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WWAR 2.002

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What we are reading – Volume <strong>2.002</strong><br />

<br />

India Strategy<br />

- ICICI Securities<br />

<br />

Uttar Pradesh-Breaking free from the shackles of ‘BIMARU’ tag<br />

- Spark Capital<br />

<br />

Update on how is GST progressing<br />

- Edelweiss<br />

<br />

Cheap data driving profound changes<br />

- Neelkanth Mishra<br />

<br />

The Value of ‘Overvalued’ Stocks<br />

- Outlook Business<br />

<br />

This investor rivals Warren Buffett and you probably haven’t heard of him<br />

- Market Watch<br />

<br />

Global Macro Mid-Year Outlook<br />

-Morgan Stanley<br />

<br />

The Psychology of Money<br />

- The Collaborative Fund


`<br />

Equity Research<br />

May 29, 2018<br />

Nifty 50: 10633<br />

ICICI Securities Limited<br />

is the author and<br />

distributor of this report<br />

Cashless status report<br />

Cash is back: CIC at 11.6% of<br />

GDP (18-May’18) – back in range<br />

14%<br />

12%<br />

10%<br />

8%<br />

6%<br />

4%<br />

CIC as a % of GDP<br />

Cashless transactions (ex-RTGS)<br />

continue to rise<br />

1,600<br />

1,400<br />

1,200<br />

1,000<br />

800<br />

600<br />

400<br />

200<br />

Previous report: “Tez-i in digital<br />

payments”<br />

11.6%<br />

Jan 11<br />

May 11<br />

Sep 11<br />

Jan 12<br />

May 12<br />

Sep 12<br />

Jan 13<br />

May 13<br />

Sep 13<br />

Jan 14<br />

May 14<br />

Sep 14<br />

Jan 15<br />

May 15<br />

Sep 15<br />

Jan 16<br />

May 16<br />

Sep 16<br />

Jan 17<br />

May 17<br />

Sep 17<br />

Jan 18<br />

May 18<br />

0<br />

Apr'11<br />

Cashless transactions (Volume in mn )<br />

Sep'11<br />

Feb'12<br />

Jul'12<br />

Dec'12<br />

May'13<br />

Research Analysts:<br />

Oct'13<br />

Mar'14<br />

Aug'14<br />

Jan'15<br />

Jun'15<br />

Nov'15<br />

Apr'16<br />

Sep'16<br />

Trendline<br />

Feb'17<br />

Jul'17<br />

72%<br />

Vinod Karki<br />

vinod.karki@icicisecurities.com<br />

+91 22 6637 7586<br />

Siddharth Gupta<br />

siddharth.gupta@icicisecurities.com<br />

+91 22 2277 7607<br />

Dec'17<br />

INDIA<br />

Strategy<br />

Cashless transactions continue their uptrend…<br />

so does cash in circulation<br />

As the transient effects of demonetisation fade, we analyse the latest trends in<br />

India’s move toward a cashless economy, which incidentally was one of the<br />

stated objectives of demonetisation. Key trends observed are:<br />

Cash levels in the economy did not decrease permanently: After dipping<br />

significantly post demonetisation, cash in circulation (CIC) at Rs19.33tn is back to<br />

the trend growth seen in the pre-demonetisation period which has resulted in CIC as<br />

a percentage of GDP inch closer to the pre-demonetisation level of ~12%.<br />

Value of cash withdrawals from ATMs has risen back to pre-demonetisation<br />

period at ~Rs2.5trn per month… In a trend reversal the amount of cash withdrawn<br />

from bank accounts via ATM’s has been inching up and is now comparable to trends<br />

seen pre-demonetisation.<br />

…although number of cash withdrawals continues to be below trend implying<br />

higher cash withdrawals per transaction at ATMs. As ATM transaction above a<br />

certain level (varies from bank to bank) are charged by banks, the quantum of cash<br />

withdrawal per ATM transaction has increased.<br />

Despite rising CIC, overall cashless transactions value (ex-RTGS) continues to<br />

grow at a faster pace than in pre demonetisation period… Overall cashless<br />

transactions (ex-RTGS) hit Rs82.8trn in Q4FY18, a robust 23% growth on the high<br />

base of last year. It indicates that the growth in electronic / digital transactions is a<br />

permanent and irreversible trend.<br />

…driven by NEFT, IMPS, UPI and cards at POS: Rise in cashless transactions is<br />

driven by NEFT (Rs18trn/month), IMPS (Rs1trn/month), UPI (Rs230bn/month) and<br />

card transactions (Rs810bn/month), growing YoY by 37%, 82%, 976% and 13%<br />

respectively.<br />

RBI’s KYC norms puts brake on the exponential rise of M-Wallets transaction<br />

value: M-Wallets transaction value grew exponentially from a pre- demonetisation<br />

base of Rs33bn/month to Rs130bn in Feb’18, but RBI’s KYC (Know your Customer)<br />

norms post Feb’18 have resulted in reversal in the value of M-Wallet transactions<br />

which fell to Rs100bn in Mar’18.<br />

POS terminals continue to rise along with number of cards issued by banks<br />

while ATM growth plateaus: Significant ramp-up by e-commerce players, banks<br />

and retail players has resulted in 2,590 POS per million persons up from 1,250 from<br />

the pre-demonetisation period. Credit cards outstanding grew a robust 26% for<br />

Q4FY18 and the number outstanding is 37mn at Mar’18-end. On the other hand the<br />

number of ATMs per million persons has remained flat at 184 since demonetisation,<br />

while Paper clearing is seeing a decline in transactions by value.<br />

Private sector banks have a distinct edge over their PSU counterparts in terms<br />

of electronic transactions, but the reverse is true for ATM networks and cash<br />

transactions at ATMs: To contextualise the impact of digital transactions, the share<br />

of internet and mobile transactions initiated by customers moved up to 85% in FY18<br />

from 3% in FY08 for HDFC Bank while during the same period the share of<br />

transactions handled by branches has fallen from 43% to 8%. Overall, private sector<br />

banks have an edge over PSU banks in electronic mode of transactions such as<br />

credit cards (Pvt bank share: 82%) and debit cards (43%) usage at POS, mobile<br />

banking (66%) and NEFT outward (51%) transactions. On the other hand PSU<br />

banks have an edge in terms of cash transactions in the form of wider ATM<br />

networks (PSU share: 71%) and higher share of cash withdrawal from ATMs (73%).<br />

Please refer to important disclosures at the end of this report


Strategy, May 29, 2018<br />

ICICI Securities<br />

Cash levels in the economy did not decrease<br />

permanently<br />

After dipping significantly post demonetisation, cash in circulation (CIC) at Rs19.33tn is<br />

back to the trend growth seen in the pre-demonetisation period which has resulted in<br />

CIC as a percentage of GDP inch closer to the pre-demonetisation level of ~12% as on<br />

18-May’18 (at 11.6%).<br />

Chart 1: Currency in circulation rose back sharply at Rs19.33tn as<br />

25<br />

Currency in circulation Trend - CIC Trend - but with the 2016 shift<br />

20<br />

(Rs tn)<br />

15<br />

10<br />

5<br />

0<br />

Jan-05<br />

Jul-05<br />

Jan-06<br />

Jul-06<br />

Jan-07<br />

Jul-07<br />

Jan-08<br />

Jul-08<br />

Jan-09<br />

Jul-09<br />

Jan-10<br />

Jul-10<br />

Jan-11<br />

Jul-11<br />

Jan-12<br />

Jul-12<br />

Jan-13<br />

Jul-13<br />

Jan-14<br />

Jul-14<br />

Jan-15<br />

Jul-15<br />

Jan-16<br />

Jul-16<br />

Jan-17<br />

Jul-17<br />

Jan-18<br />

Source: CEIC, ISec Research<br />

Chart 2: CIC at 11.6% of GDP – back in range<br />

14%<br />

CIC as a % of GDP<br />

12%<br />

11.6%<br />

10%<br />

8%<br />

6%<br />

4%<br />

Jan 11<br />

May 11<br />

Sep 11<br />

Jan 12<br />

May 12<br />

Sep 12<br />

Jan 13<br />

May 13<br />

Sep 13<br />

Jan 14<br />

May 14<br />

Sep 14<br />

Jan 15<br />

May 15<br />

Sep 15<br />

Jan 16<br />

May 16<br />

Sep 16<br />

Jan 17<br />

May 17<br />

Sep 17<br />

Jan 18<br />

May 18<br />

Note: Trailing 12-month GDP has been used, and for Apr’18 and May’18, advance estimates have been used<br />

Source: CEIC, ISec Research<br />

2


Strategy, May 29, 2018<br />

ICICI Securities<br />

Value of cash withdrawals back to pre-demon range,<br />

although number of withdrawals remains low<br />

In a trend reversal the amount of cash withdrawn from bank accounts via ATM’s have<br />

been inching up and is now comparable to trends seen pre-demonetisation, at around<br />

Rs2.5tn. However, number of cash withdrawals continues to be below trend implying<br />

higher cash withdrawals per transaction at ATMs. As ATM transactions above a certain<br />

level (varies from bank to bank) are charged by banks, the quantum of cash withdrawal<br />

per ATM transaction has increased.<br />

Chart 3: Value of withdrawals has come back within trend<br />

3.0<br />

2.5<br />

Value: Debit Card: Usage at ATMs<br />

Trendline<br />

2.0<br />

(Rs trn)<br />

1.5<br />

1.0<br />

0.5<br />

0.0<br />

Apr'11<br />

Jul'11<br />

Oct'11<br />

Jan'12<br />

Apr'12<br />

Jul'12<br />

Oct'12<br />

Jan'13<br />

Apr'13<br />

Jul'13<br />

Oct'13<br />

Jan'14<br />

Apr'14<br />

Jul'14<br />

Oct'14<br />

Jan'15<br />

Apr'15<br />

Jul'15<br />

Oct'15<br />

Jan'16<br />

Apr'16<br />

Jul'16<br />

Oct'16<br />

Jan'17<br />

Apr'17<br />

Jul'17<br />

Oct'17<br />

Jan'18<br />

Source: CEIC, ISec Research<br />

Chart 4: Number of withdrawals has reduced considerably<br />

900<br />

800<br />

700<br />

600<br />

500<br />

400<br />

300<br />

200<br />

100<br />

0<br />

Source: CEIC, ISec Research<br />

Number of usages (mn)<br />

Trendline<br />

Apr'11<br />

Jul'11<br />

Oct'11<br />

Jan'12<br />

Apr'12<br />

Jul'12<br />

Oct'12<br />

Jan'13<br />

Apr'13<br />

Jul'13<br />

Oct'13<br />

Jan'14<br />

Apr'14<br />

Jul'14<br />

Oct'14<br />

Jan'15<br />

Apr'15<br />

Jul'15<br />

Oct'15<br />

Jan'16<br />

Apr'16<br />

Jul'16<br />

Oct'16<br />

Jan'17<br />

Apr'17<br />

Jul'17<br />

Oct'17<br />

Jan'18<br />

3


Strategy, May 29, 2018<br />

ICICI Securities<br />

Overall cashless transactions continue to grow…<br />

Despite rising CIC, overall cashless transactions value (ex-RTGS) continues to grow at<br />

a faster pace than in pre-demonetisation period. Overall cashless transactions (ex-<br />

RTGS) hit Rs82.8trn in Q4FY18, a robust 23% growth on the high base of last year. It<br />

indicates that the growth in electronic / digital transactions is a permanent and<br />

irreversible trend.<br />

Table 1: Strong growth registered across payment modes<br />

Volume (mn)<br />

Value (Rs bn)<br />

Mode of Transaction<br />

Jan-Mar'17 Jan-Mar'18 Growth Jan-Mar'17 Jan-Mar'18 Growth<br />

RTGS (customer transactions) 30 34 12% 247,071 290,500 18%<br />

Paper Clearing 367 298 -19% 22,343 21,308 -5%<br />

Retail electronic clearing 1,208 1,505 25% 42,252 58,660 39%<br />

- NEFT 499 548 10% 38,527 52,759 37%<br />

- IMPS 190 309 63% 1,538 2,803 82%<br />

- NACH (National Automated Clearing House) 517 646 25% 2,154 3,073 43%<br />

Cards at POS 2,153 2,434 13%<br />

- Credit Card at POS 315 372 18% 948 1,234 30%<br />

- Debit Card at POS 852 902 6% 1,205 1,200 0%<br />

Pre-Paid Instruments (M-Wallets, PPI Cards, Vouchers) 918 1,000 9% 313 416 33%<br />

Cashless transactions (Ex-RTGS) 3,660 4,077 11% 67,062 82,818 23%<br />

UPI 14 501 34x 60 589 89x<br />

O/S Credit cards - Number and balance o/s (avg) 29 37 26% 504 666 32%<br />

Number of O/S cards – Debit Card (avg) 770 854 11%<br />

Number of POS (‘000s) (avg) 2,257 3,093 37%<br />

Number of ATMs (‘000s) (avg) 221 222 0%<br />

Mobile Banking 315 676 114% 4,394 3,649 -17%<br />

Debit Card – usage at ATM 2,115 2,235 6% 5,704 7,689 35%<br />

Source: CEIC, I-Sec Research<br />

To understand the demonetisation impact, we compared the numbers with the<br />

numbers extrapolated from the pre-demonetisation trend – and found that cashless<br />

transactions were up 55% in value terms and 72% in volume terms from the numbers<br />

suggested by the historic trend<br />

Chart 5: Monthly Cashless transactions (in value<br />

terms) (Ex-RTGS)<br />

(Rs tn)<br />

40<br />

35<br />

30<br />

25<br />

20<br />

15<br />

10<br />

5<br />

0<br />

Apr'11<br />

Sep'11<br />

Cashless transactions (Value)<br />

Feb'12<br />

Jul'12<br />

Dec'12<br />

May'13<br />

Oct'13<br />

Mar'14<br />

Aug'14<br />

Jan'15<br />

Jun'15<br />

Nov'15<br />

Apr'16<br />

Trendline<br />

Sep'16<br />

Feb'17<br />

Jul'17<br />

55%<br />

Dec'17<br />

Chart 6: Monthly Cashless transactions (in<br />

Volume terms) (Ex-RTGS)<br />

1,600<br />

1,400<br />

1,200<br />

1,000<br />

800<br />

600<br />

400<br />

200<br />

0<br />

Cashless transactions (Volume in mn )<br />

Trendline<br />

72%<br />

Apr'11<br />

Sep'11<br />

Feb'12<br />

Jul'12<br />

Dec'12<br />

May'13<br />

Oct'13<br />

Mar'14<br />

Aug'14<br />

Jan'15<br />

Jun'15<br />

Nov'15<br />

Apr'16<br />

Sep'16<br />

Feb'17<br />

Jul'17<br />

Dec'17<br />

Source: CEIC, I-Sec Research<br />

Source: CEIC, I-Sec Research<br />

4


Strategy, May 29, 2018<br />

ICICI Securities<br />

…driven by NEFT, IMPS, UPI and cards at POS<br />

Rise in cashless transactions is driven by NEFT (Rs18trn/month), IMPS<br />

(Rs1trn/month), UPI (Rs230bn/month) and card transactions (Rs810bn/month),<br />

growing YoY by 37%, 82%, 976% and 13% respectively..<br />

Chart 7: NEFT continues on the growth path<br />

25<br />

NEFT Value<br />

NEFT: Volume<br />

250<br />

20<br />

200<br />

15<br />

150<br />

(Rs tn)<br />

10<br />

100<br />

(mn)<br />

5<br />

50<br />

0<br />

0<br />

Apr-11<br />

Aug-11<br />

Dec-11<br />

Apr-12<br />

Aug-12<br />

Dec-12<br />

Apr-13<br />

Aug-13<br />

Dec-13<br />

Apr-14<br />

Aug-14<br />

Dec-14<br />

Apr-15<br />

Aug-15<br />

Dec-15<br />

Apr-16<br />

Aug-16<br />

Dec-16<br />

Apr-17<br />

Aug-17<br />

Dec-17<br />

Source: CEIC, ISec Research<br />

Chart 8: IMPS continues its exponential growth<br />

1,200<br />

IMPS: Value<br />

IMPS Volume<br />

120<br />

1,000<br />

100<br />

800<br />

80<br />

(Rs bn)<br />

600<br />

400<br />

60<br />

40<br />

(mn)<br />

200<br />

20<br />

0<br />

0<br />

Apr-11<br />

Aug-11<br />

Dec-11<br />

Apr-12<br />

Aug-12<br />

Dec-12<br />

Apr-13<br />

Aug-13<br />

Dec-13<br />

Apr-14<br />

Aug-14<br />

Dec-14<br />

Apr-15<br />

Aug-15<br />

Dec-15<br />

Apr-16<br />

Aug-16<br />

Dec-16<br />

Apr-17<br />

Aug-17<br />

Dec-17<br />

Source: RBI, I-Sec Research<br />

Chart 9: UPI continues to grow at a rapid pace<br />

300<br />

Amount (Rs. in bn)<br />

Volume (mn)<br />

250<br />

200<br />

150<br />

100<br />

50<br />

0<br />

Aug-16<br />

Sep-16<br />

Oct-16<br />

Nov-16<br />

Dec-16<br />

Jan-17<br />

Feb-17<br />

Mar-17<br />

Apr-17<br />

May-17<br />

Jun-17<br />

Jul-17<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

Apr-18<br />

Source: RBI, I-Sec Research<br />

5


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 10: Continuous addition to the member banks on UPI<br />

120<br />

No. of Banks live on UPI<br />

100<br />

80<br />

60<br />

40<br />

20<br />

0<br />

Aug-16<br />

Sep-16<br />

Oct-16<br />

Nov-16<br />

Dec-16<br />

Jan-17<br />

Feb-17<br />

Mar-17<br />

Apr-17<br />

May-17<br />

Jun-17<br />

Jul-17<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

Apr-18<br />

Source: CEIC, ISec Research<br />

Chart 11: Total cards (value) at POS terminals<br />

spikes…<br />

Chart 12: …due to increase in debit cards usage<br />

1,000<br />

900<br />

Cards value at POS<br />

700<br />

600<br />

Credit Card Usage at POS<br />

Debit Card usage at POS<br />

800<br />

700<br />

600<br />

500<br />

400<br />

(Rs bn)<br />

500<br />

400<br />

300<br />

200<br />

100<br />

(rs bn)<br />

300<br />

200<br />

100<br />

0<br />

0<br />

Source: CEIC, ISec Research<br />

Source: CEIC, ISec Research<br />

The average value of a credit card transaction was within the range of Rs3,000-3,500<br />

after briefly falling to Rs2,683 in Dec’16, while the same for an average debit card<br />

swipe remains in the range of Rs1300-1500 with a mild downtrend<br />

Chart 13: Average transaction value remains in the normal range<br />

4,000<br />

3,500<br />

3,000<br />

2,500<br />

credit card at POS<br />

debit card at POS<br />

(Rs)<br />

2,000<br />

1,500<br />

1,000<br />

500<br />

0<br />

Apr-16<br />

May-16<br />

Jun-16<br />

Jul-16<br />

Aug-16<br />

Sep-16<br />

Oct-16<br />

Nov-16<br />

Dec-16<br />

Jan-17<br />

Feb-17<br />

Mar-17<br />

Apr-17<br />

May-17<br />

Jun-17<br />

Jul-17<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

Source: CEIC, ISec Research<br />

6


Strategy, May 29, 2018<br />

ICICI Securities<br />

RBI’s KYC norms puts brakes on the exponential rise of<br />

M-Wallets transaction value<br />

M-Wallets transaction value grew exponentially from a pre- demonetisation base of<br />

Rs33bn/month to Rs130bn in Feb’18, but RBI’s KYC (Know your Customer) norms<br />

post Feb’18 have resulted in reversal in the value of M-Wallet transactions which fell to<br />

Rs100bn in Mar’18.<br />

Chart 14: M-Wallets going out of favour due to<br />

KYC norms<br />

Chart 15: M-Wallets - volume<br />

140<br />

Value: m-Wallet<br />

350<br />

Volume: m-Wallet<br />

120<br />

300<br />

100<br />

250<br />

(Rs bn)<br />

80<br />

60<br />

(mn)<br />

200<br />

150<br />

40<br />

100<br />

20<br />

50<br />

0<br />

0<br />

Apr-11<br />

Sep-11<br />

Feb-12<br />

Jul-12<br />

Dec-12<br />

May-13<br />

Oct-13<br />

Mar-14<br />

Aug-14<br />

Jan-15<br />

Jun-15<br />

Nov-15<br />

Apr-16<br />

Sep-16<br />

Feb-17<br />

Jul-17<br />

Dec-17<br />

Apr-11<br />

Sep-11<br />

Feb-12<br />

Jul-12<br />

Dec-12<br />

May-13<br />

Oct-13<br />

Mar-14<br />

Aug-14<br />

Jan-15<br />

Jun-15<br />

Nov-15<br />

Apr-16<br />

Sep-16<br />

Feb-17<br />

Jul-17<br />

Dec-17<br />

Source: CEIC, ISec Research<br />

Source: CEIC, ISec Research<br />

Number of POS, Cards continue growth, ATMs plateau<br />

Significant ramp-up by e-commerce players, banks and retail players has resulted in<br />

2,590 POS per million persons up from 1,250 from the pre-demonetisation period.<br />

Credit cards outstanding grew a robust 26% for Q4FY18 and the number outstanding<br />

is 37mn at Mar’18-end. On the other hand the number of ATMs per million persons<br />

has remained flat at 184 since demonetisation, while Paper clearing is seeing a decline<br />

in transactions by value<br />

Chart 16: POS terminals see a demonetisation-induced spike<br />

3,000<br />

POS per mn persons (LHS)<br />

ATMs per mn persons (RHS)<br />

200<br />

195<br />

2,500<br />

190<br />

185<br />

2,000<br />

180<br />

175<br />

1,500<br />

170<br />

165<br />

1,000<br />

160<br />

155<br />

500<br />

150<br />

Apr-15<br />

Jun-15<br />

Aug-15<br />

Oct-15<br />

Dec-15<br />

Feb-16<br />

Apr-16<br />

Jun-16<br />

Aug-16<br />

Oct-16<br />

Dec-16<br />

Feb-17<br />

Apr-17<br />

Jun-17<br />

Aug-17<br />

Oct-17<br />

Dec-17<br />

Feb-18<br />

Source: CEIC, ISec Research<br />

7


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 17: Number of cards continues to grow<br />

1,000<br />

900<br />

Number of Outstanding Debit Card<br />

Number of Outstanding Credit Card (RHS)<br />

40<br />

36<br />

(mn)<br />

800<br />

700<br />

600<br />

32<br />

28<br />

24<br />

(mn)<br />

500<br />

Apr-16<br />

May-16<br />

Jun-16<br />

Jul-16<br />

Aug-16<br />

Sep-16<br />

Oct-16<br />

Nov-16<br />

Dec-16<br />

Jan-17<br />

Feb-17<br />

Mar-17<br />

Apr-17<br />

May-17<br />

Jun-17<br />

Jul-17<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

20<br />

Source: CEIC, ISec Research<br />

Chart 18: While paper clearing volumes are<br />

stable…<br />

(mn)<br />

160<br />

140<br />

120<br />

100<br />

80<br />

60<br />

40<br />

20<br />

0<br />

Apr-11<br />

Sep-11<br />

Feb-12<br />

Jul-12<br />

Dec-12<br />

May-13<br />

Paper Clearing: Volume<br />

Oct-13<br />

Mar-14<br />

Aug-14<br />

Jan-15<br />

Jun-15<br />

Nov-15<br />

Apr-16<br />

Sep-16<br />

Feb-17<br />

Jul-17<br />

Dec-17<br />

Chart 19: …its clearly falling in value terms<br />

(Rs tn)<br />

14<br />

Paper Clearing: Value<br />

12<br />

10<br />

8<br />

6<br />

4<br />

2<br />

0<br />

Apr-11<br />

Sep-11<br />

Feb-12<br />

Jul-12<br />

Dec-12<br />

May-13<br />

Oct-13<br />

Mar-14<br />

Aug-14<br />

Jan-15<br />

Jun-15<br />

Nov-15<br />

Apr-16<br />

Sep-16<br />

Feb-17<br />

Jul-17<br />

Dec-17<br />

Source: CEIC, ISec Research<br />

Source: CEIC, ISec Research<br />

8


Strategy, May 29, 2018<br />

ICICI Securities<br />

Private Banks have edge in electronic transactions, but<br />

reverse true for ATM networks and cash withdrawals<br />

To contextualise the impact of digital transactions, the share of internet and mobile<br />

transactions initiated by customers moved up to 85% in 2018 from 3% in 2008 for<br />

HDFC Bank while during the same period the share of transactions handled by<br />

branches has fallen from 43% to 8%.<br />

Chart 20: Axis Bank: Digital v/s Physical<br />

Digital<br />

ATM+Branch<br />

100%<br />

90%<br />

80%<br />

70%<br />

60%<br />

50%<br />

40%<br />

30%<br />

20%<br />

10%<br />

0%<br />

FY14 FY15 FY16 FY17 FY18<br />

Source: Company data, I-Sec research<br />

Chart 21: Axis – Bank branch size reduction<br />

120%<br />

100%<br />

100%<br />

Axis Bank: Branch area trends<br />

80%<br />

60%<br />

40%<br />

54%<br />

48%<br />

20%<br />

0%<br />

Till FY13 FY14+FY15 FY16+FY17<br />

Note: FY13 average indexed to 100<br />

Source: Company data, I-Sec research<br />

9


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 22: HDFC Bank: Shift to digital in a decade<br />

Phone<br />

Banking,<br />

14%<br />

% of customer initiated transactions by channel, 2008 v/s 2018<br />

Internet and<br />

Mobile, 3%<br />

Branches,<br />

43%<br />

2008 Branches,<br />

8%<br />

ATM, 6%<br />

Phone<br />

Banking,<br />

1%<br />

2018<br />

ATM, 40%<br />

Internet and<br />

Mobile, 85%<br />

Source: Company data, I-Sec research<br />

Table 2: SBI: Share of digital transactions up from 31% in FY17 to 37% in FY18<br />

Channels share of transactions Mar-18 Mar-17<br />

Digital<br />

Internet Banking 21 18<br />

POS 13 9<br />

Mobile Banking 3 3<br />

Digital Total 37 31<br />

Other Non-Branch<br />

ATM/CDM 34 37<br />

Banking Correspondents 9 7<br />

Non-Branch Total 80 75<br />

Branch 20 25<br />

Total 100 100<br />

Source: Company data, I-Sec research<br />

Chart 23: Growth in personal loans led by Credit Cards and “others”<br />

(Rs bn)<br />

1,400<br />

1,200<br />

1,000<br />

800<br />

600<br />

400<br />

200<br />

0<br />

-200<br />

Increase in 1 year<br />

Rate of growth<br />

40%<br />

35%<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

-5%<br />

Housing<br />

Vehicle<br />

Source: CEIC, I-Sec research<br />

Education<br />

Credit Card O/S<br />

Adv. against Fixed<br />

Deposits<br />

Cons. Durables<br />

Adv. against Share,<br />

Bonds<br />

Others<br />

10


Strategy, May 29, 2018<br />

ICICI Securities<br />

Overall, private sector banks have an edge over PSU banks in electronic mode of<br />

transactions such as credit cards (Pvt bank share – including foreign banks: 82%) and<br />

debit cards (43%) usage at POS, mobile banking (66%) and NEFT outward (51%)<br />

transactions. On the other hand PSU banks have an edge in terms of cash<br />

transactions in the form of wider ATM networks (PSU share: 71%) and higher share of<br />

cash withdrawal from ATMs (73%).<br />

Chart 24: Mobile Banking: Private sector banks lead with a 63% share by value<br />

120<br />

Other PSU Banks SBI & Associates Pvt bank<br />

100<br />

Volume - mobile transactions (mn)<br />

80<br />

60<br />

40<br />

20<br />

0<br />

Jan-15<br />

Jun-15<br />

Dec-15<br />

Jun-16<br />

Dec-16<br />

Jun-17<br />

1,800<br />

1,600<br />

1,400<br />

1,200<br />

1,000<br />

800<br />

600<br />

400<br />

200<br />

0<br />

Jan-15<br />

Jun-15<br />

Dec-15<br />

Jun-16<br />

Dec-16<br />

Jun-17<br />

(Rs bn)<br />

Other PSU Banks SBI & Associates Pvt bank<br />

Value - mobile transactions (Rs bn)<br />

Source: CEIC, RBI, I-Sec research<br />

Chart 25: Private sector banks have the largest POS network with 59% share<br />

2,000,000<br />

1,800,000<br />

1,600,000<br />

1,400,000<br />

1,200,000<br />

1,000,000<br />

800,000<br />

600,000<br />

400,000<br />

200,000<br />

0<br />

Apr-11<br />

Other PSU Banks SBI & Associates Pvt bank<br />

Number of POS<br />

Sep-11<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

Source: CEIC, RBI, I-Sec research<br />

11


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 26: Credit Cards: Private Banks with 64% outstanding cards and 59% of<br />

transactions at POS (value terms) are clear leaders<br />

25<br />

20<br />

Other PSU Banks SBI & Associates Pvt bank Foreign Bank<br />

Outstanding Credit Cards<br />

15<br />

(mn)<br />

10<br />

5<br />

0<br />

Apr-11<br />

Sep-11<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

(mn)<br />

80<br />

70<br />

60<br />

50<br />

40<br />

30<br />

20<br />

10<br />

0<br />

Apr-11<br />

Other PSU Banks SBI & Associates Pvt bank Foreign Bank<br />

Number of Usages at POS<br />

Sep-11<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

300<br />

250<br />

Other PSU Banks SBI & Associates Pvt bank Foreign Bank<br />

Value of Usages at POS<br />

200<br />

(Rs bn)<br />

150<br />

100<br />

50<br />

0<br />

Apr-11<br />

Jul-11<br />

Nov-11<br />

Mar-12<br />

Jul-12<br />

Nov-12<br />

Mar-13<br />

Jul-13<br />

Nov-13<br />

Mar-14<br />

Jul-14<br />

Nov-14<br />

Mar-15<br />

Jul-15<br />

Nov-15<br />

Mar-16<br />

Jul-16<br />

Oct-16<br />

Feb-17<br />

Jun-17<br />

Oct-17<br />

Feb-18<br />

Source: CEIC, RBI, I-Sec research<br />

12


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 27: Debit Cards: PSU Banks lead in number of cards (PSU share: 84%), ATM<br />

transactions (73% by value) but lag in POS transactions (57% only)<br />

(mn)<br />

500<br />

450<br />

400<br />

350<br />

300<br />

250<br />

200<br />

150<br />

100<br />

50<br />

0<br />

Apr-11<br />

Sep-11<br />

Other PSU Banks SBI & Associates Pvt bank<br />

Outstanding Debit Cards<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

(mn)<br />

160<br />

140<br />

120<br />

100<br />

80<br />

60<br />

40<br />

20<br />

0<br />

Apr-11<br />

Sep-11<br />

Other PSU Banks a SBI & Associates Pvt bank<br />

No of usage at POS<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

250<br />

200<br />

Other PSU Banks a SBI & Associates Pvt bank<br />

Value of usage at POS<br />

150<br />

(Rs bn)<br />

100<br />

50<br />

0<br />

Apr-11<br />

Jul-11<br />

Nov-11<br />

Mar-12<br />

Jul-12<br />

Nov-12<br />

Mar-13<br />

Jul-13<br />

Nov-13<br />

Mar-14<br />

Jul-14<br />

Nov-14<br />

Mar-15<br />

Jul-15<br />

Nov-15<br />

Mar-16<br />

Jul-16<br />

Oct-16<br />

Feb-17<br />

Jun-17<br />

Oct-17<br />

Feb-18<br />

Source: CEIC, RBI, I-Sec research<br />

13


Strategy, May 29, 2018<br />

ICICI Securities<br />

(mn)<br />

450<br />

400<br />

350<br />

300<br />

250<br />

200<br />

150<br />

100<br />

50<br />

0<br />

Apr-11<br />

Sep-11<br />

Other PSU Banks SBI & Associates Pvt bank<br />

No of withdrawals at ATMs<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

1,200<br />

1,000<br />

800<br />

Other PSU Banks a SBI & Associates Pvt bank<br />

Value of withdrawals at ATMs<br />

600<br />

400<br />

200<br />

0<br />

Apr-11<br />

Jul-11<br />

Nov-11<br />

Mar-12<br />

Jul-12<br />

Nov-12<br />

Mar-13<br />

Jul-13<br />

Nov-13<br />

Mar-14<br />

Jul-14<br />

Nov-14<br />

Mar-15<br />

Jul-15<br />

Nov-15<br />

(Rs bn)<br />

Mar-16<br />

Jul-16<br />

Oct-16<br />

Feb-17<br />

Jun-17<br />

Oct-17<br />

Feb-18<br />

Source: CEIC, RBI, I-Sec research<br />

Chart 28: While PSU Banks have the largest ATM network, they have been<br />

reducing the quantum since Apr’17 (71% ATMs as at Mar’18)<br />

100,000<br />

90,000<br />

80,000<br />

70,000<br />

60,000<br />

50,000<br />

40,000<br />

30,000<br />

20,000<br />

10,000<br />

0<br />

Apr-11<br />

Sep-11<br />

Other PSU Banks SBI & Associates Pvt bank<br />

Number of ATMs<br />

Mar-12<br />

Sep-12<br />

Mar-13<br />

Sep-13<br />

Mar-14<br />

Sep-14<br />

Mar-15<br />

Sep-15<br />

Mar-16<br />

Sep-16<br />

Feb-17<br />

Aug-17<br />

Feb-18<br />

Source: CEIC, RBI, I-Sec research<br />

14


Strategy, May 29, 2018<br />

ICICI Securities<br />

Chart 29: NEFT: Private Banks lead with a 37% share as in Apr’18 (value)<br />

120<br />

100<br />

Other PSU Banks SBI & Associates Pvt bank Foreign Bank<br />

Number of NEFT outward transaction<br />

80<br />

60<br />

40<br />

20<br />

0<br />

Jan-13<br />

(Rs tn)<br />

Jun-13<br />

Dec-13<br />

Jun-14<br />

Dec-14<br />

Jun-15<br />

Dec-15<br />

Jun-16<br />

Dec-16<br />

Jun-17<br />

Dec-17<br />

10<br />

9<br />

8<br />

7<br />

6<br />

5<br />

4<br />

3<br />

2<br />

1<br />

0<br />

Jan-13<br />

Other PSU Banks SBI & Associates Pvt bank Foreign Bank<br />

Value of NEFT outward transaction<br />

Jun-13<br />

Dec-13<br />

Jun-14<br />

Dec-14<br />

Jun-15<br />

Dec-15<br />

Jun-16<br />

Dec-16<br />

Jun-17<br />

Dec-17<br />

Source: CEIC, RBI, I-Sec research<br />

15


SPARK STRATEGY<br />

Uttar Pradesh – Breaking free from the shackles of the BIMARU tag<br />

We travelled over 1000Kms across the length and breadth of Uttar Pradesh over a period of 7 days meeting various businesses each day to<br />

gauge the pulse on hats changing in the state. We conclude that UP is breaking free from the shackles of infamous BIMARU tag and is<br />

emerging as a major demand driver for many sectors such as Auto, Consumer durables, FMCG, Retail and NBFCs. We believe five epochal<br />

changes in UP in recent years have put the state at a juncture where other developed states like Gujarat, TN, Maharashtra etc. were a decade<br />

ago. These changes are: 1) Change in law and order situation and the resultant peace dividend 2) Change in road infrastructure 3) Change in<br />

availability of electricity supply 4) Youngest population among major states, and 5) Per capita income crossing the $1000 mark, an important<br />

threshold which was crossed by other developed states Gujarat, Maharashtra, TN and Karnataka a decade ago. These changes should result in<br />

a disproportionate growth for UP heavy businesses over a medium term. Most B2C companies are realigning their distribution to ride this<br />

theme ahead. From Spark coverage universe, recent commentary from Hero, Maruti, MMFS, V-Mart and Britannia are reinvigorating the same.<br />

Why Uttar Pradesh matters? If UP were a separate country, it would be the 5 th most populous country in the world after China, India, USA and<br />

Indonesia. With 224mn population, UP is comparable with Brazil (208mn) and in terms of GDP, UP ($219bn) is comparable with Bangladesh<br />

($221bn). With 27% y-o-y growth in motorcycle sales and 23% y-o-y growth in Passenger Vehicles (PVs) during in 9MFY18, UP has emerged the<br />

fastest growing market for Auto companies. Moreover, UPs share in total motorcycle sales in India has jumped from 15% in FY17 to 17% in<br />

9MFY18 and share of PVs has increased from 7.3% in FY17 to 8.4% in 3QFY18. Britannia has posted 15.2% y-o-y growth in biscuit sales in UP in<br />

FY18, making it one of the fastest growing markets for the company.<br />

What is changing in UP? There are five major changes which, we think, are pivotal in putting UP on higher growth trajectory:<br />

#1: Law and order: The state has launched a massive crackdown on criminals in the last 12 months. As per UP Police, 50 most wanted criminals<br />

have died in various encounters in the last 12 months, ~4,881 criminals have been arrested and ~5,500 criminals have applied for bail<br />

cancellation. We believe that the peace dividend can have palpable prospective impact on UP.<br />

#2: Improving road infrastructure. After our 1000Km+ road trip in UP, we are convinced that UP today has the best road infrastructure in the<br />

country. Total state govt. spends on roads & bridges at Rs 708bn in the last four years (FY14-FY17) is 1.4x the combined spend in the previous ten<br />

years (Rs. 505bn).<br />

#3: Improvement in electricity supply: Electricity availability in rural areas has seen three-fold jump from 5hrs of availability in 2012 to 18hrs of<br />

availability in 2018, while it is up 2x in urban areas from 12hrs in 2012 to 22hrs in 2018. Despite electricity demand going up, the power deficit has<br />

fallen down to 2% in FY17 down from 22% in FY10.<br />

#4: Demographic dividend: UP has the youngest population among major states with median age of 20 years which is quite low as compared to<br />

the matured states like Kerala (31 years), Tamil Nadu (29 years), Andhra (27 years) and Karnataka (26 years). Notably, adult population (age 10-19<br />

years) comprises of ~25% of total population of Uttar Pradesh, which is the highest among major States.<br />

#5: Increase in per capita income: At $1000 per capita income, UP has reached an important threshold where Gujarat, Maharashtra, TN and<br />

Karnataka were a decade ago. Further, in a state where 23% of the GDP is constituted by agriculture, Govt. focus on doubling farers income<br />

would lead to improvement in rural cash flows. We expect UPs per capita income to grow at a CAGR of 11.2% from $1006 in FY19 to $1900 by<br />

FY25E, resulting in disproportionate growth for durable goods, clothing & footwear, entertainment, medical products & services categories.<br />

find SPARK RESEARCH on<br />

(SPAK )<br />

SPARK STRATEGY<br />

22 May 2018<br />

BSE Sensex 34,616<br />

NSE Nifty 10,516<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

-5%<br />

May-17<br />

Jun-17<br />

Jul-17<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

Apr-18<br />

May-18<br />

Performance (%)<br />

Sensex BSE 200<br />

1m 3m 12m<br />

Sensex -2.1% 0.2% 10.8%<br />

BSE200 0.6% 2.3% 13.6%<br />

RESEARCH ANALYSTS<br />

GAUTAM SINGH<br />

gautam@sparkcapital.in<br />

+91 22 6176 6804<br />

VIJAYARAGHAVAN SWAMINATHAN<br />

raghavan@sparkcapital.in<br />

+91 44 4344 0022<br />

ARJUN N<br />

arjun@sparkcapital.in<br />

+91 44 4344 0081<br />

Page 2


Ears on the Ground – Takeaways from our on road trip in UP<br />

#1: Improvement in cash<br />

flow situation in rural UP<br />

Cash flows in rural UP has improved in last few months led by pick up in non-farm activities and higher realization for<br />

potato and sugarcane farmers. Potato price are up ~100% in last two months.<br />

#2: Sharp pick-up in<br />

demand for Tractors<br />

#3: Two Wheelers<br />

demand on the rise<br />

There is a clear pickup in tractor demand mainly from agriculture, construction and haulage segment. Labour shortage<br />

and need for replacement for old trucks aided by easy availability of finance are some of the major factors that are<br />

driving tractor sales.<br />

Hero is the market leader in


A) Why Uttar Pradesh matters?<br />

#1: If Uttar Pradesh were a country, it would be comparable with Brazil in population and with Bangladesh in GDP<br />

#1: If UP were a separate country, it would be the 5th most populous country #2: Every country in Africa, Europe, and South America has fewer people than UP<br />

1600<br />

1400<br />

1200<br />

1000<br />

1,370<br />

1,282<br />

Population (mn)<br />

In terms of population,<br />

UP is marginally bigger<br />

than Brazil<br />

800<br />

600<br />

400<br />

200<br />

323<br />

261 224 208 193 186<br />

USA<br />

China<br />

Indonesia<br />

India<br />

0<br />

China India United<br />

States<br />

Indonesia UP Brazil Pakistan Nigeria<br />

Countries less populous than UP<br />

Source: World Bank, Spark Capital Research<br />

Source: World Bank, Spark Capital Research<br />

#3: In terms of GDP, UP is comparable with Bangladesh<br />

#4: Key Statistics: UP vs. all states<br />

GDP ($ bn)<br />

297.0 296.5 295.5<br />

282.5 278.9<br />

Singapore<br />

Malaysia<br />

South Africa<br />

Colombia<br />

Pakistan<br />

Source: World Bank, Spark Capital Research<br />

247.0 238.7<br />

Chile<br />

Finland<br />

221.4 219.0<br />

Bangladesh<br />

UP<br />

Parameters Uttar Pradesh All States<br />

GDP size ($bn) 219 2577<br />

Share in India's GDP (%) 9% 100%<br />

Per capita GDP ($) 1,006 1,975<br />

Total population (mn) 224 1,282<br />

Population density (persons/sq km) 829 382<br />

Sex ratio (females per 1,000 males) 912 940<br />

Literacy rate (%) 67.7% 73.0%<br />

Installed power capacity (MW) 24,434 3,34,161<br />

National highway length (km) 9,017 1,22,432<br />

FDI equity inflows ($ mn) 652 3,67,900<br />

PPP projects (No) 537 9068<br />

SEZ (No) 12 222<br />

Capital Lucknow -<br />

No. of districts 71 662<br />

Source: GoI, Economic Survey, Spark Capital Research<br />

Page 4


A) Why Uttar Pradesh matters?<br />

#2: UP is emerging as a major demand driver for many sectors like Auto, FMCG, Retail etc. indicating a palpable surge in consumer demand in UP<br />

UP has emerged as the fastest growing market for two wheelers whereas rich<br />

states TN, Karnataka and Maharashtra are witnessing fatigue in demand<br />

UPs shae i total Motole sales i Idia has also juped fo % i FY to<br />

17% during 9MFY18<br />

27 26 25<br />

UP<br />

Chattisgarh<br />

Orissa<br />

23 22 21<br />

MP<br />

Bihar<br />

Assam<br />

18<br />

Jharkhand<br />

Motorcycle sales during 9MFY18 (%, yoy)<br />

10 10<br />

9<br />

6 6 5<br />

1 1<br />

-6 -7<br />

All States<br />

Delhi<br />

Gujarat<br />

Rajasthan<br />

Kerala<br />

WB<br />

Punjab<br />

Maharashtra<br />

Karnataka<br />

TN<br />

18%<br />

16%<br />

14%<br />

12%<br />

10%<br />

8%<br />

6%<br />

4%<br />

2%<br />

Share in total Motorcycle sales in India (%)<br />

17%<br />

13%<br />

15%<br />

12%<br />

9%<br />

9%<br />

6%<br />

5%<br />

5%<br />

FY11 FY12 FY13 FY14 H1FY15 FY16 FY17 9MY18<br />

UP Maharashtra Karnataka TN<br />

Source: SIAM, Spark Capital Research<br />

Source: SIAM, Spark Capital Research<br />

For passenger vehicles also UP has seen the highest growth during 9MFY18<br />

Britannia has posted 15.2% yoy growth in biscuit sales in UP in FY18, making it one<br />

of the fastest growing markets for the company<br />

23 22 20 19<br />

17 16<br />

Passenger vehicle sales during 9MFY18 (%, yoy)<br />

15 14<br />

11 11<br />

8<br />

7<br />

4<br />

30<br />

25<br />

20<br />

15<br />

Britannia's sales growth (%, yoy)<br />

15.2 15.6<br />

14.6<br />

12.7<br />

26.3<br />

22.8<br />

16<br />

-4<br />

-8<br />

-11<br />

10<br />

5<br />

9.4<br />

9.3<br />

UP<br />

Jharkhand<br />

Orissa<br />

Bihar<br />

Chattisgarh<br />

Gujarat<br />

WN<br />

Rajasthan<br />

Punjab<br />

Assam<br />

Kerala<br />

All States<br />

Tamil Nadu<br />

Delhi<br />

Maharashtra<br />

Karnataka<br />

0<br />

UP MP Gujarat<br />

FY16 FY17 FY18<br />

Source: SIAM, Spark Capital Research<br />

Source: Company presentation, Spark Capital Research<br />

Page 5


B) What is changing in Uttar Pradesh?<br />

#1: Law and order: UP, which is notorious for its poor Law & Order situation, has launched a assie akdo o iials…<br />

#1: UP govt. has opted for a massive crackdown on criminals in the last 12-months<br />

#2: Around 5000 criminals have been arrested and 5,500 have applied for bail<br />

cancelation in last one year<br />

The police has<br />

launched<br />

Opeatio<br />

Clea in Uttar<br />

Pradesh to deal<br />

with the<br />

wanted<br />

criminals.<br />

50 wanted<br />

criminals are dead<br />

4,881 criminals<br />

arrested<br />

5,500 criminals<br />

applied for bail<br />

cancelation<br />

A big rise in<br />

surrendering<br />

• 50 most wanted criminals have died in various<br />

encounters in last 12 months<br />

• 4,881 criminals have been arrested from the state<br />

• Around 5,500 criminals have applied for bail cancellation<br />

in last 12 months as they fear police encounter outside<br />

jail<br />

• A large number of criminals are either surrendering or<br />

have fled to neighbouring states.<br />

Source: Dainik Jagran, Spark Capital Research<br />

Source: Media reports, Spark Capital Research<br />

#3: Local people told us that there has been a significant change in intensity of<br />

vigilance in most of the places in the last few months<br />

#4: Mobile police patrolling (100 number) has been the most effective in<br />

controlling crimes<br />

• Withi te iutes<br />

of call, we aim to<br />

reach the doorstep<br />

of the caller in<br />

troule.<br />

• Strit istrutios<br />

are there from the<br />

top to control not<br />

only crime but to<br />

strop any form of<br />

extortion, eve<br />

teasig et.<br />

Source: Media reports, Spark Capital Research<br />

Source: Spark Capital Research<br />

Page 6


B) What is changing in Uttar Pradesh?<br />

…the peae diided o its eoo a e e udestood fo Si Lakas Peae Diided<br />

#1: Winds of change: We noted a toll plaza on inner ring road Agra that is now fully<br />

operated by only women employees – a completely unthinkable deed in old UP<br />

#2: Winds of change: Jaswant Prajapati , a food vendor in Lucknow o doest<br />

have to pay Rs. 600 weekly bribe to cops; a saving of Rs. 2,400 per month<br />

Jaswant Prajapati,<br />

who is a food<br />

vendor in Lucknow<br />

He earns ~Rs.<br />

1200 per day and<br />

saves half of it.<br />

Overall, activities<br />

have picked up as<br />

many new offices,<br />

five star hotels etc.<br />

have opened up<br />

reetl<br />

Source: Spark Capital Research<br />

Source: Spark Capital Research<br />

#3: Sri Lankan economy witnessed a sharp rebound post the decisive end of the<br />

civil war in May 2009<br />

#4: Night traffic and economic activities have increased - Takeaways from our<br />

interaction with Sateesh Kumar, a taxi driver in UP<br />

10.0<br />

9.0<br />

8.0<br />

7.0<br />

6.0<br />

5.0<br />

4.0<br />

3.0<br />

2.0<br />

1.0<br />

0.0<br />

9.1<br />

8.0<br />

3.5<br />

The Peace Dividend example from Sri Lanka<br />

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016<br />

Real GDP growth (%): Sri Lanka<br />

i. Never took any travel booking involving night travel in UP until recently<br />

because of fear of car being stolen or loot on the way.<br />

ii.<br />

iii.<br />

iv.<br />

Rise in night traffic in UP in last 6 months because the UP 100 mobile police<br />

patrolling has been very active at night.<br />

Every 10 Km, he sees a police patrol car UP 100, which has brought down<br />

criminal activities.<br />

He has started taking overnight bookings in UP. His cashflow has improved<br />

by 20% in last few months.<br />

v. Have bought one more car on finance and put it in Orix.<br />

Source: IMF, Spark Capital Research<br />

Source: Spark Capital Research<br />

Page 7


B) What is changing in Uttar Pradesh?<br />

#2: A sea change in road infra: UP now has the best road infrastructure in the country<br />

#1. Total state Govt. spend on roads & bridges at Rs 708bn in the last four years<br />

(FY14-FY17) is 1.4x the combined spend in the previous ten years<br />

#. UPs oads hae see the iggest tasfoatio i the out i the last<br />

three years both in urban and rural areas<br />

250<br />

200<br />

150<br />

Spend on roads & bridges in FY14-FY17= Rs 708bn<br />

Spend on roads & bridges in FY04-FY13 = Rs. 505bn<br />

Total spend in last 4 yrs = 1.4x the combined spend in<br />

the previous ten years<br />

131<br />

169<br />

188<br />

220<br />

Agra-Lucknow expressway is the<br />

longest expressway in India<br />

Even rural areas now are well connected<br />

with nearby cities through good roads<br />

100<br />

50<br />

16<br />

39<br />

56 57 63<br />

56 63 64<br />

85<br />

-<br />

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17<br />

UP Govt. spend on road & bridges (RS. bn)<br />

Source: RBI, Spark Capital Research<br />

Source: Spark Capital Research<br />

#3: MHCV sales in UP have seen massive jump during 9MFY18 #4: Takeaways from our interaction with leading CV financer in UP<br />

85<br />

UP<br />

55<br />

Chattisgarh<br />

33<br />

Rajasthan<br />

28 27 27<br />

Jharkhand<br />

Orissa<br />

MP<br />

Source: SIAM, Spark Capital Research<br />

MHCV sales during 9MFY18 (%, yoy)<br />

i. There as a sharp jup i dead for MHCVs i UP durig Apr-Mar,<br />

mainly led by infra spend by Govt.<br />

21 20 17 14 10<br />

Punjab<br />

All States<br />

Maharashtra<br />

Assam<br />

WB<br />

5 1 0<br />

Kerala<br />

Bihar<br />

Karnataka<br />

-2<br />

TN<br />

-9<br />

Delhi<br />

-16<br />

Gujarat<br />

ii.<br />

iii.<br />

iv.<br />

Strict laws against overloading and high infra demand led to the pick up in<br />

demand for CVs. Govt relaxed the overloading limit in UP leading to demand<br />

tapering off for higher tonnage CVs and down trading to lower tonnage.<br />

Tata Motors, Ashok Leyland, Bharat Benz and Eicher motors (in this order) are<br />

the leading players in MHCV market with Tata Motors being the leader with<br />

50%+ market share. Tata Motors has lost market share in this region.<br />

Ashok Leyland has been very aggressive in this market during last year and it<br />

has gained market share from 24% a year ago to 37% now.<br />

Source: Spark Capital Research<br />

Page 8


B) What is changing in Uttar Pradesh?<br />

#3: Electricity availability in rural areas has seen three-fold jump while it is up 2x in urban areas vs. 2012<br />

#1. Sharp improvement in availability of electricity in last 2 years<br />

#2. Energy deficit has tapered down to 2% in FY17 down from 22% in FY10<br />

25<br />

Number of hours availability of electricity in UP<br />

22<br />

120<br />

25%<br />

20<br />

18<br />

18<br />

100<br />

22%<br />

20%<br />

15<br />

10<br />

5<br />

5<br />

12<br />

10<br />

80<br />

60<br />

40<br />

20<br />

17%<br />

15%<br />

16%<br />

14%<br />

11%<br />

92 95<br />

103 106<br />

76 76 81<br />

59 65 72 76 82 87<br />

107<br />

13%<br />

93<br />

106<br />

2%<br />

15%<br />

10%<br />

5%<br />

0<br />

2012 2015 2018<br />

0<br />

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17<br />

0%<br />

Rural areas<br />

Urban areas<br />

Energy Required (BU) Energy availability (BU) Energy Deficit (%)<br />

Source: Spark Capital Research<br />

Source: GoI, Spark Capital Research<br />

#3: State Got. ais to poide poe suppl Ma: Huge saigs fo<br />

industries and small establishments<br />

#1: Enhanced power supply: UP, which used to have prolonged power<br />

outages, has seen a remarkable improvement in last couple of years. This<br />

should help saving for industrialists and households spending on power<br />

gensets, inverters, batteries etc.<br />

#2: Crackdown on power thefts: Vigilance teams have been added, frequent<br />

raids on power thieves, replacing traditional meters with smart meters are<br />

the key measures the State Govt. has taken to stop power thefts.<br />

#3: Bodes well for demand for meters, transformers, cables and durable<br />

goods. Negative for genset, inverter and battery industries.<br />

What people said on power supply and electricity tariff hikes<br />

i. Most cities have been receiving ~22 hours<br />

a day power supply.<br />

ii.<br />

iii.<br />

iv.<br />

Demand for inverter and battery has<br />

taken a massive hit because of enhanced<br />

electricity supply.<br />

Electricity tariffs have been increased<br />

around 3x for un-metered connections<br />

for non-agriculture use.<br />

Rural people were complaining about<br />

the surge in electricity price<br />

Source: Spark Capital Research<br />

Source: Spark Capital Research<br />

Page 9


B) What is changing in Uttar Pradesh?<br />

#4: Demographic dividend: UP has the youngest population among major states with median age of 20 years<br />

1) Median age of Uttar Pradesh is the lowest in India at 20, which is<br />

quite low as compared to the matured states like Kerala (31 years),<br />

Goa (30 years), Tamil Nadu (29 years), Andhra (27 years) and<br />

Karnataka (26 years).<br />

2) Proportion of population with age group (10-19 years) at ~25%~, is<br />

the highest in India among major states.<br />

3) UP has the lowest share of elderly population (60 years or more)<br />

(7.7%) among major states.<br />

4) UP is set to reap the benefits of its young population ahead.<br />

Inter-state median age comparison of India<br />

Age group between 10-19 years account for ~25% of total population of<br />

Uttar Pradesh, which is the highest among major States<br />

Name of the State % Adolescent Name of the State % Adolescent<br />

Top 5 Bottom 5<br />

UTTAR PRADESH 24.5 KERALA 16.3<br />

RAJASTHAN 22.9 TAMIL NADU 17.2<br />

UTTARAKHAND 22.5 KARNATAKA 18.9<br />

BIHAR 22.5 MAHARASHTRA 19<br />

Source: JHARKHAND Census 2011<br />

22.2 ANDHRA PRADESH 19.3<br />

A<br />

A<br />

Source: Census 2011<br />

Page 10


B) What is changing in Uttar Pradesh?<br />

#5: At $1000 per capita income, UP has reached an important threshold where Gujarat, Maharashtra, TN and Karnataka were a decade ago…<br />

UP has crossed the $1000 per capita income mark this year which is very important<br />

for discretionary consumption; India crossed the $1000 mark a decade ago in FY08<br />

1,900<br />

1,700<br />

1,500<br />

1,300<br />

1,100<br />

In terms of per capita GDP, UP is<br />

following India with a decade lag.<br />

1,061<br />

1,960<br />

The richer states - Gujarat and Maharashtra crossed the $1000 per capita mark in<br />

FY06, Tamil Nadu did it in FY07 and Karnataka crossed this mark in FY08<br />

3,500<br />

3,000<br />

2,500<br />

2,000<br />

Uttar Pradesh is where Gujarat,<br />

Maharashtra, TN and<br />

Karnataka were a decade ago.<br />

900<br />

1,006<br />

1,500<br />

700<br />

500<br />

1,000<br />

1,049<br />

FY05<br />

FY06<br />

FY07<br />

FY08<br />

FY09<br />

FY10<br />

India<br />

FY11<br />

FY12<br />

FY13<br />

UP (T+11Yrs)<br />

FY14<br />

FY15<br />

FY16<br />

FY17<br />

FY18<br />

500<br />

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18<br />

Gujarat Karnataka Maharashtra Tamil Nadu<br />

Source: GoI, RBI, Spark Capital Research<br />

Source: GoI, RBI, Spark Capital Research<br />

Agriculture accounts for 23% of the state GDP. Centre Govt. focus on doubling<br />

faes ioe ould hae a diet ipat o the states ual eoo<br />

Agri, 23%<br />

Rural cash flow has improved – takeaways from interactions with farmers in UP<br />

i. Cash flow in rural area has increased in recent months in sugarcane/potato<br />

belts<br />

Services, 51%<br />

ii.<br />

iii.<br />

iv.<br />

Pick up in non-farm activities in rural areas have also resulted in better cash<br />

flow for rural people. Wage rate has been on the rise.<br />

This season potato prices are higher (up around 100% in last one month) due<br />

to loer produtio. This ear farers realizatio has goe up.<br />

Farmers are complaining about highly volatile prices of agri commodities.<br />

They want assured prices so that they can be sure of future income<br />

Industry, 26%<br />

v. Sugarcane output has been higher this year due to ~20% higher output<br />

leading to fall in sugar prices.<br />

Source: GoI, Spark Capital Research<br />

Source: GoI, Spark Capital Research<br />

Page 11


B) What is changing in Uttar Pradesh?<br />

…futhe ise i UPs pe apita ioe to $ FYE ould ea ig dead delta fo duale goods, lothig & footea, entertainment &<br />

medical and HH products & services categories<br />

…ad popotio of o-food categories like durables goods, clothing & footwear<br />

As per-apita ioe gos, popotio of food i oeall HH sped oes do…<br />

and other HH products & services goes up<br />

Share in HH expenditure in India (%)<br />

Key category-wise share in HH expenditure in India (%)<br />

Food<br />

Fuel & light<br />

41.5 46.8 51.9 53.5 57.0<br />

48.1<br />

43.0<br />

Tobacco & intoxicants<br />

HH products & services<br />

58.5 53.2 48.1 46.5 43.0<br />

1993-94 1999-00 2004-05 2009-10 2011-12<br />

Food Non-food<br />

Source: NSSO, Spark Capital Research<br />

Source: NSSO, Spark Capital Research<br />

8.3<br />

10.0<br />

1.9<br />

2.1<br />

21.4<br />

19.8<br />

7.0<br />

5.0<br />

3.8 6.2<br />

11.1 12.1<br />

2004-05 2011-12<br />

Clothing & footwear<br />

Durable goods<br />

Education, entertainment &<br />

medical<br />

We estimate rise in per capita income in UP from current $1000 to $1900 by<br />

…<br />

2000<br />

1800<br />

1600<br />

1400<br />

1200<br />

1000<br />

800<br />

600<br />

400<br />

200<br />

0<br />

325<br />

FY05<br />

FY06<br />

FY07<br />

FY08<br />

FY09<br />

FY10<br />

Source: CSO, Spark Capital Research<br />

FY11<br />

749<br />

FY12<br />

FY13<br />

FY14<br />

FY15<br />

FY16<br />

Per capita GDP of Uttar Pradesh ($)<br />

FY17<br />

FY18<br />

1006<br />

FY19<br />

FY20<br />

Estimate<br />

FY21<br />

FY22<br />

FY23<br />

FY24<br />

1900<br />

FY25<br />

…hih should esult i ig dead delta fo duale goods, lothig & footea,<br />

Education, entertainment & medical and HH products & services<br />

Key category-wise share in HH expenditure in UP (%)<br />

48.0<br />

8.1<br />

2.0<br />

16.0<br />

7.2<br />

4.3<br />

14.5 16.2<br />

Source: NSSO, Spark Capital Research<br />

41.3<br />

6.1<br />

1.7<br />

17.8<br />

9.5<br />

7.4<br />

2011-12 2024-25E<br />

Food<br />

Fuel & light<br />

Tobacco & intoxicants<br />

HH products & services<br />

Clothing & footwear<br />

Durable goods<br />

Education, entertainment & medical<br />

Page 12


B) What is changing in Uttar Pradesh?<br />

Uttar Pradesh: Then & Now<br />

Earlier (until FY15)<br />

Now<br />

Road<br />

Infra<br />

Law and<br />

order<br />

Road<br />

Infra<br />

Law and<br />

Order<br />

GDP<br />

Growth<br />

Power<br />

Supply<br />

GDP<br />

Growth<br />

Power<br />

Supply<br />

Income per<br />

capita<br />

Dependency on<br />

Agriculture<br />

Income per<br />

capita<br />

Dependency on<br />

Agriculture<br />

Services<br />

Demography<br />

Services<br />

Demography<br />

sector<br />

sector<br />

Positive<br />

Negative<br />

Neutral<br />

Page 13


C) Ears on the Ground – Takeaas fo ou oad tip i UP i Ap<br />

1,000 kms + 200 plus channel checks in urban and rural pockets of Uttar Pradesh<br />

Spark Ears on the Ground Juggernaut<br />

The Spark strategy team traversed more than 1000 kms across the length and breadth<br />

of the Uttar Pradesh over a period of 7 days doing varied channel checks each day to<br />

judge the general demand scenario<br />

Visited more than 50 major urban and rural pockets of Uttar Pradesh with<br />

an objective to understand the current demand scenario and to identify<br />

emerging trends<br />

500+ touch points across key urban and rural pockets of UP were covered<br />

Our channel checks included:<br />

Saharanpur<br />

• Apparels shops<br />

• Auto & Auto ancs. dealers<br />

• Bank & NBFC branches<br />

• Bureaucrats, Media generalists<br />

• Cement dealers, tiles & building materials<br />

• Construction sites<br />

• Consumer durable outlets<br />

• Four wheeler dealers<br />

• Farmers, labourers<br />

• Pharmacy<br />

• Real estate developers, agents etc.<br />

• Regional sales-head, wholesalers<br />

• Toll plazas, luxury stores<br />

• Truck operators<br />

• Two wheeler dealers<br />

Shamli<br />

Meerut<br />

Ghaziabad<br />

Delhi Noida<br />

Hathras<br />

Agra<br />

Etawah<br />

Kanpur<br />

Unnao<br />

Barabanki<br />

Lucknow<br />

Page 14


Appendix: UP Budget FY19: Market borrowings to jump 22.4% yoy to Rs. 671bn in FY19BE<br />

Fiscal deficit and debt management<br />

#1: Fiscal deficit has been budgeted to remain largely unchanged at 2.96% of GDP<br />

in FY9BE, within the FRBM limit<br />

6.0%<br />

5.0%<br />

4.0%<br />

3.0%<br />

2.0%<br />

1.0%<br />

0.0%<br />

5.3%<br />

4.50%<br />

Source: UP Budget, Spark Capital Research<br />

2.95% 2.98% 2.96%<br />

FY16 FY17 FY18BE FY18RE FY19BE<br />

Fiscal Deficit (% of GDP)<br />

#2: Market borrowings has been budgeted to increase by 22.4% in FY19<br />

800<br />

22.4%<br />

700<br />

600<br />

6.8% 5.4%<br />

500<br />

4.0%<br />

400<br />

300<br />

200<br />

-15.0%<br />

100<br />

745 677 575 549 671<br />

-<br />

FY16 FY17 FY18BE FY18RE FY19BE<br />

Market borrowings (Rs. bn)<br />

Market borrowings (% of GDP)<br />

Source: UP Budget, Spark Capital Research<br />

0.3<br />

0.2<br />

0.2<br />

0.1<br />

0.1<br />

0.0<br />

-0.1<br />

-0.1<br />

-0.2<br />

-0.2<br />

#3: Interest servicing as a % of expenditure has been budgeted to fall to 7.6% of<br />

total expenditure in FY19BE<br />

10%<br />

9%<br />

8%<br />

7%<br />

6%<br />

5%<br />

4%<br />

3%<br />

2%<br />

1%<br />

0%<br />

9.3%<br />

8.1%<br />

Source: UP Budget, Spark Capital Research<br />

8.6%<br />

8.2%<br />

7.6%<br />

FY16 FY17 FY18BE FY18RE FY19BE<br />

Interest Servicing (% total expenditure)<br />

#4: Govt. aims to gradually reduce outstanding debt, which stood at 29.8% of GDP<br />

in FY18RE<br />

30.2%<br />

30.0%<br />

29.8%<br />

29.6%<br />

29.4%<br />

29.2%<br />

29.0%<br />

28.8%<br />

28.6%<br />

30.0%<br />

29.9%<br />

Source: UP Budget, Spark Capital Research<br />

29.5%<br />

29.8%<br />

29.1%<br />

FY16 FY17 FY18BE FY18RE FY19BE<br />

Outstanding debt (% of GDP)<br />

Page 30


Appendix: UP Budget FY19: Key takeaways<br />

Spending in irrigation has increased 31.6% in<br />

FY19BE over FY18RE to Rs. 142bn<br />

Fiscal deficit has been budgeted to remain<br />

largely unchanged at 2.96% of GDP in FY9BE,<br />

within the FRBM limit<br />

Rs 16.5bn has been allocated for<br />

the Smart Cities Mission<br />

Urban Infra<br />

Irrigation<br />

Fiscal deficit<br />

Total<br />

Expenditure<br />

The total expenditure in FY19 is<br />

targeted at Rs. 4,3tn. This is<br />

16.3% higher than FY18RE<br />

Capex is budgeted to increase<br />

by 30.5% in FY19 while revex is<br />

budgeted to increase at a<br />

moderate pace of 12.2%<br />

Capex vs.<br />

Revex<br />

Market<br />

Borrowings<br />

Market borrowings has been<br />

budgeted to increase by 22.4%<br />

to Rs. 671bn in FY19BE<br />

The state is estimated to spend Rs.<br />

455bn on pensions, a 22% increase<br />

over FY18.<br />

Pension<br />

Shortfall in<br />

own tax<br />

revenue<br />

UP witnessed a 15% fall in tax<br />

revenue collections during<br />

FY18 over the budget<br />

estimates<br />

Out of Rs. 197bn allocated for rural<br />

development, Rs. 29bn will be spent<br />

on roads and bridges, and Rs. 12bn<br />

will be spent on housing.<br />

Rural<br />

Spend<br />

Fall in stamp<br />

duty<br />

Collections from stamp duty were<br />

28% lower than the budget<br />

estimates.<br />

GDP<br />

Subsidies<br />

The nominal GDP of UP for FY19 has been<br />

estimated to grow only at 8% yoy to Rs.14.9tn.<br />

UP is expected to spend Rs. 116bn on subsidies<br />

in FY19BE, which is 15% higher than FY18BE<br />

Page 31


Appendix: Energy, irrigation and rural development grab the maximum delta in spending in FY19BE<br />

Sectoral Spending – Major heads<br />

Department-wise expenditure<br />

Expenditure (Rs. bn)<br />

Growth (yoy)<br />

Key Highlights<br />

FY16 FY17 FY18BE FY18RE FY19BE FY18BE FY18RE FY19BE<br />

Agriculture 29 60 396 284 116 554.7% 369.5% -59.2%<br />

Rural development 101 104 158 159 197 51.6% 52.8% 23.7%<br />

Irrigation and Flood Control 103 107 110 109 143 2.6% 1.6% 31.6%<br />

Energy 482 340 177 181 278 -47.8% -46.8% 53.7%<br />

Education 401 490 624 570 632 27.2% 16.3% 10.9%<br />

Public Works 45 237 192 195 222 -19.0% -17.8% 13.8%<br />

Urban Development 52 62 134 131 135 114.6% 110.7% 2.6%<br />

Debt Repayment 176 203 220 220 305 8.4% 8.4% 38.8%<br />

Interest payment 284 269 332 303 324 23.3% 12.4% 7.1%<br />

Others 1406 217 225 225 278 3.6% 3.7% 23.6%<br />

Total Expenditure 3,039 3,334 3,847 3,685 4,284 15.4% 10.5% 16.3%<br />

• The allocations for agriculture sector has<br />

fallen 59% yoy in FY19BE because the<br />

state had implemented a farm loan waiver<br />

in FY18, resulting in higher spending<br />

during the year.<br />

• Out of the Rs. 197bn allocated to Rural<br />

development, Rs. 29bn will be spent on<br />

roads and bridges, and Rs. 12bn will be<br />

spent on rural housing.<br />

• While allocation for energy sector has<br />

seen 53.7% yoy jump, 62% of this<br />

allocation is for revenue expenses (such as<br />

payment of interests and subsidy), and<br />

only 38% is on capital expenses.<br />

• Rs. 16.5bn has been allocated for the<br />

Smart Cities Mission. Cities selected under<br />

the Mission are Lucknow, Kanpur, Agra,<br />

Varanasi, Allahabad, Aligarh, Jhansi,<br />

Moradabad, Bareli, and Saharanpur.<br />

• Allocation for various road projects:<br />

Gorakhpur Link Expressway: Rs 5.5bn,<br />

Purvanchal Expressway: Rs 10bn, Agra-<br />

Lucknow Expressway: Rs 5bn.<br />

Source: UP Budget, Spark Capital Research<br />

Page 32


EDEL PULSE<br />

THE SHIFT<br />

ANALYSIS BEYOND CONSENSUS<br />

THE SHIFT: 11 months of GST – Strict surveillance critical<br />

Eleven months post GST implementation, we revisit our long-term thesis<br />

of formalisation of the Indian economy (refer THE SHIFT: Unorganised to<br />

organised). An integrated tax structure and anti-evasion measures under<br />

GST (e-way bill, reverse charge mechanism (RCM), bilateral validation of<br />

invoices, among critical ones) are core to our thesis of demand shift from<br />

unorganised to organised players for certain sectors. While timelines for<br />

implementation of RCM and bilateral invoice validation are unclear, interstate<br />

e-way bill was implemented from April 1, 2018 (intra-state from<br />

June 01, 2018). Our on-ground interactions with trade<br />

(dealer/distributors), industry bodies and experts highlight: 1) in the<br />

immediate period post GST rollout, unorganised trade ruled the roost due<br />

to lack of anti-evasion measures; 2) e-way bill has been widely accepted<br />

across informal trade, despite below-par surveillance; and 3) organised<br />

players have regained some lost ground, though acceleration in shift of<br />

demand to organised players hinges on strict surveillance and rollout of<br />

all anti-evasion measures. While jewellery, battery and plastic products<br />

sectors have seen demand shift post GST, the organised building material<br />

(tiles/ plywood) sector has faced challenges from informal trade.<br />

GST collections: Tough ask, anti-evasion measures critical<br />

Aggregate FY18 GST collection stood at ~7.2tn (monthly ~INR900bn). While collections<br />

were strong in the first three months, they tapered off post October 2017 before<br />

touching an all-time high monthly collection of INR1,035bn (19% higher than monthly<br />

run rate till March 2018) in April 2018. The government has set an aggressive GST<br />

collection target for FY19, implying a monthly run rate of INR1,165bn (30% higher than<br />

FY18). We believe, it will be a tough task ahead in terms of GST collections’ trajectory<br />

and will hinge on strict implementation of anti-evasion measures and surveillance.<br />

Unorganised trade losing ground post e-way bill, though early days<br />

Our interactions with dealers / distributors, industry bodies, transporters and<br />

unorganised manufacturers indicate that unorganised trade activity has reduced post e-<br />

way bill implementation. A few indicated there is a visible change in attitude of trade<br />

channels towards compliance, as incentives to trade via informal channels have<br />

reduced considerably. Some believe the e-way bill will lead to improved compliance,<br />

though strict suvelliance by the government has yet to kick in.<br />

Multiple challenges lurk around surveillance<br />

Despite smooth roll out of e-way bill, there are multiple challenges that lurk in terms of:<br />

a) liberal validity of e-way bills leading to instances of multiple use of the same e-way<br />

bill; b) on-ground checks/ inspection by officials yet to pick up; c) lack of fear amongst<br />

trade channel regarding non-compliance; and d) under-invoicing, which remains a<br />

widely prevalent modality to evade taxes amongst informal trade, though its magnitude<br />

has reduced since GST implementation.<br />

Manoj Bahety<br />

+91 22 6623 3362<br />

manoj.bahety@edelweissfin.com<br />

Nilesh Aiya<br />

+91 22 4040 7575<br />

nilesh.aiya@edelweissfin.com<br />

Ankit Dangayach<br />

+91 22 6620 3077<br />

ankit.dangayach@edelweissfin.com<br />

Raj Koradia<br />

+91 22 6623 3422<br />

raj.koradia@edelweissfin.com<br />

June 4, 2018<br />

1 Edelweiss Securities Limited


Analysis Beyond Consensus<br />

Roll out of e-way bill smooth this far with no technical glitches<br />

State-wise phased implementation had led to smooth roll-out of e-way bill with no major<br />

systems related issues observed in the initial months. e-way bill has gained wide acceptance<br />

across different industries and geographies. However, intensity of surveillance of e-way bills<br />

differs from state to state. Some challenges faced by tax payers include part truck load and<br />

related compliance issues, confusion in case of transhipment/ goods moved in multiple<br />

trucks and inability of transporters to comply with norms, among others.<br />

GST collections tapered down after initial pick-up<br />

Chart 1: May GST Collections promising – however ask rate is higher<br />

(INR bn)<br />

1,250<br />

1,000<br />

750<br />

500<br />

Monthly GST Collection<br />

936 930 951<br />

859 837 889 880 893<br />

1,035<br />

940<br />

(INR bn)<br />

1,500<br />

1,200<br />

900<br />

600<br />

GST Collection - Asking rate<br />

897<br />

987<br />

1,201<br />

250<br />

300<br />

0<br />

Aug-17<br />

Sep-17<br />

Oct-17<br />

Nov-17<br />

Dec-17<br />

Jan-18<br />

Feb-18<br />

Mar-18<br />

Apr-18<br />

May-18<br />

0<br />

Avg (2017-18)<br />

Avg (April-<br />

May'18)<br />

FY19 avg<br />

monthly asking<br />

rate<br />

Source: Ministry of Finance, Edelweiss research<br />

Aggregate GST collection for FY18 (8 months - August17-March18) stood at ~INR7.2tn,<br />

implying average monthly collection of ~INR897bn. While collection was strong in the first<br />

three months, it tapered off post October’17 before touching an all-time high monthly<br />

collection of INR1,035bn (19% higher than Nov’17-Mar’18 average collections) in April’18.<br />

The government has stated that the spurt in April GST collection may have been a year-end<br />

phenomenon and its sustainability in subsequent months needs to be monitored.<br />

Collections data released for the month of May stood at ~INR940bn, which is promising,<br />

though the asking rate is higher and it will be challenging for the Government to meet the<br />

collection target.<br />

We believe the fall in GST collections during November 2017-March 2018 was primarily led<br />

by:<br />

1. Significant destocking of inventory across the distribution chain in the period leading to<br />

GST implementation. Post GST rollout, restocking took place at a brisk pace leading to<br />

high collections in Aug-Oct’18.<br />

2. Reduction in tax rates from 28% to 18% on 178 items with effect from November 15,<br />

2017.<br />

3. Deferment of implementation of anti-evasion measures like e-way bill, bilateral<br />

validation of invoices and RCM.<br />

2 Edelweiss Securities Limited


The SHIFT<br />

Chart 2: Compliance under composition scheme picking up – Primarily includes the small tax payers<br />

Quarterly returns filed<br />

Tax collected<br />

1,250<br />

1,147<br />

7.5<br />

1,000<br />

810<br />

925<br />

6.0<br />

5.8<br />

(''000s)<br />

750<br />

500<br />

(INR bn)<br />

4.5<br />

3.0<br />

3.4<br />

4.2<br />

250<br />

1.5<br />

0<br />

June-Sept 17 Oct-Dec 17 Jan-March 18<br />

0.0<br />

June-Sept 17 Oct-Dec 17 Jan-March 18<br />

Source: Ministry of Finance, Edelweiss research<br />

GST collections target for FY19, a tough ask<br />

The government’s FY19 budgeted GST collection, implies average monthly collection of<br />

INR1,165bn (up ~30% over FY18 monthly collection). After considering April-May aggregate<br />

GST collections of ~INR2tn, the ask rate for FY19 has gone up to ~INR1.2tn per month. The<br />

government is hopeful of gradual recovery in GST collections led by pick up of economic<br />

activity and implementation of anti-evasion measures like e-way bill, which was<br />

implemented from April 1, 2018 on inter-state transactions. Further, intra-state e-way bill<br />

also implemented from June 01, 2018 across India. We believe there are strong levers with<br />

the government to curb tax evasion, which will lead to higher compliance, increased tax<br />

collection over long term, and formalisation will benefit sectors with huge unorganised<br />

presence.<br />

3 Edelweiss Securities Limited


Analysis Beyond Consensus<br />

Pulse on the ground<br />

Table 1: E-way Bill: Key highlights from our channel check<br />

•<br />

Roll out and implementation Smooth roll out has happened and no major system related issues/ glitches faced by trade.<br />

Surveillance and checks<br />

Challenges<br />

Unorganised trade situation<br />

•<br />

Phased inter-state implementation and intra-state roll out helped ease the pressure on<br />

system servers.<br />

•<br />

Implementation was planned better this time around.<br />

•<br />

Anecdotal evidence suggests that transporters are reluctant to transport goods in the<br />

absence of an e-way Bill. Freight rates for movement of goods without proper documents<br />

(including e-way Bill) have gone up considerably.<br />

•<br />

On-ground checking/ inspection by officials has yet to pick up substantially, currently it is<br />

happening in a calibrated and gradual way to curb unauthorised movement of inter-state<br />

goods.<br />

•<br />

Some believe that tight surveillance could improve tax collection and reduce unorganised/<br />

unauthorised trade going ahead.<br />

•<br />

RFID (refer Annexure 2) based checking could improve the government’s ability to monitor/<br />

inspect higher number of vehicles versus physical verification by officials.<br />

•<br />

Difficulty in preparing shipments in advance due to validity of e-way bills. In case of part<br />

truck load shipment, inability to ensure full compliance as transported deals with further<br />

movement of goods.<br />

•<br />

Involvement of multiple vehicles, trans-shipment cases involve recording details of each<br />

vehicle which is difficult for the suppliers to maintain. There are no controls on how<br />

transporters are complying on behalf of tax payers.<br />

•<br />

An e-way bill cannot be edited. Hence, in case of errors, have to be cancelled and a new one<br />

needs to be generated.<br />

•<br />

Huge working capital issues are being faced by the SMEs due to stuck GST refunds, increased<br />

compliance cost and working capital financing issues.<br />

•<br />

Unorganised players gained ground in the post GST and pre e-way Bill period due to lack of<br />

anti-evasion measures. However, visible difference has been observed post e-way Bill<br />

implementation.<br />

•<br />

Currently there’s no fear amongst the trade community and a casual approach is being<br />

adopted in terms of full compliance.<br />

•<br />

Under-invoicing, a prevalent practise, continues unabated even after e-way bill<br />

implementation. Tax evasion tactics like under-invoicing will be difficult for the government<br />

to track.<br />

•<br />

Cash availability in the system has increased as lucrative working capital terms offered to<br />

deal in cash (fast receivable collection) is incentivising cash dealings.<br />

•<br />

However, since the implementation of e-way Bill, freight rates have increased for those who<br />

dispatch goods without proper documentation, signalling visible additional cost burden to<br />

transact in cash.<br />

Source: Edelweiss research<br />

4 Edelweiss Securities Limited


The SHIFT<br />

Glimpse of surveillance measures and levers to increase compliance<br />

Fig. 1: Recent surveillance measures<br />

Intelligence Unit unearths<br />

fake bills worth INR 25 bn<br />

claiming fake ITC of INR<br />

4.5bn<br />

CGST- Mumbai arrests 2<br />

people for claiming fake ITC<br />

worth INR 72.3 mn<br />

Intelligence team-Mumbai<br />

arrests 2 people for claiming<br />

fake ITC of INR 1.2 bn<br />

Department is sending<br />

notices through automated<br />

mails to non-filers through<br />

emails asking them to submit<br />

returns within three days of<br />

the expiry of the deadline<br />

GST officers sending scrutiny<br />

notices to companies whose<br />

tax payment did not match<br />

the GSTR-1 (Sales Return)<br />

and whose GSTR-1 did not<br />

match GSTR-2A, (Purchase<br />

return)<br />

As per analysis in March, 34<br />

per cent of businesses paid<br />

INR 344 bn less tax between<br />

July-December<br />

Department initiated the<br />

mobile checking of<br />

vehicles transporting<br />

goods in Madhya Pradesh<br />

and so far about 100<br />

vehicles have been<br />

detained for violating e-<br />

way bill norms.<br />

Source: Media articles, Edelweiss research<br />

Government has set up a dedicated GST Intelligence unit<br />

Directorate General of GST Intelligence (DGSTI) is tasked with ensuring tax compliance and<br />

going further, it is expected to step up surveillance by studying the price structure,<br />

marketing patterns and classification of commodities and advise the GST authorities in<br />

plugging loopholes and ensure compliance.<br />

About DGSTI<br />

The government has set up a new unit — Directorate General of GST Intelligence (DGSTI),<br />

which is empowered to keep an eye on tax compliance as part of its plans to crackdown on<br />

evaders and invoke anti-profiteering measures. There will be at least one unit of DGSTI in<br />

each state, which will replace the existing Directorate General of Central Excise Intelligence<br />

(DGCEI).<br />

DGSTI will be mandated to collect and disseminate intelligence relating to GST evasion. It<br />

will study the price structure, marketing patterns and classification of commodities and<br />

advise the GST authorities in plugging loopholes. It will also function as think-tank to Central<br />

Board of Indirect Taxes & Customs (CBIC). The body will examine cases of suspected tax<br />

evasion and pass on its inputs to CBIC. DGSTI will also study the modus-operandi of evasion<br />

and issuance of alert notices, and co-ordinate and share information about tax evasion with<br />

other enforcement agencies.<br />

5 Edelweiss Securities Limited


Analysis Beyond Consensus<br />

Fig. 2: Anti-evasion measures and potential levers to up the compliance going ahead<br />

•Invoice matching would done<br />

by way of auto-population of<br />

data filed in GSTR 1 of the<br />

supplier into GSTR 2 of the<br />

buyer, and input tax credit on<br />

purchase of goods would only<br />

be available on matching of<br />

details in GSTR 1 and GSTR 2.<br />

Invoice<br />

matching<br />

Reverse<br />

charge<br />

mechanism<br />

(RCM)<br />

•RCM is expected to be<br />

implemented soon wherein<br />

recipient of the goods and/or<br />

services is liable to pay GST<br />

instead of the supplier.<br />

•This will encourage trade with<br />

registered dealers and help in<br />

improving tax compliance.<br />

QR code &<br />

RFID<br />

Analytics<br />

•QR code on the e-way Bill<br />

would help easier and faster<br />

verification by tax officers.<br />

•Installation of RFIDs by notified<br />

transporters and RFID readers<br />

at key locations would aid in<br />

tracking the movement goods<br />

without stopping the vehicle on<br />

the road.<br />

•GSTN has invited bids from<br />

private entities for "360-degree"<br />

profiling of taxpayers for early<br />

detection of fraud as it seeks to<br />

transform into an end-to-end<br />

platform for checking GST<br />

evasion, from being just a tax<br />

collection portal.<br />

Source: Edelweiss research<br />

6 Edelweiss Securities Limited


Cheap data driving profound<br />

changes<br />

The collapse in data prices hurts the telecom industry, but is transformative for the economy,<br />

adding 5% to GDP<br />

Neelkanth Mishra<br />

As a proportion of per capita income, data on Indian mobile networks has gone from being<br />

the most expensive globally two years ago to being the cheapest, having fallen 95 per<br />

cent. Such steep price declines affect habits and behaviour. We at Credit Suisse embarked on a<br />

study to understand the economic implications of this change.<br />

Understandably, during this period there has been a dramatic surge in data consumption, with<br />

per capita monthly usage rising eight-fold to nearly six and a half gigabytes. Indian mobile<br />

networks now claim that they carry more data than several global telecommunication companies<br />

combined. While some pride is justifiable for these firms, per capita data usage in India is still a<br />

small fraction of what it is in developed markets, and may remain so for the foreseeable future.<br />

This is because most data consumption globally is through fixed line networks, where India has<br />

made very little progress: In many countries, per capita mobile data consumption is less than half<br />

of India’s, but total data consumed is fifteen times as much.<br />

Instead, the exciting change is in the number of people who can now use mobile<br />

broadband without worrying about how much data they are consuming. We estimate that by<br />

2020 there will be 550 million Indians with data/video-capable phones, from just 200 million at the<br />

end of 2016. Each such user is a consumer as well as a worker — let us look at both the facets.<br />

Five years ago, we wrote about the “Silent Transformation” of India, on how the spread of rural<br />

roads, electricity and phones was driving never-before-seen changes to productivity. During a<br />

discussion on this report with the board of a large consumer goods company, the CEO asked<br />

“Exciting changes, but how do we build our brands with the families benefiting from these<br />

changes? They don’t watch TV!”<br />

That is indeed a significant constraint. India’s TV penetration has improved significantly in the<br />

last decade or so, but a third of the households still do not have access. For the ones that<br />

do, 95 per cent have only one TV (as against the US average of three screens per household),<br />

and minutes of TV viewing per capita in India are among the lowest in the world.<br />

Cheap video-capable phones help: If each user watches one to two hours of video on the phone,<br />

it adds 550 million to 1.1 billion screen hours per day to the 1 billion screen hours of capacity


currently available through televisions. We estimate that the share of rural consumption that<br />

can be targeted by video advertising may jump from just 27 per cent to over 95 per cent.<br />

Not only does the reach widen, but smaller advertisers can reach more niche audiences too: One<br />

can run an advertising campaign targeting only a few thousand users now, instead of relying on<br />

mass media advertising that has very large ticket-sizes for advertising spots. The cost of<br />

advertising should fall as well — the surge in volumes on some of the internet platforms has<br />

brought down the cost per impression by three-fourths in the last two years. Thus, branding<br />

reach broadens, sharpens and also becomes cheaper.<br />

A far more significant impact is likely to come from the share of India’s workforce that is<br />

connected, rising from 33 per cent in 2016 to 96 per cent in 2020. Of the myriad ways in<br />

which this helps productivity, let us discuss three.<br />

The first is a significant improvement in worker utilisation. While friction in job markets<br />

(inefficiencies in matching a job opening to a worker) is a universal challenge, in India the<br />

problem is amplified by tens of millions of workers doing multiple jobs every year. Workforce size<br />

and the unemployment rate depend on the question asked: Whether there was work in the<br />

previous six months (unemployment ratio 2.2 per cent; 474 million workers); or if there was work<br />

in the previous week (5.6 per cent; 416 million). Social media, on which Indians collectively<br />

spent 71 billion hours last year, may be a drag on productivity for some (including this<br />

author), but can significantly increase the number of days worked in a year for many by<br />

expanding the network of trust. The Nobel laureate Daniel Kahneman writes of a study that<br />

showed how repetitive exposure builds trust: Social media plays this role, improving the<br />

functioning of informal employment networks.<br />

The second is on supply chain efficiencies: India’s inventory-to-GDP ratio is the highest in<br />

the world. That is, to generate the same amount of income, there is a lot more of capital stuck in<br />

idle inventories than is necessary. The fragmented nature of India’s retail chain and the surfeit of<br />

small manufacturers compound the problems of an inefficient transportation infrastructure.<br />

Connected supply chains can improve planning, and can release capital that can be<br />

reinvested for growth. Further, in sectors like packaged food that have short shelf-lives, data<br />

connectivity is critical for business feasibility. The reason every locality in India has a bakery,<br />

but there are no national chains, is that in fast expiring products like cream rolls, the supply chain<br />

information could only travel efficiently in a radius of a few kilometres.<br />

The third and the largest impact would be through services networks that bring down fixed<br />

costs by improving utilisation. If a car costing Rs 7,00,000 runs 50,000 kilometres in say 7<br />

years (at 20 kilometres a day), just the capital cost is fourteen rupees a<br />

kilometre. However, if a taxi driver in a second hand car purchased for Rs 3,00,000 drives


1,50,000 kilometres, the capital cost falls to two rupees a kilometre, improving<br />

affordability. If taxi drivers and users are connected, this helps create jobs, and also<br />

provides more affordable transportation. This same mechanism applies to hotels, as well<br />

as skilled professionals such as beauticians, electricians and plumbers, among others.<br />

These are early days, and human ingenuity and Indian entrepreneurism can significantly amplify<br />

the positive impact. But we estimate just these three mechanisms can add nearly 5 per cent to<br />

GDP: If these play out over three years, that means 1.5 per cent a year addition to GDP growth;<br />

1.2 per cent a year if over four years. The government and the private sector have invested<br />

nearly 2 per cent of GDP in telecom infrastructure in the last four years. Even if the decline<br />

in data prices has been painful for the telecom industry, the benefits to the economy seem<br />

significant.<br />

The writer is India Equity Strategist for Credit Suisse


‘Overvalued’ Stocks<br />

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Home / Perspective / The Value Of ‘Overvalued’ Stocks | JUN 01 , 2018<br />

Perspective<br />

The Value Of<br />

Illustration: Kishore Das<br />

What should be your reaction<br />

to the success of investors who<br />

buy and hold seemingly<br />

overvalued stocks?<br />

Rohit Chauhan<br />

There is obviously no single way of making money in the stock market. There are short term<br />

traders, buy and hold guys, debt specialists and all kinds of people in-between. Each<br />

approach has its strengths and weaknesses and no one can claim that a specific approach is<br />

inherently superior to the other, unless they are equally proficient in both.<br />

I have come to realise that the most important factor to long term success is to understand<br />

which approach suits your temperament.<br />

The value of learning<br />

Some of you who have followed me on my blog, would have noticed that I try not be<br />

dogmatic about any specific style. I have tried multiple approaches and continue to do so. I<br />

do have a dominant style which suits my temperament — buy decent quality companies and<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 1/13


6/4/2018 The value of ‘overvalued’ stocks | Outlook Business<br />

hold them for the long run, but I have tried deep value, arbitrage, options and all other types<br />

of investing.<br />

Most of my experiments have been failures (see here and here) from a monetary<br />

perspective, but they have deepened my understanding on what works and does not work<br />

for me.<br />

A valid question would be, why bother? Why not find an approach which works for you and<br />

then just stick with it (and maybe even publicly defend it as your faith).<br />

Let’s consider an analogy. Let’s say you are a sculptor who likes to make figures using wood,<br />

stone and other materials. Let’s assume you are exceptionally good at making stone<br />

sculptures, but not so great on wood. You go to an exhibition and see some great wood<br />

figures and happen to meet the artist. The artist tells you about his techniques and the tools<br />

he uses. Assuming you want to get better on wood, will you start laughing at this artist and<br />

belittle his tools?<br />

In a similar fashion if you are a deep value investor, what should be your reaction to the<br />

success of investors who buy and hold seemingly overvalued stocks?<br />

Durable success<br />

I know what the first objection is to this line of thinking — the success of these investors is<br />

just dumb luck. These guys are not really practicing value investing, but a form of<br />

momentum investing. It is just that the momentum has lasted for five years in some of these<br />

cases, and sooner or later this bubble would burst.<br />

My counterpoint: sure that is possible, but what if this bubble has lasted for 10-15 years in<br />

some cases. Will you still just wave away these anomalies and label them as flukes?<br />

I prefer to take a different approach. There is no religious debate to this in my mind — if<br />

something has worked for 3+ years in the stock market, then it is worthy of investigation. A<br />

lot of bubbles and temporary fads usually get washed out in 2-3 years and so 3 years is good<br />

cut-off point.<br />

Why not 5 years? Well now we are moving from the physical to the meta-physical and<br />

debating the nature of reality.<br />

So what can one learn from this oddity where some companies manage to sell for seemingly<br />

high valuations for a very long time?<br />

New business model or value capture<br />

I think the first point to look for is whether there is a change occurring in the business<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 2/13


6/4/2018 The value of ‘overvalued’ stocks | Outlook Business<br />

model/design, wherein due to changing customer needs and priorities, a new type of design<br />

is now more suited to meet them more profitably.<br />

I would recommend reading the book – Value Migration, which goes over this concept in<br />

quite a bit of detail. The main point is that changing customer needs and priorities cause a<br />

THE BIG STORY SPECIALS PERSPECTIVE PIXTORY ENTERPRISE STRATEGY MARKETS C'EST LA VIE<br />

change in the business design best suited to meet them. Companies which can identify and<br />

EVENTS<br />

develop a business model to meet this new reality are able to accrue a lot of value for their<br />

Search Here..<br />

shareholders.<br />

For example, a rise in the income levels has caused the retail consumer to now value quality,<br />

brand image and convenience in addition to the price. As a result, companies which can<br />

meet this new set of needs have been able to create a lot of value.<br />

It is easy to see this phenomenon around us — bathroom fittings, automotive batteries,<br />

garments etc. Some of these products were commodities in the past, sold largely based on<br />

price. However increasing consumer purchasing power has meant that the priorities have<br />

shifted beyond price. Companies which have been able to adapt their business model to<br />

deliver on these new priorities of brand, quality and convenience in addition to price have<br />

delivered exceptional returns. Example: Cera Sanitary, Amara Raja, Astral Poly etc.<br />

Opportunity size with durability<br />

It is not sufficient to be able to meet the changing needs of the consumer, better than the<br />

competition. For starters, the opportunity size should be large so that the company can<br />

grow for a long time to come.<br />

This is a major advantage of the Indian markets over almost all other foreign markets. Even<br />

niches in India have a market size running to millions of consumers and hence a company<br />

which can build a good business model can easily grow for years to come.<br />

An additional point to keep in mind is the need for the company to develop a durable<br />

competitive advantage. Let’s take the case of the telecom industry in the early 2000s. The<br />

need for communication and mobile telephony was recognised by a few companies such as<br />

Airtel in the late 90s and these companies moved in quickly to satisfy the needs.<br />

The market size was in the 100s of millions and most of the telecom companies were able to<br />

scale rapidly. However the edge or competitive advantage turned out to be transitory and as<br />

a result after a few years of high profitability, we soon had a lot of price-based competition.<br />

As a result by 2007-08, most companies were losing money and did not create (actually<br />

destroyed) wealth.<br />

In such cases seemingly overvalued companies were truly overvalued.<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 3/13


6/4/2018 The value of ‘overvalued’ stocks | Outlook Business<br />

Kings of their domain<br />

A productive area for finding multi-baggers is in the microcap space, where the company<br />

operates in a niche and is growing rapidly as its business model is uniquely suited for that<br />

niche. In addition, the niche is large enough for the company to grow for a long time, yet not<br />

so big that it attracts large companies initially.<br />

There are a few examples which come to my mind. Think of air coolers a few years back<br />

(Symphony), CPVC pipes (Astral Poly) or various niche in pharma and information<br />

technology.<br />

A small company develops a unique set of skills for this specific segment and is able to<br />

dominate and grow within the segment for a long time. In addition as the niche is quite<br />

small, it does not attract much competition till it reaches a certain size.<br />

However by the time the niche is big enough to catch the attention of larger companies in<br />

the overall space, it is too late as the specific company has established a dominant<br />

competitive position and cannot be dislodged.<br />

A lot of these companies appear to be overpriced after they have started growing, but this<br />

ignores the possibility of above average growth and a dominant position for the company.<br />

Capacity to suffer<br />

This is a term used by Thomas Russo (see the talk here) to describe companies which are<br />

capable and willing to make investments in the business for the long term, even though it<br />

penalises the profit in the short term.<br />

In most cases, due to market pressures, companies are not willing to hurt short-term<br />

profitability to build the business for the long term and hence the few companies which are<br />

willing to do so, appear to be overvalued due to depressed profits.<br />

Look at the example of Bajaj Corp (an old holding which I have since exited). The company<br />

acquired the No-Marks brand in 2013 and started deducting the brand value on their P&L<br />

account. In reality the brand value was actually going up as the company continued to spend<br />

heavily on advertising (17% of sales) and hence the profit was understated.<br />

The market did not like this short-term penalty and punished the stock in 2013. The stock<br />

price has since recovered and we have a company which appeared to be overvalued due to<br />

the high investments in the business.<br />

Platform Business<br />

This link leads to a good note on what is a platform business.<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 4/13


6/4/2018 The value of ‘overvalued’ stocks | Outlook Business<br />

I do not have an example in the Indian market, but will try to explain this using the example<br />

of a well know US company. It is 2004 and a company called Google decides to launch its<br />

IPO at a then P/E of around 65. A cursory look shows the company to be grossly overvalued<br />

and as a result most of the value investors tend to give it a pass.<br />

The company has since then delivered a return of around 26% compounded and I am sure<br />

this qualifies as a great return. So why did a company which appeared so overvalued turn<br />

out to be a 10-bagger.<br />

My own understanding is that this result came about from multiple factors. To begin with,<br />

the company operates in a winner-take-all kind of a market where the No.1 company tends<br />

to dominate and capture almost all of its value. Once Google had 60%+ market share, the<br />

network effects kicked in and the company just kept getting more dominant in the search<br />

space.<br />

Once this base was built, the company extended it to other platforms such as mobile where<br />

the next leg of growth has kicked in. These types of companies also have a very low marginal<br />

cost of production and hence any growth beyond a threshold drops straight to the bottom<br />

line.<br />

This however does not explain fully the reason behind its success. We have a management,<br />

which in the words of Prof Bakshi in this note, are intelligent fanatics and also have the<br />

capacity to suffer (as referenced by Thomas Russo). As a result they have continuously<br />

invested in long-term ideas (called as moonshots) even if it meant losses in the near term.<br />

YouTube, Android etc which are now bearing fruit were drains at one point of time.<br />

Such companies have been referred as platform companies and usually appear highly<br />

overvalued in the early stages of growth. Another similar company seems to be Facebook.<br />

A point of caution: for every successful platform company, there are atleast 10 pretenders<br />

which destroy value. So it is not easy to identify such companies ex-ante (atleast for me).<br />

Rate of change matters<br />

Let me introduce a new concept: business clock speed, which I read here. This is the rate at<br />

which a business is changing. For example, the rate of change in the social media business is<br />

high and conversely, there are businesses such as paints or undergarments where the rate of<br />

change is low.<br />

I think it is quite obvious that businesses with low rate of change can create durable<br />

competitive advantage for the long term and hence a seemingly high price turns out to be<br />

cheap.<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 5/13


6/4/2018 The value of ‘overvalued’ stocks | Outlook Business<br />

On the contrary, very few high change businesses (Google, Facebook being a few<br />

exceptions) turn out to justify their sky high valuations. It is difficult to establish a strong<br />

competitive position in an industry where the basis of competition keeps changing every few<br />

years. Just look at IBM which has had to re-invent itself almost every decade to stay in<br />

business and grow its value. For every IBM, there is DEC or Sun Microsystems which did<br />

not make it.<br />

It is quite rare<br />

It is important to understand at this point that it is quite rare to find overvalued companies,<br />

which in hindsight turn out to be undervalued. A lot of overvalued companies actually turn<br />

out to be just that and so it is important for a value-minded investor to be cautious about<br />

such companies.<br />

In addition, it is not easy to identify such companies upfront (there are no simple screens<br />

for it) and one has to think deeply to develop the right insights to buy and hold such<br />

companies.<br />

So why study?<br />

As I stated in the beginning of this note — if you want to be a successful investor, it is<br />

important to have as many mental models in your head. Investing in cheap, low valuation<br />

companies is one such mental model. However this does not mean one should just wave<br />

away any company which is selling at a high price.<br />

The advantage of understanding the drivers of success is that the next time when you are<br />

evaluating a company, it makes sense to check if this company fits into any of these models?<br />

One can ask some of these questions<br />

Is the company overvalued simply because the management is investing in the business<br />

for the long term which has suppressed the near term profits?<br />

Is the company developing a new business model which meets the changing<br />

requirements of the consumer much better than competition?<br />

Does the company have a durable advantage and a large opportunity space (the case for a<br />

lot of FMCG companies in India)?<br />

Does the company have network effects or is it a platform company run by an intelligent<br />

fanatic?<br />

Has the company identified and developed a unique business model for a niche which it<br />

will dominate for a long time?<br />

https://www.outlookbusiness.com/perspective/the-value-of-overvalued-stocks-4408 6/13


6/4/2018 This investor rivals Warren Buffett — and you probably haven’t heard of him - MarketWatch<br />

Opinion: This investor rivals Warren Buffett —<br />

and you probably haven’t heard of him<br />

By Glen Arnold<br />

Published: May 31, 2018 11:40 a.m. ET<br />

The Berkshire Hathaway CEO so admired Lou Simpson that he suggested the Geico CIO could step in for him if needed<br />

Bloomberg<br />

Lou Simpson, pictured in 2011.<br />

Geico is probably the best investment Warren Buffett ever made. Much is due to the terrific performance of the insurer’s<br />

underwriters. But what turbocharged his return is the investment record of GEICO’s chief investment officer.<br />

Lou Simpson’s record at Geico from 1979 to 2010 rivals that of Buffett at Berkshire Hathaway BRK.A, +0.70% BRK.B,<br />

+0.37% but he remains little-known, except by true Buffett fans.<br />

Despite their different investment choices, Simpson, now 81 years old, and Buffett in many ways have similar investment<br />

philosophies. Buffett so admired Simpson that he suggested at one time that the Geico CIO could step in should<br />

something happen to himself and Charlie Munger. For his part, Simpson said his smaller portfolio gave him an advantage<br />

over Buffett. While they were both running concentrated portfolios of less than 15 to 20 shares (often seven companies or<br />

less), Buffett had to manage up to $40 billion whereas Simpson usually had less than $4 billion.<br />

Like Buffett, Simpson developed his investment approach through trial and error, evolving over decades. Earlier in his<br />

career, long before being hired by Geico, he was a “growth investor” often failing to properly consider whether that growth<br />

was being offered at a reasonable price. He was aiming for spectacular returns from a few star performers, hoping that he<br />

had guessed the future correctly.<br />

But through bitter experience he learned that good long-run results come from buying companies with established high<br />

performance (rather than mere promises of future riches) with low risk and at a low price.<br />

Today, many people can crunch the company’s numbers and determine whether the share price looks cheap. But they<br />

need to be equally sharp in judging qualitative factors, he told an audience at Northwestern University’s Kellogg School of<br />

Management in November 2017.<br />

“As Warren used to tell me, “You’re better off being approximately right than exactly wrong.” For example, one thing you<br />

need to determine is: Are the company’s leaders honest? Do they have integrity? Do they have huge turnover? Do they<br />

https://www.marketwatch.com/story/this-investor-rivals-warren-buffett-and-you-probably-havent-heard-of-him-2018-05-30/print 1/5


6/4/2018 This investor rivals Warren Buffett — and you probably haven’t heard of him - MarketWatch<br />

treat their people poorly? Does the CEO believe in running the business for the long term, or is he or she focused on the<br />

next quarter’s consensus earnings?”<br />

Buffett highlighted Simpson’s impressive performance data from 1980 through 2004 in his 2004 letter to shareholders.<br />

Most fund managers would consider themselves well ahead of the pack if they delivered an annual average<br />

outperformance of a mere 1 percentage point; Simpson outperformed by a stunning 6.8% percentage points over a 25-<br />

year span.<br />

Geico’s equity portfolio gained an average of 20.3% a year, compared to the S&P 500’s 13.5% SPX, +1.08% Put another<br />

way, a $10,000 investment compounded at a 13.5% annual rate becomes $237,081 after 25 years; at a 20.3% annual<br />

rate, it becomes $1,015,408.<br />

Of course, all investors have years where they underperform the market; Simpson underperformed for three years in a<br />

row. As a value investor, Simpson was out of step with the irrational exuberance of the late 1990s dot-com boom. But he<br />

stuck to his principles and delivered great results in the years following the 2000 crash.<br />

Here are five key principles that helped Simpson in his quest for outperformance.<br />

Read (all day if you can)<br />

Simpson has a voracious appetite for financial newspapers, other intelligent press, annual reports, industry reports, and<br />

generally reads five to eight hours a day. He, like Buffett, is not trading-intensive but reading-intensive and thoughtintensive<br />

Think independently<br />

Be skeptical of conventional wisdom. Obtain your own information and do your own analysis. Don’t get caught up in waves<br />

of irrational behavior and emotion. Be willing to consider unpopular and unloved companies as they often offer the greatest<br />

opportunities.<br />

Make few investments. Hold them for a long time.<br />

Simpson continues to invest through SQ Advisors, where he is chairman. Good investment ideas — companies that meet<br />

his investment criteria — are hard to find. So when he finds one, he makes a large commitment.<br />

Typically, SQ Advisors adds just one or two investments a year to a portfolio of 10 to 15 stocks and drops one or two, he<br />

told that Northwestern audience. And sometimes the best plan is to do nothing.<br />

SQ Advisors’ holdings<br />

Company Ticker Industry Shares held as of<br />

March 31<br />

(thousands)<br />

Allison Transmission ALSN, Trucks/Construction/Farm<br />

Holdings Inc. +1.33% Machinery<br />

Brookfield Asset<br />

Management Inc.<br />

Class A<br />

BAM.A,<br />

+0.43%<br />

Value as of<br />

March 31<br />

($millions)<br />

Total return -<br />

2018 through<br />

May 25<br />

8,899 $347.6 0%<br />

Investment Managers 8,839 $344.7 -4%<br />

Charles Schwab Corp. SCHW, Investment<br />

5,960 $311.2 12%<br />

+2.00% Banks/Brokers<br />

CarMax, Inc. KMX, Specialty Stores 4,948 $306.5 5%<br />

+1.41%<br />

Liberty Global PLC LBTYK, Cable/Satellite TV 9,573 $291.3 -18%<br />

Class C<br />

+2.67%<br />

Cable One Inc. CABO, Cable/Satellite TV 365 $250.7 -6%<br />

+0.35%<br />

Apple Inc.<br />

AAPL, Telecommunications<br />

1,209 $202.8 12%<br />

+1.80% Equipment<br />

Sensata Technologies ST, Electronic<br />

3,880 $201.0 2%<br />

Holding PLC +2.13% Equipment/Instruments<br />

Tyler Technologies Inc. TYL, Data Processing Services 878 $185.3 29%<br />

+0.03%<br />

Charter<br />

Communications Inc.<br />

CHTR,<br />

+0.32%<br />

Cable/Satellite TV 625 $194.4 -20%<br />

https://www.marketwatch.com/story/this-investor-rivals-warren-buffett-and-you-probably-havent-heard-of-him-2018-05-30/print 2/5


6/4/2018 This investor rivals Warren Buffett — and you probably haven’t heard of him - MarketWatch<br />

Class A<br />

Berkshire Hathaway BRK.B, Multi-Line Insurance 798 $159.1 -2%<br />

Inc. Class B<br />

+0.37%<br />

Liberty Broadband LBRDK, Specialty<br />

1,596 $136.8 -16%<br />

Corp. Class C -0.25% Telecommunications<br />

Axalta Coating AXTA, Industrial Specialties 32 $0.971 0%<br />

Systems Ltd. +1.19%<br />

SBA Communications SBAC, Real Estate Investment<br />

5 $0.876 -3%<br />

Corp. Class A +0.26% Trusts<br />

Hexcel Corp. HXL, Aerospace & Defense 5 $0.339 16%<br />

+0.89%<br />

Source: SEC 13-F filing for March 31, 2018; FactSet<br />

Simpson admits that mastering inactivity is difficult to do because it “is very boring”, but it is often the right thing to do.<br />

“Warren used to say you should think of investing as somebody giving you a fare card with 20 punches. Each time you<br />

make a change, punch a hole in the card. Once you have made your 20th change, you have to stick with what you own.<br />

The point is just to be very careful with each decision you make. The more decisions you make, the higher the chances<br />

are that you will make a poor decision,” he said at Northwestern.<br />

Buy at a reasonable price<br />

Look at the rate of return on shareholders’ money used within the business. If it is high and sustainable given the strategic<br />

position of the company and the quality of management, then there is a good chance of long-run appreciation in the share<br />

price. Cash-flow return, rather than profit return, can be a useful additional metric given that it is more difficult to<br />

manipulate than profit.<br />

Once a superior business has been identified then its shares should only be bought if the price is not excessive relative to<br />

its prospects. Simpson uses indicators such as earnings yield. He also uses the ratio of price to free cash flow.<br />

Sell your mistakes and hold the successes<br />

Investors have a tendency to hold on to losing shares — they might come back, and who wants to crystallize a loss? —<br />

while selling early those that are performing well.<br />

Simpson summed up his opposition to these notions this way during his talk at Northwestern: “One thing a lot of investors<br />

do is they cut their flowers and water their weeds. They sell their winners and keep their losers, hoping the losers will<br />

come back even. Generally, it’s more effective to cut your weeds and water your flowers. Sell the things that didn’t work<br />

out, and let the things that are working out run…If I’ve made one mistake in the course of managing investments it was<br />

selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long<br />

time.”<br />

Glen Arnold is an investor and the author of “The Deals of Warren Buffett Vol 1: The First $100 Million.”<br />

Also from Glen Arnold: 4 Warren Buffett mistakes that can make you a better investor<br />

More from MarketWatch<br />

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MM<br />

May , 8 5: PM GMT<br />

Global Macro Mid-Year Outlook<br />

Cycle Maturing but Not Ending<br />

The global expansion should continue at above-trend speed in 2H18 and<br />

2019, driven by the ongoing capex and productivity recovery. The cycle<br />

has more room to go as we see limited signs of overheating. Speed<br />

bumps could emerge if the lift in Fed real rates causes major stress in US<br />

corporate credit.<br />

For important disclosures, refer to the Disclosure Section, located at the end of this report.


M<br />

M<br />

Cycle maturing but not ending<br />

Why this cycle still has more legs<br />

An intensifying debate about the length of the global cycle: Over<br />

the last few weeks, in our conversations with investors, we sensed<br />

increased concerns about the strength and duration of the global<br />

expansion cycle. A variety of reasons have been cited as concerns.<br />

The rise of protectionism risks, softening data prints in DM, a seemingly<br />

more intense tightening in China and most recently the adverse<br />

impact that rising US yields and an appreciating USD would have on<br />

EM economies have added to worries that the cycle might end soon.<br />

Rising concerns, stable growth: Despite the emergence of these<br />

concerns, global growth has actually held up well at 4%Y in 1Q18,<br />

similar to its pace in previous quarters. Sequentially, DM growth has<br />

moderated but this has been offset by stronger EM growth, supported<br />

by China. Moreover, transitory factors have impacted DM<br />

growth in 1Q (for more details, see the box on the next page) and, as<br />

the effects of these factors fade, we expect sequential growth in DM<br />

to improve.<br />

Staying constructive on the cycle: From a broader perspective, our<br />

base case remains that the global economic expansion still has room<br />

to run. However, as the cycle matures, we do expect a slight moderation<br />

in global growth to a still above-trend pace in the coming quarters.<br />

On an annual average basis, we expect global real GDP to grow<br />

at 3.9%Y in 2018 and 3.8%Y in 2019, as compared to 3.7%Y in 2017<br />

and 3.4%Y in 2012-16. We see global nominal GDP (G3 and BRIC)<br />

growing by 6.5%Y in 2018 and 6.6%Y in 2019, compared to 6.6%Y in<br />

2017.<br />

This recovery has been different from previous cycles: We often<br />

hear the argument that this expansion has been rather long and<br />

would enter its tenth year in 2019. However, the passage of time is<br />

not the best indicator to predict when the business cycle would end.<br />

This recovery (which had been sub-par until 2016) was preceded by<br />

a very deep recession and has been interrupted by a number of temporary<br />

crises.<br />

Exhibit 3:<br />

Global growth: Moderating but still above trend<br />

Global* Real GDP growth %Y<br />

6.0%<br />

5.5%<br />

5.0%<br />

4.5%<br />

4.0%<br />

3.5%<br />

3.0%<br />

2.5%<br />

Long-term<br />

avg. = 3.5%<br />

MS f'cast<br />

2.0%<br />

2003 2005 2007 2009 2011 2013 2015 2017 2019<br />

Source: Haver Analytics, Morgan Stanley Research forecasts; *Global is Morgan Stanley coverage<br />

excluding Argentina, Venezuela, Nigeria, Saudi Arabia and Kazakhstan.<br />

Exhibit 4:<br />

Nominal GDP growth: Stable at cycle highs<br />

Global (G3 & BRIC) nominal GDP growth, %Y<br />

10%<br />

9%<br />

8%<br />

7%<br />

6%<br />

5%<br />

4%<br />

3%<br />

2003 2005 2007 2009 2011 2013 2015 2017 2019<br />

Source: Haver Analytics, Morgan Stanley Research forecasts<br />

Exhibit 5:<br />

MS f'cast<br />

Morgan Stanley real GDP growth forecasts: Base, bull and bear cases<br />

2017 2018E 2019E 2020-22<br />

Base Bear Base Bull Bear Base Bull Base<br />

GLOBAL 3.7 3.1 3.9 4.3 2.4 3.8 4.5 3.4<br />

G10 2.3 1.6 2.2 2.6 0.4 2.0 2.7 1.3<br />

US 2.3 2.0 2.7 3.1 0.4 2.2 2.8 1.2<br />

EA 2.5 1.8 2.1 2.3 0.5 1.9 3.1 1.2<br />

Japan 1.7 0.5 1.3 1.6 0.3 1.5 2.0 1.1<br />

UK 1.8 0.6 1.2 1.7 -0.1 1.0 1.8 1.4<br />

EM 4.8 4.2 5.0 5.6 3.7 5.0 5.8 4.8<br />

China 6.9 6.2 6.6 6.8 5.6 6.4 6.7 5.6<br />

India 6.4 6.5 7.5 8.2 6.5 7.7 8.5 7.3<br />

Brazil 1.0 2.1 2.7 3.1 1.8 3.4 4.0 2.3<br />

Russia 1.5 -0.5 1.8 3.0 -1.0 1.7 3.1 1.8<br />

Source: IMF, Morgan Stanley Research forecasts; Note: The above aggregates are PPP-weighted.<br />

4


M<br />

M<br />

While growth has moved to an above-trend pace in 2017 and the<br />

cycle is now maturing, there are limited signs that the cycle will<br />

be ending over the next 18 months. Our constructive view is<br />

informed by the following observations:<br />

1) Capex cycle not stretched, productivity improvements to be sustained:<br />

From the perspective of a stylised business cycle, we believe<br />

that the global economy has moved from a gradual recovery phase<br />

in 2017 to a productive growth phase (i.e., strong growth driven by<br />

capex and improvements in productivity). Both capex and productivity<br />

have improved recently after a prolonged phase of post-crisis<br />

weakness that was driven by the confluence of cyclical and structural<br />

reasons. We think that the capex cycle is not stretched as yet, given<br />

that the recovery in global investment is in its sixth quarter and<br />

investment/GDP ratios are below previous cycle peaks. We expect<br />

global (G4 and BRIC) investment growth to improve further to 4.2%Y<br />

in 2018 and 4.3%Y in 2019 from 3.7%Y in 2017. This should sustain the<br />

improvement in productivity growth and mitigate overheating concerns.<br />

Moreover, there are initial signs of a structural pick-up in productivity,<br />

as digitalisation and adoption of new technology have the<br />

potential to increase efficiency across sectors.<br />

2) No major signs of misallocation yet, except in some segments of<br />

the US private sector: On aggregate in DM, there has not been a significant<br />

uptick in private sector debt/GDP trends. Core inflation,<br />

while rising, is not yet at concerning levels. However, within DM,<br />

there is some concern about financial stability risks in the US, given<br />

that there has been a meaningful pick-up in leverage in parts of the<br />

private sector, particularly among corporates. For EM economies,<br />

misallocation typically tends to be reflected in higher inflation and<br />

significant widening of current account deficits. However, these have<br />

remained relatively contained in EM as a whole, though they are<br />

more stretched in select EMs than others.<br />

Exhibit 6:<br />

Capex recovery supporting a revival in productivity growth<br />

8%<br />

6%<br />

4%<br />

2%<br />

0%<br />

-2%<br />

Global Real Investment, %Y<br />

Global Labor Productivity, %Y - RS<br />

F'cast<br />

-4%<br />

-2%<br />

1995 1998 2001 2004 2007 2010 2013 2016 2019<br />

Source: Haver Analytics, Conference Board, Morgan Stanley Research. Note: Labour productivity data and<br />

forecasts from Conference Board, real investment forecasts from Morgan Stanley Research.<br />

5%<br />

4%<br />

3%<br />

2%<br />

1%<br />

0%<br />

-1%<br />

Transitory factors affecting DM<br />

growth in 1Q18<br />

DM growth slowed sequentially to an estimated 1.6%Q<br />

SAAR from an average pace of 2.5% over the past four<br />

quarters. The slowdown in sequential growth was broadbased<br />

across G4. However, this moderation in growth can<br />

be partly attributed to transitory factors. In the US, the<br />

main drivers were a payback in consumption in 1Q18, after<br />

widely publicised tax cuts and hurricane-related auto<br />

replacement had boosted consumption in 4Q17, and<br />

residual seasonality. In the euro area, issues such as tax<br />

hikes, the shifting of the timing of Easter, unusually cold<br />

weather and strikes in parts of the region partially<br />

impacted growth. In Japan, consumption took a hit too in<br />

1Q18 due to weather-related issues. Moreover, in some<br />

cases the dip in high-frequency indicators appears to have<br />

been more pronounced in the soft data (such as PMIs)<br />

due to heady levels previously rather than in the hard<br />

data. As the impact of these transitory factors fades, we<br />

expect growth to improve from 2Q18 onwards. However,<br />

the cycle is more mature in DM and there is less<br />

economic slack than before. Hence, we are expecting<br />

growth to return to a 2%Q SAAR pace over the forecast<br />

horizon, as compared to 2.5% over the past four quarters.<br />

Exhibit 7:<br />

EMs ex China to be the main driver of global growth<br />

Contribution to Global GDP Growth in ppt<br />

2.5%<br />

1.5%<br />

0.5%<br />

-0.5%<br />

-1.5%<br />

EMXC*<br />

-2.5%<br />

2002 2004 2007 2009 2012 2014 2017 2019<br />

DM<br />

China<br />

MS f'cast<br />

Source: Haver Analytics, Morgan Stanley Research forecasts; Note that DM includes countries under<br />

Morgan Stanley coverage only. *EMXC is Morgan Stanley coverage excluding Argentina, Venezuela,<br />

Nigeria, Saudi Arabia and Kazakhstan.<br />

MORGAN STANLEY RESEARCH 5


M<br />

M<br />

Growth outlook by region<br />

DM more advanced, EM catching up: The global cycle is undoubtedly<br />

maturing. But this masks important regional differences. The<br />

current cycle is clearly more advanced in DM, and the US is furthest<br />

along the cycle followed by Japan and the euro area. The majority of<br />

EMs excluding China are still in the early or mid-cycle stages of the<br />

business cycle. As regards China, it is difficult to classify it according<br />

to a traditional business cycle, given its countercyclical growth<br />

model (see below for a detailed discussion). We believe that China<br />

will implement further tightening to address its financial risks alongside<br />

a continuation of supply-side reforms, and face a moderate slowdown<br />

in growth as a result.<br />

DM: From balance sheet recession to self-sustaining recovery<br />

Given the maturing economic cycle in DM, we expect DM growth to<br />

moderate somewhat to 2.2%Y in 2018 and 2.0%Y in 2019 from 2.3%Y<br />

in 2017. However, this growth forecast is still stronger than the<br />

2012-16 average economic performance of 1.6%Y. Receding headwinds<br />

from deleveraging, improving inflation expectations and normalising<br />

private sector risk attitudes are supporting a recovery in<br />

aggregate demand. Stronger nominal GDP growth and improved<br />

profitability have lifted business return expectations of the corporate<br />

sector, leading to a recovery in capex spending. The resulting<br />

pick-up in productivity growth should help to sustain the DM cycle<br />

and allow for a gradual removal of monetary policy accommodation.<br />

EM: China's moderate slowdown offset by stronger growth elsewhere<br />

We expect EM growth to be 5.0%Y in 2018 and 2019, up from 4.8%Y<br />

in 2017. A policy-induced slowdown in China (from 6.9%Y in 2017 to<br />

6.6%Y in 2018 and 6.4%Y in 2019) will largely be offset by an acceleration<br />

in emerging markets excluding China (EMXC) growth from<br />

3.6%Y in 2017 to 4.1%Y in 2018 and 4.2%Y in 2019.<br />

China: Countercyclical growth model in action<br />

Policy-makers have been on a tightening path, which has raised concerns<br />

about its impact on the growth trajectory.<br />

However, this tightening cycle is different in three aspects from<br />

the 2013-15 cycle (when growth slowed significantly). We assess<br />

the pace of tightening by looking at broader credit (total social<br />

financing) growth as our preferred metric as it covers both the impact<br />

of monetary and fiscal (via tracking issuance of government bonds)<br />

tightening.<br />

6<br />

Exhibit 8:<br />

G3: Private sector exits deleveraging, risk attitudes improving<br />

9%<br />

7%<br />

5%<br />

3%<br />

1%<br />

-1%<br />

-3%<br />

G3<br />

Private Debt Growth YoY%<br />

Nominal GDP Growth YoY%<br />

-5%<br />

Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17<br />

Source: Haver Analytics, Morgan Stanley Research; Note: Private debt includes households and non-financial<br />

corporate debt.<br />

Exhibit 9:<br />

DMs: From balance sheet recession to self-sustaining recovery<br />

Private<br />

Sector's Risk<br />

Attitudes<br />

Aggregate<br />

Demand<br />

2012-16 2017-Now<br />

• In deleveraging mode<br />

• Risk-averse<br />

• Exited deleveraging<br />

• Risk attitudes normalised<br />

• Below trend • Above trend<br />

Prices • Lowflation persists<br />

Capex<br />

Risks<br />

• Lower return expectations,<br />

weak capex<br />

• Premature tightening<br />

leading to double dip<br />

recession<br />

• Risk of secular stagnation<br />

Source: Morgan Stanley Research<br />

Exhibit 10:<br />

• Pricing power comes<br />

back<br />

• Return expectations<br />

improve, capex picks up<br />

• Price and financial stability<br />

risks<br />

China: Stronger net exports contribution offsetting weaker investment<br />

Household Consumption Govt Consumption<br />

Contribution to Growth (%pt)<br />

9<br />

Investment<br />

Net Exports<br />

7.8<br />

Real GDP Growth<br />

8<br />

6.6 6.9<br />

6.6<br />

7<br />

2.6<br />

6<br />

3.2 2.7<br />

5<br />

1.0<br />

2.7<br />

4<br />

3<br />

1.2 1.3<br />

1.4<br />

2<br />

4.3<br />

1<br />

2.9<br />

2.2 2.0<br />

0.6<br />

0<br />

0.5<br />

-0.1 -0.7<br />

-1<br />

2013 2016 2017 2018E<br />

Source: CEIC, Morgan Stanley Research forecasts


M<br />

M<br />

1. The tightening cycle has been more gradual: During the<br />

2013-15 cycle, broader credit growth slowed by 930bp in a<br />

period of 25 months. In the current cycle, broader credit<br />

growth has slowed by 400bp in the past 24 months (until<br />

March 2018).<br />

2. The bulk of the tightening is now behind us: We expect a<br />

further cumulative deceleration in broader credit growth of<br />

about 100bp in the next 12 months.<br />

3. This tightening is countercyclical: In 2013-15, as tightening<br />

was under way, export growth continued to decelerate. In this<br />

cycle, export growth has been strong. Indeed, as policymakers<br />

continue to pare back stimulus in the infrastructure<br />

and real estate sectors, net exports, private investment and<br />

consumption are providing offsets, helping to support<br />

overall growth momentum. On our estimates, from 2016 to<br />

2018, the contribution of net exports to GDP growth has<br />

swung by 120bp (from being a drag to a boost), offsetting the<br />

decline in the contribution from investment.<br />

Given this backdrop, we expect only a moderate slowdown in China’s<br />

growth to 6.6%Y in 2018, and China should continue to account for<br />

about one-third of global growth in 2018.<br />

EMXC: Still in early to mid-cycle phase of the business cycle<br />

EMXC in recovery phase: In EMs excluding China (EMXC) it was the<br />

adjustment in the macro policy mix during 2012-16 that brought<br />

about a turnaround in macro stability indicators. Over the last few<br />

quarters, most EMXCs have moved out of the adjustment phase to<br />

recovery. As capacity utilisation has begun to improve with the support<br />

of consumption and exports, we have seen a broad-based<br />

recovery in investment growth over the last three quarters.<br />

Exhibit 11:<br />

EMs ex China: Adequate real rate buffers maintained<br />

5<br />

4<br />

3<br />

2<br />

1<br />

0<br />

-1<br />

-2<br />

-3<br />

EMXC Real Short Rate Differentials with US,% point<br />

2013 Taper<br />

Tantrum<br />

-4<br />

Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18<br />

Source: Bloomberg, Haver Analytics, Morgan Stanley Research; Note: EMXC includes Brazil, India, Indonesia,<br />

Korea, Mexico, Poland, Russia, South Africa and Turkey.<br />

Exhibit 12:<br />

EMs ex China: Macro stability in better shape today vs. 2013<br />

-1.0%<br />

-1.5%<br />

-2.0%<br />

-2.5%<br />

-3.0%<br />

2013<br />

Taper<br />

Tantrum<br />

EMXC*<br />

Headline<br />

Inflation<br />

%Y (RS)<br />

-3.5%<br />

3%<br />

EMXC* Current<br />

2%<br />

-4.0% Account Balance<br />

as % of GDP (LS)<br />

1%<br />

-4.5%<br />

0%<br />

Mar-09 Mar-11 Mar-13 Mar-15 Mar-17 Mar-18<br />

Source: Haver Analytics, Morgan Stanley Research; *Includes major countries which faced high inflation/<br />

large external deficits before the taper tantrum (India, Indonesia, South Africa, Turkey, Brazil and<br />

Colombia).<br />

2.8<br />

10%<br />

9%<br />

8%<br />

7%<br />

6%<br />

5%<br />

4%<br />

EM fundamentals and policy mix still favourable in aggregate…<br />

We assess EM fundamentals by looking at the policy mix including<br />

real rate buffers, fiscal policy and labour market policies, and the<br />

impact of this policy mix on macro stability indicators. The policy mix<br />

is still favourable at this juncture, with major EMs maintaining adequate<br />

real interest rate buffers, staying on a path of fiscal consolidation,<br />

while real wage growth trends are broadly in line with real GDP<br />

growth. Moreover, the inflation and current account trends for most<br />

EMs have remained well within the central banks’ comfort zone.<br />

Given the favourable policy mix and early stage of the growth cycle,<br />

there is more room for growth to be sustained at close to current<br />

levels without creating a major deterioration in macro stability indicators.<br />

…though macro stability is relatively stretched in select EMs:<br />

Macro stability risks in the bulk of the EM universe are therefore projected<br />

to remain low to moderate, though there are a few select EMs<br />

like Turkey and Argentina which do have stretched macro stability<br />

indicators and where some adjustment in the policy mix is necessary.<br />

In Colombia and South Africa macro stability indicators are also<br />

somewhat more stretched relative to other EMs, but have shown significant<br />

improvement recently.<br />

MORGAN STANLEY RESEARCH 7


M<br />

M<br />

Inflation: Higher but no major overshoot<br />

Global headline inflation is projected to rise, given a backdrop of<br />

a further reduction in output gaps, rising oil prices and fading of temporary<br />

factors that have held core inflation down in 2017 ( Exhibit 14 ).<br />

Exhibit 13:<br />

G3 core inflation to pick up further<br />

4%<br />

3%<br />

2%<br />

US Core PCE<br />

Euro Area Core<br />

Japan Core Core (adj. for consumption tax increase)<br />

MS<br />

f'cast<br />

DM core inflation rising: Global core inflation is set to pick up gradually<br />

over the forecast horizon. The increase in underlying inflation<br />

should mainly be driven by G3 core inflation, which we expect to rise<br />

from 1.3%Y in 1Q18 to 1.6%Y in 4Q18 and 1.8%Y in 4Q19 ( Exhibit 13 ).<br />

No significant overshoot relative to central banks’ targets: At the<br />

same time, our long-standing view is that a significant overshoot in<br />

G3 inflation above central banks’ goals is less likely. This is because<br />

core inflation remains relatively low as wage growth remains more<br />

moderate than during previous cycles and structural factors such as<br />

technology diffusion and globalisation continue to keep upward<br />

pressures in check.<br />

Why there are limited risks of a significant overshoot in US core<br />

PCE price inflation: In the case of the US, there has been concern<br />

that a confluence of factors – rising commodity prices, the unemployment<br />

rate moving below its long-run normal levels and past<br />

dollar weakness – will lead to an overshoot in core inflation. While<br />

our forecasts suggest that core PCE should rise modestly above the<br />

2%Y goal over the forecast horizon, we think that a significant overshoot<br />

seems less likely:<br />

First, as our US team noted, there are no indications of broadbased<br />

inflationary pressures as almost the entire rise in core inflation<br />

since last November has been driven by base effects in cellphone<br />

services (the impact of last year's price cuts dropping out) and price<br />

increases in the hospital and financial services categories.<br />

Second, wage growth is still moderate compared to previous<br />

cycles and below levels that would provide major upside risks to<br />

inflation (i.e., not exceeding the Fed’s 2%Y inflation goal plus trend<br />

labour productivity growth) ( Exhibit 15 ).<br />

Third, structural factors such as technology diffusion and globalisation<br />

are likely to check the rise in inflationary pressures.<br />

Indeed, during 2005-07, despite the confluence of a persistent<br />

depreciation in USD, a rise in commodity prices, an unemployment<br />

rate lower than its long-run normal level and accelerating wage<br />

growth and a rise in China non-commodity producer prices, core PCE<br />

did not overshoot 2%Y by a significant magnitude ( Exhibit 16 ).<br />

1%<br />

0%<br />

-1%<br />

-2%<br />

Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17 Dec-19<br />

Source: Haver Analytics, Morgan Stanley Research forecasts<br />

Exhibit 14:<br />

Morgan Stanley inflation forecasts: Base, bull and bear cases<br />

2017 2018E 2019E 2020-22<br />

Base Bear Base Bull Bear Base Bull Base<br />

GLOBAL 2.5 2.8 2.9 3.1 2.4 2.8 3.2 2.8<br />

G10 1.8 1.9 2.1 2.4 0.8 1.7 2.6 1.9<br />

US 2.1 2.6 2.6 3.0 1.1 1.9 3.0 2.0<br />

EA 1.5 1.5 1.7 1.8 0.4 1.6 2.1 1.7<br />

Japan 0.5 0.7 1.1 1.3 0.3 1.0 1.7 1.5<br />

UK 2.7 2.1 2.5 3.0 1.9 2.1 3.0 2.2<br />

EM 3.1 3.5 3.4 3.5 3.5 3.5 3.6 3.4<br />

China 1.6 2.1 2.4 2.6 1.9 2.5 2.8 2.5<br />

India 3.3 5.0 4.6 4.4 5.5 4.4 4.3 4.0<br />

Brazil 3.5 3.5 3.1 2.8 4.5 3.9 3.7 4.0<br />

Russia 3.7 5.0 3.0 2.0 7.0 4.2 2.8 4.0<br />

Source: IMF, Morgan Stanley Research forecasts; Note: Global and EM aggregates are calculated<br />

excluding Argentina and Venezuela.<br />

Exhibit 15:<br />

US: Moderate wage growth limiting upside risks to core inflation<br />

8<br />

7<br />

6<br />

5<br />

4<br />

3<br />

2<br />

Average Hourly Earnings, %Y 3MMA<br />

Compensation Per Hour*, %Y 4QMA<br />

Labor Productivity %Y 12QMA plus 2% Inflation<br />

1<br />

Mar-86 Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10 Mar-14 Mar-18<br />

Source: BLS, Haver Analytics, Morgan Stanley Research; *Inflationary pressures from a tightening labour<br />

market are limited so far as wage growth remains moderate and below productivity growth (non-farm<br />

business sector output per hour in this graph) plus the 2%Y inflation target.<br />

8


M<br />

M<br />

EM inflation – rising but also not above targets on a sustained<br />

basis: Inflation in EM is set to rise too, given that the ongoing economic<br />

recovery should lead to a rise in capacity utilisation. Headline<br />

inflation will likely also rise in the near term due to higher energy<br />

prices. However, for most economies, we are expecting inflation to<br />

remain within the central banks’ targets (or comfort zones) as the<br />

overall policy mix remains favourable. Productivity growth is recovering,<br />

an adequate level of real rates is being maintained, fiscal policy<br />

is still on a path of consolidation and there is no major distortion of<br />

labour markets.<br />

Central banks on a path of policy<br />

normalisation...<br />

DM central banks to reduce monetary accommodation: As DM<br />

growth remains relatively strong, we should see a further tightening<br />

of labour markets and rise in capacity utilisation driving core inflation<br />

higher, which should continue to encourage central banks to lean<br />

against still easy financial conditions. G4 central banks should either<br />

continue (in the case of the Fed) or embark on a path of policy normalisation.<br />

While we expect the ECB to end asset purchases in December<br />

2018 and hike deposit rates in June 2019 and the BoJ to adjust the<br />

10-year JGB yield to around 0.15% in 1Q19, monetary policy will still<br />

be expansionary (see Exhibit 17 for detailed forecasts on central<br />

bank policy actions).<br />

How restrictive will the Fed get? As the Fed's policy normalisation<br />

process is already well under way, there are concerns that further<br />

rate hikes would lift real rates to meaningfully restrictive levels and<br />

weigh on growth. Our base case projections are that real policy rates<br />

will reach ~0.2% by December 2018 and 0.7% by December 2019.<br />

This implies that real rates would rise above natural (r*) in 1Q19 and<br />

would be about 20bp higher than r* in 4Q19 1 . The key question that<br />

arises in this context is what level of real rates would risk a major<br />

slowdown in growth. In the previous two cycles, real policy rates had<br />

risen by about 200bp above the natural rate before the expansion<br />

ended a few quarters later. In this regard, considering our forecast of<br />

actual real rates and r*, we project the US expansion to be sustained<br />

through to end-2019 (we see a recession probability of 15%).<br />

1. Our estimate of the natural rate of interest (r*) is 0.5%, which is based on the<br />

Laubach and Williams model (2003) but calculated based on our trend productivity<br />

growth estimate of 1.7%.<br />

Exhibit 16:<br />

US: Core PCE did not overshoot by significant magnitude above 2%Y in<br />

2005-07<br />

9%<br />

7%<br />

5%<br />

3%<br />

1%<br />

-2%<br />

Assessing the sensitivity of higher oil prices<br />

Given the recent rise in oil prices, there has been an<br />

increased attention on the impact higher oil prices could<br />

have on headline inflation. In this regard, for the G4 +<br />

BRIC economies, we have analysed the impact of a<br />

sustained average US$10/bbl increase in Brent crude<br />

prices relative to what futures are pricing. Our analysis<br />

suggests that headline inflation (G4 + BRIC) would be<br />

above our baseline forecast by 20bp in 2018 and 10bp<br />

in 2019. Importantly, the pass-through to G3 core<br />

inflation would be more moderate and occur with<br />

somewhat of a lag, raising our 2018 forecast by 5bp and<br />

our 2019 forecast by 10bp above the baseline forecast of<br />

an average 1.4%Y in 2018 and 1.7%Y in 2019.<br />

-4%<br />

Unemployment<br />

-6%<br />

Gap* (RS)<br />

Jun-03 Jun-04 Jun-05 Jun-06 Jun-07<br />

Exhibit 17:<br />

Key central banks: Next moves<br />

Central<br />

Bank<br />

Policy Action<br />

Fed 2 more hikes in 2018, 3 hikes in 2019<br />

ECB<br />

BOJ<br />

Begin tapering asset purchases in Oct-18, ending purchases<br />

in Dec-18. One 15bp deposit rate hike in Jun-19<br />

Adjust 10Y JGB yield target to "around 0.15%" (0-0.3%) in<br />

1Q19<br />

BOE 1 hike in 3Q18, 2 hikes in 2019<br />

PBOC<br />

USD TWI %Y - LS, leading<br />

by 18M, above zero<br />

indicates USD deprecation<br />

Increase in bank deposit rates via liberalisation of deposit<br />

rate caps<br />

RBI 1 hike in 4Q18, 2 hikes in 2019<br />

BCB 25bp cut in 2Q18, 125bp hike in 2019<br />

CBR 2 more cuts in 2018, on hold in 2019<br />

Average Hourly<br />

Earnings %Y - RS<br />

China Non-Commodity PPI %Y (RMB) -<br />

LS, leading by 14M<br />

US Core PCE<br />

%Y - RS<br />

Source: CEIC, Haver Analytics, Morgan Stanley Research; Note: TWI stands for trade-weighted index.<br />

*Unemployment gap = actual unemployment rate minus long-run normal level.<br />

4%<br />

3%<br />

2%<br />

1%<br />

0%<br />

-1%<br />

Dec-07<br />

Source: Morgan Stanley Research forecasts<br />

MORGAN STANLEY RESEARCH 9


M<br />

M<br />

Bull-base-bear scenarios – DM<br />

Bear Base Bull<br />

US: Ellen Zentner & US Economics Team<br />

Trade fears lead to a decline in investment,<br />

while volatile markets negate the benefit from<br />

tax stimulus. Additionally, global growth flags.<br />

The Fed forgoes hiking in September as the balance<br />

sheet tightening triggers adverse financial<br />

market developments. With incoming data<br />

pointing to negative GDP growth in 4Q18, the<br />

Fed begins to cut rates back towards zero as the<br />

US enters recession and halts balance sheet<br />

drawdown simultaneously.<br />

The expansion continues, with tailwinds from<br />

fiscal stimulus countering the effects of trade<br />

tensions and heightened market volatility.<br />

Household consumption holds up well and<br />

capex continues to be a source of strength,<br />

supporting productivity growth. Growth accelerates<br />

to an average 2.7%Y in 2018 with a<br />

rebound in 2Q following a slow start to the<br />

year caused by transitory factors before<br />

slowing to 2.2%Y in 2019.<br />

The theory of low multipliers in a late-cycle environment<br />

does not hold. Fiscal multipliers turn out<br />

to be larger than expected and propel GDP<br />

growth to above 3%Y. A non-linear Phillips curve<br />

comes through with a vengeance and monetary<br />

policy responds more aggressively. The economy<br />

goes through a boom/bust cycle that ends in US<br />

recession by end-2019.<br />

Euro area: Daniele Antonucci & EA Economics Team<br />

Trade policy uncertainty escalates, thus<br />

implying weaker output growth and lowering<br />

business sentiment more generally. Financial<br />

conditions tighten, which the ECB fails to offset<br />

with a more expansionary policy – given a more<br />

limited toolkit.<br />

The euro area is becoming more mid-cycle,<br />

with growth slowing from 2.5%Y in 2017 to<br />

~2.0%Y on average in 2018 and 2019. With<br />

less slack in the economy, inflation continues<br />

to rise and the ECB keep normalising policy,<br />

but more gradually than previously envisaged.<br />

Wage growth rises faster as we move into a<br />

steeper part of the Philips curve. Productivity<br />

accelerates in a reaction to a stronger recovery in<br />

capex. Fiscal policy becomes more supportive<br />

and boosts GDP by a more meaningful extent.<br />

Japan: Takeshi Yamaguchi & Hiromu Uezato<br />

Weaker external demand including a US recession<br />

hurts Japan’s exports and capex. If PM Abe<br />

steps down due to declining Cabinet support<br />

rates, some of the policies in Abenomics could<br />

be reversed. Other downside risks include<br />

higher oil prices andpremature policy normalisation<br />

by the BoJ.<br />

We retain our view that the mild economic<br />

expansion will continue as a trend until the<br />

next consumption tax hike in October 2019.<br />

That said, we think the economy has entered<br />

the late-cycle phase of its expansion. Japan is<br />

making a gradual exit from deflation.<br />

Japan’s exports and capex gain from a stronger<br />

than-expected global recovery. We see a risk of<br />

more expansionary fiscal policy towards 2019<br />

ahead of important national elections and the<br />

c-tax hike. PM Abe announcing a postponement of<br />

the next c-tax is still a possibility. An early snap<br />

election could reduce political uncertainty.<br />

UK: Jacob Nell<br />

Trade talks break down ('no deal'). The UK<br />

moves into a WTO relationship with the EU in<br />

March 2019, pushing the economy into a recession,<br />

and keeping the MPC on hold through the<br />

forecast horizon.<br />

We see heightened uncertainty, before a lastminute<br />

deal for a soft Brexit. Growth stalls in<br />

the Brexit endgame in 4Q18/1Q19, before a<br />

modest 2019 recovery. The MPC hikes once<br />

this year, pauses until the UK has navigated<br />

Brexit, and then hikes twice in 2019.<br />

Early agreement on a soft Brexit outcome drives<br />

a rebound in growth, which holds at nearly 2%Y<br />

through 2018/19.In this scenario, we would expect<br />

more aggressive tightening from the MPC, with<br />

the policy rate reaching 1.75% by end-2019.<br />

MORGAN STANLEY RESEARCH 17


M<br />

M<br />

Bull-base-bear scenarios – EM<br />

Bear Base Bull<br />

China: Robin Xing, Jenny Zheng & Zhipeng Cai<br />

A rise in US-China trade friction/weaker-thanexpected<br />

growth in the US could drag down<br />

China’s exports growth, and a more aggressive<br />

domestic tightening could weigh on both public<br />

and private capex. As a result, GDP growth<br />

could decelerate rapidly to 6.2%Y in 2018 and<br />

5.6%Y in 2019, and CPI could be subdued at<br />

2.1%Y in 2018 and 1.9%Y in 2019 amid weaker<br />

wage growth.<br />

The financial system remains impaired and is<br />

unable to fully support a recovery in growth.<br />

Policy uncertainty prevails in the run-up to and<br />

post the election, which, coupled with weaker<br />

trade and tighter financial conditions globally,<br />

results in businesses holding back on spending,<br />

posing a drag on growth.<br />

External demand weakens. New geopolitical<br />

tensions result in the US adding systemic Russian<br />

SOEs to the OFAC SDN list. The state<br />

increases control over the economy and fails to<br />

deliver micro reforms to boost growth, which<br />

translates into lower investment. This keeps<br />

uncertainty high and investment depressed. Oil<br />

price and RUB volatility translate into higher<br />

inflation.<br />

A non-reformist candidate wins the presidential<br />

elections, does not push forward the pension<br />

reform and puts in place unorthodox measures.<br />

This brings into question debt sustainability<br />

and puts pressure on the currency, creating<br />

strong inflationary pressures and triggering the<br />

central bank to start hiking rates earlier than<br />

expected, impacting growth negatively.<br />

We expect China’s real GDP growth to moderate<br />

from 6.9%Y in 2017 to 6.6%Y in 2018 and<br />

6.4%Y in 2019, led by weaker public and property<br />

investment growth amid calibrated policy<br />

tightening. Meanwhile, we expect a mild CPI<br />

reflation, from 1.6%Y in 2017 to 2.4%Y in 2018<br />

and 2.5%Y in 2019, led by higher core CPI and<br />

food price normalisation.<br />

India: Derrick Kam, Avni Jain<br />

A synchronous recovery in consumption and<br />

exports lifts capacity utilisation, which incentivises<br />

the corporate sector to invest. Moreover, a<br />

repair of corporate balance sheets and recapitalisation<br />

of state-owned banks leads to an<br />

improvement in sentiment. Both these factors<br />

should pave the way for a private capex recovery<br />

in 2018, which sets the stage for a sustained<br />

growth cycle.<br />

Russia: Alina Slyusarchuk<br />

An orthodox policy-makers’ response to the<br />

new external shocks helps to stabilise the<br />

economy. Inflation averages 3.0%Y in 2018, supporting<br />

household real incomes. The CBR moves<br />

to neutral monetary policy, cutting rates to<br />

6.75% in 2018. The fiscal rule preserves budget<br />

discipline and results in a federal budget surplus<br />

at 1.5% of GDP.<br />

Brazil: Arthur Carvalho & Thiago Machado<br />

The consumer should continue to benefit from<br />

the materially lower interest rate, with some<br />

releveraging likely in 2H18. On investment<br />

growth, although we see capex growth<br />

remaining in positive territory, we believe that<br />

political uncertainty will have some adverse<br />

impact. Benign inflation should lead to one last<br />

cut in May, taking rates to 6.25%. Inflation<br />

should normalise and trigger the central bank<br />

to hike rates again in 2019.<br />

A stronger-than-expected global recovery and<br />

milder-than-expected pace of domestic deleveraging<br />

could lift China’s exports and capex. As<br />

a result, real GDP growth can remain resilient at<br />

6.8%Y in 2018 and 6.7%Y in 2019, supporting<br />

headline CPI at 2.6%Y in 2018 and 2.8%Y in<br />

2019, close to the upper bound of the PBOC’s<br />

comfort zone.<br />

The capex recovery happens at a quicker and<br />

stronger pace due to a combination of a<br />

stronger pick-up in demand and easing lending<br />

conditions, strengthening the growth<br />

momentum. Stronger fiscal spending ahead of<br />

the elections would boost consumption expenditure,<br />

particularly in rural areas.<br />

The Comprehensive Government Action Plan,<br />

with the pro-reform agenda including measures<br />

such as infrastructure investment, redistribution<br />

of spending towards education and healthcare<br />

as well as public service reform, boosts sentiment,<br />

supports investment and increases<br />

potential growth. Geopolitical tensions ease.<br />

Western sanctions are lifted gradually, supporting<br />

business confidence and growth further.<br />

A reformist candidate wins the presidential<br />

elections and puts the pension reform back on<br />

track, which should lead to a pick-up in confidence.<br />

This would impact growth positively, creating<br />

slight inflation pressures, which would be<br />

partly offset by a stronger currency. The central<br />

bank would then engage in a hiking cycle, but<br />

bring rates to a lower level as compared to our<br />

bear case.<br />

18


M<br />

M<br />

India: Towards a full-fledged recovery<br />

Derrick Kam<br />

Avni Jain<br />

(852) 2239 7826<br />

(91) 6118 1850<br />

With end demand holding up well, private capex appears poised<br />

for a recovery later this year. As the economy enters into a fullfledged<br />

recovery, we expect the central bank to embark on a<br />

shallow rate hike cycle beginning from 4Q18.<br />

We maintain our expectation for a recovery in real GDP growth to<br />

7.5%Y in 2018 and further to 7.7%Y in 2019, from 6.4%Y in 2017. More<br />

importantly, we believe that the economy is on track towards a fullfledged<br />

recovery, as we expect a recovery in private capex later this<br />

year.<br />

Full-fledged recovery to take hold: Since September 2017, economic<br />

growth has been recovering as the economy is leaving behind<br />

the headwinds caused by the currency replacement programme and<br />

GST implementation. Private consumption expenditure has<br />

remained robust while exports growth, despite the volatile monthly<br />

movements, has also been on a recovery path. More recently, we<br />

have begun to see incipient signs of a revival in investment activity,<br />

with capital goods imports and order books of engineering and construction<br />

firms posting strong growth in recent months.<br />

Looking ahead, as end demand holds up well, we are confident that<br />

a recovery in private capex will be under way later this year. Indeed,<br />

with the current recovery in consumption and exports, capacity utilisation<br />

ratios have already begun to pick up, rising to 74.1% in 4Q17<br />

from 71.8% previously. Corporate balance sheet fundamentals are<br />

improving, with interest rates dipping below corporate revenue<br />

growth and also reflected in favourable trends in credit ratios (ratings<br />

upgrade to downgrade ratio). Together, these factors should<br />

lead to a recovery in private capex in 2018.<br />

Temporary spike in CPI inflation: Softer sequential trends in food<br />

prices have led to weaker headline CPI inflation, while core measures<br />

of inflation have been edging up. Incorporating higher oil prices and<br />

taking on board the incoming food price trends, we have revised our<br />

forecast upwards marginally to 4.6%Y for 2018. In the June 2018<br />

quarter, favourable base effects should kick in and lead to a temporary<br />

spike in headline inflation. However, these effects will likely fade<br />

by July, and we expect headline inflation to average 4.0%Y in the<br />

December 2018 quarter.<br />

A shallow rate hike cycle from 4Q18: We expect the RBI to commence<br />

its rate hike cycle from 4Q18, as we think that the MPC does<br />

have time to pause and assess more incoming data before acting in<br />

4Q. This is predicated on our view that we don’t expect a significant<br />

overshoot of inflation relative to the RBI’s target (hence reducing the<br />

urgency/impetus to hike rates) and that the economic recovery will<br />

be on a surer footing by then (as we expect private capex to show<br />

signs of recovery). Against this backdrop of greater certainty and a<br />

more sustained recovery in growth, the central bank can then move<br />

to commence a shallow rate hike cycle. Over 2018-19, we pencil in a<br />

total of only three rate hikes, taking the terminal policy rate to 6.75%.<br />

Risks skewed to the downside: In addition to the swings in trade<br />

and financial conditions at a global level, the domestic factors of private<br />

capex momentum and the election outcome in May 2019 would<br />

be the key swing factors. In the bull case, the capex recovery happens<br />

at a quicker and stronger pace due to a combination of a stronger<br />

pick-up in demand and easing lending conditions, strengthening the<br />

growth momentum. In the bear case, the financial system remains<br />

impaired and is unable to fully support a recovery in growth. Policy<br />

uncertainty prevails in the run-up to and post the election which, coupled<br />

with weaker trade and tighter financial conditions globally,<br />

should result in businesses holding back on spending, posing a drag<br />

on growth.<br />

India: Forecast summary<br />

2016 2017 2018E 2019E<br />

Real GDP (%Y) 7.9 6.4 7.5 7.7<br />

Private consumption 8.3 5.7 7.4 7.3<br />

Government consumption 9.0 11.1 7.6 7.6<br />

Gross fixed investment 10.5 6.6 7.9 8.6<br />

Contribution to GDP (pp)<br />

Final domestic demand 8.8 6.4 7.4 7.6<br />

Net exports 0.2 -0.8 0.0 0.1<br />

Inventories -1.0 -0.3 0.0 0.0<br />

Unemp. rate (% labour force) NA NA NA NA<br />

CPI (%Y) 5.0 3.3 4.6 4.4<br />

Core CPI (%Y) 4.8 4.6 5.2 4.6<br />

Policy rate (eop, %) 6.25 6.00 6.25 6.75<br />

General govt. balance (% GDP) -7.0 -6.7 -6.5 -6.3<br />

Gross govt. debt (% GDP) 67.8 66.7 68.0 68.0<br />

Current account balance (% GDP) -0.6 -1.5 -1.6 -2.2<br />

Source: CSO, RBI, CEIC, Morgan Stanley Research forecasts<br />

MORGAN STANLEY RESEARCH 25


Psychology of Money<br />

The<br />

1, 2018 by Morgan Housel<br />

Jun<br />

6/8/2018 The Psychology of Money · Collaborative Fund<br />

About Investments People Blog Projects<br />

(PDF version here)<br />

et me tell you the story of two investors, neither of whom knew<br />

each other, but whose paths crossed in an interesting way.<br />

Grace Groner was orphaned at age 12. She never married. She<br />

L<br />

never had kids. She never drove a car. She lived most of her life alone in a<br />

one-bedroom house and worked her whole career as a secretary. She was, by<br />

all accounts, a lovely lady. But she lived a humble and quiet life. That made<br />

the $7 million she left to charity after her death in 2010 at age 100 all the<br />

more confusing. People who knew her asked: Where did Grace get all that<br />

money?<br />

But there was no secret. There was no inheritance. Grace took humble<br />

savings from a meager salary and enjoyed eighty years of hands-off<br />

compounding in the stock market. That was it.<br />

Weeks after Grace died, an unrelated investing story hit the news.<br />

Richard Fuscone, former vice chairman of Merrill Lynch’s Latin America<br />

division, declared personal bankruptcy, fighting off foreclosure on two<br />

homes, one of which was nearly 20,000 square feet and had a $66,000 a<br />

month mortgage. Fuscone was the opposite of Grace Groner; educated at<br />

Harvard and University of Chicago, he became so successful in the<br />

investment industry that he retired in his 40s to “pursue personal and<br />

charitable interests.” But heavy borrowing and illiquid investments did him<br />

in. The same year Grace Goner left a veritable fortune to charity, Richard<br />

stood before a bankruptcy judge and declared: “I have been devastated by<br />

the financial crisis … The only source of liquidity is whatever my wife is able<br />

to sell in terms of personal furnishings.”<br />

The purpose of these stories is not to say you should be like Grace and avoid<br />

being like Richard. It’s to point out that there is no other field where<br />

these stories are even possible.<br />

In what other field does someone with no education, no relevant experience,<br />

no resources, and no connections vastly outperform someone with the best<br />

education, the most relevant experiences, the best resources and the best<br />

connections? There will never be a story of a Grace Groner performing heart<br />

surgery better than a Harvard-trained cardiologist. Or building a faster chip<br />

than Apple’s engineers. Unthinkable.<br />

But these stories happen in investing.<br />

That’s because investing is not the study of finance. It’s the study of how<br />

people behave with money. And behavior is hard to teach, even to really<br />

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smart people. You can’t sum up behavior with formulas to memorize or<br />

spreadsheet models to follow. Behavior is inborn, varies by person, is hard to<br />

measure, changes over time, and people are prone to deny its existence,<br />

especially when describing themselves.<br />

Grace and Richard show that managing money isn’t necessarily about what<br />

you know; it’s how you behave. But that’s not how finance is typically taught<br />

or discussed. The finance industry talks too much about what to do,<br />

and not enough about what happens in your head when you try to<br />

do it.<br />

This report describes 20 flaws, biases, and causes of bad behavior I’ve seen<br />

pop up often when people deal with money.<br />

1. Earned success and deserved failure fallacy: A tendency to<br />

underestimate the role of luck and risk, and a failure to recognize<br />

that luck and risk are different sides of the same coin.<br />

I like to ask people, “What do you want to know about investing that we can’t<br />

know?”<br />

It’s not a practical question. So few people ask it. But it forces anyone you ask<br />

to think about what they intuitively think is true but don’t spend much time<br />

trying to answer because it’s futile.<br />

Years ago I asked economist Robert Shiller the question. He answered, “The<br />

exact role of luck in successful outcomes.”<br />

I love that, because no one thinks luck doesn’t play a role in financial<br />

success. But since it’s hard to quantify luck, and rude to suggest people’s<br />

success is owed to luck, the default stance is often to implicitly ignore luck as<br />

a factor. If I say, “There are a billion investors in the world. By sheer chance,<br />

would you expect 100 of them to become billionaires predominately off<br />

luck?” You would reply, “Of course.” But then if I ask you to name those<br />

investors – to their face – you will back down. That’s the problem.<br />

The same goes for failure. Did failed businesses not try hard enough? Were<br />

bad investments not thought through well enough? Are wayward careers the<br />

product of laziness?<br />

In some parts, yes. Of course. But how much? It’s so hard to know. And when<br />

it’s hard to know we default to the extremes of assuming failures are<br />

predominantly caused by mistakes. Which itself is a mistake.<br />

People’s lives are a reflection of the experiences they’ve had and the people<br />

they’ve met, a lot of which are driven by luck, accident, and chance. The line<br />

between bold and reckless is thinner than people think, and you cannot<br />

believe in risk without believing in luck, because they are two sides of the<br />

same coin. They are both the simple idea that sometimes things happen that<br />

influence outcomes more than effort alone can achieve.<br />

After my son was born I wrote him a letter:<br />

Some people are born into families that encourage education; others<br />

are against it. Some are born into flourishing economies encouraging<br />

of entrepreneurship; others are born into war and destitution. I want<br />

you to be successful, and I want you to earn it. But realize that not all<br />

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success is due to hard work, and not all poverty is due to laziness.<br />

Keep this in mind when judging people, including yourself.<br />

2. Cost avoidance syndrome: A failure to identify the true costs of<br />

a situation, with too much emphasis on financial costs while<br />

ignoring the emotional price that must be paid to win a reward.<br />

Say you want a new car. It costs $30,000. You have a few options: 1) Pay<br />

$30,000 for it. 2) Buy a used one for less than $30,000. 3) Or steal it.<br />

In this case, 99% of people avoid the third option, because the consequences<br />

of stealing a car outweigh the upside. This is obvious.<br />

But say you want to earn a 10% annual return over the next 50 years. Does<br />

this reward come free? Of course not. Why would the world give you<br />

something amazing for free? Like the car, there’s a price that has to be paid.<br />

The price, in this case, is volatility and uncertainty. And like the car, you<br />

have a few options: You can pay it, accepting volatility and uncertainty. You<br />

can find an asset with less uncertainty and a lower payoff, the equivalent of a<br />

used car. Or you can attempt the equivalent of grand theft auto: Take the<br />

return while trying to avoid the volatility that comes along with it.<br />

Many people in this case choose the third option. Like a car thief – though<br />

well-meaning and law-abiding – they form tricks and strategies to get the<br />

return without paying the price. Trades. Rotations. Hedges. Arbitrages.<br />

Leverage.<br />

But the Money Gods do not look highly upon those who seek a reward<br />

without paying the price. Some car thieves will get away with it. Many more<br />

will be caught with their pants down. Same thing with money.<br />

This is obvious with the car and less obvious with investing because the true<br />

cost of investing – or anything with money – is rarely the financial fee that is<br />

easy to see and measure. It’s the emotional and physical price demanded by<br />

markets that are pretty efficient. Monster Beverage stock rose 211,000%<br />

from 1995 to 2016. But it lost more than half its value on five separate<br />

occasions during that time. That is an enormous psychological price to pay.<br />

Buffett made $90 billion. But he did it by reading SEC filings 12 hours a day<br />

for 70 years, often at the expense of paying attention to his family. Here too,<br />

a hidden cost.<br />

Every money reward has a price beyond the financial fee you can see and<br />

count. Accepting that is critical. Scott Adams once wrote: “One of the best<br />

pieces of advice I’ve ever heard goes something like this: If you want success,<br />

figure out the price, then pay it. It sounds trivial and obvious, but if you<br />

unpack the idea it has extraordinary power.” Wonderful money advice.<br />

3. Rich man in the car paradox.<br />

When you see someone driving a nice car, you rarely think, “Wow, the guy<br />

driving that car is cool.” Instead, you think, “Wow, if I had that car people<br />

would think I’m cool.” Subconscious or not, this is how people think.<br />

The paradox of wealth is that people tend to want it to signal to others that<br />

they should be liked and admired. But in reality those other people bypass<br />

admiring you, not because they don’t think wealth is admirable, but because<br />

they use your wealth solely as a benchmark for their own desire to be liked<br />

and admired.<br />

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This stuff isn’t subtle. It is prevalent at every income and wealth level. There<br />

is a growing business of people renting private jets on the tarmac for 10<br />

minutes to take a selfie inside the jet for Instagram. The people taking these<br />

selfies think they’re going to be loved without realizing that they probably<br />

don’t care about the person who actually owns the jet beyond the fact that<br />

they provided a jet to be photographed in.<br />

The point isn’t to abandon the pursuit of wealth, of course. Or even fancy<br />

cars – I like both. It’s recognizing that people generally aspire to be respected<br />

by others, and humility, graciousness, intelligence, and empathy tend to<br />

generate more respect than fast cars.<br />

4. A tendency to adjust to current circumstances in a way that<br />

makes forecasting your future desires and actions difficult,<br />

resulting in the inability to capture long-term compounding<br />

rewards that come from current decisions.<br />

Every five-year-old boy wants to drive a tractor when they grow up. Then you<br />

grow up and realize that driving a tractor maybe isn’t the best career. So as a<br />

teenager you dream of being a lawyer. Then you realize that lawyers work so<br />

hard they rarely see their families. So then you become a stay-at-home<br />

parent. Then at age 70 you realize you should have saved more money for<br />

retirement.<br />

Things change. And it’s hard to make long-term decisions when your view of<br />

what you’ll want in the future is so liable to shift.<br />

This gets back to the first rule of compounding: Never interrupt it<br />

unnecessarily. But how do you not interrupt a money plan – careers,<br />

investments, spending, budgeting, whatever – when your life plans change?<br />

It’s hard. Part of the reason people like Grace Groner and Warren Buffett<br />

become so successful is because they kept doing the same thing for decades<br />

on end, letting compounding run wild. But many of us evolve so much over a<br />

lifetime that we don’t want to keep doing the same thing for decades on end.<br />

Or anything close to it. So rather than one 80-something-year lifespan, our<br />

money has perhaps four distinct 20-year blocks. Compounding doesn’t work<br />

as well in that situation.<br />

There is no solution to this. But one thing I’ve learned that may help is<br />

coming back to balance and room for error. Too much devotion to one goal,<br />

one path, one outcome, is asking for regret when you’re so susceptible to<br />

change.<br />

5. Anchored-to-your-own-history bias: Your personal experiences<br />

make up maybe 0.00000001% of what’s happened in the world<br />

but maybe 80% of how you think the world works.<br />

If you were born in 1970 the stock market went up 10-fold adjusted for<br />

inflation in your teens and 20s – your young impressionable years when you<br />

were learning baseline knowledge about how investing and the economy<br />

work. If you were born in 1950, the same market went exactly nowhere in<br />

your teens and 20s:<br />

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There are so many ways to cut this idea. Someone who grew up in Flint,<br />

Michigan got a very different view of the importance of manufacturing jobs<br />

than someone who grew up in Washington D.C. Coming of age during the<br />

Great Depression, or in war-ravaged 1940s Europe, set you on a path of<br />

beliefs, goals, and priorities that most people reading this, including myself,<br />

can’t fathom.<br />

The Great Depression scared a generation for the rest of their lives. Most of<br />

them, at least. In 1959 John F. Kennedy was asked by a reporter what he<br />

remembered from the depression, and answered:<br />

I have no first-hand knowledge of the depression. My family had one<br />

of the great fortunes of the world and it was worth more than ever<br />

then. We had bigger houses, more servants, we traveled more. About<br />

the only thing that I saw directly was when my father hired some<br />

extra gardeners just to give them a job so they could eat. I really did<br />

not learn about the depression until I read about it at Harvard.<br />

Since no amount of studying or open-mindedness can genuinely recreate the<br />

power of fear and uncertainty, people go through life with totally different<br />

views on how the economy works, what it’s capable of doing, how much we<br />

should protect other people, and what should and shouldn’t be valued.<br />

The problem is that everyone needs a clear explanation of how the world<br />

works to keep their sanity. It’s hard to be optimistic if you wake up in the<br />

morning and say, “I don’t know why most people think the way they do,”<br />

because people like the feeling of predictability and clean narratives. So they<br />

use the lessons of their own life experiences to create models of how they<br />

think the world should work – particularly for things like luck, risk, effort,<br />

and values.<br />

And that’s a problem. When everyone has experienced a fraction of what’s<br />

out there but uses those experiences to explain everything they expect to<br />

happen, a lot of people eventually become disappointed, confused, or<br />

dumbfounded at others’ decisions.<br />

A team of economists once crunched the data on a century’s worth of<br />

people’s investing habits and concluded: “Current [investment] beliefs<br />

depend on the realizations experienced in the past.”<br />

Keep that quote in mind when debating people’s investing views. Or when<br />

you’re confused about their desire to hoard or blow money, their fear or<br />

greed in certain situations, or whenever else you can’t understand why<br />

people do what they do with money. Things will make more sense.<br />

6. Historians are Prophets fallacy: Not seeing the irony that<br />

history is the study of surprises and changes while using it as a<br />

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guide to the future. An overreliance on past data as a signal to<br />

future conditions in a field where innovation and change is the<br />

lifeblood of progress.<br />

Geologists can look at a billion years of historical data and form models of<br />

how the earth behaves. So can meteorologists. And doctors – kidneys<br />

operate the same way in 2018 as they did in 1018.<br />

The idea that the past offers concrete directions about the future is<br />

tantalizing. It promotes the idea that the path of the future is buried within<br />

the data. Historians – or anyone analyzing the past as a way to indicate the<br />

future – are some of the most important members of many fields.<br />

I don’t think finance is one of them. At least not as much as we’d like to<br />

think.<br />

The cornerstone of economics is that things change over time, because the<br />

invisible hand hates anything staying too good or too bad indefinitely. Bill<br />

Bonner once described how Mr. Market works: “He’s got a ‘Capitalism at<br />

Work’ T-shirt on and a sledgehammer in his hand.” Few things stay the same<br />

for very long, which makes historians something far less useful than<br />

prophets.<br />

Consider a few big ones.<br />

The 401(K) is 39 years old – barely old enough to run for president. The<br />

Roth IRA isn’t old enough to drink. So personal financial advice and analysis<br />

about how Americans save for retirement today is not directly comparable to<br />

what made sense just a generation ago. Things changed.<br />

The venture capital industry barely existed 25 years ago. There are single<br />

funds today that are larger than the entire industry was a generation ago.<br />

Phil Knight wrote about his early days after starting Nike: “There was no<br />

such thing as venture capital. An aspiring young entrepreneur had very few<br />

places to turn, and those places were all guarded by risk-averse gatekeepers<br />

with zero imagination. In other words, bankers.” So our knowledge of<br />

backing entrepreneurs, investment cycles, and failure rates, is not something<br />

we have a deep base of history to learn from. Things changed.<br />

Or take public markets. The S&P 500 did not include financial stocks until<br />

1976; today, financials make up 16% of the index. Technology stocks were<br />

virtually nonexistent 50 years ago. Today, they’re more than a fifth of the<br />

index. Accounting rules have changed over time. So have disclosures,<br />

auditing, and market liquidity. Things changed.<br />

The most important driver of anything tied to money is the stories people tell<br />

themselves and the preferences they have for goods and services. Those<br />

things don’t tend to sit still. They change with culture and generation. And<br />

they’ll keep changing.<br />

The mental trick we play on ourselves here is an over-admiration of people<br />

who have been there, done that, when it comes to money. Experiencing<br />

specific events does not necessarily qualify you to know what will happen<br />

next. In fact it rarely does, because experience leads to more overconfidence<br />

than prophetic ability.<br />

That doesn’t mean we should ignore history when thinking about money. But<br />

there’s an important nuance: The further back in history you look, the more<br />

general your takeaways should be. General things like people’s relationship<br />

to greed and fear, how they behave under stress, and how they respond to<br />

incentives tends to be stable in time. The history of money is useful for that<br />

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kind of stuff. But specific trends, specific trades, specific sectors, and specific<br />

causal relationships are always a showcase of evolution in progress.<br />

7. The seduction of pessimism in a world where optimism is the<br />

most reasonable stance.<br />

Historian Deirdre McCloskey says, “For reasons I have never understood,<br />

people like to hear that the world is going to hell.”<br />

This isn’t new. John Stuart Mill wrote in the 1840s: “I have observed that not<br />

the man who hopes when others despair, but the man who despairs when<br />

others hope, is admired by a large class of persons as a sage.”<br />

Part of this is natural. We’ve evolved to treat threats as more urgent than<br />

opportunities. Buffett says, “In order to succeed, you must first survive.”<br />

But pessimism about money takes a different level of allure. Say there’s going<br />

to be a recession and you will get retweeted. Say we’ll have a big recession<br />

and newspapers will call you. Say we’re nearing the next Great Depression<br />

and you’ll get on TV. But mention that good times are ahead, or markets<br />

have room to run, or that a company has huge potential, and a common<br />

reaction from commentators and spectators alike is that you are either a<br />

salesman or comically aloof of risks.<br />

A few things are going on here.<br />

One is that money is ubiquitous, so something bad happening tends to affect<br />

everyone, albeit in different ways. That isn’t true of, say, weather. A<br />

hurricane barreling down on Florida poses no direct risk to 92% of<br />

Americans. But a recession barreling down on the economy could impact<br />

every single person – including you, so pay attention. This goes for<br />

something as specific as the stock market: More than half of all households<br />

directly own stocks.<br />

Another is that pessimism requires action – Move! Get out! Run! Sell! Hide!<br />

Optimism is mostly a call to stay the course and enjoy the ride. So it’s not<br />

nearly as urgent.<br />

A third is that there is a lot of money to be made in the finance industry,<br />

which – despite regulations – has attracted armies of scammers, hucksters,<br />

and truth-benders promising the moon. A big enough bonus can convince<br />

even honest, law-abiding finance workers selling garbage products that<br />

they’re doing good for their customers. Enough people have been<br />

bamboozled by the finance industry that a sense of, “If it sounds too good to<br />

be true, it probably is” has enveloped even rational promotions of optimism.<br />

Most promotions of optimism, by the way, are rational. Not all, of course.<br />

But we need to understand what optimism is. Real optimists don’t believe<br />

that everything will be great. That’s complacency. Optimism is a belief that<br />

the odds of a good outcome are in your favor over time, even when there will<br />

be setbacks along the way. The simple idea that most people wake up in the<br />

morning trying to make things a little better and more productive than wake<br />

up looking to cause trouble is the foundation of optimism. It’s not<br />

complicated. It’s not guaranteed, either. It’s just the most reasonable bet for<br />

most people. The late statistician Hans Rosling put it differently: “I am not<br />

an optimist. I am a very serious possibilist.”<br />

8. Underappreciating the power of compounding, driven by the<br />

tendency to intuitively think about exponential growth in linear<br />

terms.<br />

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IBM made a 3.5 megabyte hard drive in the 1950s. By the 1960s things were<br />

moving into a few dozen megabytes. By the 1970s, IBM’s Winchester drive<br />

held 70 megabytes. Then drives got exponentially smaller in size with more<br />

storage. A typical PC in the early 1990s held 200-500 megabytes.<br />

And then … wham. Things exploded.<br />

1999 – Apple’s iMac comes with a 6 gigabyte hard drive.<br />

2003 – 120 gigs on the Power Mac.<br />

2006 – 250 gigs on the new iMac.<br />

2011 – first 4 terabyte hard drive.<br />

2017 – 60 terabyte hard drives.<br />

Now put it together. From 1950 to 1990 we gained 296 megabytes. From<br />

1990 through today we gained 60 million megabytes.<br />

The punchline of compounding is never that it’s just big. It’s always – no<br />

matter how many times you study it – so big that you can barely wrap your<br />

head around it. In 2004 Bill Gates criticized the new Gmail, wondering why<br />

anyone would need a gig of storage. Author Steven Levy wrote, “Despite his<br />

currency with cutting-edge technologies, his mentality was anchored in the<br />

old paradigm of storage being a commodity that must be conserved.” You<br />

never get accustomed to how quickly things can grow.<br />

I have heard many people say the first time they saw a compound interest<br />

table – or one of those stories about how much more you’d have for<br />

retirement if you began saving in your 20s vs. your 30s – changed their life.<br />

But it probably didn’t. What it likely did was surprise them, because the<br />

results intuitively didn’t seem right. Linear thinking is so much more<br />

intuitive than exponential thinking. Michael Batnick once explained it. If I<br />

ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a<br />

few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your<br />

head will explode (it’s 134,217,728).<br />

The danger here is that when compounding isn’t intuitive, we often ignore its<br />

potential and focus on solving problems through other means. Not because<br />

we’re overthinking, but because we rarely stop to consider compounding<br />

potential.<br />

There are over 2,000 books picking apart how Warren Buffett built his<br />

fortune. But none are called “This Guy Has Been Investing Consistently for<br />

Three-Quarters of a Century.” But we know that’s the key to the majority of<br />

his success; it’s just hard to wrap your head around that math because it’s<br />

not intuitive. There are books on economic cycles, trading strategies, and<br />

sector bets. But the most powerful and important book should be called<br />

“Shut Up And Wait.” It’s just one page with a long-term chart of economic<br />

growth. Physicist Albert Bartlett put it: “The greatest shortcoming of the<br />

human race is our inability to understand the exponential function.”<br />

The counterintuitiveness of compounding is responsible for the majority of<br />

disappointing trades, bad strategies, and successful investing attempts. Good<br />

investing isn’t necessarily about earning the highest returns, because the<br />

highest returns tend to be one-off hits that kill your confidence when they<br />

end. It’s about earning pretty good returns that you can stick with for a long<br />

period of time. That’s when compounding runs wild.<br />

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9. Attachment to social proof in a field that demands contrarian<br />

thinking to achieve above-average results.<br />

The Berkshire Hathaway annual meeting in Omaha attracts 40,000 people,<br />

all of whom consider themselves contrarians. People show up at 4 am to wait<br />

in line with thousands of other people to tell each other about their lifelong<br />

commitment to not following the crowd. Few see the irony.<br />

Anything worthwhile with money has high stakes. High stakes entail risks of<br />

being wrong and losing money. Losing money is emotional. And the desire to<br />

avoid being wrong is best countered by surrounding yourself with people<br />

who agree with you. Social proof is powerful. Someone else agreeing with<br />

you is like evidence of being right that doesn’t have to prove itself with facts.<br />

Most people’s views have holes and gaps in them, if only subconsciously.<br />

Crowds and social proof help fill those gaps, reducing doubt that you could<br />

be wrong.<br />

The problem with viewing crowds as evidence of accuracy when dealing with<br />

money is that opportunity is almost always inversely correlated with<br />

popularity. What really drives outsized returns over time is an increase in<br />

valuation multiples, and increasing valuation multiples relies on an<br />

investment getting more popular in the future – something that is always<br />

anchored by current popularity.<br />

Here’s the thing: Most attempts at contrarianism is just irrational cynicism<br />

in disguise – and cynicism can be popular and draw crowds. Real<br />

contrarianism is when your views are so uncomfortable and belittled that<br />

they cause you to second guess whether they’re right. Very few people can do<br />

that. But of course that’s the case. Most people can’t be contrarian, by<br />

definition. Embrace with both hands that, statistically, you are one of those<br />

people.<br />

10. An appeal to academia in a field that is governed not by clean<br />

rules but loose and unpredictable trends.<br />

Harry Markowitz won the Nobel Prize in economics for creating formulas<br />

that tell you exactly how much of your portfolio should be in stocks vs. bonds<br />

depending on your ideal level of risk. A few years ago the Wall Street Journal<br />

asked him how, given his work, he invests his own money. He replied:<br />

I visualized my grief if the stock market went way up and I wasn’t in it<br />

– or if it went way down and I was completely in it. My intention was<br />

to minimize my future regret. So I split my contributions 50/50<br />

between bonds and equities.<br />

There are many things in academic finance that are technically right but fail<br />

to describe how people actually act in the real world. Plenty of academic<br />

finance work is useful and has pushed the industry in the right direction. But<br />

its main purpose is often intellectual stimulation and to impress other<br />

academics. I don’t blame them for this or look down upon them for it. We<br />

should just recognize it for what it is.<br />

One study I remember showed that young investors should use 2x leverage<br />

in the stock market, because – statistically – even if you get wiped out you’re<br />

still likely to earn superior returns over time, as long as you dust yourself off<br />

and keep investing after a wipeout. Which, in the real world, no one would<br />

actually do. They’d swear off investing for life. What works on a spreadsheet<br />

and what works at the kitchen table are ten miles apart.<br />

The disconnect here is that academics typically desire very precise rules and<br />

formulas. But real-world people use it as a crutch to try to make sense of a<br />

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messy and confusing world that, by its nature, eschews precision. Those are<br />

opposite things. You cannot explain randomness and emotion with precision<br />

and reason.<br />

People are also attracted to the titles and degrees of academics because<br />

finance is not a credential-sanctioned field like, say, medicine is. So the<br />

appearance of a Ph.D stands out. And that creates an intense appeal to<br />

academia when making arguments and justifying beliefs – “According to this<br />

Harvard study …” or “As Nobel Prize winner so and so showed …” It carries<br />

so much weight when other people cite, “Some guy on CNBC from an<br />

eponymous firm with a tie and a smile.” A hard reality is that what often<br />

matters most in finance will never win a Nobel Prize: Humility and room for<br />

error.<br />

11. The social utility of money coming at the direct expense of<br />

growing money; wealth is what you don’t see.<br />

I used to park cars at a hotel. This was in the mid-2000s in Los Angeles,<br />

when real estate money flowed. I assumed that a customer driving a Ferrari<br />

was rich. Many were. But as I got to know some of these people, I realized<br />

they weren’t that successful. At least not nearly what I assumed. Many were<br />

mediocre successes who spent most of their money on a car.<br />

If you see someone driving a $200,000 car, the only data point you have<br />

about their wealth is that they have $200,000 less than they did before they<br />

bought the car. Or they’re leasing the car, which truly offers no indication of<br />

wealth.<br />

We tend to judge wealth by what we see. We can’t see people’s bank accounts<br />

or brokerage statements. So we rely on outward appearances to gauge<br />

financial success. Cars. Homes. Vacations. Instagram photos.<br />

But this is America, and one of our cherished industries is helping people<br />

fake it until they make it.<br />

Wealth, in fact, is what you don’t see. It’s the cars not purchased. The<br />

diamonds not bought. The renovations postponed, the clothes forgone and<br />

the first-class upgrade declined. It’s assets in the bank that haven’t yet been<br />

converted into the stuff you see.<br />

But that’s not how we think about wealth, because you can’t contextualize<br />

what you can’t see.<br />

Singer Rihanna nearly went broke after overspending and sued her financial<br />

advisor. The advisor responded: “Was it really necessary to tell her that if<br />

you spend money on things, you will end up with the things and not the<br />

money?”<br />

You can laugh. But the truth is, yes, people need to be told that. When most<br />

people say they want to be a millionaire, what they really mean is “I want to<br />

spend a million dollars,” which is literally the opposite of being a millionaire.<br />

This is especially true for young people.<br />

A key use of wealth is using it to control your time and providing you with<br />

options. Financial assets on a balance sheet offer that. But they come at the<br />

direct expense of showing people how much wealth you have with material<br />

stuff.<br />

12. A tendency toward action in a field where the first rule of<br />

compounding is to never interrupt it unnecessarily.<br />

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If your sink breaks, you grab a wrench and fix it. If your arm breaks, you put<br />

it in a cast.<br />

What do you do when your financial plan breaks?<br />

The first question – and this goes for personal finance, business finance, and<br />

investing plans – is how do you know when it’s broken?<br />

A broken sink is obvious. But a broken investment plan is open to<br />

interpretation. Maybe it’s just temporarily out of favor? Maybe you’re<br />

experiencing normal volatility? Maybe you had a bunch of one-off expenses<br />

this quarter but your savings rate is still adequate? It’s hard to know.<br />

When it’s hard to distinguish broken from temporarily out of favor, the<br />

tendency is to default to the former, and spring into action. You start fiddling<br />

with the knobs to find a fix. This seems like the responsible thing to do,<br />

because when virtually everything else in your life is broken, the correct<br />

action is to fix it.<br />

There are times when money plans need to be fixed. Oh, are there ever. But<br />

there is also no such thing as a long-term money plan that isn’t susceptible to<br />

volatility. Occasional upheaval is usually part of a standard plan.<br />

When volatility is guaranteed and normal, but is often treated as something<br />

that needs to be fixed, people take actions that ultimately just interrupts the<br />

execution of a good plan. “Don’t do anything,” are the most powerful words<br />

in finance. But they are both hard for individuals to accept and hard for<br />

professionals to charge a fee for. So, we fiddle. Far too much.<br />

13. Underestimating the need for room for error, not just<br />

financially but mentally and physically.<br />

Ben Graham once said, “The purpose of the margin of safety is to render the<br />

forecast unnecessary.”<br />

There is so much wisdom in this quote. But the most common response, even<br />

if subconsciously, is, “Thanks Ben. But I’m good at forecasting.”<br />

People underestimate the need for room for error in almost everything they<br />

do that involves money. Two things cause this: One is the idea that your view<br />

of the future is right, driven by the uncomfortable feeling that comes from<br />

admitting the opposite. The second is that you’re therefore doing yourself<br />

economic harm by not taking actions that exploit your view of the future<br />

coming true.<br />

But room for error is underappreciated and misunderstood. It’s often viewed<br />

as a conservative hedge, used by those who don’t want to take much risk or<br />

aren’t confident in their views. But when used appropriately it’s the opposite.<br />

Room for error lets you endure, and endurance lets you stick around long<br />

enough to let the odds of benefiting from a low-probability outcome fall in<br />

your favor. The biggest gains occur infrequently, either because they don’t<br />

happen often or because they take time to compound. So the person with<br />

enough room for error in part of their strategy to let them endure hardship<br />

in the other part of their strategy has an edge over the person who gets wiped<br />

out, game over, insert more tokens, when they’re wrong.<br />

There are also multiple sides to room for error. Can you survive your assets<br />

declining by 30%? On a spreadsheet, maybe yes – in terms of actually paying<br />

your bills and staying cash-flow positive. But what about mentally? It is easy<br />

to underestimate what a 30% decline does to your psyche. Your confidence<br />

may become shot at the very moment opportunity is at its highest. You – or<br />

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your spouse – may decide it’s time for a new plan, or new career. I know<br />

several investors who quit after losses because they were exhausted.<br />

Physically exhausted. Spreadsheets can model the historic frequency of big<br />

declines. But they cannot model the feeling of coming home, looking at your<br />

kids, and wondering if you’ve made a huge mistake that will impact their<br />

lives.<br />

14. A tendency to be influenced by the actions of other people who<br />

are playing a different financial game than you are.<br />

Cisco stock went up three-fold in 1999. Why? Probably not because people<br />

actually thought the company was worth $600 billion. Burton Malkiel once<br />

pointed out that Cisco’s implied growth rate at that valuation meant it would<br />

become larger than the entire U.S. economy within 20 years.<br />

Its stock price was going up because short-term traders thought it would<br />

keep going up. And they were right, for a long time. That was the game they<br />

were playing – “this stock is trading for $60 and I think it’ll be worth $65<br />

before tomorrow.”<br />

But if you were a long-term investor in 1999, $60 was the only price available<br />

to buy. So you may have looked around and said to yourself, “Wow, maybe<br />

others know something I don’t.” And you went along with it. You even felt<br />

smart about it. But then the traders stopped playing their game, and you –<br />

and your game – was annihilated.<br />

What you don’t realize is that the traders moving the marginal price are<br />

playing a totally different game than you are. And if you start taking cues<br />

from people playing a different game than you are, you are bound to be<br />

fooled and eventually become lost, since different games have different rules<br />

and different goals.<br />

Few things matter more with money than understanding your own time<br />

horizon and not being persuaded by the actions and behaviors of people<br />

playing different games.<br />

This goes beyond investing. How you save, how you spend, what your<br />

business strategy is, how you think about money, when you retire, and how<br />

you think about risk may all be influenced by the actions and behaviors of<br />

people who are playing different games than you are.<br />

Personal finance is deeply personal, and one of the hardest parts is learning<br />

from others while realizing that their goals and actions might be miles<br />

removed from what’s relevant to your own life.<br />

15. An attachment to financial entertainment due to the fact that<br />

money is emotional, and emotions are revved up by argument,<br />

extreme views, flashing lights, and threats to your wellbeing.<br />

If the average America’s blood pressure went up by 3%, my guess is a few<br />

newspapers would cover it on page 16, nothing would change, and we’d move<br />

on. But if the stock market falls 3%, well, no need to guess how we might<br />

respond. This is from 2015: “President Barack Obama has been briefed on<br />

Monday’s choppy global market movement.”<br />

Why does financial news of seemingly low importance overwhelm news that<br />

is objectively more important?<br />

Because finance is entertaining in a way other things – orthodontics,<br />

gardening, marine biology – are not. Money has competition, rules, upsets,<br />

wins, losses, heroes, villains, teams, and fans that makes it tantalizingly close<br />

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to a sporting event. But it’s even an addiction level up from that, because<br />

money is like a sporting event where you’re both the fan and the player, with<br />

outcomes affecting you both emotionally and directly.<br />

Which is dangerous.<br />

It helps, I’ve found, when making money decisions to constantly remind<br />

yourself that the purpose of investing is to maximize returns, not minimize<br />

boredom. Boring is perfectly fine. Boring is good. If you want to frame this<br />

as a strategy, remind yourself: opportunity lives where others aren’t, and<br />

others tend to stay away from what’s boring.<br />

16. Optimism bias in risk-taking, or “Russian Roulette should<br />

statistically work” syndrome: An over attachment to favorable<br />

odds when the downside is unacceptable in any circumstance.<br />

Nassim Taleb says, “You can be risk loving and yet completely averse to<br />

ruin.”<br />

The idea is that you have to take risk to get ahead, but no risk that could wipe<br />

you out is ever worth taking. The odds are in your favor when playing<br />

Russian Roulette. But the downside is never worth the potential upside.<br />

The odds of something can be in your favor – real estate prices go up most<br />

years, and most years you’ll get a paycheck every other week – but if<br />

something has 95% odds of being right, then 5% odds of being wrong means<br />

you will almost certainly experience the downside at some point in your life.<br />

And if the cost of the downside is ruin, the upside the other 95% of the time<br />

likely isn’t worth the risk, no matter how appealing it looks.<br />

Leverage is the devil here. It pushes routine risks into something capable of<br />

producing ruin. The danger is that rational optimism most of the time masks<br />

the odds of ruin some of the time in a way that lets us systematically<br />

underestimate risk. Housing prices fell 30% last decade. A few companies<br />

defaulted on their debt. This is capitalism – it happens. But those with<br />

leverage had a double wipeout: Not only were they left broke, but being<br />

wiped out erased every opportunity to get back in the game at the very<br />

moment opportunity was ripe. A homeowner wiped out in 2009 had no<br />

chance of taking advantage of cheap mortgage rates in 2010. Lehman<br />

Brothers had no chance of investing in cheap debt in 2009.<br />

My own money is barbelled. I take risks with one portion and am a terrified<br />

turtle with the other. This is not inconsistent, but the psychology of money<br />

would lead you to believe that it is. I just want to ensure I can remain<br />

standing long enough for my risks to pay off. Again, you have to survive to<br />

succeed.<br />

A key point here is that few things in money are as valuable as options. The<br />

ability to do what you want, when you want, with who you want, and why<br />

you want, has infinite ROI.<br />

17. A preference for skills in a field where skills don’t matter if<br />

they aren’t matched with the right behavior.<br />

This is where Grace and Richard come back in. There is a hierarchy of<br />

investor needs, and each topic here has to be mastered before the one above<br />

it matters:<br />

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Richard was very skilled at the top of this pyramid, but he failed the bottom<br />

blocks, so none of it mattered. Grace mastered the bottom blocks so well that<br />

the top blocks were hardly necessary.<br />

18. Denial of inconsistencies between how you think the world<br />

should work and how the world actually works, driven by a desire<br />

to form a clean narrative of cause and effect despite the inherent<br />

complexities of everything involving money.<br />

Someone once described Donald Trump as “Unable to distinguish between<br />

what happened and what he thinks should have happened.” Politics aside, I<br />

think everyone does this.<br />

There are three parts to this:<br />

You see a lot of information in the world.<br />

You can’t process all of it. So you have to filter.<br />

You only filter in the information that meshes with the way you think the<br />

world should work.<br />

Since everyone wants to explain what they see and how the world works with<br />

clean narratives, inconsistencies between what we think should happen and<br />

what actually happens are buried.<br />

An example. Higher taxes should slow economic growth – that’s a common<br />

sense narrative. But the correlation between tax rates and growth rates is<br />

hard to spot. So, if you hold onto the narrative between taxes and growth,<br />

you say there must be something wrong with the data. And you may be right!<br />

But if you come across someone else pushing aside data to back up their<br />

narrative – say, arguing that hedge funds have to generate alpha, otherwise<br />

no one would invest in them – you spot what you consider a bias. There are a<br />

thousand other examples. Everyone just believes what they want to believe,<br />

even when the evidence shows something else. Stories over statistics.<br />

Accepting that everything involving money is driven by illogical emotions<br />

and has more moving parts than anyone can grasp is a good start to<br />

remembering that history is the study of things happening that people didn’t<br />

think would or could happen. This is especially true with money.<br />

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19. Political beliefs driving financial decisions, influenced by<br />

economics being a misbehaved cousin of politics.<br />

I once attended a conference where a well known investor began his talk by<br />

saying, “You know when President Obama talks about clinging to guns and<br />

bibles? That is me, folks. And I’m going to tell you today about how his<br />

reckless policies are impacting the economy.”<br />

I don’t care what your politics are, there is no possible way you can make<br />

rational investment decisions with that kind of thinking.<br />

But it’s fairly common. Look at what happens in 2016 on this chart. The rate<br />

of GDP growth, jobs growth, stock market growth, interest rates – go down<br />

the list – did not materially change. Only the president did:<br />

Years ago I published a bunch of economic performance numbers by<br />

president. And it drove people crazy, because the data often didn’t mesh with<br />

how they thought it should based on their political beliefs. Soon after a<br />

journalist asked me to comment on a story detailing how, statistically,<br />

Democrats preside over stronger economies than Republicans. I said you<br />

couldn’t make that argument because the sample size is way too small. But<br />

he pushed and pushed, and wrote a piece that made readers either cheer or<br />

sweat, depending on their beliefs.<br />

The point is not that politics don’t influence the economy. But the reason this<br />

is such a sensitive topic is because the data often surprises the heck out of<br />

people, which itself is a reason to realize that the correlation between politics<br />

and economics isn’t as clear as you’d like to think it is.<br />

20. The three-month bubble: Extrapolating the recent past into<br />

the near future, and then overestimating the extent to which<br />

whatever you anticipate will happen in the near future will impact<br />

your future.<br />

News headlines in the month after 9/11 are interesting. Few entertain the<br />

idea that the attack was a one-off; the next massive terrorist attack was<br />

certain to be around the corner. “Another catastrophic terrorist attack is<br />

inevitable and only a matter of time,” one defense analyst said in 2002. “A<br />

top counterterrorism official says it’s ‘a question of when, not if,” wrote<br />

another headline. Beyond the anticipation that another attack was imminent<br />

was a belief that it would affect people the same way. The Today Show ran a<br />

segment pitching parachutes for office workers to keep under their desks in<br />

case they needed to jump out of a skyscraper.<br />

Believing that what just happened will keep happening shows up constantly<br />

in psychology. We like patterns and have short memories. The added feeling<br />

http://www.collaborativefund.com/blog/the-psychology-of-money/ 15/17


6/8/2018 The Psychology of Money · Collaborative Fund<br />

that a repeat of what just happened will keep affecting you the same way is<br />

an offshoot. And when you’re dealing with money it can be a torment.<br />

Every big financial win or loss is followed by mass expectations of more wins<br />

and losses. With it comes a level of obsession over the effects of those events<br />

repeating that can be wildly disconnected from your long-term goals.<br />

Example: The stock market falling 40% in 2008 was followed, uninterrupted<br />

for years, with forecasts of another impending plunge. Expecting what just<br />

happened to happen soon again is one thing, and an error in itself. But not<br />

realizing that your long-term investing goals could remain intact, unharmed,<br />

even if we have another big plunge, is the dangerous byproduct of recency<br />

bias. “Markets tend to recover over time and make new highs” was not a<br />

popular takeaway from the financial crisis; “Markets can crash and crashes<br />

suck,” was, despite the former being so much more practical than the latter.<br />

Most of the time, something big happening doesn’t increase the odds of it<br />

happening again. It’s the opposite, as mean reversion is a merciless law of<br />

finance. But even when something does happen again, most of the time it<br />

doesn’t – or shouldn’t – impact your actions in the way you’re tempted to<br />

think, because most extrapolations are short term while most goals are long<br />

term. A stable strategy designed to endure change is almost always superior<br />

to one that attempts to guard against whatever just happened happening<br />

again.<br />

If there’s a common denominator in these, it’s a preference for humility,<br />

adaptability, long time horizons, and skepticism of popularity around<br />

anything involving money. Which can be summed up as: Be prepared to roll<br />

with the punches.<br />

Jiddu Krishnamurti spent years giving spiritual talks. He became more<br />

candid as he got older. In one famous talk, he asked the audience if they’d<br />

like to know his secret.<br />

He whispered, “You see, I don’t mind what happens.”<br />

That might be the best trick when dealing with the psychology of money.<br />

✉<br />

Jun 1, 2018 by Morgan Housel · @morganhousel<br />

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