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January 27, 2000


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Devangshu Datta

Getting ready for doom

It's never much fun being the skeleton at the feast. But it can be very profitable being the lone bear in a bunch of bulls. Fund manager Marc Faber of the Hong Kong based "The Gloom, Bloom and Doom Report" fame has made his money by a focus on the dark side. Ravi Batra is another who has profitably predicted "nine of the last four global recessions" in Paul Samuelson's words.

Steven Leeb, editor of the influential Personal Finance and The Big Picture newsletters, is one of those bears. In his 1999 book Defying The Market, he outlined his belief that the decade 2000-2010 would see global recession. He also suggested portfolios that could be effective hedges against both inflation and deflation.

The book is geared for American investors but the logic is universal. Reverse engineering the logic and substituting for India is an interesting exercise that highlights some crucial similarities and differences in the two financial environments.

Leeb's argument starts by pointing out that Gordon Moore's famous Law that computing power will double every 18 months is now breaking down. For example, the Pentium II and Pentium III are merely 15-20 per cent quicker than their predecessor while the Pentium I was more than twice as fast as the 486. Leeb cites evidence of similar slowdowns in hi-tech breakthroughs across the entire spectrum of pure and applied sciences.

Thus, he says, technological innovation in the near future will be incremental rather than exponential. So productivity increases in agriculture and manufacturing, and efficiency improvement in services will slow. At the same time, demand for food and energy will rise along with higher standards of living in developing economies. This demand will lead to inflation and scarcities. The search for more energy and food will also result in further environmental degradation.

If policy makers increase money supply to foster growth, this will add to inflation. If policy makers squeeze money supply, it will cause deflation. Catch-22. As Leeb also says, with a global economy that is highly dependent on trade, a crisis anywhere will have repercussions elsewhere. One has to agree, after the Asian Flu and the Mexican Crisis.

Leeb also points out that technology investments are made on the assumption of exponential growth. Hence, in a slower growth phase, valuations could be completely out of whack and end in a stock market meltdown. Since many economies, especially USA, and the global IT industry are heavily leveraged to stock market returns, a crash would cause very serious discontinuities.

Obviously this has huge implications for India. Several high-growth areas like IT, entertainment and pharmaceuticals are geared to global conditions. So, are exports and tourism. Leeb's predictions and prescriptions are thus interesting to an Indian audience. He suggests portfolios with a 2000-2010 perspective. Investors could hedge between 24-32 per cent for deflation, 28-36 per cent for inflation and 6 per cent for environmental concerns, adding up to around 66 per cent in all hedges. The rest (34 per cent) should be placed in "growth franchises", which will continue to perform well regardless of the economic cycle. Leeb has a zero weightage for tech stocks!

In "growth franchises", he suggests global consumer stocks like Coke and Gillette, the entertainment major Disney, two pharma majors in Pfizer and Merck, and the unique investment reinsurance vehicle Berkshire Hathaway.

An Indian could mimic by substituting local Gillette arm Indian Shaving Products, and perhaps picking Hindustan Lever instead of the unlisted Coke. Disney could be replaced by Zee Telefilms. An Indian could also buy local arms of Pfizer and Abbott or indeed, most other global pharma majors. He can also take fliers on homegrown outfits like Ranbaxy, Dr. Reddy's Labs and Nicholas Piramal.

There is no local substitute for Berkshire Hathaway, which is Warren Buffett's investment holding company and also the highest net worth re-insurance company in the world. There are no Indian re-insurance options and unlikely to be listed ones in the near future. Berkshire has also delivered 30 per cent compounded return on equity over 40 years and it's tough to suggest a mutual fund that can do that.

Leeb was prescient enough to suggest investor should look at energy stocks in early 1999 when oil prices were at 10 year lows. In the energy sector, Leeb suggests broadband buying as a hedge against inflation. Big vertically integrated companies survive bad patches better and exploration outfits make more when demand rises. There are a lot of homegrown choices here starting with the Reliance group and the PSUs. There will be more options after full liberalisation in 2002.

So far, an Indian would have little trouble mimicking. Another inflation hedge is a bunch of small-caps with high liquidity, good earnings growth and low debt on the balance sheet. Fine, these are also available for the savvy stock picker.

It is on the next set of hedges that problems arise. In inflationary times, real estate and gold are top assets. An American can invest small sums in real estate by buying units in Real Estate Investment Trusts (REITs). These are combination mortgages of many properties and a great way to participate in real estate at low prices with minimal risk. An American can also invest in gold mining stock.

An Indian could invest in housing finance companies but that's not the same. These companies struggle with high inflation, when real estate does well. Otherwise an Indian has to actually buy land. Again, although gold is available, gold stocks aren't. This means an Indian will inevitably be overweight if he invests in gold and real estate. He will also carry large risks in the specific real estate.

The deflation hedges are also tough to replicate. In deflationary periods, deep discount long-term bonds and zero coupon bonds do well. The sum of all future interest payments is the difference between price and face value for a zero, so zeros are more rate-sensitive than coupon bonds. Whatever, the fact remains, an Indian can't buy bonds except on an IPO. There isn't a secondary market to speak of. Perhaps a combo of money market mutual funds is an acceptable substitute.

The environmental hedges are impossible. There simply aren't that many green companies around. Nor can an Indian invest in food companies like Monsanto. Again, Leeb's suggestion of insurance and re-insurance companies who will be in a position to charge high premiums against environmental damage risks aren't available to an Indian.

Summing up, an Indian investor can replicate the growth franchise part of the American portfolio. He can hedge inflation via energy stocks and small growth stocks. He can't hedge environmental damage at all. He can't hedge with real estate and gold without enormously overweighing his portfolio allocation. He can't hedge deflation very efficiently via the bond market and he can't participate in insurance plays at all. So an Indian investor will be forced into a more aggressive posture whether he likes it or not.

Devangshu Datta

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