Thursday, October 30, 2008

Honey, the economy is shrinking!!

So I'm back in India after my trip to dubai and have been continuously asked by multiple people while I was in dubai and over the last two days as me and Hemisha have been visiting people for Diwali about the state of the economy and how I think things will play out. I've tried to spend some time thinking my own thoughts about the same and figuring out how the economy will play out and how it will affect my life and business. So here are some of my thoughts about what is happening at the moment.

We are entering a time of uncertainty and fear. Smart companies and smart families will err on the side of caution. Their own earning potential and financial situation may have not deteriorated but being stingy has never hurt anyone and so they will try and curb discretionary spending and reduce unnecessary overheads.

What will happen because of this slowdown in smart families spending? It's like 10 families stuck on an island with a million dollars in cash to trade between themselves. If each of them just spends 100,000 USD across the year, the GDP is just 1,000,000 USD while if they were to spend it twice (once from the money they earn from trading with others), then the GDP is 2,000,000 and thrice then 3,000,000 USD. Basically spending money helps the economy to grow without the government having to insert more money into the system. As people reduce or defer their spending we will see the economy shrinking.

You will see corporates earning lesser money as a function of time - e.g. Fewer people will go to watch movies and fewer people will spend money on that new pair of diamond earrings. What does this mean ? Companies will be forced to shrink also i.e. they will be forced to 'right size' themselves to keep in mind the new reality. They can do this in two ways - by reducing variable costs and secondly by controlling supply and distribution i.e. by going slow on rollout of new projects that may cannibalize their existing outlets - Think Shoppers stop having only one outlet to service the whole of Bombay from 1991 - 2000.

This forced contraction of some of the largest consumer oriented businesses will mean a multiplier effect on the sentiment of people at large. Many people will be out of jobs and many companies who were dependent on a large number of 'cookie cutter' projects will see their business plans go from looking like a hockey stick to one looking like a jump from a cliff. Sad but unfortunately true.

My view is this shrinkage of spending and the economy will mean we will see very bleak times over the next 3-4 years. Reason being that people have built the foundations of empires on the premise that consumption is there (which it was 3 months ago) and very few have the money to build out the entire building. Money being like water will chase the best returns it can get and in todays environment finding the best return is a bit chaotic so most owners of capital will adopt a wait and watch or else 'take it or leave it' attitude. Smart entrepreneurs will focus on sales and growing businesses organically but that means that we will not see heady days and wild spending for 2-3 years ahead.

I would love to belv. that the economy will recover sooner but I doubt it. For it to recover, it will need the discovery of a new disruptive business model - think software exports, Call centers etc. so that capital can flood into that sector and salaries can go through the roof, confidence in the economy improves and droves of people start spending money together again. If there is such a disruption we will see the economy improve in a 3-4 year time frame else we should be prepared for this to take longer. It will improve but it will take longer because over that period of time, significant number of people who should have been buying on a yearly basis have deferred their decision until it is no longer possible and so when sentiment improves they all look at purchasing together and because of businesses having contracted investment in capacity has not been made and so individual businesses will see high revenues per unit (per McDonalds outlet) etc. thus making the case for rolling out a larger number of outlets more compelling.

I personally feel this correction is a good thing. My generation is fortunate to have seen this and thus to learn a few things:-
1. Equity is a risky investment and Debt always supersedes equity. Very few people realize this when they invest in the equity markets but businesses can have negative net worth. You can't see a negative figure on CNBC and you can't buy any stock for negative money but equity can go to negative and when that happens companies are bankrupt and debt superseding equity means the debt holders now own the company with the equity holders getting NOTHING. Hence, I think it's important for most people to use leverage carefully and to ensure that they have complete confidence that the managements of companies they are backing are putting money into projects that absolutely must be done and are borrowing money from reliable sources at fair terms.

2. Never trust others when it comes to investments. Unfortunately anyone with an MBA can create an obvious systemic incentive. Which means that all investment advisers had a vested interest in selling you products as they were getting a commission on the same. Your bank manager has a target to meet and hence was talking to you about ULIPs or trying to get you to book FDs. My view is that most investment advisory firms will go bankrupt. They have just eroded all trust among their clientele and they will never be able to recover. Funnily, most of their employees seem to have been belving their own spiel and I expect most of them will now realize that all the commissions that they made selling ULIPs are now down to 10% of their value. We've learnt that the old tactic works best - compare apples to apples and then play 2-3 providers and take the cheapest product. Never get into any situation where you are not comparing apples to apples.

3. We seem to be continuously reminded that we need to manage things that are within our control - time and our resources effectively. These are the two things that we control and relying on anything or anyone external to help us with time management or providing us additional resources is just putting our achievement of goals at risk.

No comments:

Post a Comment

Thank you for your comment. It should appear shortly.

If not debt, then equity?

Given that my last post discourages entrepreneurs from raising debt apart from a few specific cases namely:- 1. Very high ROCE low risk bus...