Many moons ago, Fundoo Professor wrote- I dont want to be a toll bridge, I want to be its meaning– and if there was ever a business which embodied the idea of an emerging moat then it should be this business.
Every once in a while a book arrives which leaves you spinning, disoriented and exhilirated at the same time. This is that kind of a book.
This book is also one of those, which deftly switches narrative styles- traverses time and contexts and yet keeps an unerring focus on the underlying theme- the Automat Kalashnikova -47. Otherwise known as AK-47.
The journalism is sweeping, the research intensive and history rich- C J Chivers, its author, at once makes “The Gun” a combined narrative of human fantasies, intentions, values, ingenuity and follies.
From the fantasy of Dr Gatling to produce an efficient weapon of war to end all wars to Leonid Minin who was the modern day merchant of death, lord of war arming insurgencies around
the world – the scope and revelations of C J Chivers is broad and comprehensive.
“The price of a Kalashnikov is the barometer of a society’s fears”
Chivers covers the eclectic personalities of gun history from Gatling, to Maxim to Hugo Schmeisser inventor of sturmgewehr(German assault rifle of WW-II fame), finally to firmly focus on Mikhail Kalashnikov- the inventor of the AK-47. But deep within the story also lies the failure of the Soviet state and the paradoxes it gives birth to. Rarely in mankind’s history an invention has been made by deliberation by committees and finetuned and improved upon by an entire nation. AK-47 is an exception. AK-47 though was initially conceived by Kalashnikov and yet the final product which we today see is a gun made by committees, by deliberative bodies and push and pull of Cold War politics. AK-47 long ceased to be Kalashnikov’s gun and instead took a turn towards being the Soviet Union’s gun.
The Gun is also a story of the insurgency and unrest that mars the 21st century. As Cummings, a gun runner remarked, that the demand of AK-47 remains- “an index of human follies”
One idea that repeatedly repeats itself in the book is the apparent simplicity of design, the huge margins of safety attributed to the major operating system of the gun which decided its longevity. Stories of child soldiers retrieving caches of AK-47 years after being buried and then testing them successfully tells a story of its durability. What made the AK-47 so robust?
Neither nature’s ravages nor human stress tests were able to find a fault in it?
In many ways- the core takeaway for me was simplicity trumps. American made M-16, were a shattering and embarrassing failure against AK-47 in Vietnam. They jammed!
But why did they? Weren’t American manufacturing processes better than Soviet ? Wasnt American industry more innovative than Soviet?
M-16 had a lot of flaws.And these flaws were a combination of misguided institutional preferences and blindfolded trudging in strategic space. But from the perspective of engineering- it was too perfect!
It used modern manufacturing techniques which used precision cutting, very high level of calibration and tolerance levels. It was tightly fit and the gap between moving parts was so less that only modern automation could assemble such an engineering marvel.
The idea of engineering precision which enabled man to reach moon (equivalent to firing an intercontinental missile to land on a precise volleyball) was put to use. Tolerance levels shrunk to millimeters and even fractions of that.
When compared to M-16, AK-47 was an abomination of craftsmanship. When one removed its spring, the entire mechanism rattled and jangled. The cartridge feeder system was so designed that when a bullet was fired, the bolt action which expelled the cartridge pulled back a full 150% of a cartridge’s length.
Now what does it mean?
Think about a gun- and the soldier wielding it. Like the soldier- the gun also will travel to various climates, operate in various punishing environments and in extremely stressful combat situations. The gun had to be robust enough to keep operating in all circumstances.
For an automatic, one of the major problems is “failure to extract”. Failure to extract implies a gun’s inability to eject out the spent cartridge( like below, resulting in jamming of guns like in right). This implied that the gun had to keep ejecting cartridges at all times. Now being an automatic machine gun – it comes with its own uniqueness. The gun has to keep operating in long bursts thus the temperature inside a barrel can go extremely high.
In such cases, metal expands in unpredictable ways and any “precision” casting part will soon jam. In contrast, AK-47 because of its huge margins of safety- operated without any hitch at all times.
Long operations also meant accumulation of soot, possible accumulation of dirt etc. AK-47 was so ably designed with enough tolerances that Soviet gun testers had difficulty in making it jam. It was dragged through sand, soaked in salt water and dipped in bog and yet it fired. In one revealing place- Chivers discusses how a friend of Kalshnikov described the tests after it was dragged through sand
“Look, look, sand is flying away in all directions- like a dog shaking of water from its fur”
The system due to its inherent margin of safety was self-correcting.
The implications and lessons for an investor are clear:
1. Maintain adequate tolerance level in your thinking- account for stresses in your viewpoint.
2. Adaptability of mind (because of high margin of safety he has gained in being flexible) renders an investor profitable and less prone to adverse events.
As one reads through the book- the motif is clear. While Soviets were time and again ready to challenge status quo and imitate their opponents, America found itself hobbled and paralysed by remnants of past and blind shutting out of any criticism for self. For once- the Soviets became free thinkers and the Westerns became ossified thinkers.
And free thinkers- won again!
There has been a lot of chatter, pleading, begging, hectoring, bullying and also inane hoping in favour of a rate cut by our RBI governor. Each fortnight every man on the street confidently predicts that there will be a rate cut. I am reminded of my father who predicted each years school exam question papers by pointing out each question as likely and very important.
However, I being the dogmatic and the contrarian stand firmly against any rate cut at this moment. However fortunately I do have some reasons in support of my stand, other than the usual one being “copper the crowd”.
Before I go forward, let me explore the various reasons the cut-mongers are forwarding. One of the most vocal and loud voices is from the government itself. It argues that a rate cut will inject liquidity into the economy, fuel credit expansion and bolster growth. Another section, equally astute argue that a rate cut will have the added implication of “rationalising” the cost of capital. In turn it will make many, now distressed borrowers into prime assets, reducing NPA of the PSU banks and improving hold your breath, credit expansion.
Another class argues that this will again bring in the risk taking animal spirits back into the economy. For good measures it will also improve infrastructure spending for the private players. Needless to say, many of the infrastructure contractors are having a tough time maintaining their cash flow on one hand and juggling the bureaucratic maze, fogginess in regulations etc on the other. All in all, the argument is broadly in line with the benefits of credit expansion.
What are the biggest problems staring ahead of us, right now? The biggest problem is a lack of economic growth. But this is also a very limiting answer. What kind of growth do we really need? Does the growth of 2003-2008 sound extremely desirable, especially in the wake of the cockroaches that are coming out of the various closets?
Let me offer an answer. We need growth, no doubt. Let that be a two digit growth- I will be the first person to call for policies which drive them. But definitely a mindless credit expansion is not the way to go forward. Let us tease out the various ideas here. Growth and its nature needs to be determined going forward for our policymakers. What do we really desire. I cannot say I have all of its facets down pat, but I definitely have some ideas:
1. We need a high technology driven growth. A growth which is fuelled by genuine innovation improving the efficiency of Indians and others. Our incremental capital output ratio since 2003 to 2011 has hovered around 4. This implies that Rupees 4 of capital was required to drive the output of 1 Rupee. Not a great number, but it looks stellar when compared to the ICOR of 2014. It is at a dismal 7. This ratio has to be reduced and this is only possible when real innovation comes through. A higher or lower cost of capital is not going to prove any difference here purely because the real engines of innovation- our MSMEs are anyway not considered credit worthy by our banks. What is needed is to encourage more venture capitalists, angel investors etc.
2. Any country can post stellar growth numbers if reported in a currency which is depreciating fast. Let us report our numbers in Zimbabwean dollars, we can have a mind boggling growth rate. This growth rate however is not because we Indians suddenly stopped reproducing and started producing more. This growth rate will look enormous simply because the “unit” which we have chosen to express ourselves itself is falling at a high rate. To rationalise the perspective, would we want an inflation-driven growth?
When I term a growth as inflation driven, it effectively implies that the total economic value added in the country is consistently and far less than the reported gross domestic product of the country. This is because GDP of a country is expected to reflect the total economic value added at the first place. If it is consistently beating the real fundamental then definitely it’s the inflation which is bufferring up the ship .
What about the usual adage that a little bit of inflation is always a positive thing for the economy?, you may ask. Sure enough, but we have so much in our country right now that we can happily export some of it and yet have more than we need.
3. The most sanest of ideas in favour of a rate cut is that of infrastructure boost. The current cost of capital is definitely a death bugle for many of our fine(and often fine paying) infrastructure companies. They were squeezed by a lethargic government and high cost of capital. Project overruns and fast deteriorating balance sheets are the welcome boards which greet any infrastructure CEO each morning.
However the bigger question is, is this a band aid on the problem or a real excision of the cancer? I argue that the real problem is not high cost of capital but the lack of capital. Each infrastructure project has a horizon of 20-25 years in the books of the companies. Bridges etc can be included as 40 years assets. However a bank financing these projects invariably has to match the asset and liability duration for prudential loan servicing. However by the norms of RBI long duration loans are not allowed to be issued by the banks. The logic goes that the banks are not financing or venture capital institutions but rather short term financing businesses.
In these contexts of numerous paradoxes and the proverbial chicken and egg situation- lowering the cost of capital wont be as helpful as opening up the entire bond market will be.
Asset-Liability mismatch is a clear problem and its only solution is financing has to move away from banks to properly functioning bond markets.
4. One of the biggest issue which compelled me to write this article is the problem of inflation. As individual investors the greatest problem we have is not lack of growth. It is inflation. Every dollar you earn from your paycheque or your investments is subjected to the swords of taxation. However taxation like all matters of devil need not be always visible, tangible and directly observable. You can have invisible, intangible and indirectly observable taxation as well. We know it by the name of inflation. To understand the implication of the same, consider the usual discounted cash flow mechanism to calculate the net present value of any investment avenue. At 8% real growth rate and another 8% long term historical inflation rate. This makes our index return a 16% compounded growth rate over the long term. This in essence brings a benchmark on all other investments we make. 16% in index will be our opportunity cost. This renders anything less than 24-25% less than desirable. An owner-manager with such business dynamics will find doing business tantamount to running on a treadmill. Lots of huffing and puffing but zero displacement. And needless to say a vast majority of our equity markets and ergo a common investors portfolio will consist of the businesses with their return on capital ranging from 18-25%.
Is it any surprise that in spite of capital markets having a history of more than 100 years in India we Indians still buy gold and not businesses? We have the answer even if we don’t know it. Between government and inflation nothing is left for us.
As in biology, survival first- growth next: similarly purchasing power survival first, hence the predilection of Indians towards purchase of hard assets: gold, silver, real estate etc.
Coming back to our original point if owner manager finds running a treadmill at 24-25% return on capital then surely the minority shareholders will find his capital not sweating enough for him. He may feel rich but he definitely wont be rich.
RBI thankfully has for the first time inflation targetting its core concern(which should be). I salute and thank Urjit Patel and Raghuram Rajan for bringing this pragmatism. There has been quite a bit of chatter and I hope a chatter rooted in genuinity, that Finance Ministry too supports inflation targeting and intends to make it a statutory responsibility. If that is so then it will be necessary to stick to the goals of 6% inflation by Jan 2015 (which seems to be slightly challenging) and 4% inflation by Jan 2016 (which seems to be genuinely difficult to achieve) which Dr Rajan earlier in December 2013 announced. In that light, the cuts should be indefinitely postponed; reforms of bond markets, capital markets, infrastructure norms accelerated and FDI norms relaxed.
Rate cut is no solution. At least I fail to see it as one of any of the problems we Indians are facing.
I often talk how Indian markets even if they scale the 2008 highs are far cheaper than they were in 2009 or 2010. Here the idea is rooted in the simple idea that, a 100 bucks earned 6 years back is has a higher value than 100 bucks earned today. So NIFTY at 6300+ is cheaper today (in relative terms atleast, if not in absolute terms) than 6300+ in 2008.
However, there is an idea of “shifting grounds” here. Let us assume that 6300 of 2008 is achieved! This implies 9450, adjusted for 7% inflation over 6 years. But even in that, circumstances the 9450 Rupees of today is not equivalent to the 6300 Rupees of 2008. This is because in 2014 1 Rupee is 25% cheaper than 1 Rupee of 2008, since rupee has fallen recently very steeply. Thus the real amount NIFTY has to rise, to adjust this fall is ~12600.
This makes our Indian markets cheap by atleast 53%. This is a silent fall! Had market fallen by 50% from the highs, we would have screamed “Bear!” but no one is looking things this way. Asset prices are still quoted in rupees which makes them cheaper not costlier. However good robust businesses are inflation proof. Or to be less categorical, good robust businesses are less affected by inflation. Thus their core business operations are working and growing well. And hence they are relatively cheaper!
A similar but opposite effect can be seen in the case of Nestle’ Inc and Swiss Franc. It can’t be said better than the residing guru of the value investing world
In the fall of 2011, somewhere in South Mumbai, a single line flashed on the computer.
“What do you think of DISHTV? Good buy?”
DISHTV, had already by then fallen quite a bit. From the highs of 140-150 it was trading at Rs 77-80. Once a darling, it was now hungrily eyed by investors and punters alike. Investors still believed in its “market opportunity” story and punters liked it for its volatility. On top of it, it was present on futures and options market as well. Optimists argued with an ever rising middle class and government’s push for digitization, DISHTV will have significant tailwinds. Coupled with the fact that DISHTV had access to easy programming content from Zee TV(its parent company), investors were merely biding for time.
In the mid week of August of 2011, I completed my thesis of DISHTV. The thesis
can be found here(some bug in dropbox preventing me from sharing a working link here). It didnt take a rocket scientist to conclude that not only the company was significantly overvalued even at those levels but also followed an inherently unsustainable business model. It could have been easily killed, if things went like this since they lost money on every connection.
Since then, the market consolidated, the pricing has increased, their revenues improved and yet their inherent profitability levels were lower than ever before.
“In retailing, to coast is to fail.”
V-Mart is trying out to win a game, where few have won before and those who have are always looking behind their shoulders. Retailing is a business meant for masochists. To win here, you just have to find a fanatic management.
A thesis on V-Mart (written by me) can be found here
I would request you to kindly acknowledge the source if you forward it to anyone else.
Last year in 2012, I invested about 10% of my personal portfolio in Atul Auto. This decision was backed by certain ideas which are outlined in the following investment theses. Additionally, an addendum is also given outlining the valuation and capital considerations.
I would be obliged if you acknowledge the source.
Imagine you reside in a country called Capitex. This country is similar to our world in many ways except for one. Here you can enter a contract with a kid to own a part of his future income stream for a price paid today which will help him in his education, development etc. This seeming evolution has something to do with their social structure. Capitex society is a very tightly knit society. Here social approval and sanctions travel far and travel fast. Naturally, an unethical or a doubtful person will not be allowed to sell his stake to any far off person. Perhaps this is a side effect of such an innovation, so that investor risk and information asymmetry is minimized.
Now you have identified a very interesting and talented boy who has certain things going for him. You go ahead and own a part of his future income stream. Now, it so happens that he also has a twin. Their father is more predisposed towards this boy’s twin and unfortunately the father is not a very good man to associate with. Sure he knows how to nurture a talent, he knows how to get things done. But he can also be ruthless in his dealing, disproportionate in his vindictiveness and has a leaning towards bragging.
They grow up and go their own ways. There is seemingly zero connect between the two brothers except for the father. The two brothers do well in their respective business. Our investment slowly becomes systemically important, has honest advisors to assist him and is subjected to “sane and effective” behavior oversight. However his twin, well… lets just say he was a man of his own ethics.
One fine morning, the twin gets arrested for perpetrating a big fraud. The economic offenses task force appointed by the government swoop in and conclude that the twin was trading “empty promises”. The father knew about it, and he refused to act. Plus many of the safeguards which was necessary to follow by the twin were either found to be insufficient or just non existent. It’s a huge breach of trust here.
As is wont, the social sanction snowballed into a complete isolation. The brother, your investment, though he has no connect with this bad egg for 3-4 years has also found himself to be vilified, mistrusted and well to say politely tarballed. The father is also facing similar social sanctions. Now our investment, this brother has grown to be systemically important, the advisors and behaviour regulators are opining that the father should sever all his ties with the brother. As investors like you, there are others who fear that the father might pressurize this good son to pay for the faults of his bad egg.
Now there are some questions here:
- Is the good son legally mandated to pay for the bad son’s misdeed?
- Will the good son be allowed to pay by behaviour regulators?
- Will the severing of ties with the father be a good thing for the brother or a bad thing or a neutral thing.
- Finally and most importantly, common men like you are panicking regarding the fitness of this brother to respect his obligations, should you or should you not worry about this?
- If you should not, what will be your approach? Wait and watch or buy more of his future income stream?