demonetization of property and gold

There is still talk of demonetization; some in favor and some not. Cracking down on corruption and black money is a good idea. Whether demonetization will bring about the required change remains to be seen. That said, Indians no longer hoard most of their cash in the form of cash; both storage and security issues have caused them towards property and gold; of course, they were always the conduit. Yet, the proportion representing hard cash has significantly reduced, and that representing property and gold has significantly increased.  

So property and gold it is for the Indians. How to deal with that pretax cash diverted to land, building, and gold? Asking them to use aftertax cash rather than pretax is not useful; remember, it has not worked. Will asking them not to pay tax on capital gains work? I don't think it is a good idea. 

Why should people who deal in property and gold be treated differently from to say, a business owner? It would be like if you start a business, profits will be taxed. If you buy and sell either property or gold, profits will be exempt. Little funny, wouldn't it be? 

Investing is a serious business, whether in equities, debt, property or precious metals. The intention is to make profits out of the transaction; so that should make it a business. And it is a business, not any different, even for those who transact occasionally. When a home buyer for primary residence sells it after a decade or so, profits made are investment profits, albeit long term. 

Lack of regulation and bad intent of people have been the cause of this massive hoarding of black money in the form of property and gold. Crackdown on this is really important.

I haven't got nice things to say about gold; but have four suggestions, though. One of the best ways to stop corruption in gold is to tax it heavily; make it more expensive. It would also be additional income for the government. If people still want to buy gold, so be it. Second, every transaction on gold should be based on the PAN of the buyer; No PAN, no transaction. Third, increase the tax rate on capital gains. The idea is to pay heavy penalty by those who buy and sell gold. Fourth, all transactions should take place through banks such as cheque, net banking, and transfers. If someone does not have a bank account and wants to buy gold, that person got the priorities wrong. Needless to say, the authorities should keep an eye on the income of the buyer and buying pattern. 

It is a little different for properties. Investing in properties is a good deal. But in India, rents are not aligned to the market prices of properties. Due to this, the investor is brought to hope for increase in prices to offer reasonable returns. Excessive dependency on prices has made property transactions similar to that of a not-cash-generating asset. The investor will make money only when a greater fool is found. It is pathetic as investors are forced to overpay; blame it on the regulation. As prices seem high enough, buyers consider that using pretax cash is more profitable. It is a vicious cycle: black money channeled to buy property; consideration upon sale received in cash is again used to buy property; and so on.

Bringing tighter regulation is the key to deal with corruption in land and buildings. The single most important thing is to have a mechanism to track every transaction online. Make PAN compulsory for the transaction; I am not sure if it is there in rural areas when small plots of land are bought and sold. Reduce the complexities involved in capital gains tax on property. Bring rentals in line with market prices. For that to happen, value of the transaction should be included for registration purposes. Stamp duty and rentals are then based upon the market value. Again, make transactions through banking channels compulsory; cash cannot be used. Profits made on sale of land and buildings are investment gains; these should be taxed appropriately.

It would be an interesting idea if long term is when property is held for more than 5 years. And how about having a progressive system - short term<= 5 years; 5 to 10 years; 10 to 20 years, and more than 20 years - for capital gains tax?

Demonetization of property and gold, how's that!

ideas to have fun, make money

The Indian stock market ended 2016 at 8185.80, which is just 3% ahead of last year.  

The returns from stock markets are not linear. You cannot expect fixed stream of cash flows from equity; for that you have to go to bonds. Alas, returns from bonds are almost always lower than equities. And in present times, man, it is going to be just equities, if your aim is to make money. 

What amazes me is that people expect stock market returns to be always, always positive. That shows lack of knowledge about what really equities are. 

When you start a business, you are ready to wait for years to make it worthwhile for you. You are aware that some years will be good, and some will be not as good. Yet, you expect the business to be viable in the longer run. When you are a businessman, like many that I know, you are also a highly concentrated investor; that is, most of your wealth is tied to your business. It is because you know that you are making a career out of your business, and want to stay that way for a long, long time. That is great. 

But then, why do you see your stock market investments any differently? When you buy a share in the stock of, say, Nestle, why do you expect it to increase in value every day, week, month, quarter and year? Do you think the value of Nestle as a business should change significantly by the day? Just like your private business, Nestle is also in a business, which is going to be good some years, and not as good in some. This is the crux of investing. The earlier you get it, the wealthier you get in life. 

People who invest in properties do not check price quotes on a daily basis, do they? They are crazy, if they do. There aren't quotes anyway, unless a transaction takes place. Just because there are quotes for your stocks, you are tempted to check. That's crazy too.

The resolution for the coming year is about taming your wild behavior. Stock investing is as much about human emotions as it is about intelligence. If you are not dumb, and are in control of your emotions, you are more likely to be a winner in this game. 

I have four ideas to share which are just enough make someone have fun, and make money at the same time. Don't forget to enjoy life. 

Hate those guys; the crooks

Stop listening to the pundits. Oh yes, stop listening to all those self-proclaimed value investors who write blogs, make up stories, quote Buffett and Munger, and then charge you for their offerings. They quote some philosophers as well just to spice it up. Know that they cannot teach you anything about stock market investing. If they knew, they would have invested for themselves and made money. There would be no need to charge you for their products. I know some of them who also invest in mutual funds; which means they give their money to others to manage. How ironic for someone who claims having knowledge to teach people about equity investing to trust someone else to manage money? It is because they have to pay their bills, they have the need to coin stories to tempt the gullible. Don't get swayed by their morally corrupt thoughts.

Don't care market prices investing

Invest in equities on a periodic basis. The best way is to invest in a broader index in good times and bad. Buying the index each month either in fixed units or fixed currency is good. Here you are not bothered about market prices because the prices average out in your favor in the long run. 

Market prices are the key investing

Then wait for the right opportunity to invest in individual securities. If you think that Nestle is a good business, you analyze the business and come up with a value. You buy the stock only when price is much lower than value. Here you do care about market prices. Your returns are directly proportional to the price that you pay. 

Caution: You cannot play this game if you are not interested in equity analysis or simply have no time. Then you are much better off investing in the index itself. You are guaranteed to earn returns equivalent to the market returns. You would be crazy again if you consider that is not enough. Equities outplay all other investment alternatives if played long enough. 

Control

The promise you have to make is to have a check on yourself, always. Control your emotions: greed, fear and envy. You will not only be having fun in life, but also be wealthier than you ever think you will be.

Speculate in moderation

On a side note, I am also an advocate of speculation. I am aware of the kick it gives; so some more fun is alright. But it should comprise an insignificant portion of your net worth. So if you are so keen, play along. 

8% government bonds

With interest rates falling, and projected to fall in the coming months, for investors in debt instruments, it has become a matter of importance. The 10-year government treasury is now at 6.46%; and 1-year treasury is yielding 6.32%. Bank deposit rates for one year are currently less than 7%. 

When safer debt instruments are below 7%, you tend to check out debt funds, which can probably give returns in the range of 8-9%; not assured though. 

There is one more option for the investors seeking risk-free debt. That is the government's 8% bonds. These were issued in April 2003, and yield a return of a little more than 8%. The catch, however, is the lock-in period of 6 years. 

With the brokerage fee of 1% on purchase, the pre-tax return on cumulative comes to 7.98% and on non-cumulative, 7.94%. At least, these are assured returns. If you estimate that inflation and therefore interest rates are likely to be lower during the period, these are better options compared to bank deposits, especially if you are in the lower tax rate.

For someone, who is in the tax rate of 0%, the returns are not bad to lock-in for 6 years. But then of course, all depends upon the opportunity cost of the investor. 

value of property

Many financial advisors consider that house property where one lives is not an investment. This is because the house is not going to be sold at all as the family lives in it. Great. They also advise that since the property has annual payments such as taxes and maintenance to be made, that should be included as a liability. Super. The value of the house would not be part of one's net worth. 

What if there is an investment made in an equity instrument, which the investor inherited from parents, and does not intend to sell ever, but wants to pass on to the children? Going by the earlier logic, the investor who owns shares of Coke, which are planned to be passed on to the next generation, should not include them in the calculation of net worth. 

Let's fix that conception. Any item that has value in the market should be included as part of net worth. Even car, expensive watch, etc. can be included. However, as a cautious analyst, I do not include any asset whose value depreciates over time. So the car goes out. I don't like the idea that an expensive watch has any meaningful value. I don't have the stupid habit of buying watches anyway. The more assets without having cash flows one owns, the more speculative the net worth becomes.

Back to the property. Even when the investor has only one house property where the family lives, and intends to live forever, there could be occasions where the family may decide to sell. This may be due to cash problem, or may be due to the idea of cashing in. When the property price becomes quite high in the area, the investor may decide to sell and move to an area where the price is low. Of course, house property is part of your net worth. 

Value of the property: Most buyers of house property do not think about its value. For them, the value and price of the property are just the same. I don't blame them per se, especially in India, where if someone really looks at the value of the property, it is difficult to buy at all. Nevertheless, it makes sense to at least understand the gap (the premium) that is being paid when it is bought. 

Value of any cash flow generating asset is the present value of all cash flows discounted at an appropriate rate. House property is not an exception. The cash inflows are rents, and cash outflows are taxes and maintenance. The value of the property is then the present value of annual net cash flows attached to the property. That is true even when the family intends to live in the house because if not, the investor would have rented the property. 

Let's consider an example. An apartment with annual rentals of Rs.360,000 has a market price of Rs.17.50 m in a suburban Mumbai. The annual costs are minimal; so I will ignore them in the calculations. That is a rental yield of just 2%. What the market is saying is that any expectation above that rate should come from the market itself. The 10-year government treasury has a yield of 6.50%. So to match that, the market price has to appreciate by 4.50%. It is a bit simplistic because there is growth in rentals too. Yet, if the investor wanted 6.50%, government treasuries would be the option, not house property. The expected rate of return for the property is some points above that rate. 

Assuming that rentals will grow at 7% annually (they may not if inflation remains lower) for the next 10 years, and after that they will grow at 5% on perpetuity (they may not), we have all the cash flows available to bring them to the present value. The value of the property now is a function of the expected rate of return. 

At the market price of Rs.17.50 m, the investor will get 7.562%. If the expected rate of return is 10%, the buy price has to be Rs.8.83 m, a markdown of 50%. There is no question that the market price would go that far down in Mumbai. At least they have not so far. That is why I consider that rentals and property prices in India are not aligned. To have an expectation of a reasonable rate of return, either the rentals will have to go up, or the prices will have to come down. Neither has happened in the past 20 years or so that I have seen. 

So what will the investor do? Owning a house is always a dream; so it is easy for the investor to make the decision. Just look around and track a few properties. Buy the one that is most liked in terms of its design as a trade off with the market price. The investor and the family moves in. There is no time to think about intrinsic value of the house property. 

There is another way of calculating value of the house property, It is how most equity analysts calculate the value of stocks. Take the cash flows for 5-10 years, and plug a multiple for the stable growth value.

This is how it works for the house property. All cash flows for the 10 years remain the same. Year 11 value is the expected sale price of the property. The value (is that price?) of the house property then becomes a function of both the expected rate of return and the expected sale price at year 11. 

If the investor reckons that it will be sold for say, Rs.27.50 m, the value of the property becomes Rs.13.70 m at 10% expected rate of return. At the market price of Rs.17.50 m, the investor will have to sell the property for Rs.37.34 m in year 11 in order to get a rate of return of 10%. With all the speculation about market prices after a decade, it becomes murkier. 

There isn't much choice for the investor. A better gamble would be this: Buy the property at the market price, with limited application of timing (i.e. buy when the prices are generally lower); live until the working life; upon retirement, sell the expensive property and move to a place where the prices are more reasonable on a relative basis.

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.