underwater

Through A Looking Glass : Inverted Thinking For A Deflationary World

Sanjeev

Sanjeev

You know it when you try and open your eyes underwater. The first thing you notice is that you can’t breathe, and that gives you limited staying power. Even if you can still think clearly (for example, if you are attached to an oxygen tank), you can’t see straight because the refraction of light in water distorts your vision.

Declaimer: This article written was originally in March 2015, and some of the data points may be outdated.

Living in a deflationary world

Living in a deflationary world (or, in the case of India, a disinflationary world) is rather like waking up underwater. For starters, you have to adjust your inflationary expectations. At 25 years of age (and almost all the time thereafter), we look forward to ‘higher earnings’. Almost my entire working life, wage inflation has stayed above 10%, and higher salaries have paid off debt burdens. What we thought was higher earnings was really nothing but wage inflation. Our sense of ‘performance’, where we got used to getting higher pay for a ‘redesignation’ (which we called a promotion), was measured by the size of our pay hike.

All this will change to a more ‘truthful’ world, which will demand higher levels of (economic) intelligence from the ordinary citizen. Many of our old filters will fall away as we move to a different world. Some of them I will recount below:

We will get 1-3 promotions and real salary growth (of >50% cumulatively) in an entire career. Mostly, we will get annual hikes of                  <5%, sometimes zero. These promotions will see genuine changes in job description and responsibilities.

  • We will lose our jobs 1-3 times in our careers. Most of the time, it will be for no fault of our own; we were just sitting at the wrong place at the wrong time. Watch not just your salary, but also the larger pie from where it comes. The quality of the pie from where your salary originates will fluctuate as the economy restructures many times.

We are seeing one such global restructuring, where the biggest industry in the world (energy) is going to shrink in economic and pricing power, even as volume demand grows exponentially. The aftershocks from such a tectonic change will be felt in every sub-sector of the global economy.

We will have to invert our attitudes to compounding.
  • We will have to invert our attitudes to compounding. This is a difficult concept, so please think about it carefully. In Compound Interest, we think about a certain corpus (a.k.a. Principal), and attached to that (or consequent to that) is a certain (positive) Interest Rate, or ROI. Whenever we see a flow of returns, we can calculate backward through a process called Discounting, to get a Net Present Value (NPV). Discounting is the reverse of compounding, where you take a flow of (positive) returns over time, and work out the corpus (NPV) that would have earned such an equated return over time, at a particular Compounding Rate (i.e. ROI).

Now what happens if the Return Rate is negative, i.e. Interest Rates are negative? This can happen in a deflationary world, as the Swiss National Bank has very spectacularly shown. If your flow of returns turns negative, what happens to your NPV?

Considering that the Discount Rate in your mind is still a positive number because you still live in Alice’s “real” world on this side of the Looking Glass, you would get a negative number as the NPV. But in the world of Tweedledum and Tweedledee, you would have to discount the negative cash flow by a negative Discounting Factor, which is derived from the negative Interest Rate, which comes from working backward from a deflationary environment. Can you imagine how Alice felt in her Wonderland world? This negative divided by a negative would give you a positive (corpus), which brings you back to your real-world on this side of the Looking Glass. This is illustrated in the 3 Tables below.

In Table 1, you have the normal situation prevailing in today’s world, i.e. all Cashflows are discounted to T0. The cumulative NPV of a Rs.100 cash flow for 10 years at a Discount Rate of 10% comes to a healthy Rs.772.

But in Table 2, we change the sign on the Discount Rate, and that is when the fun starts. Now the FUTURE cashflows are more valuable because we now live in a deflationary environment. You can see that represented in the rising Discount Factor, which is increasing the value of the flow discounted to T0. Mind you, in a deflationary environment, you get a HIGHER Net Present Value if the cash flow can be maintained. So businesses that are able to maintain margins in a deflationary environment will be MORE valuable than they are now. This is very significant.

Most businesses, however, will lose margins in a deflationary environment. Let us assume that a good quality business will be losing margins at the same rate as deflation. Notice that in 10 years, cashflows have dropped by 37% (from 100 to 63), but the NPV has dropped by only 22%, from Rs.1340 to Rs.1052. That is just about 2%, in a deflationary environment that is running at -5%, in a company losing margins at -5%. In moderate deflation (like the kind faced by Japan), there is no impact on net economic welfare. This is what we see in Japan, where per capita indicators of economic welfare have not done badly at all because productivity gains have made up for deflation.

Now let us try the mental calisthenics that are needed to live in a deflationary world.

Right now, when you think of returns, you have a mental image of a large pot of cash (worth Rs.100) that is your corpus. We ‘invest’ this at the beginning….the simplest form of such an investment is a Bank Deposit. There are other, more sophisticated models (like Insurance), where the corpus is invested later, and the returns sometimes come earlier.

Now think in terms of flows. Your earnings are a flow, suppose this is a salary flow we are talking about. Now, if you had a negative Discount Rate, a future flow would be preferable to a current holding of cash. That is the meaning of negative Interest Rates. So the same amount receivable in the future is actually more valuable than cash in the Bank. You worry that the Cash in your Bank is being eaten away at the rate of, say, 1% per annum. So you go and put your money into a Govt bond that pays, say, 0.01% interest. At least it preserves your cash, and gives you money receivable in the future, with some safety and security. Your actual return from the Govt is the 0.01% cash return PLUS the Opportunity Loss of MINUS 1% SAVED, i.e. you get a return of 1.1%, which isn’t so bad. So Japan’s zero Interest Rates are not bad in a country with deflation of -1.2% or so.

Or you spend the money, preferring to consume it now than see it rot away. Or you put the money into a sustainable business with low debts so that you get tomorrow’s cashflows.

All this sounds sensible, but remember, what you want to do is exactly the opposite. You expect prices to fall, so you want to delay consumption, not postpone it. That is why the Swiss National Bank’s actions are unprecedented. They have created an environment of negative Interest Rates, which create a bigger disincentive to holding cash. This should get the velocity of money back to ‘normal’ levels, and create some inflation.

The way you would value equities in a deflationary environment is also very different. Normally, we look for high ROE, which happens when you make a ‘spread’ over the cost of debt. So a company should have a high ROCE, make a healthy ‘spread’ over the cost of debt, and hence leave shareholders with a high ROE. But in a deflationary environment, margins drop disproportionately, ROCE falls and the survivors are the companies with low debt. For example, the sugar industry has seen a 30% increase in input costs with a 7% drop in sugar price realizations, a good example of what happens in deflation. Now, in this environment, the high-debt players like Renuka Sugars/ Bajaj Hindusthan have been decimated, while the likely survivor will be the low-debt Balrampur. By the time the industry emerges again from its deflationary spiral, the latter will be a very strong company in an industry weakened by persistent deflation. Supply has to fall to balance inadequate demand, and this will come from bankruptcies, which will happen in the high-debt players.

So in a context like this, you look for low debt and survivability, and you discount future cashflows as more valuable than current cashflows. Most investors are not able to see things that way, and that leaves some hidden gems for value investors.

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