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The $25 trillion question

N Mahalakshmi | March 17, 2003

Legendary Indian investor Chandrakant Sampat fears that the rapid change in technology may spell doom for the capital markets in a few years.

But two other astute investors from Generation Next beg to differ. Their view, essentially, is that as long as capitalism survives capital markets can never die.

Chandrakant Sampat is known to be one of the most successful investors in India. Starting  from scratch, Sampat's obsession with wealth, coupled with a strong dose of patience and precision, has helped him build a fortune in the Indian share market. But these days, he isn't touching equities. Not that he is tired of making  money. "The risks are too high," says Sampat.

And he is not referring to the Sensex plunging below the 3000 mark, or corporate earnings deteriorating over the next quarter. He is worried about something more  substantial. Something most people would not even care to think about at this point of time.

His pessimism arises from two counts. The first one relates to the state of the Indian economy and thereby, the fortunes of the corporate sector. The second and the more scary one has to do with global trends in business.

Sampat's concerns about the Indian economy relate to the growing fiscal deficit. If it continues to compound at the rate of 11 per cent per annum (as has been the case in the past decade), it will cumulate to -- hold your breath -- about $1 trillion by 2010.

The other concern is with the state of the Indian corporate sector. With 80 per cent of the 6,000-odd companies listed on the stock exchanges having negative EVA (economic value added), there is a paucity of worthwhile investment avenues, he feels.

The bigger bombshell is this. The accelerating rate of innovation threatens the survival of capital markets.

According to Sampat and several other eminent thinkers and researchers globally, innovation is resulting in shorter business cycles which means shorter life-spans for companies.

In order to survive in the rapidly innovating world, companies will have to generate cash flows to compensate for the high-risk of being thrown out of business quickly.

In other words, they will have to make enough money in order to ensure that they are able to establish themselves all over again in case there is any development that radically alters the way their business is conducted.

This, he says, will not be restricted to the technology sector alone.

The kinds of technology that are likely to come in the next few years may bring about changes beyond one's imagination right now.

This phenomenon, Sampat says, will only mean that there will be lesser or no scope for capital formation. The moot question then is, can capital markets survive?

If money continuously moves in favour of the in-thing, what will happen to obsolete businesses or companies that are stuck with obsolete technology? What happens to the $25 trillion of market capitalisation that global markets boast of today?

Sampat is 74, and has been managing investments for nearly five decades. Given his vast experience and spectacular success with stocks, not even the best fund manager can dismiss his argument without giving it a second thought. For, in a domain that is half science and half art, experience really counts.

But Sampat says the rules of the game are changing. "Experience is not an asset. The future is going to be entirely different and the past can provide little clue about the future," he states point blank.

Having said that, he refuses to provide any cue on what investors can do to get the best out of stocks over the long-term. Instead, he touches upon some scientific theories and concepts that can be applied to the world of finance to fathom out the mystery.

What investors should do

America is way ahead of India when it comes to technology. Not surprisingly, a lot of serious thought has gone behind formulating investment strategies for the technology business, and ways to cope with innovation.

In the middle of the technology boom in December 2000, Michal J Mauboussin, investment strategist at CSFB, had prepared a report on ‘innovation and markets.'

The report observed that economic long waves -- economic booms that result from the launch of general purpose technologies -- are coming at faster and faster rates, suggesting that industry and product life cycles are shortening.

As a consequence, corporate longevity is on the wane. The average life of a company in the S&P today is less than 15 years; dramatically less than half of that a century ago. The declining competitive advantage periods, even as economic returns for the market leaders in knowledge industries soar, meant that traditional multiple analysis was useless.

Mauboussin said: "An accelerating rate of innovation shakes the investing process to its very roots. It forces us to revisit deeply-held beliefs about portfolio diversification, appropriate portfolio turnover, sustainable competitive advantage, competitive strategy analysis, and valuation metrics."

As part of the overall strategy to deal with innovation, the report pointed to some general steps as well as specific recommendations for stock picking.

The general steps included:

Re-assess diversification: Here is the conundrum. The increase in company-specific volatility suggests that a portfolio must be larger to be fully diversified than in the past.

On the other hand there appears to be a higher incidence of winner-take-most outcomes in various industries. In which case you must concentrate your bets on the winner. Balancing diversification with winner-take-most markets is a major challenge.

Update valuation tools: Our accounting system was essentially designed 500 years ago to track the movement of physical goods.

It is grossly inadequate to reflect today's economic realities, which include a surge in intangibles, employee stock options, and greater real option value. Applying historical P/Es to the today's market in nonsensical.

This is by no means a justification for valuations. It is simply to stress that investors cannot intelligently judge current circumstances with outdated tools.

Update mental models: Most investors grew up in a world dominated by tangible capital. The world is rapidly evolving to one based on intangible capital.

While the laws of economics have by and large not been repealed, it is important to recognise that properties and characteristics of intangible capital are different from tangible capital.

Accordingly, investors need to update mental models to deal with the new sources and means of value creation.

The report suggested the following steps for individual stock picking:

Avoid the twilight: It is often hard for market leaders to stay on top for long since there are a number of factors working against them.

First, the stock market tends to build lofty expectations for growth and earnings. Market leaders feel the pressure to deliver against those expectations and hence tend to rely heavily (and perhaps too long) on their current technology.

Second, many innovations come from small companies with limited bureaucracies and a strong mission. This is not to say that market leaders cannot stay on top. But for that its managers have to be hugely adaptive.

Furthermore, since stock prices react to changes in expectations, there must be room for upward revisions. Essentially, it is important to be wary of current market leaders, especially those with sizeable market capitalisations. These companies are often the most vulnerable to future innovation.

Find the future: Investors must isolate those companies that represent the next generation. Here, the focus is on finding the next disruptive technology. We like the strategy that Geoff Moore and his co-author suggest in the Gorilla Game.

They recommend owning all companies that are potential winners in the gorilla game (winner in the winner-take-most market) and paring back all holdings, except the gorilla as it emerges.

Avoid innovation: Some industries and companies remain relatively sheltered from the competitive ravages of innovation. A plausible volatility-dampening strategy is the barbell approach -- a mix of high growth technology stocks and relatively innovation-insensitive stocks.

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There is something missing in the India formula. It is this: In order to fully understand how to adjust to change, one needs to have ...

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