warren buffett

Bill Gates’ favourite business book tells us why Tata Nano “really” failed

TATA NANOVivek Kaul

In July this year Bill Gates wrote a blog. He titled it The Best Business Book I’ve Ever Read. As he wrote “Not long after I first met Warren Buffett back in 1991, I asked him to recommend his favorite book about business. He didn’t miss a beat: “It’s Business Adventures, by John Brooks,” he said. “I’ll send you my copy.” I was intrigued: I had never heard of Business Adventures or John Brooks.” Gates got a copy of the book from Buffett. “Today, more than two decades after Warren lent it to me—and more than four decades after it was first published—Business Adventures remains the best business book I’ve ever read. John Brooks is still my favorite business writer. (And Warren, if you’re reading this, I still have your copy),” Gates added. The book is essentially a collection of 12 long articles (I don’t know what else to call them) that Brooks wrote for the New Yorker magazine, where he used to work. A chapter that should be of interest to Indian readers is The Fate of Edsel. A reading of this chapter clearly tells us why Tata Nano, the most hyped Indian car ever, has failed to live up to its hype. But before we get to that, here is a brief summary of the chapter. In 1955, the Ford Motor Company decided to produce a new car, which would be priced in the medium range of $2,400 to $4,000. The car was designed more or less as was the fashion of the day. It was long, wide, lavishly decorated with chrome, had a lot of gadgets and was equipped with engines which could really rustle up some serious power. The car was called the Edsel. It was named after Edsel Ford, the only son of Henry Ford who started the Ford Motor Company. In 1943, Edsel Ford had died at a young age of 49, of stomach cancer. In fact, even before the Edsel car was launched there was a lot of hype around it. As Brooks writes “In September 1957, the Ford Company put its new car, the Edsel, on the market, to the accompaniment of more fanfare than had attended the arrival of any other new car since the same company’s Model A. A model brought out thirty years earlier.” The company had already spent $250 million on the car, before it was launched. The Business Week called it more costly than any other consumer product in history. Given this huge cost, Ford had to sell around 200,000 Edsels in the first year, if it had to get its investment back. Nevertheless, two years, two months and fifteen days later, it had only sold 109,446 Edsels. This included cars bought by Ford executives, dealers, salesman, workers etc. The number amounted to less than 1% of the cars sold in America during that period. On November 19, 1959, it pulled the plug on the car. Estimates suggested that Ford lost around $350 million on the car. So what went wrong? Some of the feedback from trade publications was negative. Over and above that, some of the cars that were sent out initially were badly made. As Brooks writes “Automotive News reported that in general the earliest Edsels suffered from poor paint, inferior sheet metal, and faulty accessories, and quoted the lament of a dealer about one of the first Edsel convertibles he received: “The top was badly set, doors cockeyed, springs sagged.”” Some individuals who worked on making and launching the car liked to believe in later that it was the because of the Sputnik, the first artificial space satellite launched by the Soviets that led to the car not selling. As Brooks puts it “October 4th[1957], the day the first Soviet Sputnik went into orbit, shattering the myth of American technical pre-eminence and precipitating a public revulsion against Detroit’s fancier baubles.” Detroit was the city were the biggest motor companies in the United States were head-quartered back then. While these could have been reasons for the car not selling, the real reason for the car not selling was the hype that accompanied it. As Brooks writes “It was agreed that the safest way to tread the tightrope between overplaying and underplaying the Edsel would be to say nothing about the car as a whole but to reveal its individual charms a little at a time—a sort of automotive strip tease…The Ford Company had built up an overwhelming head of public interest in the Edsel, causing its arrival to be anticipated and the car itself to be gawked at with more eagerness than had ever greeted any automobile before it.” C Gayle Warnock, director of public relations of the Edsel division of Ford, shares an interesting example, which provides the real reason behind the failure of the Edsel car. In 1956, a senior official working on the Edsel launch (in fact it wasn’t called the Edsel then, it was just the E-Car) gave a talk about it in Portland, Oregon. Warnock was aiming for some coverage regarding the event in the local press. But what he got was something he had not expected. The story got picked up by wire services and was splashed all across the country. As Warnock recounts in the chapter “Clippings [of the media coverage] came in by the bushel. Right then I realized the trouble we might be headed for. The public was getting to be hysterical to see our car, figuring it was going to be some kind of dream car—like nothing they’d ever seen. I said… “When they find out it’s got four wheels and one engine, just like the next car, they’re liable to be disappointed.”” And this is precisely the reason why the Edsel flopped. The hype was so much that the public expected something that was totally out of the world. But what Ford was basically giving them in the rephrased words of Larry Doyle, the head of sales at the Edsel division, “exactly the car that they had been buying for several years.” As Doyle put it “We gave it to them and they couldn’t take it.” Further, it did not help that the first lot of cars was not properly manufactured. “Within a few weeks after the Edsel was introduced, its pitfalls were the talk of the land,” writes Brooks. Now replace the word Edsel with Nano and the situation stays more or less the same. The hype around the car was huge. When the car was launched in 2009, the entire world media was in Delhi for the launch. In fact, before the car was launched the rating agency Crisil said that the car could expand the Indian car market by 65%. People who had cars were already worried about the traffic on the roads getting worse than it already was, because of the Nano. Before the car was launched in 2009, prices in the used car market fell by 25-30%, given Nano’s expected price point of Rs 1 lakh. Nonetheless, Nano could not live up to the hype. In a May 2014 newsreport, the Business Standard pointed out that “Launched in 2009,Nano sales between 2010-11 and 2012-13 constituted 23-24 per cent of Tata Motors’ total sales. But Nano sales declined dramatically after peaking to 74,527 in 2011-12. The numbers came down by more than 70 per cent in two years to 21,129 in 2013-14. Tata Motors has set up a facility at Sanand in Gujarat to make 250,000 Nanos a year.” So, the car sold nowhere near the numbers it was expected to. What did not help was that when the car actually started hitting the market in 2010, some units caught fire. After all the hoopla around the Nano, this wasn’t what the public was ready to accept. Brooks’ sentence written for Edsel can be re-written for Nano as well: “After the Nano was introduced, its pitfalls were the talk of the land.” Further, the hype around the car was so huge that the people were expecting something totally out of this world. They did not know what they wanted, but they did not want, what they got. The question that remains is how much could you expect out of a car which was supposed to be sold at Rs 1 lakh? The article originally appeared on www.FirstBiz.com on Nov 18, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Why investors behave like football goalkeepers and how that hurts

goalkeeperVivek Kaul  
A very good friend of mine recently decided to take a sabbatical. But two weeks into it he started getting fidgety. The prospect of not doing anything was turning out to be too hot to handle for him. So, one morning he called up his boss and told him that this decision to go on a sabbatical was not the right one, and given this, he wanted to get back to work.
My friend’s boss, had taken a sabbatical last year, and understood the value of a big break away from work. Given this, he refused to let my friend get back to work so soon, and suggested that he continue with the sabbatical, now that he had decided to take one.
One more week into the sabbatical, my friend simply couldn’t handle it. One day he simply landed up at work, without consulting his boss. And thus ended his sabbatical.
The point in sharing this story is that it is difficult “do nothing”, even though at times it might be the most important thing to do.
In a recent interview to Wisden, the former Australian cricketer Dean Jones, pointed out that two thirds of Sachin Tendulkar’s game was based around forward defence, back-foot defence and leaving the ball, without trying to play it. As Amay Hattangadi and Swanand Kelkar write in a research eport titled The Value of Doing Nothing and dated February 2014 “As any coach would vouch, letting the ball go is possibly as important as hitting good shots in the career of a batsman.”
In fact, not doing anything is a very important part of successful investing. But the investment industry is not structured liked that. They have to ensure that their customers keep trading, even if it is detrimental for the them. As Arthur Levitt, a former Chairman of the Securities Exchange Commission, the stock market regulator in the United States, writes in Take on the Street – How to Fight for Your Financial Future “Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don’t own and sell the ones you do., because that’s how they make money for themselves and their firms. They earn commissions even when you lose money.”
The brokers only make money when investors keep buying and selling through them. This is also true about insurance and mutual fund agents, who make bigger commissions at the time investors invest and then lower commissions as the investors stay invested.
As Adam Smith (not the famous economist) writes in The Money Game “They could put you in some stock that would go up ten times, but then they would starve to death. They only get commissions when you buy and sell. So they keep you moving.”
Levitt proves this point by taking the example of Warren Buffett to make his point. “Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc and one of the smartest investors I’ve ever met, knows all about broker conflicts. He likes to point that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But, any broker who did that would have starved to death.”
Hence, it is important for stock brokers, insurance and mutual fund agents to get their investors to keep moving from one investment to another.
But how do stock brokers manage to do this all the time? Andy Kessler has an excellent explanation for this in Wall Street Meat. As he writes “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”
But why are these analysts taken seriously more often than not? As John Kenneth Galbraith writes in The Economics of Innocent Fraud “ And there is no easy denial of an expert’s foresight. Past accidental success and an ample display of charts, equations and self-confidence depth of perception. Thus the fraud. Correction awaits.”
This has led to a situation where investors are buying and selling all the time. As Hattangadi and Kelkar point out “In fact, the median holding period of the top 100 stocks by market capitalisation in the U.S. has shrunk to a third from about 600 days to 200 days over the last two decades.” Now contrast this data point with the fact that almost any and every stock market expert likes to tell us that stocks are for the long term.
This also happens because an inherent action bias is built into human beings. An interesting example of this phenomenon comes from football. “In an interesting research paper, Michael Bar-Eli2 et al analysed 286 penalty kicks in top soccer leagues and championships worldwide. In a penalty kick, the ball takes approximately 0.2 seconds to reach the goal leaving no time for the goalkeeper to clearly see the direction the ball is kicked. He has to decide whether to jump to one of the sides or to stay in the centre at about the same time as the kicker chooses where to direct the ball. About 80% of penalty kicks resulted in a goal being scored, which emphasises the importance a penalty kick has to determine the outcome of a game. Interestingly, the data revealed that the optimal strategy for the goalkeeper is to stay in the centre of the goal. However, almost always they jumped left or right,” write Hattangadi and Kelkar.
Albert Edwards of Societe Generale discusses this example in greater detail. As he writes “When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But the goalkeeper doesn’t do that. And there is a good reason for it. As Hattangadi and Kelkar write “ The goalkeepers choose action (jumping to one of the sides) rather than inaction (staying in the centre). If the goalkeeper stays in the centre and a goal is scored, it looks as if he did not do anything to stop the ball. The goalkeeper clearly feels lesser regret, and risk to his career, if he jumps on either side, even though it may result in a goal being scored.”
Investors also behave like football goalkeepers and that hurts them.
The article originally appeared on www.firstbiz.com on February 8, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)  

Why Chidu can’t do a Warren Buffett in the budget

P-CHIDAMBARAM
Vivek Kaul
The legendary investor Warren Buffett wrote an editorial in the New York Times sometime in August 2011 where he made an interesting point. In 2010, his income and payroll taxes came to around $6.94million. While that might sound like a lot of money, but Buffett had paid tax at a rate of only 17.4%. This was lower than any of the 20 other people who worked in Buffett’s office in Omaha, Nebraska. The tax burdens of his 20 employees mounted to anywhere between 33-41% and it averaged around 36%.
So Buffett was paying $17.4 as tax for every $100 that he earned. On the other hand his employees were paying more than double tax of $36 for every $100 that they earned. Of course that was not right.
But why was this the case? This was primarily because Buffett’s employees were paying tax on the salary they earned by working for Buffett. Buffett was making money primarily as long term capital gains on selling shares and he was paying tax on that.
The tax rate on income from salary was much higher than the tax rate on income from long capital gains made on selling shares. This benefited the rich Americans like Buffett. The richest 10% of the Americans own 80% of the stocks listed on the New York Stock Exchange as well as the NASDAQ. Buffett wants this to be set right by making the rich pay higher taxes.
In India there has been talk about making the rich pay higher taxes as well. C Rangarajan, a former RBI governor, and an economist who is known to be close to both the prime minister Manmohan Singh and finance minister P Chidambaram, had remarked in January earlier this year “We need to raise more revenues and the people with larger incomes must be willing to contribute more.”
Chidambaram himself has advocated this school of thought when he said “We should consider the argument whether the very rich should be asked to pay a little more on some occasions.”
So does taxing the rich make sense? It is not a simple yes or no answer. Allow me to explain. Like is the case in the United States, even in India different kinds of incomes are taxed at different rates.
Income from salary is taxed at the marginal rate of 10/20/30 percent whereas long term capital gains from selling shares/equity mutual funds is tax free. Short term capital gains from selling shares/equity mutual funds is taxed at 15%.
Interest earned on bank fixed deposits and savings accounts is taxed at the marginal rate of tax. So is the income earned from post office savings schemes and the senior citizens savings scheme. In comparison dividends received from shares is tax free in the hands of the investor.
Long term capital gains on debt mutual funds are taxed at 10% without indexation or 20% with indexation, whichever is lower. Indexation essentially takes inflation into account while calculating the cost of purchase. Let us say an investor buys a debt mutual fund unit at a price of Rs 100. A little over a year later he sells it at Rs 110. Let us say the inflation during the course of that year was 8%. Hence, his indexed cost of purchase will be Rs 108 (Rs 100 + 8% of Rs 100).
In this case the capital gains would be Rs 2 (Rs 110 – Rs 108) and he would end up paying a tax of 40 paisa (i.e. 20% of Rs 2). Hence, a 40 paisa tax is paid on capital gains or an income of Rs 10 (Rs 110 – Rs 100), meaning an effective income tax rate of 4% (40 paisa expressed as a percentage of Rs 10).
In case an individual had invested Rs 100 in a fixed deposit paying an interest of 10%, he would have earned Rs 10 at the end of the year as interest from it. On this he would have had to pay a minimum tax of 10%(assuming he earns enough to fall in a tax bracket) because interest earned from a fixed deposit is taxed at the marginal rate of income tax. Whereas as we saw in case of a debt mutual fund the effective rate of income tax came to around 4%.
Along similar lines long term capital gains from sale of property is taxed at 20% post indexation. So the effective rate of tax is much lower in case of capital gains made on selling property as well. In fact, even this tax need not be paid if one buys capital gains bonds or another property within a certain time frame. And given that a large portion of property transactions are in black, the effective rate of income tax comes out even lower.
The point I am trying to make is that the modes of income for the rich like share dividends, capital gains from selling shares, equity mutual funds, debt mutual funds or property for that matter, are taxed at lower effective income tax rates, in comparison to the modes of investment of the aam aadmi. 
The purported logic at least in case of long term capital gains from shares being tax free is that it will encourage the so called retail investor/small investor to invest in the stock market and thus help entrepreneurs raise capital for their businesses. But that as we all know has not really happened. And essentially this regulation has been helping those who already have a lot of money. What I fail to understand further is why should investing in a debt mutual fund like a fixed maturity plan (which works precisely like a fixed deposit does and matures on a given day) be more beneficial tax wise vis a vis investing in a fixed deposit?
As we saw in the earlier example a fixed deposit investor pays minimum tax at the rate of 10% on the interest earned. He could even pay an income tax as high as 30% . On the other hand a debt mutual fund investor pays an effective tax at the rate of 4%, irrespective of which marginal rate of income tax he falls under. Why should that be the case?
I think we need to move towards a more equitable income tax structure where various modes of income, at least those earned through investing, should be taxed at the same rate. For starters indexation benefits which are currently available on debt mutual funds and sale of property should also be available when calculating the tax on interest earned on fixed deposits and savings accounts. Inflation doesn’t only impact those investing in debt mutual funds and property, it also impacts those who invest in bank fixed deposits and savings accounts.
Further long term capital gains on selling shares/equity mutual funds should be taxed at marginal rates with indexation benefits being taken into account. That would make the tax system more equitable than from what it currently is.
It would also amount to the rich paying more tax without introducing a higher tax rate or a surcharge of 10% on the highest marginal rate of 30%(which would mean an effective rate of 33%), as is being suggested currently.
Several experts are against this move and I partly agree with them. As an article in the India Today points out “Economist Surjit S. Bhalla argues that there is no real rationale for taxing the top income segment any further. Bhalla uses official data to show that the top 1.3 per cent of income taxpayers in India already account for 63 per cent of total personal tax revenue. In comparison, in the US, the top 1 per cent of taxpayers contribute just 37 per cent of total income taxes.”
That’s a fair point against higher taxes for the rich. But what we really need to know is what is the effective rate of income tax being paid by the rich? Is the situation similar to Buffett’s America, where Buffett pays an effective income tax of 17.4% whereas his employees pay an average tax of 36%? Only the Income Tax department can answer that.
Having said that, I don’t see India moving towards a more equitable income tax structure. In order to do that long term capital gains on selling stocks which is currently at zero percent would have to be done away with. And that would mean long term capital gains on stocks being taxed in a similar way as debt mutual funds/property currently are.
Hence, stock market investors would end up paying some income tax. And that as we have seen in the past, this is something they don’t like. Any attempt to tax them is met by mass selling and the stock market falling.
A falling stock market would mean that dollars being brought in by foreign investors will stop to come or slowdown. When foreign investors bring dollars, they sell those dollars to buy rupees, which they use to invest in the stock market in India. This perks up the demand for the rupee leading to its appreciation against the dollar.
A stronger rupee would mean a lower oil import bill. Oil is bought and sold internationally in dollars. If oil is worth $110 per barrel, and one dollar is worth Rs 55, it means India pays Rs 6050 per barrel ($110 x Rs 55) of oil. If one dollar is worth Rs 50, it means India pays a lower Rs 5500 per barrel ($110 x Rs 50) of oil.
Lower oil imports would help control our current account deficit which is at record levels. It would also help control our fiscal deficit as the government forces the oil marketing companies to sell products like kerosene, cooking gas and diesel at a loss and then compensates them for the loss. It would also help oil companies control their petrol losses.
This is a dynamic that Chidambaram cannot ignore. He will have to keep the foreigners and the stock market investors happy to ensure that the stock market keeps rising. Meanwhile, the rich will continued to be taxed at lower effective rates.
The article originally appeared on www.firstpost.com on February 21, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])  

‘Warren Buffett does not practice what he preaches’

Satyajit Das is an internationally renowned derivatives expert. His works include the best-selling Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. His latest book Extreme Money – Masters of the Universe and the Cult of Risk deals with the messy details of the 2008 financial crisis, the lessons from which have still not been learnt, feels Das. As he puts it, “We keep repeating the same mistakes over and over…The only lesson of history after all is that no one learns the lessons of history.” 
In this freewheeling interview with Vivek Kaul, he talks about how investing is never going to be the same again, why financial TV is pornography, and that Warren Buffett does not practice what he preaches. The interview will be published in two parts. This is the first part.
Why do you call “financial TV” pornography?
Pornography is formulaic, explicit subject matter is depicted to sexually excite the viewer. Financial TV shares the characteristics of pornography — sleaze, intrusiveness and a desire to titillate and shock. It is a 24/7 Joycean stream of consciousness, a financial noise machine with the inevitability and repetition of all sexual congress. No one seriously relies on financial TV for deep insight. If it is on TV, then it’s already happened. It’s entertainment. Attractive men and women cater to all possible proclivities in the audience. It’s like wall paper or eye candy – pleasant but not essential. In dealing rooms, generally you don’t even have the sound on, so it is like pornography in another sense – dialogue is superfluous. The only time financial TV is interesting is when I am invited on to offer my money making insights – buy low, sell high etc.

Whatever his record as an investor, there are differences between Buffett’s pronouncements about the standard of conduct he requires of others and that he follows. Getty Images
You say that investment genius was always little more than a short memory and a rising market? You write that the assumed sophistication of finance and financiers is overrated. Why do you say that?
Investing is like captaining a cricket side – 90 percent luck and 10 percent skill, in the words of former Australian Test captain Richie Benaud. But as he said, don’t try it without the 10 percent! The last 30 years were an exceptional period of investment history which provided high returns for reasons which are unique to that period. The best investment strategy would have been to buy stock or real estate and leverage it up. Then go to sleep or play golf for 25 years. You would have been a rich man.
When people make money, they theorise too much about it – hence all the books about trading success. The latest fad is about explaining the trader’s personality via his biology. Some research suggests that male traders perform better when they have elevated testosterone levels. As prices increase and decrease, traders experience chemical changes. Euphoria caused by boosted testosterone levels from successful trades drives higher risk taking. Losses or reversals increase levels of the defensive steroid cortisone leading to risk-aversion. The experimental data is thin.
Could you elaborate on that?
If correct, you could take steps on banks and fund managers to manage risk. You could artificially manipulate the biology of traders and investment managers to improve performance. It is not hard to imagine a future where traders will need to have their supplements –uppers and downers (in the old parlance) — at hand to improve trading, similar to the experience of competitive sports where drugs have become relatively commonplace to improve performance. It is also not hard to imagine internal risk mangers and regulators insisting on regular monitoring of hormone levels as part of the compliance regime, with attendant cheating.
Isn’t that far fetched?
This is not far-fetched. Already, organisations are adopting unusual initiatives to gain a critical edge. A trader at Steve Cohen’s SAC Capital was allegedly forced by his boss to take female hormones and wear articles of women’s clothing at work, leading to a sexual relationship between the men, one of whom was married. The bizarre behaviour was to eliminate the trader’s aggressive male attitude, making him a more obedient and detail-oriented trader. How can you take an industry which actually does this seriously!
Does Warren Buffett practice what he preaches?
Talking about Warren Buffett is like discussing the existence of God. He is either great or he is not (the minority view). I am an atheist. Whatever his record as an investor, there are differences between Buffett’s pronouncements about the standard of conduct he requires of others and that he follows. While he dispenses finely crafted criticism of derivatives as weapons of mass destruction, Berkshire Hathaway (Buffett’s holding company) makes extensive use of derivatives and invested in Salomon Brothers and General Reinsurance, both participants in derivative markets.
During the crisis, Buffett, a significant investor in Moody’s, was silent about the problems surrounding rating agencies. Having uncharacteristically declined an invitation to appear in June 2010, Buffett testified before the Financial Crisis Inquiry Commission under subpoena. Buffett emphasised that he knew little about the rating process other than its profit margins. He had never visited Moody’s offices, not even knowing where they were located. He also defended Moody’s not acknowledging any failure or complicity of the agencies in creating the bubble. When Goldman Sachs was indicted for alleged violations in structuring and selling CDOs (collateralised debt obligations, a kind of security backed by loans and bonds), Buffett, a major investor in Goldman, defended the firm, its actions and its CEO.

Satyajit Das.
Could you tell us a little more about this?
Critics have frequently pointed out anomalies in the firm’s corporate practices. Berkshire Hathaway’s dual-class share arrangement gives Buffett voting control whilst owning 34 percent of the equity. Until a decade ago, Berkshire Hathaway’s seven-person board of directors consisted of mainly insiders such as Buffett’s son. The new ‘independent’ directors include Bill Gates, a close friend of Buffett, and his regular bridge partner, as well as co-investor in the Gates Foundation. Critics also pointed to that fact Buffett’s partner Charlie Munger’s family owned a 3 percent stake in BYD, the Chinese electric battery maker, before Berkshire bought a stake in 2008.
As to his record as an investor, there are a number of interesting aspects. Firstly, what is the right benchmark to measure his performance against – it can’t be the broad market index. Secondly, the source of his investment success is not that complicated. His main source of investment capital is the premium income from his insurance businesses (cash received today against a promise to honour a future contingent claim). This provides him with effective economic leverage (at low interest cost) to buy low beta assets. The strategy worked well but whether it will continue to work is more difficult. The past, as they say, is “another country”.
In your book Extreme Money you write “Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” You paraphrase it to write “give me enough debt and I shall make you all the money in the world”. Can you elaborate?
Borrowing amplifies economic growth. Debt allows society to borrow from the future. It accelerates consumption and investment spending, as borrowed money is used to purchase something today against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years is accelerated because of the availability of cheap borrowing. In this way, debt generates economic growth. In financial markets, debt and leverage amplify returns.
Could you explain this through an example?
Assume an investor uses $20 of its own money – equity – and borrows $80 (80 percent of the value) to purchase an asset for $100. If the asset increases in value by 10 percent to $110, then the investor’s equity increases on paper to $30 ($110 minus the fixed amount of debt of $80). If the investor maintains its leverage at 5 times then it can buy $150 of assets (funded by $30 of equity and $120 of debt). If the investor can now leverage 6 times then it can buy $180 of assets (funded by $30 of equity and $150 of debt). The investor still only has his original $20 investment in cash, unless he sells the asset to realise paper gains, which can vanish.
But now, this $20 supports even more debt, as much as $160 (the $180 of assets that the investor can buy if it leverages six times less its original investment). The real leverage is around nine times, which means an 11 percent fall in the value of the asset purchased can wipe out the investor’s wealth entirely. Where the supply of assets does not increase as quickly as the supply of debt, the price increases allow the process to continue. In the period to 2007, the use of leverage, in different ways, to make money was rampant. Unfortunately, it was never real money. Of course, when prices start to fall the entire process operates in reverse.
The interview was originally published on www.firstpost.com on October 2o, 2012. http://www.firstpost.com/economy/warren-buffet-does-not-practice-what-he-preaches-496581.html
Vivek Kaul is a writer. He can be reached at [email protected]

'You can shut the equity market, India would still be doing fine'


Have you ever heard someone call equity a short term investment class? Chances are no. “I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it… You can build a case for equities on a three year basis. But long term investing is all rubbish, I have never believed in it,” says Shankar Sharma, vice-chairman & joint managing director, First Global. In this freewheeling
interview he speaks to Vivek Kaul.
Six months into the year, what’s your take on equities now?
Globally markets are looking terrible, particularly emerging markets. Just about every major country you can think of is stalling in terms of growth. And I don’t see how that can ever come back to the go-go years of 2003-2007. The excesses are going to take an incredible amount of time to work their way out. They are not even prepared to work off the excesses, so that’s the other problem.
Why do you say that?
If you look at the pattern in the European elections the incumbents lost because they were trying to push for austerity. And the more leftist parties have come to power. Now leftists are usually the more austere end of the political spectrum. But they have been voted to power, paradoxically, because they are promising less austerity. All the major nations in the world are democracies barring China. And that’s the whole problem. You can’t push through austerity that easily in a democracy, but that is what is really needed. Even China cannot push through austerity because of a powder-keg social situation. And I find it very strange when people criticise India for subsidies and all that. India is far less profligate than many nations including China.
Can you elaborate on that?
Every country has to subsidise, be it farm subsidies in the West or manufacturing subsidies in China, because ultimately whether you are a capitalist or a communist, people are people. They don’t necessarily change their views depending on which political ideology is at the centre. They ultimately want freebies and handouts. In a country like India, they don’t even want handouts they just want subsistence, given the level of poverty. The only thing that you can do with subsidies is to figure out how to control them. But a lot of it is really out of your control. If you have a global inflation in food prices or oil prices you are not increasing the quantum in volume terms of the subsidy. But because of price inflation, the number inflates. So why blame India? I find it absurd that the Financial Times or the Economist are perennially anti-India. They just isolate India and say that it has got wasteful expenditure programmes. A lot of countries hide things. India, unfortunately, is far more transparent in its reporting. It is easy to pick holes when you are transparent. China gives no transparency so people assume that whatever is inside the black box must be okay. That said, I firmly believe the UID program, when fully implemented, will make subsidies go lower by cutting out bogus recipients.
If increased austerity is not a solution, where does that leave us?
Increased austerity, while that is a solution, it is not achievable. If that is not possible what is the solution? You then have a continual stream of increasing debt in one form or the other, keep calling it a variety of names. But you just keep kicking the can down the road for somebody else to deal with it as long as the voter is happy. Given this, I don’t see how you can have any resurgence. Risk appetite is what drives equity markets. Otherwise you and I would be buying bonds all the time. In today’s environment and in the foreseeable future, we are overfed with risk. Where is the appetite to take more risk and go, buy equities?
So are you suggesting that people won’t be buying stocks?
Well you can get pretty good returns in fixed income. Instead of buying emerging-market stocks if you buy bonds of good companies, you can get 6-7% dollar yield, and if you leverage yourself two times or something, you are talking about annual returns of 14-15% dollar returns. You can’t beat that by buying equities, boss! Even if you did beat that by buying equities, let’s say you made 20%, it is not a predictable 20%, which has been my case for a long time against equities. Equities are a western fashion. I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it: it is about the whole entertainment quotient attached to stock investing that drives investors. There is 24-hour television. Tickers. Cocktail discussions. Compared with that, bonds are so boring and uncool. Purely financially, shorn of all hype, equities have never been able to build a case for themselves on a ten-year return basis. You can build a case for equities on a three-year basis. But long-term investing is all rubbish, I have never believed in it.
So investing regularly in equities, doing SIPs, buying Ulips, doesn’t make sense?
I don’t buy the whole logic of long-term equity investing because equity investing comes with a huge volatility attached to it. People just say “equities have beaten bonds”. But even in India they have not. Also people never adjust for the volatility of equity returns. So if you make 15% in equity and let’s say, in a country like India, you make 10% in bonds – that’s about what you might have averaged over a 15-20 year period because in the 1990s we had far higher interest rates. Interest rates have now climbed back to that kind of level of 9-10%. Divide that by the standard deviation of the returns and you will never find a good case for equities over a long-term period. So equity is actually a short-term instrument. Anybody who tells you otherwise is really bluffing you. All the fancy graphs and charts are rubbish.
Are they?
Yes. They are all massaged with sort of selective use of data to present a certain picture because it’s a huge industry which feeds off it globally. So you have brokers like us. You have investment bankers. You have distributors. We all feed off this. Ultimately we are a burden on the investor, and a greater burden on society — which is also why I believe that the best days of financial services is behind us: the market simply won’t pay such high costs for such little value added. Whatever little return that the little guy gets is taken away by guys like us. How is the investor ever going to make money, adjusted for volatility, adjusted for the huge cost imposed on him to access the equity markets? It just doesn’t add up. The customer never owns a yacht. And separately, I firmly believe making money in the markets is largely a game of luck. Even the best investors, including Buffet, have a strike rate of no more than 50-60% right calls. Would you entrust your life to a surgeon with that sort of success rate?! You’d be nuts to do that. So why should we revere gurus who do just about as well as a coin-flipper. Which is why I am always mystified why so many fund managers are so arrogant. We mistake luck for competence all the time. Making money requires plain luck. But hanging onto that money is where you require skill. So the way I look at it is that I was lucky that I got 25 good years in this equity investing game thanks to Alan Greenspan who came in the eighties and pumped up the whole global appetite for risk. Those days are gone. I doubt if you are going to see a broad bull market emerging in equities for a while to come.
And this is true for both the developing and the developed world?
If anything it is truer for the developing world because as it is, emerging market investors are more risk-averse than the developed-world investors. We see too much of risk in our day to day lives and so we want security when it comes to our financial investing. Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life. But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry, boss, that has never happened.
And the developed world is different?
It’s exactly the opposite in the west. Rightly or wrongly, they have been given a lifestyle which was not sustainable, as we now know. But for the period it sustained, it kind of bred a certain amount of risk-taking because life was very secure. The economy was doing well. You had two cars in the garage. You had two cute little kids playing in the lawn. Good community life. Lots of eating places. You were bred to believe that life is going to be good so hence hey, take some risk with your capital.
The government also encouraged risk taking?
The government and Wall Street are in bed in the US. People were forced to invest in equities under the pretext that equities will beat bonds. They did for a while. Nevertheless, if you go back thirty years to 1982, when the last bull market in stocks started in the United States and look at returns since then, bonds have beaten equities. But who does all this math? And Americans are naturally more gullible to hype. But now western investors and individuals are now going to think like us. Last ten years have been bad for them and the next ten years look even worse. Their appetite for risk has further diminished because their picket fences, their houses all got mortgaged. Now they know that it was not an American dream, it was an American nightmare.
At the beginning of the year you said that the stock market in India will do really well…
At the beginning of the year our view was that this would be a breakaway year for India versus the emerging market pack. In terms of nominal returns India is up 13%. Brazil is down 3%. China is down, Russia is also down. The 13% return would not be that notable if everything was up 15% and we were up 25%. But right now, we are in a bear market and in that context, a 13-15% outperformance cannot be scoffed off at.
What about the rupee? Your thesis was that it will appreciate…
Let me explain why I made that argument. We were very bearish on China at the beginning of the year. Obviously when you are bearish on China, you have to be bearish on commodities. When you are bearish on commodities then Russia and Brazil also suffer. In fact, it is my view that Russia, China, Brazil are secular shorts, and so are industrial commodities: we can put multi-year shorts on them. So that’s the easy part of the analysis. The other part is that those weaknesses help India because we are consumers of commodities at the margin. The only fly in the ointment was the rupee. I still maintain that by the end of the year you are going to see a vastly stronger rupee. I believe it will be Rs 44-45 against the dollar. Or if you are going to say that is too optimistic may be Rs 47-48. But I don’t think it’s going to be Rs 60-65 or anything like that. At the beginning of the year our view that oil prices will be sharply lower. That time we were trading at around $105-110 per barrel. Our view was that this year we would see oil prices of around $65-75. So we almost got to $77 per barrel (Nymex). We have bounced back a bit. But that’s okay. Our view still remains that you will see oil prices being vastly lower this year and next year as well, which is again great news for India. Gold imports, which form a large part of the current account deficit, shorn of it, we have a current account deficit of around 1.5% of the GDP or maybe 1%. We imported around $60 billion or so of gold last year. Our call was that people would not be buying as much gold this year as they did last year. And so far the data suggests that gold imports are down sharply.
So there is less appetite for gold?
Yes. In rupee terms the price of gold has actually gone up. So there is far less appetite for gold. I was in Dubai recently which is a big gold trading centre. It has been an absolute massacre there with Indians not buying as much gold as they did last year. Oil and gold being major constituents of the current account deficit our argument was that both of those numbers are going to be better this year than last year. Based on these facts, a 55/$ exchange rate against the dollar is not sustainable in my view. The underlyings have changed. I don’t think the current situation can sustain and the rupee has to strengthen. And strengthen to Rs 44, 45 or 46, somewhere in that continuum, during the course of the year. Imagine what that does to the equity market. That has a big, big effect because then foreign investors sitting in the sidelines start to play catch-up.
Does the fiscal deficit worry you?
It is not the deficit that matters, but the resultant debt that is taken on to finance the deficit. India’s debt to GDP ratio has been superb over the last 8-9 years. Yes, we have got persistent deficits throughout but our debt to GDP ratio was 90-95% in 2003, that’s down to maybe 65% now. So explain that to me? The point is that as long as the deficit fuels growth, that growth fuels tax collections, those tax collections go and give you better revenues, the virtuous cycle of a deficit should result in a better debt to GDP situation. India’s deficit has actually contributed to the lowering of the debt burden on the national exchequer. The interest payments were 50% of the budgetary receipts 7-8 years back. Now they are about 32-33%. So you have basically freed up 17% of the inflows and this the government has diverted to social schemes. And these social schemes end up producing good revenues for a lot of Indian companies. The growth for fast-moving consumer goods, mobile telephony, two wheelers and even Maruti cars, largely comes from semi-urban, semi-rural or even rural India.
What are you trying to suggest?
This growth is coming from social schemes being run by the government. These schemes have pushed more money in the hands of people. They go out and consume more. Because remember that they are marginal people and there is a lot of pent-up desire to consume. So when they get money they don’t actually save it, they consume it. That has driven the bottomlines of all FMCG and rural serving companies. And, interestingly, rural serving companies are high-tax paying companies. Bajaj Auto, Hindustan Lever or ITC pay near-full taxes, if not full taxes. This is a great thing because you are pushing money into the hands of the rural consumer. The rural consumer consumes from companies which are full taxpayers. That boosts government revenues. So if you boost consumption it boosts your overall fiscal situation. It’s a wonderful virtuous cycle — I cannot criticise it at all. What has happened in past two years is not representative. It is only because of the higher oil prices and food prices that the fiscal deficit has gone up.
What is your take on interest rates?
 I have been very critical of the Reserve Bank of India’s (RBI) policies in the last two years or so. We were running at 8-8.5% economic growth last year. Growth, particularly in the last two or three years, has been worth its weight in gold. In a global economic boom, an economic growth of 8%, 7% or 9% doesn’t really matter. But when the world is slowing down, in fact growth in large parts of the world has turned negative, to kill that growth by raising the interest rate is inhuman. It is almost like a sin. And they killed it under the very lofty ideal that we will tame inflation by killing growth. But if you have got a matriculation degree, you will understand that India’s inflation has got nothing to do with RBI’s policies. Your inflation is largely international commodity price driven. Your local interest rate policies have got nothing to do with that. We have seen that inflation has remained stubbornly high no matter what Mint Street has done. You should have understood this one commonsensical thing. In fact, growth is the only antidote to inflation in a country like India. When you have economic growth, average salaries and wages, kind of lead that. So if your nominal growth is 15%, you will 10-20% salary and wage hikes – we have seen that in the growth years in India. Then you have more purchasing power left in the hands of the consumer to deal with increased price of dal or milk or chicken or whatever it is. If the wage hikes don’t happen, you are leaving less purchasing power in the hands of people. And wage hikes won’t happen if you have killed economic growth. I would look at it in a completely different way. The RBI has to be pro-growth because they no control of inflation.
So they basically need to cut the repo rate?
They have to.
But will that have an impact? Because ultimately the government is the major borrower in the market right now…
 Look, again, this is something that I said last year — that it is very easy to kill growth but to bring it back again is a superhuman task because life is only about momentum. The laws of physics say that you have to put in a lot of effort to get a stalled car going, yaar. But if it was going at a moderate pace, to accelerate is not a big issue. We have killed that whole momentum. And remember that 5-6%, economic growth, in my view, is a disastrous situation for a country like India. You can’t say we are still growing. 8% was good. 9% was great. But 4-5% is almost stalling speed for an economy of our kind. So in my view the car is at a standstill. Now you need to be very aggressive on a variety of fronts be it government policy or monetary policy.
What about the government borrowings?
The government’s job has been made easy by the RBI by slowing down credit growth. There are not many competing borrowers from the same pool of money that the government borrows from. So far, indications are that the government will be able to get what it wants without disturbing the overall borrowing environment substantially. Overall bond yields in India will go sharply lower given the slowdown in credit growth. So in a strange sort of way the government’s ability to borrow has been enhanced by the RBI’s policy of killing growth. I always say that India is a land of Gods. We have 33 crore Gods and Goddesses. They find a way to solve our problems.
So how long is it likely to take for the interest rates to come down?
The interest rate cycle has peaked out. I don’t think we are going to see any hikes for a long time to come. And we should see aggressive cuts in the repo rate this year. Another 150 basis points, I would not rule out. Manmohan Singh might have just put in the ears of Subbarao that it’s about time that you woke up and smelt the coffee. You have no control over inflation. But you have control over growth, at least peripherally. At least do what you can do, instead of chasing after what you can’t do.
Manmohan Singh in his role as a finance minister is being advised by C Rangarajan, Montek Singh Ahulwalia and Kaushik Basu. How do you see that going?
I find that economists don’t do basic maths or basic financial analysis of macro data. Again, to give you the example of the fiscal deficit and I am no economist. All I kept hearing was fiscal deficit, fiscal deficit, fiscal deficit. I asked my economist: screw this number and show me how the debt situation in India has panned out. And when I saw that number, I said: what are people talking about? If your debt to GDP is down by a third, why are people focused on the intermediate number? But none of these economists I ever heard them say that India’s debt to GDP ratio is down. I wrote to all of them, please, for God’s sake, start talking about it. Then I heard Kaushik Basu talk about it. If a fool like me can figure this out, you are doing this macro stuff 24×7. You should have had this as a headline all the time. But did you ever hear of this? Hence I am not really impressed who come from abroad and try to advise us. But be that as it may it is better to have them than an IAS officer doing it. I will take this.
You talked about equity being a short-term investment class. So which stocks should an Indian investor be betting his money right now?
I am optimistic about India within the context of a very troubled global situation. And I do believe that it’s not just about equity markets but as a nation we are destined for greatness. You can shut down the equity markets and India would still be doing what it is supposed to do. But coming from you I find it a little strange…
I have always believed that equity markets are good for intermediaries like us. And I am not cribbing. It’s been good to me. But I have to be honest. I have made a lot of money in this business doesn’t mean all investors have made a lot of money. At least we can be honest about it. But that said, I am optimistic about Indian equities this year. We will do well in a very, very tough year. At the beginning of the year, I thought we will go to an all-time high. I still see the market going up 10-15% from the current levels.
So basically you see the Sensex at around 19,000?
At the beginning of the year, you would have taken it when the Sensex was at 15,000 levels. Again, we have to adjust our sights downwards. A drought angle has come up which I think is a very troublesome situation. And that’s very recent. In light of that I do think we will still do okay, it will definitely not be at the new high situation.
What stocks are you bullish on?
We had been bearish on infrastructure for a very long time, from the top of the market in 2007 till the bottom in December last year. We changed our view in December and January on stocks like L&T, Jaiprakash Industries and IVRCL. Even though the businesses are not, by and large, of good quality — I am not a big believer in buying quality businesses. I don’t believe that any business can remain a quality business for a very long period of time. Everything has a shelf life. Every business looks quality at a given point of time and then people come and arbitrage away the returns. So there are no permanent themes. And we continue to like these stocks. We have liked PSU banks a lot this year, because we see bond yields falling sharply this year.
Aren’t bad loans a huge concern with these banks?
There is a company in Delhi — I won’t name it. This company has been through 3-4 four corporate debt restructurings. It is going to return the loans in the next year or two. If this company can pay back, there is no problem of NPAs, boss. The loans are not bogus loans without any asset backing. There are a lot of assets. At the end of every large project there is something called real estate. All those projects were set up with Rs 5 lakh per acre kind of pricing for land. Prices are now Rs 50 lakh per acre or Rs 1 crore or Rs 1.5 crore per acre. If nothing else, dismantle the damn plant, you will get enough money from the real estate to repay the loans of the public sector banks. So I am not at all concerned on the debt part. If the promoter finds that is going to happen, he will find some money to pay the bank and keep the real estate.
On the same note, do you see Vijay Mallya surviving?
100% he will survive. And Kingfisher must survive, because you can’t only have crap airlines like Jet and British Airways. If God ever wanted to fly on earth, he would have flown Kingfisher.
So he will find the money?
Of course! At worst, if United Spirits gets sold, that’s a stock that can double or triple from here. I am very optimistic about United Spirits. Be it the business or just on the technical factor that if Mallya is unable to repay and his stake is put up for sale, you will find bidders from all over the world converging.
So you are talking about the stock and not Mallya?
Haan to Mallya will find a way to survive. Indian promoters are great survivors. We as a nation are great survivors.
How do you see gold?
I don’t have a strong view on gold. I don’t understand it well enough to make big call on gold, even though I am an Indian. One thing I do know is that our fascination with gold has very strong economic moorings. We should credit Indians for having figured out what is a multi century asset class. Indians have figured out that equities are a fashionable thing meant for the Nariman Points of the world, but for us what has worked for the last 2000 years is what is going to work for the next 2000 years.
What about the paper money system, how do you see that?
I don’t think anything very drastic where the paper money system goes out of the window and we find some other ways to do business with each. Or at least I don’t think it will happen in my life time. But it’s a nice cute notion to keep dreaming about.
At least all the gold bugs keep talking about the collapse of the paper money system…
I know. I don’t think it’s going to happen. But I don’t think that needs to happen for gold to remain fashionable. I don’t think the two things are necessarily correlated. I think just the notion of that happening is good enough to keep gold prices high.
(A slightly smaller version of the interview appeared in the Daily News and Analysis on July 31,2012. http://www.dnaindia.com/money/interview_you-can-shut-the-equity-market-india-would-still-be-doing-fine_1721939)
(Interviewer Kaul is a writer and can be reached at [email protected])