Tuesday 24 September 2013

Demographics : A Twin Edged Sword

Demographics as subject remained at the periphery of academic research until 1980 but has gained prominence as a field thereafter. Observers of the human condition have remarked upon the subject in the early 20th century. Wicksell in 1914 (notorious year) and the mighty Keynes in 1937 have both espoused strong views on the decline of fertility and its effects.

I was briefly introduced to the concept as part of the CFA curriculum but more robustly by Goldman Sachs’s epochal report on BRICS. Since then untold reams of paper have been offered to the deity of demographic dividend by the Indian broking Industry. Every investment banker on the subcontinent has used its divine prophecy to justify Everest eclipsing valuations. With a skill that would make a practicing psychologist blush, the smarter amongst these used it to subtly induce a mortal fear of being “left out”. Remember, no fear is greater than the fear of being left out of a juicy deal, in the mind of the brilliant investment manager, managing other people's money.

So intoxicating were the results of this new medicine that hard nosed businessmen and risk loving investment managers were equally mesmerised. Had the party lasted a little longer, there was a real danger of the government including Applied Demographics in the list of psychotropic substances and amending the Narcotic Drugs and Psychotropic Substances Act (1985) suitably. No doubt a great ruckus would have ensued if the proposal were put up for a vote in Parliament, since the people's representatives were equally drunk on it. Thankfully, since that did not come to pass, God alone (beyond CAG’s domain) knows, what it would have “cost” to get the hallucinogen out of the list.

In my ramblings (of a serious nature), I will attempt to look at the various aspects of demographics as they impact the developed markets and as usual end with the Indian perspective, which feels like a polar opposite only at the surface. I will begin with the myth of demographic dividend before making comparisons in the modern era.

The Myth of Young and Ageing Nations

It is not the first time in the history, that many nations are facing the prospect of a declining population. The population of Europe was 70 mn in 1340. The Great Famine and Black Death brought it down to 37 mn in 1350. It took 200 years for the population to climb back to 1340 levels.

The idea that larger populations provide a basis for larger markets and by extension larger economies is intuitive and perhaps therefore correlated to economic power, wealth and military might by observers.

Anybody could point out that Europe's gilded age was marked by globe spanning empires of at least   3 European nations and an era of high growth in population and wealth. However a keen historian would point out that the period between 1700 and 1900 was a period where European population grew from 100 mn to 400 mn and was the period that overlapped with the Agricultural Revolution and the Industrial Revolution. Arguably the two revolutions had a more profound impact on wealth and society than mankind's affinity for procreation.
India a historically wealthy nation also experienced wealth without population growth. W. H. Moreland, a noted historian pegs India's population at around 100 mn in 1600 A.D. Another historian Kingsley Davis estimates India's population at between 100 to 140 mn in 300 B.C. Two millenia of no growth in population coinciding with India's most prosperous era.

If population were the most important factor, China and India would be far larger than they are today. A snapshot of the top 10 economies in the world shows that smaller populations can build and sustain much larger economies. The 2012 statistics from World Bank provide ample evidence

GDP (USD tn)
Population (mn)
United States
United Kingdom
Russian Federation

My simple argument here is that technological innovations have greater impact on economic growth than naturally synchronised procreation. It was perhaps the inability to participate in the industrial and agricultural revolutions that impoverished a once wealthy Indian nation.
It is easier to relate when one thinks about Microsoft's innovative products which made it easier to use technology. Again, Facebook, Twitter and Linked in are examples of technology driven innovations which revolutionised the way in which people communicate. In the process they created new markets where none existed or expanded existing markets in a manner that brought in hundreds of millions of new users.


Based on Eurostat forecasts, over 100 regions are expected to experience substantial decline in population between 2008 and 2030. Most of these regions fall in East European countries but some also lie in Germany, Spain, Italy and Greece. Four regions in Germany, Chemnitz, Saxony-Anhalt, Dresden and Thuringia are anticipated to see declines greater than 20% as are some regions in Bulgaria.

Opinion regarding impact of population declines is divided. In fact there are pressure groups in almost every European nation propagating population decline. Concerns about over population run deep within some societies. In the 1950's it spurred Dutch Prime Minister Drees to exhort his countrymen to immigrate. Al Gore's documentary, An Inconvenient Truth, is based Hardin's Tragedy of the Commons written in1968 which attributes the tragedy directly to over population. I will jump directly to the article's unequivocal conclusion : “Freedom to breed will bring ruin to us all”. Even until the late 90's over population was considered to be the root cause of unemployment and housing shortages. Most countries have learnt to live the pressures of rising population.

Public Goods

Over population can lead to congestion in accessing public goods and services. The most obvious congestion experience is traffic. Congestion poses similar challenge to access health care, public transport, education, parking and public housing.

On the other hand, how would declining populations affect these very same public goods? A declining tax base would make it difficult for governments to maintain the same level and quality of public goods. An increase in tax rates would be inevitable. In countries providing defined benefit pensions which are not entirely funded (which is the case with most) the system would break down. Pay as you go pensions are heavily reliant on increasing contributions from rising populations to meet their obligations. Sounds like “rob Peter to pay Paul” is now official.

If tax rates cannot be raised then the level of service has to come down. The government would have to calibrate its spending and eliminate some of the public goods. Modern history provides little evidence to inspire trust in government's ability to reduce public expenditure. In aspects such as law and order and defence my sympathy lies with the government, simply because a slack in law enforcement or defence due to under staffing and under budgeting would degenerate into harrowing social and political problems.

Housing & Behavioural Paradoxes

For most people, their houses remain a substantial part of their wealth. A declining population may reduce demand for housing with negative connotations for house prices as well as rental yields. Opinion on this aspect will be divided depending on the group individuals belong to. If you are young and seeking to purchase a house or a rent an apartment, you are likely to view this change positively. Conversely owners would experience anxiety and face the prospect of increasing property taxes to shoulder the burden created by a population decline.

Another paradox in public opinion relates to the location of population decline. The NIMBY (Not in My Back Yard) syndrome is very dominant. People support population decline at national and international levels but not in their neighbourhoods.

Capital Flows and Asset Prices

Erik Lueth in his paper for the IMF argues that capital flows area result of business cycle fluctuations, volatile fiscal policies, long term growth trends and demographic change. Individual countries are at different stages of demographic transition and therefore result in capital flows. Countries which are ahead in the transition would experience slowing or negative labour growth and would benefit from investing in countries at the early stages of demographic transition and witness strong labour growth. The recipients would benefit from higher output per worker.

He concludes that demographic factors are no help in correcting global imbalances that are observed today. He makes two other important observations
1.    The US will remain a capital importer while China will remain an exporter of capital for over a decade.
2.    Counter intuitively, he concludes that asset price melt downs may not happen assuming mobility of capital. Relocation of production from fast ageing economies to slower ageing economies will improve everybody’s welfare and asset prices may actually rise!

My experience of listed markets tells me that asset owners will certainly feel pain in the short term although Mr Leuth may stand correct over a longer term.

Non Materialistic Concerns

The positive aspects of population decline, especially the materialistic ones are fairly obvious, less congestion, lower cost of housing, better infrastructure etc. Non materialistic benefits such as lower population pressure, better environment and perhaps even less noise pollution would have many supporters in today's world.


Businesses are also concerned by declining population as it impacts available labour. Smaller regional enterprises may be unable to make up for loss of customers and face termination.

In a globalised world, economics provides an answer : mobility of labour. Theory assumes that labour will move to find employment opportunities and thus regions facing labour shortages will see an influx from regions experiencing surplus. In the real world, economics is generally subservient to politics and has to co-exist. Thus mobility of labour transforms into immigration. Most countries have immigration policies which are focused on controlling influx. This is true even for US which is a nation of immigrants.

Immigration is a political issue and generally causes friction in labour markets. It evokes strong reactions from local. Immigrants are rarely assimilated completely in their new societies. Ethnic identities are more persistent and immigrants' attachment to religion, cultural traditions, and language act as significant barriers. That the economic benefits of immigration are unevenly spread add fuel to the fire. Businesses benefit from cheaper labour while the less educated local labour faces stiff competition for jobs and sees only negative economic benefits.

Indian Outlook

Closer home, we are faced with the problem of plenty (population wise).
India's modern history is chequered with respect to population. It briefly flirted with compulsory sterilisation and most of today's ministers and senior bureaucrats were groomed in an era that looked at the country's fertility rates with dismay and termed it the Population Bomb. I realised that policy makers had changed their outlook upon hearing Mr Yashwant Sinha, then finance minister, refer to the demographic dividend in his post budget interview some time in 2001 or 2002. He had previously made mortgage payments tax deductible to increase disposable income for tax payers. The focus had shifted to a consumption led economy.

India's demographic dividend was a result of the sharp decline in fertility in the 80's and 90's. Investors' optimism was based on its particularly fortuitous timing. India's working age population was surging just as China's began to decline.

Indian polity has no stomach for economic upheavals. It watches helplessly as GDP growth rates have dwindled from 9% to 4.4% and estimated to slip further. An official report on public finances in 2012 warns that slower growth combined with a demographic bulge could result in political destabilisation. The new Governor of RBI, Mr Raghuram Rajan has earlier stated that jobs are the top priority.

Heading into the last quarter of 2013, corrective action by the government is conspicuous by its absence.

The size of the problem is unprecedented. India will add an estimated 125 mn people to the working age group of 15 to 65 over the next decade and another 103 mn in the subsequent decade. Net new jobs created between 2004-05 and 2009-10 stood at nil compared to 60 mn net new jobs in the previous 5 year period. China's boom created 130 mn net jobs from 2002 to 2012.

The quality aspect is equally daunting. A recent survey came up with astonishing numbers and got cited by The Economist. It found that about half of the engineers graduating from India's colleges are not fit for employment. Putting the numbers in perspective is of little help. Consider this : Approximately100 K engineers graduate every year in the US. In China, the number is approximately 500 K. In India, 1.4mn engineers graduate every year but over half are unemployable. The result of such over supply is that Indian firms employ an engineer to do an electrician's job at paltry salaries. This oversupply remains across professions. Newly graduated dentists  draw salaries of Rs 7000 (~ 112 USD) per month in Mumbai. The city alone adds 300 to 400 new dentists every year.

Pressure to feed the population

Jobs are important to pay for life's expenses. The first being food. Food production seems destined to fall behind needs even with present populations, and population growth multiplies the problems. For importers, the prospect is made worse because food is not a single world market. When threatened with a shortage, exporters typically stop the exports, as India has most recently done with onions.

Jeremy Grantham of GMO also writes about the food problem and believes that the food crisis began some years ago. It will become dire as we move ahead. He estimates the first catastrophes in Iran and Egypt based on the availability of water. India has passed the Food Security Bill, which is bound to have repercussions in the global food market. He also believes that a solution has been found to meet the agrarian crisis in the form of no till farming.

Glimmer of Hope

The Centre for Study of Developing Societies and Konrad Adenauer Stiftung, a German think tank found that nearly twice as many of today’s 18 to 33 year olds say they are interested in politics as did in 1996. 20 % of rural men and 22 % of college educated young men say they participate in protests. If India's youth is finally trying to shape its own future, there may be some hope, else double the security guards and increase their pay.


The demographic bulge is not a God given right upon a nation to prosper. Like any other opportunity it comes with its own challenges which require foresight and management. For India low growth can lead to a repeat of the 70's and 80's where new job opportunities were few and educated unemployment was rampant. In Bollywood, this socio economic problem was reflected in the rise of the “angry young man”, the most successful protagonist of which is our living legend Mr Amitabh Bacchan. Let's hope that mantle need not be passed on in this generation. 

The economic benefits of a demographic surge are less certain but a political change is more likely given the increased literacy, affluence and a widespread awareness about the progress of other nations vis a vis our short comings, thanks to a strong media.

Friday 16 August 2013

Is Capitalism No More ?

At the onset, apologies to all readers for the recent silence on this blog. My excuse is that I have been grappling with various ideas and have still not connected the dots to my satisfaction but I think an discussion could help. So please feel free to post your opinions and comments on this blog and help make the discussions multifaceted. I will flag off with some recent musings.

Capitalism : Seth Klarman’s letter quotes Pew Research Centre’s finding that 50% of Americans aged between 18 to 29 view capitalism negatively. Who can blame them after the post Lehman crisis? Logically this set of people would have directly or vicariously experienced the strains of the great fall in employment. Then it’s natural to extrapolate that the youth in PIIGS countries would share the same feelings on this subject. What with Spain registering almost 50% unemployment among people aged under 30. The Economist, a good barometer of opinion, also ran extensive coverage on capitalism v/s state sponsored capitalism with conclusions favouring the latter.

For investors, these opinions should evoke serious thought. Capital markets (Stocks, bonds currency and commodities, along with their various derivatives) are the penultimate expression of capitalism, which is, efficient allocation of capital towards productive resources, and therefore will bear the brunt of a change in ideology. 

Today’s youth is disillusioned with capitalism. These decision makers of tomorrow will surely clamour for sociopolitical changes. Revolution in Egypt, and the Arab Spring, the civil war in Syria, overthrow of Libya’s dictator are examples. But what do democracies evolve into?  

Plato’s five regimes, describe the cycle of political (d)evolution starting with Aristocracy, Timocracy, Oligarchy, Democracy and Tyranny. All five forms of government are easily available for study in today’s world. So by natural evolution, democracies will become chaotic before they degenerate into dictatorships, as it happened in ancient Rome. 

Does political structure have an impact on economic growth and capital markets ? 

Ruchir Sharma, in his new book, effectively argues that democracy is not a pre requisite for economic growth. Authoritarian regimes like China have achieved higher growth rates for much longer periods. Real life observation suggests that in any controlled regime, incentives and disincentives are created to conform to the ruler’s philosophy and not to laws of economics. This disparity tends to stifle capital market growth but high GDP growth can be achieved. Capital markets truly flourish when they have the freedom to allocate capital. Accordingly, New York and London remain the biggest financial centres today and have not been over taken by Hong Kong or Singapore or Moscow more than 5 years after the financial crisis.

Today’s beliefs will shape tomorrow’s decisions. The shift in ideologies will have widespread repercussions on society itself and the manner in which society reshapes its views on wealth and welfare. Let’s take an example.

If there was a single statistic to track economic health, then it would be debt. The US government debt has increased from USD 6 trillion in 2009 to USD 16 trillion now. This debt has been used to bail out failed enterprises including banks. Despite its colossal size, this liquidity has had a meagre effect on the real economy. It has revived speculative positions and resulted in asset price inflation. Naturally asset owners have benefited. The rich tend to own the most assets and they effectively received the bail out while the not so well off lost their jobs and even faced penury. The funds have not been used for social goods such as public health, infrastructure assets or education. Hence what obligation will today’s disillusioned youth feel for carrying this debt burden and service it? What will convince the next generation to toil and repay the previous generation’s debt obligations? Expecting future generations to pay for today’s decadence marks a return of feudal era slavery.  

Imagine the consequences of such default. What will be the fate of bond holders especially pension funds who hold these long term bonds? How will pensioners make do?

Will these obligations lead to chaos and then as Plato predicts, democracies will degenerate into a dictatorships?

Food for thought : A famous dictator, Adolf Hitler, reneged of paying reparation for the damages of World War 1 to external parties (France and England primarily) upon assuming power.

Many dots remain unconnected and your thoughts are welcome.

Incomplete as the framework is, as an exercise for the grey cells, let’s attempt to apply it to our domestic framework  

Indian Context : The entrenched feeling of despondency across all strata of people is something that I have never witnessed before. Will this lead to a regime change ? For the past 20 years, we have had governments of all hues and stripes in Delhi. Currently, the government seems to be fighting the judiciary, the regulatory bodies, the central bank, the armed forces, investigative agencies, itself, the industry and terrorists and Maoists whenever possible and elections soon. Indefatigable !!!

In this chaos, sometimes even the numbers don’t add up. 16th August’s Business Standard shows very interesting statistics. The top 30 companies (Sensex) have reported sales growth of under 2 %. This posits a question. If the top 30 companies which account for about 50% of the India’s total market capitalisation are reporting nominal sales growth rate of under 2 %, how can the Indian economy report a real GDP growth rate of 5%? 


Perhaps the market is also pondering the same. As I write the BSE Sensex is 749 points in the red. Noted economist Hyman Minsky wrote that stability leads to instability. In India, No Action has resulted in a Reaction. Would you agree ?

Monday 22 July 2013

Long Term Stock Selection

Stock selection is complicated business. Formulaic approches seldom work over a long term. Even super investors such as Walter Schloss had to return back money to investors saying he could no longer find stocks that fit his value framework. George Soros' too shut down his Quantum fund and returned money to investors saying he could not understand the markets.

How can ordinary investors then hope to allocate capital effectively ? I reiterate, there are no fixed answers but some tools provide a broad direction. Hard work is essential.

How do we identify good companies ?

I recently attended an investment workshop and had the privilege of interacting with India’s best investors. Unerringly every legend’s message boiled down to two essential ingredients 1) high return on capital and 2) business’ ability to deploy large amounts of capital without reducing return on capital. 

This seems like investors’ utopia but a large sample of companies have been able to demonstrate this ability for varying lengths of time. Needless to say, the most consistent of these enjoy very high valuation multiples. Essentially capital allocation decisions create most of the value
The company has three choices 1) invest in existing business 2) invest in a new business or 3) return money to share holders. Markets tend to reward companies opting for options 3 and 1 (in that order) but abhor option 2. Capital allocation decisions are subject to management influence. A business earning suboptimal returns and ploughing back cash in the same business will actually destroy value. By themselves indicators such as ROCE and capital allocation decisions do not provide a clear picture about investment attractiveness of the business.

One measure that I use is capex / unit compared to the margin / unit. This is just another form of estimating payback.  It allows me to rank businesses. Let me illustrate : 

A prominent two wheeler manufacturer in India has capital expenditure / motorcycle of about Rs 7700 and margin / motorcycle of about Rs 4800. That its balance sheet exhibits negative working capital, much larger than its capex requirement is very thick icing on the cake. Using the same yardstick for an oil refiner, we see capital expenditure could be approximately Rs 3600 per barrel per day while mid cycle margins could range between Rs 450 to Rs 550 per barrel at current exchange rates. A popular car manufacturer exhibits capex of Rs 122000 with margins per car of Rs 30000. 

Ranking these businesses for a long term investment horizon is very simple now. Additionally this framework can be applied for evaluating diversification decisions or change in business models.
It saves time and focuses my attention on the more important and difficult aspects of evaluating the business, namely, the competitive advantages, the moats and the longevity of cash flows from the current model. The last being the most difficult.

Consistent and conservative accounting policy is another time tested indicator of good companies. Generally speaking, conservative accounting policies lead to understatement of reported profits and therefore reduce incidence of taxation thereby becoming a cash preserving strategy. Consistently applied, this becomes a source of wealth creation for shareholders. 

Illustration: Let’s take 2 companies A and B with A depreciating assets over 10 years and charging R&D expense to its P&L. B on the other hand capitalises 50 % of its R&D expense and depreciates assets over their estimated useful working life of 20 years. For the next 10 years A’s reported profits will be substantially lower than B’s assuming identical size of assets, expenses and income. At similar tax rates, A’s tax bill will be much lower than B’s and cash flow will be much higher. This additional cash re invested in the business every year will create substantially more value for company A’s shareholders than B. For a long term investor, the virtues of conservative accounting policy cannot be overstated.
Size, brand name, parentage (MNC’s), even longevity are various factors used to describe good businesses / companies. However, we think good companies are not necessarily large, neither the most visible nor grouped in one or two sectors. In essence these are companies which continually evaluate themselves internally on stringent benchmarks similar to those used by external investors. 

Typically such conservative companies tend to minimise risk to their cash flows and thus have a higher chance of succeeding. Their focus on cash flow over reported profits is reflected in their valuations too.

Identifying good companies requires familiarity which comes from in depth knowledge which is a result of tracking these companies and their managers across cycles, interacting with their customers, competitors and creditors. In short bottom up research.

From time to time, some of these companies 1) fall out of favour and become cheap (FMCG sector from 2001 to 2006) 2) suffer business setbacks for eg: a failed product line (GSK Consumer’s ready to drink, bottled Horlicks milk for pregnant women) or 3) suffer valuation multiple contraction due to adverse publicity which has little impact on their core business. Investors have to be prepared to invest in these companies at such times.

Luck favours the prepared mind. The stock market requires preparedness in the following terms 1) tracking a sufficiently large universe to be able to spot opportunities in different market conditions 2) investing strategy should enable deploying significant amounts of capital in such opportunities and 3) maintaining investment discipline even under adverse conditions.

A look back in history suggests that investment opportunities are always present but it is the level of preparedness that is the key to returns.