The Relationship Between Needs, Markets & The Economy
In the 'natural' world, there are jungles, which is where mankind originated (now we need excursion tours to take our children there, or we see it on TV). Most of what we are like has happened because of where we come from. Evolution responds to the environment, hence survivability is all about adapting (to our environment). Yet we know very little of the environment that built us, preferring instead to live in what we are used to, i.e. our comfort zones. Most of our needs originate in the jungles. We fulfill such needs based on instincts developed there, yet we do it through a mechanism as hi-tech as our computer screens. The paradigms, in which our brains think, are full of jungle idiom, captured by a battery of channels like Discovery, Animal Planet & The National Geographic.
Yet, in our 'civilised' economy, markets fulfill these needs (with their primal origins). To the perceptive observer, it is obvious that markets, which form the 'asset allocation' function of the larger economy, follow the same rules as the jungles where their participants came from. But this is not so evident to the market participant himself.
How many of us would relish losing our way in the jungles, or being marooned on a jungle island (without Aishwarya Rai for company, mind you!!!). The primal environment has a lot of risk, uncertainty (and volatility alternating between risk and opportunity)……very similar to our markets. In this series, I will try and equate jungles with markets and try and point out just where the right behaviour helps. Let me start. Warthogs can live on burnt and dormant tubers lying a few inches under the soil. They can also survive on muddy water. It makes them the most 'survivable' among the jungle beings just after a big drought, or after a jungle fire. Normally, warthogs are ignored by predators like lions and tigers because they are dirty, muddy, their flesh inedible and they are too small. But just after a jungle fire, or a drought, they suddenly become everybody's target. Their habit of wallowing in muddy backwaters, makes them easy to find and of course, kill. Warthogs themselves have never developed this insight, otherwise (despite their superior survivability) they would have done better for themselves. They continued their behaviours, ending up as “easy prey” on lion meathunts.
Deer have never philosophised on their lot in life either. Could it be that their habit of herding together might be the reason why lions and tigers tend to target them? "Security in numbers" only reduces the probability that you will specifically be targeted, but it actually increases the probability that you will be generally targeted. Lions and tigers have been known to stalk herds, leaving individual deer alone.
I doubt whether these increasing numbers of IT-types ever think of themselves as deer (or as lemmings, but that is another story), but have they ever stopped to consider that this piece of "jungle insight" might be useful. If they are wary of the tigers and leopards who want a piece of their flesh, they might take another look at that builder who is paying good money for their e-mail addresses these days. Or those "Wealth Managers" who have started to invite them to 5-star hotels for their favourite curd rice and payasam……
In the beginning, the West thought they were boring old nerds willing to write millions of lines of code while they were busy doing better things (remember Y2K?). Suddenly, these dowdies have started to 'Bangalore' the Americans, hollowing out Silicon Valley of all its intellectual caliber. I am reminded how in South Africa during the heyday of apartheid, fashionable Johannesburg housing colonies gave honorary white status to the 'yellow Japanese'. We can now see Western sensibilities becoming ever-more elastic to accommodate both South India and South China.
Just like an American and his consuming habits is the plankton on which the world economy feeds, we now have this new plankton in the Indian economy. In the olden days, it used to be consumerist Delhi, with its devil-may-care Punjabi, obsessed with his 'Mruti' and his drawing room. Today, there is new (plankton) fish in the sea, whose habits and waterholes need to be tracked.
Plankton is the basic (food) building block of the sea. All life in the sea depends directly or indirectly on plankton. Small fish are basically 'food converters' for larger fish, who in turn, are food for seals, sharks and whales. Any shortage of plankton will eventually lead to a life crisis higher up the food chain. In deciding the future well-being of life in the sea, it makes sense to look at plankton populations.
In our civilized, virtual world, plankton is the first-time buyer of real estate, shares or other volatile investments. They earn their money in the real economy, producing goods and services for parasites like me who sit at the edges of marketplaces. Then they take loans and buy their first house, first shares/ bonds. Without an interminable supply of such 'plankton', the denizens of our virtual jungles who live higher up the food chain, would be threatened with extinction. However, unlike real plankton, the crowds in our markets don't think of themselves like that. The people who thought the market had topped at 15,000 will be buying at 19,000. The 'funds' and operators created such a violent rush catching out the bears, whose covering will create the market top, will be helped by a new supply of 'plankton', i.e. market first-timers (BPO/ IT guys who think they are intelligent because they are 'crorepatis' before 30). Who is buying DLF at 4 per cent of Indian GDP? What kind of investor will apply for IPO shares of a new power co that will be capitalized at 2 per cent of India's GDP without an operating business? Residential construction is usually at 6-7 per cent of GDP, although housing bubbles in Spain/ US can take it to 16-18% of GDP. To justify its current valuation at 30 per cent cost of capital, DLF would have to do 7-8 per cent of India's GDP, i.e. the entire value of real estate built in India in a normal (non-bubble) year. Remember, current margins of housing construction companies include a certain amount of 'arbitrage' of land prices, besides the normal construction margins. The former will compress.
This is very similar to a calculation I did in 2000 for Big IT. I told myself that all stocks are finally 'bonds', who must generate earnings to 'pay back' their stock prices. If that be true, the big IT companies were growing at 135 per cent, but were valued at 200-300 times earnings. If stock prices were bonds, it would take 25+ years to get my money back from a good, debt-free IT company, even as regular bonds were to return my money in 10-12 years. Using the same logic, I found a sugar company that generated 23 per cent average RONW over 12 years, available at 2.35 times forward earnings. That is a 'payback' of less than two years. So short (sell) IT, buy sugar. As we saw, the big IT companies dropped 65-90 per cent from their peaks, while sugar went up 30 times in the 2005-06 euphoria.
Today, those same sugar companies are losing 20 per cent of their net worth even in the recently reported quarters (and will probably keep doing so for another 1-2 years), yet they are valued at 2.5 times book value. When they were making profits at 12 per cent of net worth, these companies were available at 30 per cent discount to book value.
One of the 'demographic dividends' of India's young population is the seemingly interminable supply of 27-year-old clerks with their freshly minted salaries, ready to buy anything….besides the goodies in the malls, they are also buyers of high-priced, low-value shares.
This column appeared in October, 2007 issue of Mutual Fund Insight.
Jungles, Markets & Needs
In the jungle of our modern world, everyone feeds of someone else. And it is the planktons that are fed upon more often than not. So what fate awaits the planktons of the investment markets?
The Relationship Between Needs, Markets & The Economy
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