine. We should not take Donald Trump literally, but we ought to take him seriously. There is no budget system in China, being a non-democratic society. Automation is skyrocketing due to spiraling labor costs. On the shadow banking system, it is a natural consequence of market development and regulatory arbitrage. Even the government relies on shadow banking to finance some activities. Further liberalization of the banking sector is desirable.



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Stock Picking vs Portfolio Construction: The Role of Checklists

Contributed by: Jitendra Chawla, CFA
On 25 April 2017, CFA Society India –Delhi Chapter hosted Prof Sanjay Bakshi and Paresh Thakkar of ValueQuest Capital LLP for a talk on Stock Picking vs Portfolio Construction: The Role of Checklists. The event was a huge success with more than hundred enthusiastic participants attending the talk.
The following is a summary of Prof Bakshi’s and Paresh’s speech/comments during the presentation.

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Captain Sully and the Hudson River landing
Prof Bakshi started the talk by showing a clip from the movie Sully. On January 15, 2009, Chesley Sullenberger, better known as Captain Sully, was a pilot in command of a US Airways Flight 1549, an Airbus A320 taking off from LaGuardia Airport. Shortly after takeoff, the plane struck a large flock of birds and lost power in both engines. Quickly determining he would be unable to reach any airport, Sullenberger piloted the plane to a water landing on the Hudson River. All aboard were rescued by nearby boats.
After the incident, there was an investigation and public hearing. During that hearing, it was alleged that Captain Sully made a mistake and endangered lives by landing the plane in Hudson. He should have tried to get to the nearest airport which was seven miles away.
The investigators even tried to replicate the situation on a flight simulator and showed that he could have landed the plane. Sully made a point in his defence that those trying to say he made a mistake are not taking into account the ‘human element’. The pilot who had landed the plane in the simulation exercise had practiced it seventeen times before he could do it successfully. Later on, when they incorporated a 35 second delay (which is the least time any pilot would have taken to react in a real life situation) in the simulator exercise, the plane crashed.
The National Transportation Safety Board ruled that Sullenberger made the correct decision in landing on the river instead of attempting a return to LaGuardia because the normal procedures for engine loss are designed for cruising altitudes, not immediately after takeoff.
What is the difference between what we do and Sully situation?
–    A flight lasts only a few hours but our investment operations last more than a decade.
–    We can afford to be more reflective (while Sully had all of 208 seconds), though some sort of value investing operations do require a quick response (e.g. if there is massive moat impairment in a position), however, most of the time, most of our decisions are slow decisions.
–    Longer decision time means feedback is delayed. It is unlike day trading or for that matter archery or shooting, where you get instant feedback on your performance.
–    Life is not long enough to allow for feedback to be a good teacher in long-term value investing. Therefore, we have to rely on vicarious learning or learning from past experience of others.
What is the similarity between what we do and Sully situation?
–    Good portfolios are like good airplanes. They do not usually crash as they have multiple engines. If one engine fails, there is a fallback option. In portfolio management parlance, a crash would be equivalent of a decimation of earnings (and not decline in market value) of any position in the portfolio.
–    Multiple engines are there to create redundancy. The principal of redundancy is also applied in civil engineering e.g. in the construction of a bridge, where the bridge is constructed to bear 3x the maximum load it is expected to bear.
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
-Warren Buffett
–    Similarly, to have robust portfolios, one should create redundancy which is actually nothing but a margin of safety. The weights of various investments in the portfolio should be restricted to a maximum number (say 1/6th of the total portfolio) so that any unexpected negative outcome doesn’t threaten its very existence.
Casinos, Insurance companies and Margin of Safety
“In order to take proper advantage of the margin-of-safety principle in investment operations, its almost always essential that the investor practices adequate diversification. A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss – and in the case of common stocks, that the probabilities favor an ultimate profit.”
-Benjamin Graham
–    One can best understand the concept of margin of safety by understanding how a casino operates. A casino is usually a safe place for an investor/owner as casinos tilt the odds in their favour. The casinos make sure they have the winning edge. Players do not stand a chance. As a collective, they are playing a game that they can never win in the long term as the odds are not in their favour.
–    Consider the game of American roulette. It has 38 slots – numbers 1-36, 0 and 00. If player bets on a number and the winning number matches, the player wins 35x. Otherwise, he loses the bet amount. Eg: If a player bets Rs 1,000 on a number his probability of winning Rs 35,000 is 2.63% and the probability of losing 1,000 Rs is 97.37%. Expected value is negative Rs 53.20.
–    This is how Casinos make sure they have a winning edge:
  • Set the odds against the players. They have a small albeit a clear edge  (in the long run, house wins)
  • Since they have a slight edge, they need to diversify a lot.  So they make sure to get lots of players to play (Any one player’s outsized winnings cannot bankrupt them)
  • Put limits on bet size (No player can keep increasing bet size to harm the casinos in case he/she gets lucky on an oversized bet)

Insurance business does something similar to casinos to manage risk.

“What counts in [insurance] business is underwriting discipline. The winners are those that unfailingly stick to three key principles.

1.    They accept only those risks that they can properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

2.    They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly unrelated risks.

3.    They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.”
-Warren Buffett on Principles of Insurance Underwriting

–    In both the businesses (Casinos and Insurance), there is one common principle:
The lower the edge (margin of safety) of the casino over the customer, the higher the need to diversify, and vice versa.
–    Just like casinos and insurance businesses, a prudent investor should reduce the probability of failure (and increase probability of success) by combining margin of safety with proper diversification.
“The individual probabilities may be turned into a reasonable approximation of certainty by the well-known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be the cornerstone of a sound investment.”
– Benjamin Graham
What does it mean for Concentrated Investing?
–    If a narrow edge warrants a diversified portfolio, a concentrated portfolio would warrant a wider edge.
–    In concentrated portfolios, you don’t want even a single position to blow up, as that would be a major setback.
–    That means one has to be extra careful while selecting what to include in the portfolio. Rejection rates have to be very high. One needs to add layers of protection, apply strict filters so that the few ideas which can pass those filters are the most robust ones.
Redundancy: Adding layers of protection
–    The Idea of “Margin of Safety” is based on the idea of Redundancy in Engineering.
–    Critical components of a system are duplicated with the intention of increasing reliability of the system. If one component fails, the other one acts as a backup making it a fail-safe system.
–    In such a system, all components must fail before the system fails. If each one rarely fails, and events of failure of each is independent of others, the probability of all three failing (system failure) will be extremely small.
–    Similarly, good portfolios also need several layers of protection. All this protection has a cost in the form of reduced return. It is because the investor will sacrifice some return to avoid blow ups. This protection will come from
1.    Avoiding what doesn’t work
2.    Seeking what does work
–    From experience of self and others, one can look for patterns, and decide on a stringent exclusion criterion which very few ideas could pass. It will reduce the clutter.
Avoiding what doesn’t work
–    Managing a concentrated portfolio is probably opposite of how most venture capitalists (VCs) work.
–    VCs are looking for disrupters, whereas a value investor with a concentrated portfolio would be looking for businesses which are steady and without any threats of disruption
–    VCs cast their net wide. They take many small bets initially as there is a high probability that more than half of the investments become zero. On the other hand, a value investor  with a concentrated portfolio cannot afford even a single position to end up as a total loss
–    As the VCs find a few winning ideas amongst the many small bets, they put larger chunks of capital in those ideas, thereby backing a few outsized winners.
–    Conversely, a prudent Value investor with a concentrated portfolio will look at pruning his positions if they become disproportionately high thus limiting their bet size.
–    Unlike a VC, this is what we (ValueQuest) do:
  • Keep a strict filter and prevent bad ideas from creeping into the portfolio i.e. avoiding what doesn’t work
  • Concentrate on a select few ideas, but each of them should be robust and have a higher probability of success, as we can’t afford any blow- ups
  • Not seek brilliance but would like to avoid stupidity
  • We believe in prevention
“Wisdom is prevention but very few people do much about it.”
“I particularly recommend attention to the idea that an ounce of prevention is worth a pound of cure —except it really isn’t often a mere pound. An ounce of prevention is often worth a ton of cure.”
“Many things are easier to prevent than fix. . .You get in a dumb enough situation, like trying to cross a train track when there’s a train coming, and you end up with a problem that’s extremely hard to fix.”
“You don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.”
                            – Charlie Munger
“It is better to try to be consistently not stupid than to be very intelligent. “
                            -Peter Bevelin
“To some extent, the record of Berkshire— to the extent it’s been good—has not occurred because we’ve done brilliant things, but because we’ve probably done fewer dumb things than most. “
-Warren Buffett
The Importance of CONSEQUENCES as opposed to PROBABILITIES
–    In financial markets and in the world of business, lots of people take unnecessary risks  – equivalent to jumping out of a plane with a parachute which opens 99% of the time. These actions may have low probability of failure, but the consequences of failure are fatal
–    If a CONSEQUENCE of an action is NOT ACCEPTABLE to us, then no matter how low the probability, we must avoid that action.
–    Warren Buffett uses a metaphor of a gun with a million chambers in it with only one chamber with a bullet in it. He says that if someone offered to pay him any sum of money to put the gun on his temple and pull the trigger once, he won’t. Irrespective of the offer, he would decline.
–    If there is a remote loss scenario with an outcome that’s unacceptable, then no matter how small the probability of that outcome, actions that can produce that outcome must be rejected.
“Obviously, if you leverage enough, you can get higher returns on equity, but you often have a chance of disaster. I think we are more disaster-resistant than most other places. As a friend of mine once said, “I don’t want to go back to go. I’ve been to go.” “
-Charlie Munger
“Huge debt, we are told, causes operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly — and unnecessary — accident if the car hit even the tiniest pothole or sliver of ice.”
-Warren Buffett
 “The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.”
-Warren Buffett
Other Things We Avoid
–    Week Financial Structures – You don’t need 30 ratios, but maybe two or three to determine whether the financial structure of a company is weak or not. Avoid weak ones and your chances of survival increase.
–    Complexity and Unpredictability – If we do not understand a business and can not visualise it a decade down the line, we would like to avoid it.
–    Models Prone to Disruption – If we don’t know whether the company is strong enough to survive or some other rival can disrupt it with new technology, we will avoid it.
–    Binary Outcome Situations – Cases where either the company is a big success or they perish completely (e.g. e-com companies).
–    Lack of Pricing Power – Businesses which do not have the ability to pass on pain of inflation to customers (e.g. power companies in India).
–    Corporate Mis-governance – No amount of margin of safety can justify being partners in a business which doesn’t respect minority shareholders.
–    Overvaluation – This is a functional equivalent of a bet where the odds are against you.
Seeking what does work
–    Moats – High RoC businesses which have a competitive edge. These businesses have inbuilt shock absorbers.
–    Entry Barriers – Businesses which are not easy to compete with by new entrants. Strong brands, Long gestation etc.
–    Owner Operators (Soul in the Game) – Business should be the only/primary source of income. Reputation/identity of promoter associated with that business.
–    Difficult to replicate, Admirable Corporate Culture.
–    Growth – Good sustainable growth. Long runways. Growing size of the overall industry. Growing market share because of low cost or better management. Unlike Buffet, not interested in non-growing or declining businesses (e.g. newspapers) as we can not take out cash as he can. Would prefer to pay up for quality rapidly growing company.
–    Ability to self-finance growth – Happy with entrepreneurs conscious about leverage, asset allocation, using incremental capital wisely. More happy with those who never dilute capital to grow. If they have diluted, it should be for a good reason.
–    Good Governance
–    Reasonable Valuation
Role of Checklists
–    A checklist is needed to protect ourselves against our own mental flaws, biases and laziness. A checklist forces you to look for contradicting evidence.
–    Qualities of a Good Checklist
  • It should focus on things that really matter
  • It should be short (for example you don’t need six ratios to determine if a business has strong balance sheet or not)
  • There should be some deal breaker questions while other questions may require trade-off
Our Initiation Checklist
  • Focuses on three things: Business, People, Price – in that order (no tradeoffs)
  • We try to make it short
  • We have deal-breaking questions. For example, if a business is pro-social or not
System of Redundancy in Stock Picking
–    Layer 1 – Avoid things that don’t work
–    Layer 2 – Seek good businesses, run by good people, at good prices
–    But this is not enough because of risk tend to gets aggregated at the portfolio level.
–    Some examples of Risk Aggregation in Portfolio
  • Geographical
  • Customer/Supplier Concentration
  • Regulatory
  • Judicial
  • B2B vs. B2C
  • Local vs. Exporters
  • Market Capitalisations
–    For example, let’s say we invest in five companies which are
1.    Dominant in their industries
2.    Run by great owner operators
3.    All exporters
4.    in different industries but have customers in the US
–    They are all wonderful investments individually but have one common factor which leads to aggregation of risk. What if USD/INR goes to 45? The probability of that happening may be very low but if it happens, the Consequences for the portfolio could be and would be significant. If such a scenario is unacceptable to you, then you have to take care of it in portfolio formation. It will probably involve sacrificing returns as you may have to forgo some investments which may be suitable individually but may not fit well with the rest of the portfolio by creating a probable outcome which may not be acceptable.
–    It is just one way to demonstrate how risks get aggregated at the portfolio level. There could be many other ways depending on what is there in the portfolio. You have to be creative and think about these scenarios as you don’t know where risk is going to come from. You have to carry the worry gene not just in initiating a position but also in building the portfolio.
–    So, in a good, robust system, the Risk Manager Should be allowed to overrule an excitable stock picker. But in reality, the stock picker and the risk manager are the same guys. They are just wearing different hats. The stock picker wears the “creative” hat and his “worry gene” prevents him from recommending ideas that have a significant risk of permanent capital loss.
–    The risk manager’s worry gene making him think about how “shit happens” at the portfolio level (recall what happened to a respected fund because of an oversized position in Valeant) and how to put in limits to rein in the excitement of the stock picker.
–    A Well-constructed portfolio will almost always cost money in terms of sacrificed returns
–    We are not trying to maximize returns, because that may also mean that we may go to zero (or anywhere close to zero). We do not want that.
–    That is why Risk matters as much as returns.
  1. Slide deck for the presentation by Prof Sanjay Bakshi and Paresh Thakkar
  2. The Investment Checklist: The Art of In-Depth Research by Michael Shearn
  3. The Checklist Manifesto: How to Get Things Right by Atul Gawande
  4. Buffet comments on LTCM
  5. Clip from the movie “Sully”


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How to Value any Company in the World with Valuation


Contributed by: Ashwini Damani

On 24th April 2017, the Kolkata Chapter of CFA Society India organised a session on “How to Value any Company in the World with Valuation Model”. It was conducted by a prolific speaker, Andrew Stotz, CFA who has been voted the No. 1 Analyst in Thailand for the years 2008 and 2009. Being a tech savvy speaker that he was, the presentation started off in a unique style, with almost the entire presentation being run through an iPhone and live blogged by his associates sitting in Thailand. In fact, the entire presentation (replete with pictures of the day) was already uploaded by the end of the session on the blog

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•    Andrew dwelled on the fact that, the world of investing and finance can be very complex, and hence it is imperative to keep things ‘Simple’. It is only by keeping things simple, will you be able to make people follow you, hear you and understand you – “Simplicity is the ultimate sophistication” he said.

•    He spoke about how his entrepreneurial journey with his business CoffeWorks has helped him become a better analyst. He remarked that, because he ran a business himself, he was more aware of challenges and risk involved in a business. Moreover, being a businessman also helped him in asking the right questions to the management and understand its abilities better.

•    He mentioned that ethics, values and fighting spirit are the most important traits for any skilled person to attain success.

•    Andrew underlined a simple process to identify if there can be an increase in the value of a company.

o    Revenue –  Company should strive to increase it

o    Cost –  Company should strive to reduce it

o    Investment Amount – Company should strive to reduce it

o    Risk – Company should strive to reduce it

This could be simplified mathematically by the following formula

((Revenue 0 – Costs 0) (1 – Retention Rate 0)(1+growth)) / (Cost of equity – growth)

He said that any company which could manage the above four areas, would end up increasing dividends being paid out to the shareholders.

•    Going ahead on to his rigorous framework, Andrew gave ten steps Valuation Model, for valuing any company in the world. In his view, the first 7 points are about forecasting and the last 3 points are about valuation. So he emphasised that if we can get the forecasting part right, we could do a better job at valuation – and true to the part he said, forecasting cannot be done by sitting behind a computer, but rather going out on the field and getting some raw data points. The 10 points are as follows:

1.    Revenue growth – It is the most important piece in the entire valuation chain. Whatever you do, in the end, you have to dumb it down to a growth rate. Hence it is important to get this part right. An analyst needs to forecast the trend of revenue growth by assessing how fast or slow the company is growing and what kind of latent demand exists for the product.

2.    The cost to create – Core profitability of the product outlines the competency of the management. One should critically assess the margins and its expansion potential.

3.    Cost to run – the Selling, General and Administrative Expenses (SGA) costs of a company should be examined carefully.

4.    Investment in core Assets- What kind of amount is locked in the core investments of the company? The analyst should also find out if management can bring it down, or it should be increased to keep pace with the growing demand.

5.    Investment in inventory – Should be minimalistic, because, in the end, you maintain and grow your market by liquidating the inventory.

6.    Net accounts receivable – Should be trending lower relative to the sales. Higher net accounts receivable will entail higher costs.

7.    Dividend payout Ratio –This is what you finally payout to the shareholders. The analyst should effectively assess current payouts and expected future dividends.

8.    The cost of equity – It is a measure of risk of the business and gets reflected in the discounting model.

9.    Fade of investment return – What will be the tapering growth going ahead.

10.    Terminal growth – the horizon value.

Not only was the content relevant and great, but his style of presentation was also brilliant. We at the Kolkata chapter, we are thankful to Andrew.


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