dosanomics and financial independence

Raghuram Rajan's dosanomics became quite popular; and he is a smart person. Nominal rate is the sum of real rate and inflation. Therefore, if you take out inflation from nominal rate, what remains is the real rate. 

And real rates are more important than nominal rates. For instance, if you earn 10% on your investment, and inflation during the period was 10%, you have not moved forward; it is a status quo situation. However, if inflation was 11%, you earned a negative return. What it means is that looking at only the nominal rate of return in isolation is not a good idea. Inflation is an implicit tax on your returns. Ignore it at your own peril. That is why we like returns that beat inflation, rather than those that beat a benchmark such as the market index. If we are not able to retain our purchasing power, there is no point in harping about beating the index. If anything is worth doing, it is worth doing well.

So how does the dosanomics fair in terms of our wellbeing?

Mr. Rajan's thoughts:

He explains further:

Is it really so? Let's check out, especially for a retired person.

Let's have a retiree whose annual expenses are Rs.720,000 and assets are worth Rs.10 m. When interest rates are 8%, the retiree earns Rs.800,000; however, with a tax rate of 10%, the net earnings are Rs.720,000. 

Now, if interest rates come down to, say, 6% because inflation moderates to say, 5.52%, the financial equation for our retiree changes. After-tax earnings will be Rs.552 k with a lower tax rate of 8%. Annual expenses will be, nonetheless, higher than Rs.720 k; with 5.52% inflation, they will be Rs.759 k, leaving the retiree with a hole of Rs.207 k. 

Note that for the working people, with active earnings capacity, this may not impact much since annual earnings tend to compensate increase in costs, albeit at different levels.

It will get interesting next year. Even after assuming no change in rates, the hole gets bigger. The assets will be worth Rs.9,531,107. The retiree is clearly worse off.

There are two solutions to this: One is that the retiree should have had much higher assets to start with, which is to say, not to retire so soon. Another is to find an alternative source of income while retired; I guess that happens only by working again. 

This is exactly what someone asked Mr. Rajan:

And this is what he got:

The retiree with annual expenses of Rs.720 k, and with inflation of 5.4%, will have annual costs of Rs.1.2 m in ten years. How much will the earnings be by that year for someone who had assets of Rs.10 m? Not much compared to the costs.

Of course, there is a third solution to the retiree. That is to increase the gap between after-tax earnings rate and inflation. If after-tax earnings are say, 12%, the retiree should be fine. That would be possible only when assets are invested in equities rather than bank deposits. The problem here is that equity returns are not linear, because of which annual drawings may obstruct growth in equity in future years. You cannot rely on only equity returns for retirement, where you require stable earnings.

There is yet another solution: Reduce annual costs. That may be possible when the retiree chooses to live in a smaller, low cost place. 

Whatever the options are, dosaonomics may not be suitable for a retired person. Retirement is a key decision, and it is worthwhile to think about how much assets one should have before taking the leap.

Interest rates are moving downwards.

I would like to call it financial independence, rather than retirement. Whether it happens at 30, 40 or 60, the idea is to have sufficient passive income to be able to finance living costs. Working then becomes optional: you can sit on couch or beach, or take up work that interests you. You can even choose to be busy breathing in, breathing out. Earnings, if any, from such activity then are only incidental, not a requirement. 

troubled twins

To make money in stocks, usually, one has to stay focused on the story for a considerable period of time. The story is linked to the business behind the stock, not to the ticker price. So here it goes: in the short term, you do not know how the market prices will react; but in the long term, the prices are more aligned to the business performance. If the business does well, the stock prices go up. 

The risk in the business then depends upon the type of the business, the operating leverage, and the financial leverage. For instance, you take on too much debt, the business becomes that much vulnerable. 

Both Rcom and Rpower seem to have failed the investors big time. Unless one has played the game of high-and-low prices periodically, which is never easy, these businesses haven't given adequate returns to the investors.

Rcom is worth Rs.87 b now, from its peak of Rs.1742 b in 2008. 

Rpower is worth Rs.110 b now, from its peak of Rs.813 b in 2008.

Both businesses earn poor returns on capital employed. I wonder when they will be able to turnaround. 

demonetization, digitalization, and the windfall

The demonetization
The government announced on 8 Nov that by midnight of the day high value notes of Rs.500 and Rs.1000 would no longer be legal tender. It also noted that all cash holdings should be deposited into the bank account of the owner of cash by 30 Dec 2016. 

Well, the responses thereafter have been mixed; some in favor, and some opposing. That is obvious in a democracy. And that the news media is busy tackling the matter in a way that suits their ratings and increases advertisement revenues is another matter. That is obvious too because they are running a business, not public service; never mind the moral grounds, have they ever? As mentioned, that's another matter.

India is a country where most of the transactions take place in cash; it could be as much as 70-90% as pointed out by some sources. Therefore, cash is an essential commodity for the most. The digital currency has been picking up only recently. The idea is to move towards a cashless economy, where most (and all high value) transactions are carried out in an electronic form: net banking; debit cards; credit cards; and other e-platforms. This is good for the long term. 

How about the short term? There are consequences of course, especially for the poor, and emergency situations. And discussions about this galore. The purpose of this post is to check what is in place for the cash that is hoarded in India. 

Cash is held by the businesses, in the normal course, which is scheduled for depositing the next day; cash is held by the working individuals, in good faith, to carry out their daily affairs; cash is also held by housewives as part of their routine savings. These are all, may be, after-tax rupees. Besides, cash is also hoarded by these businesses and individuals as evasion of taxes; black money. 

The action
All genuine cash holders might takeout cash, and deposit in their bank accounts as authorized by the government. If the tax officials find any mismatch between the cash deposited and income tax returns filed in prior years, there could be tax and penalty levy. Despite this, genuine cash holders would be better off by declaration and deposits. 

However, the guilty would have to think before any action. They have a few options:

Option 1: Declare the black money, and deposit in bank accounts. Be open to scrutiny, and pay taxes and penalty. This could open up their box of...; be prepared for that.

Option 2: Do not declare, which is to say that take the cash and burn it. Let the smog be; let this be their festival of firecrackers without noise pollution. The loss is equal to the value of cash burnt. Move forward with life. 

There is another option for them: Donate the cash (without expecting anything in return) to as many poor as possible, with each poor person getting a very small value in cash, which can be deposited in that person's bank account for use. This will yield the cash hoarders good wishes from the poor. This option is not as ethical as option 1; yet.

The consequence
Nevertheless, it would be interesting to find out how the whole thing is actually going to play out. Here's the RBI's balance sheet as of June 2016; it had Rs.17,077 b of currency notes issued. 

We also note from its annual report that the RBI had Rs.16,415 b of currency notes in circulation as of March 2016.

How much is the black money held in cash? Let's take Rs.17,000 b as the value of notes. Of this say, Rs.15,000 b is from high value notes of Rs.500 and Rs.1000, which have ceased to be legal tender. Now, it is anyone's guess that how much of this Rs.15 t is held in the form of black money. For the sake of arithmetic, 25% comes to Rs.3,750 b. Too high? assume 10%; too low? assume 40%. The fact is that we do not know yet.

The windfall: Any cash that is not deposited in the bank account will become worthless. When it becomes worthless, the RBI will have that much lesser obligation to honor. People have been speculating about this proportion of lower liability, and about the likely use of that windfall: It could stay with the RBI as part of its reserves, which means lesser currency in circulation; is that lower inflation? It could be used to issue additional currency notes of equivalent value without impacting inflation. It could be paid out to the government as dividends. It could be used as a special equity boost to the public sector banks. It could be used to extinguish the government debt. It could be...blah blah blah...

The fact is that we do not know: 1) The size of cash that will be trashed; 2) The likely action by the RBI - to print new currency of the equivalent value, or to not to print at all; and 3) The likely use of the windfall.

As a consequence, though, at least some part of that parallel (black) economy will be gone. In the short term, these informal small businesses and real estate operators will be hurt, and will be forced to either close their operations or become part of the formal (after-tax) economy. In the long run, the share of the formal economy is likely to increase resulting in higher GDP. 

However, the value of black money is much larger in the form of gold and real estate as compared to cash holdings. Hoarded gold and unaccounted real estate are much difficult to crack. That said, going forward, even these transactions will be difficult to deal with before-tax cash. 

The idea of a digital economy is tempting. Let's wait and see how it will play out.

it ain't about how hard ya...

Markets are spooky these days. Nov 8 has been quite eventful what with elections in the US and demonetization in India.

From Nov 1, the index has fallen 6%. Much of that (5%) came after that eventful 8th day of Nov. 

Other things remaining same, investors go where there is less risk; perceived risk that is. Foreign investors could go to the US perhaps; but for how long would they remain there? Domestic investors could go to government bonds (would they?), or gold (again for how long?). They could go to real estate, may be, but chances aren't that high.  

Investors often fail to ask a question fundamental to their financial wellbeing, has anything fundamental to the business changed which is likely to remain for long?

With US not growing as much as it would like to, Europe and Japan, not anywhere, Latin America struggling, and China trying to check where it is heading, I reckon eventually a good portion of global money has to come to India. I mean it is for their own good, if they want better returns. And domestic investors will not like to sit and watch others party. So there is; the Indian equity markets are not going to be short of cash.

Short term fluctuations in the markets are routine. In fact, these are the opportunities to act. Real money is made when invested for long term. That is why investing calls for proper analysis and homework before action. Without analysis of facts there is only speculation; and one should speculate at one's own peril.

Often, men and women, tough and weak, smart and foolish, are all brought down to knees by the markets. What's to be done, take the hit and go back? In these times, investors should go to Rocky Balboa for advice, rather than to the so-called experts. 

Yeah, it ain't about how hard ya hit; it's about how hard you can get hit and keep moving forward.

diwali top picks worth Rs.13 t

Each year, India celebrates Diwali with much fun; and why not with so much mythology behind it. Also each year, Indian talking heads talk about top stock picks during Diwali. There's one here; but they are there everywhere. Each has his/her own picks, and no one is spared from hearing it, unless of course one switches off financial media during the time, and stops commuting altogether for you find talking heads in Mumbai suburban trains too. 

There is so much fanfare in doing it that for normal humans, filled with the spirit of greed, it is quite difficult not to listen and act. And act they do; every time, each year. 

I usually do not give a damn about what these pundits have to say, but sometimes, it is sheer fun to mock them; and I enjoy that immensely. I have so much regard and respect for them that I only just fall short of shorting their buy recommendations.

This year, instead of asking how much money the festival would bring to the investors, I thought of checking out how much money it would take away from them. The festival has its own charm, but people who celebrate it have some perverse attitude, which I attribute to the natural human behavior: being stupid of course. Here's how. 

People celebrate the festival by bursting firecrackers. Never mind, there is both noise and air pollution; let's leave that discussion for some other time as I take up bashing one at a time lest I too go berserk. The firecracker industry is estimated to be worth Rs.100 b. So in our analysis, it amounts to taking out Rs.100 b each year and burning it; you hear that noise and smog? I do, but I also see the potential financial loss it brings upon those who burst. 

The stock market has the potential to grow more than 12% in the next decade. Then there are dividends. The rate of return is less important (we can choose any rate) compared to the potential financial impact. Let's just use 12% as the opportunity cost. I picked equity markets rather than bank deposits or bonds because these people choose to burn the cash anyway. If this cash was put in equity markets, just the market index, instead, 12% was a probabilistic rate of return. 

If we assume Rs.100 b is the market for firecrackers, the cash flow would be worth Rs.1,700 b in 25 years at 12%. The cash flow would earn dividends each year, and also grow further.

Rs.1,700 b is the cost of just one year's stupidity. We know that stupidity carries through the years; Rs.100 b is burnt each year. So the future value of that annuity would be Rs.13,333 b in 25 years. And I have not even considered growth in stupidity, that is, Rs.100 b is not going to stay constant; it is going to increase year after year; think about a perpetual growth rate, and the potential financial loss is staggering.

Sure, we can celebrate the festival softly with family and friends, and have as much fun. I wonder where else we could find a combo of increasing noise, polluting air and losing Rs.13,333 b.