Choosing Words Carefully

If words, designations, concepts are not right, judgments are not clear; works do not prosper; punishments do not strike the right man, and the people do not know where to set hand and foot.

Therefore the superior man chooses words that can be employed without doubt, and forms judgments that can be converted into actions without fear of doubt. The superior man tolerates no imprecision in his speech.

– Confucius

Dining At The Buffet

The workings of free capital markets require that in order to overcome investors’ innate aversion to risk, seemingly riskier investments must offer the possibility of higher returns providing “risk premiums.” But when risk aversion is at cyclical lows, risk premiums needn’t be generous; people will invest anyway. Too many people trying to dine at the buffet simultaneously can lead to a disorderly process and skimpy portions. I recommend that you look twice at the cost of admission and – if you do decide to partake – proceed carefully.

– Howard Marks


Both governments and universities have done very, very little for innovation and discovery, precisely because, in addition to their blinding rationalism, they look for the complicated, the lurid, the newsworthy, the narrated, the scientistic, and the grandiose…Simplicity, I realized, does not lead to laurels.

– Nassim Nicholas Taleb, Antifragile

Thinking and Intellectual Independence 

What is it that characterizes the thinker? First of all, and obviously, vision…The thinker is pre-eminently a man who sees where others do not. The novelty of what he says, its character as a sort of revelation, the charm that attaches to it, all come from the fact that he sees. He seems to be head and shoulders above the crowd, or to be walking on the ridge-way while others trudge at the bottom. Independence is the word which describes the moral aspect of this capacity for vision. Nothing is more striking than the absence of intellectual independence in most human beings: they conform in opinion, as they do in manners, and are perfectly content with repeating formulas. While they do so, the thinker calmly looks around, giving full play to his mental freedom. He may agree with the consensus known as public opinion, but it will not be because it is a universal opinion. Even the sacrosanct thing called plain commonsense is not enough to intimidate him into conformity. What could seem nearer to insanity, in the sixteenth century, than the denial of the fact—for it was a fact—that the sun revolves around the earth? Galileo did not mind: his intellectual bravery should be even more surprising to us than his physical courage…Einstein’s denial of the principle that two parallels can never meet is another stupendous proof of intellectual independence.

– Ernest Dimnet

Living Life

It is a deeply held conviction within economics that our world can be reduced to models that are founded on the solid ground of axioms, plumbed by deductive logic into rigorous, universal mathematical structures. Economists think they have things figured out, but our economic behavior is so complex, our interactions are so profound that there is no mathematical shortcut for determining how they will evolve. The only way to know what the result of these interactions will be is to trace out their path over time: we essentially must live our lives to see where they will go. There is no formula that allows us to fast-forward to find out what the result will be. The world cannot be solved; it has to be lived.

– Richard Bookstaber

Financing A Business

The accounting equation, a fundamental identity of accounting, states that:

Assets = Liabilities + Owner’s Equity

A business converts debt (liabilities) and equity (owner’s equity) into assets that generate cash flows. Those on the right side of the equation make claims on this cash flow depending on the security they hold. Debt capital providers receive a coupon on their investment, while equity capital providers participate in the upside (and downside) as the owners of the business.

With that 20-second crash course in accounting and corporate finance out of the way, the question, both practical and philosophical, every entrepreneur has to answer is how the business should be funded.

Selecting the capital source for a business is one of the most important strategic choices an entrepreneur makes. Founders may not necessarily think through it in the way I have described above, but as Prime Minister PV Narasimha Rao said once, not taking a decision is also a decision.

Venture capital investors are equity participants, and expect higher returns compared to public equity investors. In recent years, the terms attached to equity investment by venture investors have turned equity into a quasi-debt instrument.

Debt financing is suitable for relatively predictable and regulated sectors, such as infrastructure and power, and it is unsuitable for riskier and innately unpredictable endeavours such as creative projects or technical innovation. Debt funding has an added advantage because interest payments are tax deductible, a provision introduced in the First World War.

Let’s examine what’s been happening in some sectors through the financing lens:

India e-commerce – Several e-commerce players raised very large sums of money at, it is now obvious with the benefit of hindsight, unjustifiably high valuations. These companies thought they were raising equity, but it was actually debt disguised as equity. This was not unique to Indian startups, and happened in other markets too. Venture capitalist Bill Gurley eloquently described the phenomenon as the “calcification of the cap table”. Onerous covenants on equity and the fund-raising arms race made the capital structure of many startups fragile, and the fragility has broken many companies. The calcification happened because founders chased higher and higher paper valuations. The price equity investors extracted for the high valuation was to take debt-like protections in case things went sideways. The transformation of equity into debt-like instruments was necessitated partly by the drive for higher headline valuation numbers. This is always irresponsible. Instead of fund-raising being a means to the end of building a business, fund-raising at ever-increasing valuations became an end in itself. While e-commerce startups have to do a capital raise to continue investing in the business, Amazon simply parks a chunk of the cash flows from its thriving marketplace and cloud businesses into India. Amazon is more conservatively financed than its Indian competitors and that is making a very big difference.

India telecom – Telecom spectrum is the essential “raw material” to run a telecom business. The corruption-mired allocation of this scarce and valuable resource by the Congress-led UPA government is one of the biggest scandals in India’s history. After the scandal, it became politically difficult to not maximize revenues on auctions of telecom spectrum. The legacy players borrowed huge sums of money from government-owned banks to license spectrum. Then Reliance Industries entered the business with Jio, funding spectrum acquisition and network buildout through very large equity-funded investments. Reliance can afford to invest on this scale because of its oil refining business. That business generates huge cash flows, and Reliance is investing some of this cash into its new telecom business. In a sense, Reliance Industries is doing to legacy telecom companies what Amazon is doing to e-commerce startups. Both Amazon and Reliance are investing equity, while the others are investing debt.

Global media and entertainment – A few months ago, Netflix issued corporate debt to fund new content. This is quite risky. Netflix’s low-rated and high-interest bonds were lapped up by investors starved of yield in the current low interest rate environment. It says something about the present environment that even though Netflix has told investors it will turn to bond markets to raise money frequently and invest the proceeds into a speculative assets like films and television shows, investors are handing over billions of dollars to the company knowing Netflix will keep burning cash. At the same time, digital music streaming startups in the US and India have raised enormous amounts of capital from private investors, probably with onerous terms attached – so these instruments may be labeled equity, but work more like debt. The problem the streaming services face is that the more money they make, the more content owners (typically large music labels and media companies) extract from them. As the intermediary, streaming services have limited bargaining power with the content owners. They are running the classic Red Queen race. The bet investors in such companies are taking is that the subscriber base can grow fast enough to a large enough scale so that eventually the economics of the model tilts in the favour of the licensee (i.e., the streaming service).

India agriculture – Indian agriculture is woefully over-regulated. Farmers have little control over both the price they can get for produce and where they are allowed to sell their output. For decades, India has simultaneously romanticized and infantilized the farmer. Farming is simply not viewed as a business, even though it is one. As if it wasn’t enough, farmers are left to the mercy of the weather too because India has a dearth of irrigation infrastructure. About 45% of employment is in the agriculture sector. Most people (we are talking tens of millions of people) just default to agricultural employment as there are limited opportunities to do anything else in rural India. There isn’t much equity capital entering farming, as farming tends to be largely subsistence-based. Deprived of equity funding sources, farmers turn to loans from formal and informal sources. They don’t have much of an incentive to invest in productivity tools for their farms either, because of pricing and other regulatory distortions. Given the high dependence of India’s population on farming and the inefficiencies built into Indian agriculture, every now and then there is a political clamour for farm loan waivers. This is a vicious cycle, and can only be broken by structural policy reforms for the sector.

When evaluating an investment, I find it very useful to think both backwards and forwards about how the business has been financed and how it will be financed. It reveals a lot about both the economics of the business and the management behind it.

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