One of the biggest lies of our times

Jun 14, 2010

In this issue:
» Infosys does not see debt crisis impacting positive outlook
» RBI asks to brace for more capital inflows
» Japan is headed towards a disaster says its new PM
» Is China losing its manufacturing edge?
» ...and more!

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It is amazing how much of modern finance is built on extremely wrong and misleading models. Many of them coming to light in the aftermath of the subprime crisis. Inflation may not be a model in the strict sense of the word. But if Jim Rogers is to believed, it could well have a very important distinction. That of being one of the most abused financial indicators in the world. In a recent interview, Rogers, one of the most successful investors of our times, has come down heavily on the US Government's reluctance to admit widespread inflation. "If you go to the shop, whether it's groceries, or education or insurance or health care, prices are going up for everything. The government lies about it in the US", Rogers is believed to have said. We do not know whether Rogers is right or wrong. However, the US Government has played around with the methodology of calculating inflation many times in the past. And this raises serious questions over the authenticity of the number.

Rogers is also of the opinion that there are some countries like India that do not lie about inflation. And he could well be right on the ball here as well. However, the way it is calculated in India may not be a correct reflection of the consumption patterns prevailing in the economy. And this once again raises a big question mark over its utility.

Investors could do well to remember that inflation as an indicator of price levels may not be the most precise metric. However, it is an ever present threat. So, how does one protect oneself against it? As Warren Buffett says, "Predicting rain doesn't count, building an ark does". And you ark could well be stocks of companies that have strong pricing power and strong balance sheets and available at reasonable valuations.

 Chart of the day
If today's chart of the day is any indication, Bangalore, India's original silicon valley, may soon have other cities knocking at its doorsteps. Although software exports from the so called Software Technology Parks of India (STPI) have come down in FY10 over FY09 for most of the cities, the drop in the case of Bangalore is the most prominent. So, is Bangalore losing its edge? Well, the verdict is pretty split right now. However, if the city does not address its infrastructure problems fast enough, the gap will continue to narrow, we believe. Also, with STPIs very close to losing their tax exemption status, a lot of business is being snapped by SEZs and this could impact the IT growth in the city as well.

Source: LiveMint

"Money tries to come to places where it gets better returns". Going by this simple logic, it is but natural that investors will seek investments offering higher returns. And the Indian central bank which is overlooking the flow of funds from abroad sees this trend catching up. More and more capital from developed markets is finding its way to India. Take the very fact - the difference between the risk free rate between the US and India is at least 4% to 5%. This itself is testimony to the scope of higher returns.

The RBI believes that there may be a surge in capital coming to India in search of higher return. FIIs have so far invested US$ 5 bn in domestic stocks as against an investment of US$ 17.5 bn in 2009. However, in an attempt to avert the Euro zone risk, investors may choose to park more funds in emerging markets. While long term money may be good, the RBI itself has been skeptical about the risks attached to managing too much short term money. Short term funds also have a tendency to push up valuations temporarily. Domestic investors in particular need to be careful about not getting carried away by some temporary buoyancy in the markets.

Politicians are not worried about the government taking up huge amount of debt on its books. Or so we think in general. But if one were to read what the new Japanese Prime Minister thinks, one might have another opinion as well. In his first major speech after getting elected as prime minister, Mr. Naoto Kan has warned his people of a looming crisis. As he's said, "Our country's outstanding public debt is huge... our public finances have become the worst of any developed country. Like the confusion in the Euro-zone triggered by Greece, there is a risk of collapse if we leave the increase of the public debt untouched..."

Japan's total debt currently stands at 2 times its GDP. And given that its average citizen is getting older, Japan will need to start borrowing from the rest of the world. Now, that calls for a prompt action. Or the land of the rising sun might see its sunset sooner than later.

Just like water and electricity find their own level, the rewards within an economic system tend to even out. We all know how super normal profits in an industry attracts more competition, eventually resulting in normalization of profits. Similarly, poor profits leads to an exit of players, again resulting in a normalization of profits. It holds true for other factors of production. Capital gravitates towards higher risk-adjusted returns. And tellingly, labour wages eventually rise to kill the cheap-labour arbitrage between countries.

Take the example of China. Its cheap labour is at the core of its status as the world's factory. Given its population base of 1.3 bn, there traditionally has been an unlimited supply of a young work force. But that is changing. The recent strike at a Honda factory and suicides at Foxconn has brought to focus issues of better working conditions and wages. Given the ageing population and increasing rural prosperity, this is a trend that it likely to continue. Slowly but surely, the cheap-labour arbitrage will end. Just like it did in Japan and Taiwan in the past. When that happens, a new country will become the world's factory and China will search of a new source of competitive advantage. The process of economic leveling will continue.

Tech bellwether Infosys appeared optimistic but cautious about future business prospects at its recently held 29th AGM. "We are not ignoring the threat of highly leveraged economies", Mr Murthy stated. Indian IT has significant exposure to Europe. This is however restricted to stable economies in UK, Germany and France. Exposure to the troubled PIGS nations is thankfully limited.

Indian companies are now getting used to the extreme swings in currencies, first with the dollar and now the euro. Infosys, which has always had the strongest operating margins among its peers, hopes to maintain them at current levels. It may even cut costs if necessary. We are still positive on this industry due to its strong fundamentals, however we do expect a slowdown in growth v/s its earlier sunshine levels.

Meanwhile, the Indian indices witnessed a fresh buying interest during the afternoon session as the BSE-Sensex was trading around 230 points higher at the time of writing. Heavyweights like Infosys, Reliance and HDFC Bank were seen driving a major portion of the index's gains. Meanwhile, most of Asia closed in the positive territory today whereas Europe is also trading in the positive territory currently.

 Today's investing mantra
"To thrive as a value investor, you have to risk being called a dummy from time to time." - Christopher Browne

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1 Responses to "One of the biggest lies of our times"


Jun 14, 2010

The word inflation by itself says that something is blown out. Prices are certainly an indication.
But as mentioned in your newsletter, misdirection is happening.
Though people can be confused for sometime with technical blaw-blaw, soon people will feel the danger of the blown out costs.

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