Deflation, Disruption and Distraction
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For many years, it was assumed that prices only rise. This is no longer true. Falling prices can wreak havoc on the returns of an existing investment. The world was previously divided into the new and the old economy, where the former was riding the wave of disruption while the latter was considered boring but predictable. This is also no longer true. Disruption is everywhere. Information deluge is making it difficult to separate the signals from the noise, resulting in distraction to the point that decision-making itself has become paralysed.
Let us look at the trend of deflation. In the telecom industry, we are witnessing the impact of Reliance Jio entering an established industry with a low price offering.
In the power sector, we saw a lot of capacities that were built earlier assuming higher electricity prices but which are now struggling because prices have come down significantly.
In the pharmaceutical sector, we are seeing US generic-drug makers under a lot of pricing pressure.
The technology sector is becoming automated, which is causing pricing pressure.
Banking is also witnessing this due to the new wave of financial companies; media is experiencing it due to the internet; active money managers are feeling it from exchange-traded funds (ETFs)… the list goes on.
Disruption is the next broad trend that is a result of migration of technological developments into traditional sectors. The ‘sharing economy’ is impacting industries. With e-commerce gaining strength, the retail sector is struggling.
More importantly, with internet impacting logistics and marketing, new companies in the consumer goods sector can easily compete with existing traditional and famous branded companies. With robotics and additive manufacturing (3D printing), traditional low-cost advantages are getting eroded.
Distraction due to the rise of (social) media and easier access to information can be quite disorienting. Take the present case of the posturing of various countries on the debate of global trade. Is that to be taken seriously? Will the future of global trade be very different than the present? If yes, what will be its contours?
How does an investor decide on allocating capital when all the above three trends are going to impact his future returns? There are no easy answers, but that does not mean these questions should be ignored. Also, not all of the above trends are necessarily bad.
Lower prices increase volumes. Take Infosys for example. Its ‘per employee realization’ has come down by 9% over the past 3 years, but simultaneously, volume—measured by person months—has seen a growth of 37%.
Disruption may be bad for the lethargic but can present great opportunities for companies that can ride the disruption wave. Jio, for example, has seen data utilization of nearly 1,100 petabytes in a month due to its lower pricing, compared to the rest of the telecom companies, which have been in the region of 100-150 petabytes per month. This gives many media companies an opportunity to reach out to new customers. Plus, newer businesses such as telemedicine or remote education seem viable.
Distraction, on the other hand, may result in assets getting mis-priced. Take renewable energy’s expected impact on fossil fuel-based electricity generators or the impact of electric vehicles on internal combustion engine-based cars. If the disruption is not as extensive as feared, there may be a significant amount of money that can be made by investing in those industries whose prices are now depressed.
While no generic antidote can be prescribed for avoiding the ill effects of these three factors on your investments, a few aspects can be looked at before investing.
Companies that invest in research and development (R&D) may have a better chance to ride the wave of disruption. Indian pharmaceutical companies, despite the price pressures on US generic drugs, are investing significant sums of capital in R&D. Some Indian manufacturing companies are investing in R&D because they want to tap global markets and need sophisticated products to achieve market penetration.
Companies that depreciate their fixed assets at a rate reflecting the true economic life of the asset may find it easier to adapt to the changing environment. Infosys was one of the first companies that realized the obsolescence rate of computers. It changed its depreciation policies in the 1990s to recoup costs and invest in newer machines.
Companies that treat their capital providers with respect will always have access to cheaper funding amongst their peers. That itself will help them compete nimbly with new-age competitors who may have been funded at a very low cost of capital. To achieve this goal would mean sufficient transparency, following stringent accounting norms and continuous engagement with investors to meet their expectations.
Companies that can attract the best talent will win the battle. To attract the best talent, companies need to create a culture of meritocracy.
Finally, companies that treat their customers well and listen carefully to what they are saying, will be able to adapt to the future. In fact, they will rule over it.
Huzaifa Husain is head-equities, PineBridge Investments, India