In my country, India, traffic is a well known and accepted problem. With the growth in number of vehicles, Of course infrastructure is not able to cope up leading to congestion in most of the roads in the urban area.
One of the quickest solution applied by the authorities is to create one way traffic on most of the congestion prone junctions. This of course solves the problem when there are only few junctions with traffic problem and when a city has limited one ways. If the number of one ways are increased beyond a limit, the solution back fires with increased traffic conditions rather than smooth traffic.
Traffic is directly proportionate to number of vehicles are present at a particular point in time. if there is a particular bottleneck with of movement of 1 car a second where there are 2 cars coming e ery second, we will have an increased traffic. as every other car will have to wait every second. And very soon there will be a huge queue of cars. If 3 cars want to pass every second, the traffic will be twice as high for case of 2 cars. and Nth car will need N seconds to cross the bottleneck.
After a while, the queue will become so long that some other alternate route (typically longer with less traffic) will become more attractive than this bottleneck and some adventurous drivers will start exploring this alternative. With this diversion, with time, the traffic situation may get to an equilibrium.
Of course, this is an ideal case and there will be many realistic cases possible because the drivers may try out multiple ways to go ahead of others which may actually end up in some sort of deadlock.
Now lets talk about a complete city, lets say there is total of X of road lanes in the city. Length of a car is Y meters. and there are Z number of cars on the road at a particular time. As long as X is way too high compared to Y*Z, there should not be major traffic. Now lets say there are few bottlenecks and to solve problems around the bottlenecks one way traffic is implemented by autorities. Since now amount of travel every car needs to do incfreases, there is a risk that every car is going to stay on the road for longer time thereby increasing number of vehicles on the road at a particular time. (Assumed that cars are on the road only during the travel. otherwise they are parked outside the road). And there will be a threshold after which the time on the road increases so much that the solution back fires.
After talking about traffic, now let us try realating it to business and economy...
Consider every car to be an individual who wants to travel some distance to reach financial goals. To reach these goals he invests his savings and is trying to make it grow. External situation right from rains, tornados to government policies to frauds done by industrialists will create bottlenecks for this individual to move towards his goals. Just as in traffic bottleneck, as soon as he knows that a particular way may take longer than another long but fast way, he will start shifting his/her investments. the only difference here is that everyone gets information at differnet time from different sources analysed differently, hence there is complete caos.
To manage all these and to provide benefits to those who are not well to do, all the governments have different rules for different groups of individuals like different income tax rules, unequal priorities etc. These things work only till the time these rules and policies are fairly limited to total number of people otherwise, it may create bigger problems than solving problems at hand.
Wednesday, July 8, 2009
Tuesday, June 30, 2009
Price Vs Cost Vs Quality
Definitions
Price in economics and business is the result of an exchange and from that trade we assign a numerical monetary value to a good, service or asset.
In economics, business, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore.
Quality in business, engineering and manufacturing has a pragmatic interpretation as the non-inferiority or superiority of something. Quality is a perceptual, conditional and somewhat subjective attribute and may be understood differently by different people.
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Couple of days back I went to a restaurant where menu card had prices which were at least 10 times the price on other restaurants. At least thrice the cost of a good five star restaurant. And even then, this restaurant was packed with a huge queue. In this time of recession, there still people exist who are willing to pay such high prices for a commodity equivalent!!!
Even when you see the goods produced in China, the quality is not all that bad for the price those goods are offered. Then why does a human still goes for more expensive stuff?
If I produce something, all the expenses that I incur are added to get my cost of production. Price is the value at which I sell the produced good. In other words, for a buyer, price is the amount I am ready to pay for a particular good or service. This story is complete only when I bring quality in the loop.
When I buy a toilet cleaner, I pay for the perceived cleanliness that this cleaner will bring to my toilet. When I buy burger, I pay for fulfilling hunger that I may have. or just for the fact that I like the taste of a particular burger.
Lets take a little complicated item - car. The cost of manufacture of a typical car including cost of R&D etc. would be around USD 5,000. There are cars for sale right from this price of USD 5,000 to USD 100,000. Why would someone pay 20 times for a car when his/her basic need of travel is satisfied by paying so little. To make things complicated, these rich people would never drive their own car - so it may not be for driving fun. They would have a home-office which makes them travel very little and when travelling, most of their travel happens in the air!!! So is it only for the status that they get by buying such an expensive piece of machinery?
For the manufacturer,
profit = ( price - cost ) * number of goods sold
And to maximise my profits, I need to either increase price and to have customers buy at that price by improving perceived quality of my goods, or reduce my cost without reduction in perceived quality of my finished good. Or increase number of goods sold. Number of goods sold is directly proportional to the difference in the perceived quality by the customers and my list-price.
Now the only question is How to quantify quality? ... Such a simple question. but unanswered in most of the textbooks...
Tuesday, April 7, 2009
Correction and War
I am no expert in predicting future. However, few thoughts about future which don't let me sleep well at night....
I am writing this blog when worldover equity markets are stabalising or even moved up by 10 - 50% from the lows. Economy in most of the regions is picking up. Although everything looks to be good around, I have fair amount of doubt that the real situation could be worse than what it seems.
In 1930's we have witnessed a great depression. Most of the experts say it was not as bad as this correction. Economy came out of that one only after the second world war.
Experts say that this correction is near over and now things will be good going forward. However I have resons to belive otherwise. If governments infuse trillions of dollers in the economy, at some point in time, it will start showing signs of return to normalcy. But is it really tending to be normal in longer term? Sooner or later the governments will have to get back the money that they have invested in economy. Governments earn by way of taxes or by way of privetising government owned entities, or by creating wealth by government owned entities. If governments are not able to raise enough funds they will have to print new money. Let me look at each on of these with respect to what is happening in the economy.
Taxes - When economy is growing, everyone is earning more and more, economy has faster rotation of money. And for every interchange, government gets taxes. For everyone getting salary or for every soap sold, government gets small % of money as taxes. But with the economy in correction, the speed of rotation of money is reduced substantially. People are loosing jobs, their salaries are getting reduced. Companies are making losses. In such case where are the people and companies who would pay taxes to the governments?
In terms of privatisation, most of the govenments around the globe have already privatised most of the businesses that they used to control including banking, electricity generation and distribution etc. However, there is a small little scope of privatisation, where are the people interested in purchasing those?
Lastly, about generating money from government owned businesses. The most profit making business for governments at this time, is only defence materials (warheads, warcrafts, Nuclear technologies for war etc.) Which does extreamly good during the time of war.
Now let me get to the way people think. People come into groups (country, locality, society) because they get benefitted by being in groups. And all the groups want to make most for the people they represent. And that is where fights, wars between the groups happen.... In todays scenario, we already have governments making statements like providing jobs only to their nationals and forcing reduce outsourcing. We already have governments fighting over natural resources like Oil....
In my opinion, in medium term, things are going to be more and more difficult for the economy which is going to lead to a large scale war (if not world war). And only then economies worldwide are going to come back to normal....
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All the information used here is from general information from newspapers and different articles and I have no insider information nor connections to any government politics. The information available with me may not be correct or misguiding, reader discretion is requested.
I am writing this blog when worldover equity markets are stabalising or even moved up by 10 - 50% from the lows. Economy in most of the regions is picking up. Although everything looks to be good around, I have fair amount of doubt that the real situation could be worse than what it seems.
In 1930's we have witnessed a great depression. Most of the experts say it was not as bad as this correction. Economy came out of that one only after the second world war.
Experts say that this correction is near over and now things will be good going forward. However I have resons to belive otherwise. If governments infuse trillions of dollers in the economy, at some point in time, it will start showing signs of return to normalcy. But is it really tending to be normal in longer term? Sooner or later the governments will have to get back the money that they have invested in economy. Governments earn by way of taxes or by way of privetising government owned entities, or by creating wealth by government owned entities. If governments are not able to raise enough funds they will have to print new money. Let me look at each on of these with respect to what is happening in the economy.
Taxes - When economy is growing, everyone is earning more and more, economy has faster rotation of money. And for every interchange, government gets taxes. For everyone getting salary or for every soap sold, government gets small % of money as taxes. But with the economy in correction, the speed of rotation of money is reduced substantially. People are loosing jobs, their salaries are getting reduced. Companies are making losses. In such case where are the people and companies who would pay taxes to the governments?
In terms of privatisation, most of the govenments around the globe have already privatised most of the businesses that they used to control including banking, electricity generation and distribution etc. However, there is a small little scope of privatisation, where are the people interested in purchasing those?
Lastly, about generating money from government owned businesses. The most profit making business for governments at this time, is only defence materials (warheads, warcrafts, Nuclear technologies for war etc.) Which does extreamly good during the time of war.
Now let me get to the way people think. People come into groups (country, locality, society) because they get benefitted by being in groups. And all the groups want to make most for the people they represent. And that is where fights, wars between the groups happen.... In todays scenario, we already have governments making statements like providing jobs only to their nationals and forcing reduce outsourcing. We already have governments fighting over natural resources like Oil....
In my opinion, in medium term, things are going to be more and more difficult for the economy which is going to lead to a large scale war (if not world war). And only then economies worldwide are going to come back to normal....
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All the information used here is from general information from newspapers and different articles and I have no insider information nor connections to any government politics. The information available with me may not be correct or misguiding, reader discretion is requested.
Correction and Insurance
We all know that in this recession most of the large insurance companies had to be bailed out by government. I am trying to find reasons of they going so bad and government who is acting so strict with other industries being nice to insurance companies....
Why do we all buy insurance? To safeguard ourselves from the risks. If I die tomorrow, i want my kids to be taken care of. If I have an accident, I want to be taken care of. If I loose my house in storm, I want money buy a new one and so on and so forth...
How do insurance companies make money? Since all the people buying insurance do not have tragedies at the same time, Insurance company can pay off the people in problem by money taken from others. They of course do need to make profits to pay salaries of the agents and managers...
Now, the premium is calculated based on perceived risks. Risks are based on Past information and data. Now before this correction, we did not have any information or data to calculate premiums effectively for all the insurances that these companies had provided.
Secondly, all these insurance companies were insuring banks and other businesses for unnecessary risks that they were taking. In a booming market, more the risks you take more the rewards. And all your risks are hedged by paying small premium to insurance companies and when you are faced with negative consequences, you go back to Insurance companies.
Thirdly, and more importantly, Insurance companies pay agents based on number of policies sold. So more the risk agents makes you take, more money you pay them and in a booming economy where quarterly results are of utmost importance, you end up taking more and more risks at premiums which may not be justified. And still you take risks just to please your investors...
Now, with the snowball effect in real estate which entered other markets swiftly, insurance companies were forced to pay too much which made them unsustainable. And if the government would not have bailed these insurance companies, there would have been catastrophic disaster in financial sector...
Everyone who would have taken risks on insurance would have immediately sold of everything to reduce the risks and whole economy would have been shattered...
Even those with health insurance would have been denied basic healthcare and by law of land, basic health is responsibility of the government and then, the treasury would not have been able to meet even most basic healthcare requirements...
Why do we all buy insurance? To safeguard ourselves from the risks. If I die tomorrow, i want my kids to be taken care of. If I have an accident, I want to be taken care of. If I loose my house in storm, I want money buy a new one and so on and so forth...
How do insurance companies make money? Since all the people buying insurance do not have tragedies at the same time, Insurance company can pay off the people in problem by money taken from others. They of course do need to make profits to pay salaries of the agents and managers...
Now, the premium is calculated based on perceived risks. Risks are based on Past information and data. Now before this correction, we did not have any information or data to calculate premiums effectively for all the insurances that these companies had provided.
Secondly, all these insurance companies were insuring banks and other businesses for unnecessary risks that they were taking. In a booming market, more the risks you take more the rewards. And all your risks are hedged by paying small premium to insurance companies and when you are faced with negative consequences, you go back to Insurance companies.
Thirdly, and more importantly, Insurance companies pay agents based on number of policies sold. So more the risk agents makes you take, more money you pay them and in a booming economy where quarterly results are of utmost importance, you end up taking more and more risks at premiums which may not be justified. And still you take risks just to please your investors...
Now, with the snowball effect in real estate which entered other markets swiftly, insurance companies were forced to pay too much which made them unsustainable. And if the government would not have bailed these insurance companies, there would have been catastrophic disaster in financial sector...
Everyone who would have taken risks on insurance would have immediately sold of everything to reduce the risks and whole economy would have been shattered...
Even those with health insurance would have been denied basic healthcare and by law of land, basic health is responsibility of the government and then, the treasury would not have been able to meet even most basic healthcare requirements...
Monday, March 30, 2009
Correction and Real estate
We all know that the current correction started in the real estate market. Let us try to see why real estate makes the best place.
Real estate is much different than current money markets that we know. No two estates are the same. Even the two adjoining plots or apartments one above the other with exact specification are not identical. Their specifications always differ. Secondly, how ever matured the real estate market becomes, we can never be able to do as good price discovery as that for lets say stock market as the amount of transactions are way too less and discrete. Thirdly, rather than price being discovered through a auctioning process, it is mo decided by the agent as for all the limitations we have, we are (buyer and seller) dependent on the agent to help us with pricing. And most importantly, the agent is not doing trade in either buyers nor sellers benefit, but to his own. And earlier the transaction is triggered, earlier he will get his charges.
Last and probably the most important difference is that the underlining asset is something that we may not be able to part with. Lets say I own Citibank stock and the stock starts going down or up, I take a decision to sell it and the whole transaction can be done in less than a second. But if you replace stock with my home, I may be limited with all the restrictions like where to sleep if I sell it today. At least 50-60 % of the real estate properties are being used directly as against liquid assets like stocks. and that includes the open farm lands...
So what happens is that the real estate market reacts to news slower. Secondly, because it reacts to news slower, people believe that it does not react to news at all.
Now lets see why this correction actually started. With newer laws like SoX etc. in place, US government thought nothing could go wrong with the financial institutions. Actually even the financial institution heads thought that nothing can go wrong with their institutions.
We thought having closer data points is enough to do a good quality risk management. banks at a point in time were 16 times leveraged on the price of the real estate. In simple words if a real etate is worth 100,000.00 USD, then a bank would have given away loan worth of about USD 1,600,000.00 against it. I am not going to cover why this actually happened. But the fact of the matter is that the banks thought if they can track the prices and the paying capacity of the owner, they are better off.
Secondly, there were a lot of speculators who came in becasue of it. Now, if I can get whole of the real estate free (without investing a penny) and that the real estate prices are going up by more than 25% every annum, I would just need to go and buy... all I am asked is my salary slip!!!
Now, some intelligent investor starts selling all the real estate he has and as real eastate reacts to the news very slow, he has ample time to get off all the property he owns. And by the time it starts showing, others will also start following him.
Now those who are over leaveraged to make a quick buck cannot hold on to their losses, and the bank auctions his property at much lower rates. All the intelligent people in bank do not understand that they are doing bad for themselves while auctioning the property. Even a eight standard kid can tell you that if you auction a property at half the price, all properties nearby are going to go down by half. And if their prices go down, bank will have more and more defaulters. And that is where the spiralling effect starts!!!
Some intelligent people in banks did have insurance cover for the risks they were taking. Lets discuss insurance companies and correction in next post...
Real estate is much different than current money markets that we know. No two estates are the same. Even the two adjoining plots or apartments one above the other with exact specification are not identical. Their specifications always differ. Secondly, how ever matured the real estate market becomes, we can never be able to do as good price discovery as that for lets say stock market as the amount of transactions are way too less and discrete. Thirdly, rather than price being discovered through a auctioning process, it is mo decided by the agent as for all the limitations we have, we are (buyer and seller) dependent on the agent to help us with pricing. And most importantly, the agent is not doing trade in either buyers nor sellers benefit, but to his own. And earlier the transaction is triggered, earlier he will get his charges.
Last and probably the most important difference is that the underlining asset is something that we may not be able to part with. Lets say I own Citibank stock and the stock starts going down or up, I take a decision to sell it and the whole transaction can be done in less than a second. But if you replace stock with my home, I may be limited with all the restrictions like where to sleep if I sell it today. At least 50-60 % of the real estate properties are being used directly as against liquid assets like stocks. and that includes the open farm lands...
So what happens is that the real estate market reacts to news slower. Secondly, because it reacts to news slower, people believe that it does not react to news at all.
Now lets see why this correction actually started. With newer laws like SoX etc. in place, US government thought nothing could go wrong with the financial institutions. Actually even the financial institution heads thought that nothing can go wrong with their institutions.
We thought having closer data points is enough to do a good quality risk management. banks at a point in time were 16 times leveraged on the price of the real estate. In simple words if a real etate is worth 100,000.00 USD, then a bank would have given away loan worth of about USD 1,600,000.00 against it. I am not going to cover why this actually happened. But the fact of the matter is that the banks thought if they can track the prices and the paying capacity of the owner, they are better off.
Secondly, there were a lot of speculators who came in becasue of it. Now, if I can get whole of the real estate free (without investing a penny) and that the real estate prices are going up by more than 25% every annum, I would just need to go and buy... all I am asked is my salary slip!!!
Now, some intelligent investor starts selling all the real estate he has and as real eastate reacts to the news very slow, he has ample time to get off all the property he owns. And by the time it starts showing, others will also start following him.
Now those who are over leaveraged to make a quick buck cannot hold on to their losses, and the bank auctions his property at much lower rates. All the intelligent people in bank do not understand that they are doing bad for themselves while auctioning the property. Even a eight standard kid can tell you that if you auction a property at half the price, all properties nearby are going to go down by half. And if their prices go down, bank will have more and more defaulters. And that is where the spiralling effect starts!!!
Some intelligent people in banks did have insurance cover for the risks they were taking. Lets discuss insurance companies and correction in next post...
Monday, February 23, 2009
Correction, but where did all the money go?
Message to readers: Most of the readers of my blog have commented that it is bit difficult to follow the complex topics. hence I have decided to make these blogs simpler. If you think otherwise, please put in your comment and I will take more liberty to write more complex things...
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Yes, globally we are in correction (I don't prescribe to recession, but to correction...) for long now. And all the analysts keep non saying the there is shortage of money supply. But before the correction started, everything was good. Then where did all the money go?
Let us start with understanding role of central banks and macro economic fundamentals. Lets say there are only 2 persons in the economy. They transact using money (or cash bills). As per my earlier post, what ever they pay for is for the effort that they put in. That effort will be converted into cash equivalent based on need and supply. (called demand and supply in a larger context).
Lets say now there is also central bank to control inflation, growth and many more factors. Lets say both these persons have $100 each. that is $200 in the economy. Person A deposits his $100 in the bank. Now bank has $100 to be lent to someone who wishes to start a business. lets say Person B takes that $100 on loan from bank to start his business. Now in economy there are total of $300 ($100 of person A which bank has liability to pay. Person B's $100 and $100 given to person B as loan) In other words now person B has purchasing power of $200, and A with purchasing power of $100.
Lets say person B starts producing goods. He is going to get paid for the efforts. Lets say for some products that person A buys from B, person A pays $50 to person B. Now since bank has to pay $50 to person A, that is typically done by printing new $50 bills (in real world where transactions are mostly bank transfers, central banks dont even need to print money). Now person B can repay his loan of $50 or can reuse the $50 for more business. If he repays his loan, the total cash in economy becomes $250.
This sounds so simple!!!
But a logical question is how does central bank control inflows and outflows in the money market? there is concept of CRR (cash reserve ratio) this basically control the lending % of the banks. So the banks cannot lend all the money which is deposited with them. then the interest rate (repo, reverse repo rates) which defines cost of capital. In today's world I may not be comfortable taking loan at 10% interest. But in booming economy when I have surety of job etc. I may actually take loan at high interest rates.
In times when people are not very optimistic, they tend to repay the loans and not to take more loans and not to spend a lot. All these things siphen away liquidity from the economy
Things can get as complex as you can think with multiple banks, foreign exchanges, multiple people taking decisions based on it and natural issues like earthquakes. If readers ask for, I will talk about more complex things.
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Yes, globally we are in correction (I don't prescribe to recession, but to correction...) for long now. And all the analysts keep non saying the there is shortage of money supply. But before the correction started, everything was good. Then where did all the money go?
Let us start with understanding role of central banks and macro economic fundamentals. Lets say there are only 2 persons in the economy. They transact using money (or cash bills). As per my earlier post, what ever they pay for is for the effort that they put in. That effort will be converted into cash equivalent based on need and supply. (called demand and supply in a larger context).
Lets say now there is also central bank to control inflation, growth and many more factors. Lets say both these persons have $100 each. that is $200 in the economy. Person A deposits his $100 in the bank. Now bank has $100 to be lent to someone who wishes to start a business. lets say Person B takes that $100 on loan from bank to start his business. Now in economy there are total of $300 ($100 of person A which bank has liability to pay. Person B's $100 and $100 given to person B as loan) In other words now person B has purchasing power of $200, and A with purchasing power of $100.
Lets say person B starts producing goods. He is going to get paid for the efforts. Lets say for some products that person A buys from B, person A pays $50 to person B. Now since bank has to pay $50 to person A, that is typically done by printing new $50 bills (in real world where transactions are mostly bank transfers, central banks dont even need to print money). Now person B can repay his loan of $50 or can reuse the $50 for more business. If he repays his loan, the total cash in economy becomes $250.
This sounds so simple!!!
But a logical question is how does central bank control inflows and outflows in the money market? there is concept of CRR (cash reserve ratio) this basically control the lending % of the banks. So the banks cannot lend all the money which is deposited with them. then the interest rate (repo, reverse repo rates) which defines cost of capital. In today's world I may not be comfortable taking loan at 10% interest. But in booming economy when I have surety of job etc. I may actually take loan at high interest rates.
In times when people are not very optimistic, they tend to repay the loans and not to take more loans and not to spend a lot. All these things siphen away liquidity from the economy
Things can get as complex as you can think with multiple banks, foreign exchanges, multiple people taking decisions based on it and natural issues like earthquakes. If readers ask for, I will talk about more complex things.
Thursday, February 19, 2009
Traffic and Personal finances
Most of us who believed that equity investment is the only best way to beat the inflation, are not in very good shape. Of course I know a few who have made millions by going short. Or saved losses by getting out of the market at the right time. However, most of us are not in a very good shape. Today I try to see what makes us take wrong decisions or right decisions at wrong time.
I want to talk about stock market but not about fundamentals nor about technicals on stock market. Imagine you are driving in the crowded street and the car next to you want to overtake you. You of course dont want him to overtake you so you try to come on his/her way. He will try to come as close as you as to make you believe that he may hit you to give you indication that you need to give him a way. At the same time being scared of hitting you. On the other hand you also know that you run a risk of him hitting you but at the same time being just enough cautious you want to block his way.
In Stock market, lets say there are 2 people who have same stock. Both of you want the price of the stock to move up. But at the same time, you want to sell your stocks just before the other guy as he selling before you may take down the price. And you selling will definitely reduce price for him. Now both of you have same interest of stock price to go up. But at the same time he is your competitor when it comes to selling the price.
Now lets talk about information asymmetry. In real market there are hundreds and thousands of traders, investors. Everyone waiting for the right time to buy and right time to sell. Your decisions are based on information. No matter what you follow - fundamental analysis or technical. You want to be ahead of the curve to sell/buy before others take the same decision. at the same time, you dont want to be a loner. After buying a stock, you want others to imitate you to take the price in your favour for you to sell it at the right time. all those who have power of knowledge, will try to use the knowledge to their advantage before disseminating the knowledge to others. and if the chain is huge, by the time the last guy gets the knowledge, first guy would have already started liquidating his stocks.
And this all happens in a very methodical manner. Just like the traffic situation, the big guys want to make money in market - more than others. And at the other end, they need the smaller players to make making money (or at least feel that they are making) because these smaller guys are the ones who lack cutting edge information/knowledge.
Its human to be selfish. But we always try to strike right balance of being social at the same time...
I want to talk about stock market but not about fundamentals nor about technicals on stock market. Imagine you are driving in the crowded street and the car next to you want to overtake you. You of course dont want him to overtake you so you try to come on his/her way. He will try to come as close as you as to make you believe that he may hit you to give you indication that you need to give him a way. At the same time being scared of hitting you. On the other hand you also know that you run a risk of him hitting you but at the same time being just enough cautious you want to block his way.
In Stock market, lets say there are 2 people who have same stock. Both of you want the price of the stock to move up. But at the same time, you want to sell your stocks just before the other guy as he selling before you may take down the price. And you selling will definitely reduce price for him. Now both of you have same interest of stock price to go up. But at the same time he is your competitor when it comes to selling the price.
Now lets talk about information asymmetry. In real market there are hundreds and thousands of traders, investors. Everyone waiting for the right time to buy and right time to sell. Your decisions are based on information. No matter what you follow - fundamental analysis or technical. You want to be ahead of the curve to sell/buy before others take the same decision. at the same time, you dont want to be a loner. After buying a stock, you want others to imitate you to take the price in your favour for you to sell it at the right time. all those who have power of knowledge, will try to use the knowledge to their advantage before disseminating the knowledge to others. and if the chain is huge, by the time the last guy gets the knowledge, first guy would have already started liquidating his stocks.
And this all happens in a very methodical manner. Just like the traffic situation, the big guys want to make money in market - more than others. And at the other end, they need the smaller players to make making money (or at least feel that they are making) because these smaller guys are the ones who lack cutting edge information/knowledge.
Its human to be selfish. But we always try to strike right balance of being social at the same time...
Monday, February 9, 2009
Debt and Equity
In one of business meetings I attended last week, we came to conclusion that for a high debt industry, it is fine to have low margins as what really matters is return of Equity. After meeting, I found out that it is not as straightforward as it looks, hence this post on my thoughts...
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For ease of understanding let me first define the terms. (not because I think I know more than you, but just to make sure that we are all at the same level of understanding. My knowledge is more from practice and not from books as much hence would like to be corrected if any of my definitions are faulty)
Equity - deployed capital by the investors who expect profits from the venture to be shared.
Debt - Loan taken for doing business. Debtor expects interest gains no matter how good or bad the business is doing.
RoE (Return on equity) - return on equity - profits made by business per $ invested in equity.
RoCe (Returrn on Capital employeed) - return on all the capital (equity + debt) deployeed.
Liability - all returnable/payable amount (Debt, interests, payments to be made etc...)
Profit Margin (margin) - profit per $ of revenue
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Lets take case of a business. A Business is a venture undertaken to improve value for every stakeholder. For Investors what really matters is returns he gets for every $ he invests int he venture. In other words it is nothing but RoE that investor is concerned about. In old times when banks, financial institutions, stock markets were far less active, one would invest his own cash to do a business expecting pure returns on the capital.
With time, theories came to have break even point of about 5 years. This has duel meaning. If you consider human life span of about 40 - 50 years of work time, I would like no investments going more than 10% of my life. An intelligent businessperson puts maximum of 20% of his wealth in any business and hence he expects 5 years of breakeven (5 year cycle of starting new venture every year)
with time, businessmen wanted to have as high RoE as possible with shorter and shorter time to break even. Firstly to see ways to increase your margins thereby increasing returns. another way is to look at increasing revenue itself. To increase revenue, one of the chosen path is to go debt way. If with $100 I have, I can make $100 or revenue, Can I raise debt of $100 on top to make revenue of $200? Lets look at the math -
Assuming I have 10% margins. Earlier I was making $10 with RoE of 10%. In the second scenario, I am making RoE of 20%!!! Sounds great!!! If I can fool my DEBTOR and raise $1000 in stead ($100 from me and $900 from DEBTOR), I make RoE of 100% :) Now as I have such huge gains possible, can I get into business giving less margin? Lets say even if I make 5% margin, my RoE if whooping 50%...
Too good to believe....
After doing little argument with self, I figured out an anomaly in this calculation. firstly, I did not consider all the liabilities while calculating. For instance, interests. Lets say I can raise money at 10% interest (which is the minimum in my area), What ever debt I raise, I end up paying all my excess profits only as interest and I am unnecessarily taking risks.
Lets talk about Risks. Risk is unexpected (+ve or -ve) outcome of any task, venture etc. When I talked about those the expected numbers in terms of revenue, margin etc. All were mere assumptions. these assumptions are mostly called estimates to make it sound more scientific. And in a business venture, many things can affect to change the assumptions. even if I am in a business as stable as healthcare, I may see a sudden drop in number of patients to have much lesser revenues or dip in profit margin. Even if the probability is low, there is a probability and when this happens, I have to pay the interest from my base profits...
Lets say, for some reason, I can only make revenue of $100 in stead of $200, Then my RoE is zero and if it were to fall below, I will have to accept erosion of my capital which will lead me to a downward spiral.
And that is exactly happened couple of years back. there were businesses which were making huge profits with over leverage. Showing the RoE and such indications, they raised more debt. All was good till the economy was growing. (Was is really growing?) But when all of a sudden the spending pattern of customers change, the first organizations to hit were the once who were over leveraged. And even those who were marginally leveraged had difficult time because of the downward spiral.
It was a double edged sword for low margin organizations as they could not even reduce price points as reduced margins at reduced revenue hit them from both sides...
For a healthy business I strongly believe to have 0 debt (max to 50% of equity). and high profit margins. and there is nothing like having cash (& cash equivalent) on your balance sheet by which you could afford to have -ve margin to stay in business or even take over your competitors who have working capital issues.
Cheers...
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For ease of understanding let me first define the terms. (not because I think I know more than you, but just to make sure that we are all at the same level of understanding. My knowledge is more from practice and not from books as much hence would like to be corrected if any of my definitions are faulty)
Equity - deployed capital by the investors who expect profits from the venture to be shared.
Debt - Loan taken for doing business. Debtor expects interest gains no matter how good or bad the business is doing.
RoE (Return on equity) - return on equity - profits made by business per $ invested in equity.
RoCe (Returrn on Capital employeed) - return on all the capital (equity + debt) deployeed.
Liability - all returnable/payable amount (Debt, interests, payments to be made etc...)
Profit Margin (margin) - profit per $ of revenue
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Lets take case of a business. A Business is a venture undertaken to improve value for every stakeholder. For Investors what really matters is returns he gets for every $ he invests int he venture. In other words it is nothing but RoE that investor is concerned about. In old times when banks, financial institutions, stock markets were far less active, one would invest his own cash to do a business expecting pure returns on the capital.
With time, theories came to have break even point of about 5 years. This has duel meaning. If you consider human life span of about 40 - 50 years of work time, I would like no investments going more than 10% of my life. An intelligent businessperson puts maximum of 20% of his wealth in any business and hence he expects 5 years of breakeven (5 year cycle of starting new venture every year)
with time, businessmen wanted to have as high RoE as possible with shorter and shorter time to break even. Firstly to see ways to increase your margins thereby increasing returns. another way is to look at increasing revenue itself. To increase revenue, one of the chosen path is to go debt way. If with $100 I have, I can make $100 or revenue, Can I raise debt of $100 on top to make revenue of $200? Lets look at the math -
Assuming I have 10% margins. Earlier I was making $10 with RoE of 10%. In the second scenario, I am making RoE of 20%!!! Sounds great!!! If I can fool my DEBTOR and raise $1000 in stead ($100 from me and $900 from DEBTOR), I make RoE of 100% :) Now as I have such huge gains possible, can I get into business giving less margin? Lets say even if I make 5% margin, my RoE if whooping 50%...
Too good to believe....
After doing little argument with self, I figured out an anomaly in this calculation. firstly, I did not consider all the liabilities while calculating. For instance, interests. Lets say I can raise money at 10% interest (which is the minimum in my area), What ever debt I raise, I end up paying all my excess profits only as interest and I am unnecessarily taking risks.
Lets talk about Risks. Risk is unexpected (+ve or -ve) outcome of any task, venture etc. When I talked about those the expected numbers in terms of revenue, margin etc. All were mere assumptions. these assumptions are mostly called estimates to make it sound more scientific. And in a business venture, many things can affect to change the assumptions. even if I am in a business as stable as healthcare, I may see a sudden drop in number of patients to have much lesser revenues or dip in profit margin. Even if the probability is low, there is a probability and when this happens, I have to pay the interest from my base profits...
Lets say, for some reason, I can only make revenue of $100 in stead of $200, Then my RoE is zero and if it were to fall below, I will have to accept erosion of my capital which will lead me to a downward spiral.
And that is exactly happened couple of years back. there were businesses which were making huge profits with over leverage. Showing the RoE and such indications, they raised more debt. All was good till the economy was growing. (Was is really growing?) But when all of a sudden the spending pattern of customers change, the first organizations to hit were the once who were over leveraged. And even those who were marginally leveraged had difficult time because of the downward spiral.
It was a double edged sword for low margin organizations as they could not even reduce price points as reduced margins at reduced revenue hit them from both sides...
For a healthy business I strongly believe to have 0 debt (max to 50% of equity). and high profit margins. and there is nothing like having cash (& cash equivalent) on your balance sheet by which you could afford to have -ve margin to stay in business or even take over your competitors who have working capital issues.
Cheers...
Friday, January 30, 2009
Government and cost of haircut
This post is in continuation to the last post named “Fear and Corrections” but reading the previous post is not mandatory.
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In today’s scenario, central banks with support from the government are the ones who are busiest entities across the globe. More and more creative stuff is coming out from governments in form of newer packages and changes to the existing packages. In macro economy, the most difficult thing is to predict outcome of the action. Humans are very unpredictable and they may react to the stimulus differently. And it takes long time to get the results of the packages. There are more than 100 different leading and lagging indicators of economy, and no two economists would agree on methodology or on their view of the economy.
The complexity increases with global integrated economy where action by one government impacts other government. The only good thing is that these governments are forced and also willing to work together.
I have chosen haircut to compare, as impact of correction is seen in service industry the least. And services like haircut seldom see any correction. However bad the correction, everyone needs to have a haircut and haircut being a mundane task, also attracts no price hikes when economy is doing good.
Wait a sec, if haircut is an essential service, why do 5 star hotels charge 10-20 times more for a haircut? This could be explained by way of perceived value creation. I have been to many hair saloons where people visit only to get information about local politics even gossips on what is happening in their neighbours homes!!! Or if one brands himself as a lifestyle quotient, people with money tend to pay more for all these. But in difficult times, these are the people who get out of job the first.
In current scenario though, the situation is more grim. Even the small time saloons are talking about risk of loosing business as middle class people have started doing the job themselves to save these seemingly small amounts.
And that I believe is the measure of the depth of correction much more realistic on the ground data than any of those economic indicators who take 6-12 months to formally declare a recession (I still call it correction)
Right now, in Davos, industry leaders are working out together ways in which they can bring the economy back on track. But majority of them are not comfortable of governments hand as they believe, governments dont understand business as well as them and they are wary about time by which governments will give back control to them.
But as far as I am concerned, there is no industry or industrialist who is knowledgeable or experienced enough nor have enough resources to take us back on path of growth.
-------------------------------------------------------------------------------------------------------------------------------------
In today’s scenario, central banks with support from the government are the ones who are busiest entities across the globe. More and more creative stuff is coming out from governments in form of newer packages and changes to the existing packages. In macro economy, the most difficult thing is to predict outcome of the action. Humans are very unpredictable and they may react to the stimulus differently. And it takes long time to get the results of the packages. There are more than 100 different leading and lagging indicators of economy, and no two economists would agree on methodology or on their view of the economy.
The complexity increases with global integrated economy where action by one government impacts other government. The only good thing is that these governments are forced and also willing to work together.
I have chosen haircut to compare, as impact of correction is seen in service industry the least. And services like haircut seldom see any correction. However bad the correction, everyone needs to have a haircut and haircut being a mundane task, also attracts no price hikes when economy is doing good.
Wait a sec, if haircut is an essential service, why do 5 star hotels charge 10-20 times more for a haircut? This could be explained by way of perceived value creation. I have been to many hair saloons where people visit only to get information about local politics even gossips on what is happening in their neighbours homes!!! Or if one brands himself as a lifestyle quotient, people with money tend to pay more for all these. But in difficult times, these are the people who get out of job the first.
In current scenario though, the situation is more grim. Even the small time saloons are talking about risk of loosing business as middle class people have started doing the job themselves to save these seemingly small amounts.
And that I believe is the measure of the depth of correction much more realistic on the ground data than any of those economic indicators who take 6-12 months to formally declare a recession (I still call it correction)
Right now, in Davos, industry leaders are working out together ways in which they can bring the economy back on track. But majority of them are not comfortable of governments hand as they believe, governments dont understand business as well as them and they are wary about time by which governments will give back control to them.
But as far as I am concerned, there is no industry or industrialist who is knowledgeable or experienced enough nor have enough resources to take us back on path of growth.
Thursday, January 29, 2009
Fear and Correction
A lot of people talk about greed and recession. So this topic must sound as a lot debated and talked about by everyone. However I wish to provide bit different point of view.
Fear is what we all are born with. Biggest fear being fear of ultimate truth – the death. We know that for us nothing exist after death. But we still talk about planning of all sorts after death. My children, my wife, my parents should be able to live happily even after my death. But does it really matter to me as I myself will not exist after my death?
Another fear is fear of dejection or fear of un-acceptance from peers. If I don’t have enough money, would my wife treat me the same, would my banker still have faith in me?
I don’t consider fear of loosing your wealth as a fear as it is actually a reason or input to fear of dejection. To me fear is only which is related to either personal existence or societal existence of human.
I don’t understand recession. To me you only can have corrections. Some are at higher depth, some are longer and so on and so forth. But there are no recessions.
Greed is not lack of fear but only a solution – the best solution that we find to work around my fear. For example. I know that I may loose m job in 6 months, I want my money to give me max possible return on investment. In a longer timeframe also, as I am always running against time, I want to get maximum RoI and that is what people call greed.
Once economy is going through correction, different kind of fear comes into play. Now I am fearful of loosing my capital against highest possible RoI. And when everyone is fearful, snow ball effect increase the correction. Till the time, more intelligent who also don’t have to worry about erosion of capital start worrying about RoI, they start doing investments which take economy out of correction.
There of course is a role of government in all this, and I will try to cover it in my next post.
Fear is what we all are born with. Biggest fear being fear of ultimate truth – the death. We know that for us nothing exist after death. But we still talk about planning of all sorts after death. My children, my wife, my parents should be able to live happily even after my death. But does it really matter to me as I myself will not exist after my death?
Another fear is fear of dejection or fear of un-acceptance from peers. If I don’t have enough money, would my wife treat me the same, would my banker still have faith in me?
I don’t consider fear of loosing your wealth as a fear as it is actually a reason or input to fear of dejection. To me fear is only which is related to either personal existence or societal existence of human.
I don’t understand recession. To me you only can have corrections. Some are at higher depth, some are longer and so on and so forth. But there are no recessions.
Greed is not lack of fear but only a solution – the best solution that we find to work around my fear. For example. I know that I may loose m job in 6 months, I want my money to give me max possible return on investment. In a longer timeframe also, as I am always running against time, I want to get maximum RoI and that is what people call greed.
Once economy is going through correction, different kind of fear comes into play. Now I am fearful of loosing my capital against highest possible RoI. And when everyone is fearful, snow ball effect increase the correction. Till the time, more intelligent who also don’t have to worry about erosion of capital start worrying about RoI, they start doing investments which take economy out of correction.
There of course is a role of government in all this, and I will try to cover it in my next post.
Tuesday, January 27, 2009
Rich People and Hard (Smart) work
Note: This post is follow up to my earlier post. You dont need to read the earlier post, but reading will help get you the thread better...
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We teach our kids to do hard work while at school. We tell them if you study hard, you will get a good graduation degree and so better job hence better salary and better standard of living. But if you study richest of the rich in this world, you will find more than 60% of the rich (also true for successful people in general) did not do very well in school. Were their parents telling them to put in less of hard work? Or were they dumb? or were they focusing on different things? Answer to most of these question is "No". they were also trying equally hard. But just that they could not fair well in their student time.
I would like to take this to another level. If the people in developing countries are not doing as well as their counterparts in developed world, does it mean that they put in less of effort? again answer is "no". And I have explained in my previous post that it is because of unequal advantage the developed world gets, standard of living of developing countries is not as good.
If that is the case, then always people from developing countries should be laggards. In reality we see a fair share of rich people in forbes list of billionaires who are from these developing countries. Am I contradicting myself? Yes, and that is exactly what I wish to talk about....
Let me compare cost and price. (many woud already know it, but this is only for completion sake) Cost of an item is actual cost incurred by the producer. example, if a person takes 8 hours to dig a hole cost of the hole to the digger would be 8 * hourly rate of labour. If there is some raw material involved, you may add cost of te raw material, you may also add cost of renting of the equipment used. But PRICE is what consumer is ready to pay for. If you dig a hole in jungle, price of the hole may be zero. But if you dig a water reservoir in a place with scarecity of water, buyer may be ready to pay thousands based on their need.
After defining cost and price, lets start looking at these two things in play. You buy same artifact in a designer shop for whooping 500% additional cost without even thinking on the cost of the item. It may be becasue of the perceived value you get. Companies spend about 30-70% of the costs on marketing alone and marketing is only for increasing perceived value. We all know it well but keep pray to it again and again...
Let me come back to hard / smart work. You must have wondered as to why a stock trader makes millions withouot generating any value while as the businessman who is actually manufacturing goods get relatively less for all the efforts he put. Or for that matter a sales clerk after working for 10+ hours gets salary worth pea nuts when compared to the profits investor in wal mart. that takes me to my next principle. You get paid for either your effort, your knowledge or your risks. and in the same order. One who puts in effort gets the minimum and one who takes risks gets more. (Of course this is generic statement as more risks does not mean more gain)
This is why parents tell their children to acquire knowledge in early days to improve chances of earning more in future. But I would like to make one important point that to really becoming rich, we need to teach our children to rather take risks than to acquire knowledge.
Taking you back to my previous post, people from developed countries enjoy the benefits as their ancestors have taken much higher risks like travelling to new places without knowing the outcome. And surprisingly now, developing countries are taking far more risks than developed countries. With this economic power is definitely set to shift very soon... Please be warned...
--------------------------------------------------------------------------------------------------
We teach our kids to do hard work while at school. We tell them if you study hard, you will get a good graduation degree and so better job hence better salary and better standard of living. But if you study richest of the rich in this world, you will find more than 60% of the rich (also true for successful people in general) did not do very well in school. Were their parents telling them to put in less of hard work? Or were they dumb? or were they focusing on different things? Answer to most of these question is "No". they were also trying equally hard. But just that they could not fair well in their student time.
I would like to take this to another level. If the people in developing countries are not doing as well as their counterparts in developed world, does it mean that they put in less of effort? again answer is "no". And I have explained in my previous post that it is because of unequal advantage the developed world gets, standard of living of developing countries is not as good.
If that is the case, then always people from developing countries should be laggards. In reality we see a fair share of rich people in forbes list of billionaires who are from these developing countries. Am I contradicting myself? Yes, and that is exactly what I wish to talk about....
Let me compare cost and price. (many woud already know it, but this is only for completion sake) Cost of an item is actual cost incurred by the producer. example, if a person takes 8 hours to dig a hole cost of the hole to the digger would be 8 * hourly rate of labour. If there is some raw material involved, you may add cost of te raw material, you may also add cost of renting of the equipment used. But PRICE is what consumer is ready to pay for. If you dig a hole in jungle, price of the hole may be zero. But if you dig a water reservoir in a place with scarecity of water, buyer may be ready to pay thousands based on their need.
After defining cost and price, lets start looking at these two things in play. You buy same artifact in a designer shop for whooping 500% additional cost without even thinking on the cost of the item. It may be becasue of the perceived value you get. Companies spend about 30-70% of the costs on marketing alone and marketing is only for increasing perceived value. We all know it well but keep pray to it again and again...
Let me come back to hard / smart work. You must have wondered as to why a stock trader makes millions withouot generating any value while as the businessman who is actually manufacturing goods get relatively less for all the efforts he put. Or for that matter a sales clerk after working for 10+ hours gets salary worth pea nuts when compared to the profits investor in wal mart. that takes me to my next principle. You get paid for either your effort, your knowledge or your risks. and in the same order. One who puts in effort gets the minimum and one who takes risks gets more. (Of course this is generic statement as more risks does not mean more gain)
This is why parents tell their children to acquire knowledge in early days to improve chances of earning more in future. But I would like to make one important point that to really becoming rich, we need to teach our children to rather take risks than to acquire knowledge.
Taking you back to my previous post, people from developed countries enjoy the benefits as their ancestors have taken much higher risks like travelling to new places without knowing the outcome. And surprisingly now, developing countries are taking far more risks than developed countries. With this economic power is definitely set to shift very soon... Please be warned...
Population and standard of living
Most of the readers would say, its a no brainer. More the population more the poverty. and it can be proven based on data. Look at India, China. Look at parts of United states where there is huge population, all these areas tell the same story. If this is so obvious, then why am I writing on this topic?
Let us start with understanding the very basic of the economy. Have you ever asked how much do you pay for your fuel, or for food or any item. Fuel is available in earth, what we (supposedly) pay for is cost of the effort. When you pay $2 for bread, you pay for the effort of the farmer, baker, marketing, sales etc. All this payment is only for the effort of humans. Or at least supposed to be for the effort of the humans. If that is true, in the developed world with currencies and commodity trading (which is fairly regulated across the globe) why does poverty is directly proportional to population?
If a country has more population, it has more manpower which is what you pay for while buying any product or service.... With this logic, all the countries with more population should be able to create more wealth hence more progressed hence standard of living of these countries should actually be much higher...
Let me try to help you find the solution through simple psychology and philosophy theories.
Human is a intelligent social selfish animal. At the core, Human is an animal, then a selfish animal and social only because he is selfish. He may not have been interested in being selfish if he was not given a motivation of either financial or emotional. And these motivations are based on the basic traits of an animal. And he developed intelligence to win over other species or fello humans.
In earlier days there used to be different groups of humans living together invading on other groups for land, food or sex. In todays world it is replaced by boundaries of countries. It is desirable for each of the countries to have their population in a good standard of living. So called developed nations are little ahead of the curve to have higher standard of living. And they have been using people from other part of world to create wealth for them (slavery in US, Invasion of England etc.) But again the argument is that - this happened in last century of even earlier. Today most part of the world has free trade and open policies. then why does it still happen?
the answer lies in the efficiency of conversion (from raw material to finished good), available resources (tangible and intangible), experience and knowledge, etc.
If we as human kind really want to help and support each other, we need to provide all the above things to all those who actually need it. Today, the rich countries provide financial benefits to poor countries. There are a lot of fundraisers who raise funds and help people in poor countries. But this is exactly what is making the not so well developed nations dependant on the developed nations.
This post talks at macro economy point of view and does not talk about how it could be handled at an individual level. I will try to cover individualistic point in my later posts...
Let us start with understanding the very basic of the economy. Have you ever asked how much do you pay for your fuel, or for food or any item. Fuel is available in earth, what we (supposedly) pay for is cost of the effort. When you pay $2 for bread, you pay for the effort of the farmer, baker, marketing, sales etc. All this payment is only for the effort of humans. Or at least supposed to be for the effort of the humans. If that is true, in the developed world with currencies and commodity trading (which is fairly regulated across the globe) why does poverty is directly proportional to population?
If a country has more population, it has more manpower which is what you pay for while buying any product or service.... With this logic, all the countries with more population should be able to create more wealth hence more progressed hence standard of living of these countries should actually be much higher...
Let me try to help you find the solution through simple psychology and philosophy theories.
Human is a intelligent social selfish animal. At the core, Human is an animal, then a selfish animal and social only because he is selfish. He may not have been interested in being selfish if he was not given a motivation of either financial or emotional. And these motivations are based on the basic traits of an animal. And he developed intelligence to win over other species or fello humans.
In earlier days there used to be different groups of humans living together invading on other groups for land, food or sex. In todays world it is replaced by boundaries of countries. It is desirable for each of the countries to have their population in a good standard of living. So called developed nations are little ahead of the curve to have higher standard of living. And they have been using people from other part of world to create wealth for them (slavery in US, Invasion of England etc.) But again the argument is that - this happened in last century of even earlier. Today most part of the world has free trade and open policies. then why does it still happen?
the answer lies in the efficiency of conversion (from raw material to finished good), available resources (tangible and intangible), experience and knowledge, etc.
If we as human kind really want to help and support each other, we need to provide all the above things to all those who actually need it. Today, the rich countries provide financial benefits to poor countries. There are a lot of fundraisers who raise funds and help people in poor countries. But this is exactly what is making the not so well developed nations dependant on the developed nations.
This post talks at macro economy point of view and does not talk about how it could be handled at an individual level. I will try to cover individualistic point in my later posts...
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