Interest Rates: Why is it so important ?

Interest rates or coupons attached to a fixed debt is a significant component to ensure a rewarding portfolio. But the market interest rate has now been manipulated, as can be seen from psychological terms noted below. 

Interest rates are determined by the subjective decision of individuals to spend money now or in the future. In other words, interest rates are determined by the preference of borrowers and lenders. The market forces help in creating a natural Interest rate regime. 

Typically, the higher (or lower) the interest rate is, the more (or less) people will save. Likewise, the higher (or lower) the interest rate is, the smaller (or greater) will be investment. Because investment rather than savings is seen nowadays as being conducive for growth, the lowering of the interest rate is perceived as advancing economic prosperity.

The artificial lowering of the market interest rate induces additional investment. At the same time, savings decline and consumption increases. As a result, the economy starts living beyond its means. The boom is economically unsustainable because the policy-induced deviation of the market interest rate from the neutral interest rate causes malinvestment.

In today's fiat-money regime, money is produced through bank circulation credit: when they lend to private households, firms, and public-sector entities, banks increase the money supply. Money creation through bank circulation credit is onone hand money creation out of thin air- a rise in the money supply that is not backed by real savings while on the other hand, bank circulation credit wreaks havoc with the essential function of the interest rate.

The rise in bank circulation credit necessarily lowers the market interest rate to below the natural interest rate. The natural interest rate is the interest rate that would prevail had there been no expansion of bank circulation credit.

Discrepancy between the market interest rate and the natural interest rate sets into motion the boom-bust cycle in an unhampered market. The market interest rate (adjusted for risk and inflation premiums) is expressive of peoples' time preference, and it corresponds with the natural interest rate. It allows for people allocating current income to consumption, savings, and investment in accordance with their true preferences.

This downward manipulation of the interest rate provokes an economically unsustainable boom, which must be followed by bust.

Note: This blog has been inspired from previous International publication.

Guidebook for Simple Investments Part II

What Investors Must Do To Get it Right? 

1) There is a huge disconnect between markets and the economic reality. Global investors should look for opportunities to find a good investment relative to their currency, as there is a huge shortage of US dollars in the financial system and shortage is  likely to inflate further. 

2) The cost of money was cheap in the last 10 years mainly because of the Central Bankers QE window. Dollar denominated debt in emerging and developed economies has exploded in the last decade. This year has been different because of suspension of global trade and fall in demand. This is likely to persist  and has led to Investors’ risk appetite  reduction forcing them to look for safety and recession proof business. 

3) Investors must use an efficient way that meets their asset scale and channel  them into long-term planning as well as asset allocation. 

4) Investors should evaluate to ensure the cost of services provided by companies are not way too high in the next 5 years as reduction in variable and fixed cost will be in play immediately before pricing improves. Investors will have to sharpen their focus on operating fundamentals

5)  Investors will have to ensure the borrowing costs and tenure of the money at disposal are proportionate to the investment time horizon as most of the problems erupt not because of borrowing costs but from the redemption pressure during extraordinary events/circumstances.

6) Investors with a really long term horizon should also look at assets which may not produce results immediately but are yet viable as well as sustainable  in the longer duration. 

7) The geography of the investment should be the priority as US , Europe and Asia Pacific offer varied opportunities to Investors. 

8) Internet and Tech related assets are not cheap in any geography. Investors need special skills and capabilities to figure out the winners herein from 2020 onwards

9)  Geopolitics, Climate and Fiscal Policy are going to play important roles in the next 2 - 3 years . Investors still don’t have many options beyond Tech and software business. Investors love the stable recurring revenue streams and the ability to rapidly scale businesses to serve a wide range of customers in multiple industries. At the same time, the fixed costs for SaaS companies are  lower than for traditional software firms.

10) Investors should align with top performers and not risk with potential losers. Winners will stand out doing things differently and have the ability to scale up the value and pricing. Losers may compromise too much in value and eventually will not be able to gain in pricing. 

Guidebook for simple Investment Part I

GUIDEBOOK FOR SIMPLE INVESTMENT - PART I

Why Investors Don’t Get It Right Most Of The Times

• Data, discounted cashflow, and EBITDA, have failed the analysis of investment and business since 2008. 
•  Early stage investment based upon future projections, multiple rounds of fundraising at higher valuation, fancy numbers and complicated figures have all failed the test of time especially in the last 10 years. 
• Multiple rounds of capital were thrown in as investments into business where no meaningful growth and revenue was visible. 
• Too much money was chasing the same stories in the hope that they would turn out to be the next Google, Facebook, or Instagram…
• Investors were rather gambling to identify the next Mark Zuckerberg or Larry Page…
• Many founders simply imitate an idea hoping that they are holding the “Next Big Thing” after a Google or a Facebook. These entrepreneurs have failed themselves and their Investors.
• Big money was spent to increase the customer database. But the money spent per customer acquisition was seldom worth the returns earned. ROCE (Return on Capital Employed) was neglected formula for years and Investors have suffered because of this ignorance.
• Many Investors have funded businesses to acquire customers aggressively and have demanded more value for the same customer in multiple funding rounds. Owners have forgotten to leverage product to gain customers. A successful product helps to find true price value of each customer in the long run. It’s the success of the product which is more valuable than the value of customer in initial phase of the business.
• ROA and ROE compounded with ROCE is fail proof, fool-proof and must be widely used to measure the business.
• The key is in the quality of the business operation measured by Capital allocation, Management Ability, Corporate, Disruption, and Product Performance. All these are core competencies and extremely difficult to imitate.
• Higher valuation boosts Investor wealth and helps increase confidence for future rounds of funding. In most cases, the investment value is in the mind which rules rather the true value of the business.
• In a Bullish scenario, performance and competition are the name of the investment game. Investors have bet on multiple vehicles and called it a diversified portfolio. In reality, it was a gamble to spread the risks and hope that at least one or two turn out to be the multi-bagger.
• Large Investors have typically only imitated contemporaries. Why not, when low Interest rate fund is available at disposal?  Historically, it is a proven fact that low Interest rates lead to higher prices in risk assets and fuel competition for ownership at multiple levels, further inflating prices. 
• Asset allocation becomes key with potentially negative interest rates in the US, slowing of global trade and thus reduced supply, increasing the risk of surprise inflation markedly. 

To be Continued….

DUE DILIGENCE 2020

PRIVATE EQUITY DUE DILIGENCE  - New Era 2020

• The era of EV/EBITDA has long been favoured instead of revenue growth or margins . The macros are affected and hence PE’s will now be lower. This makes the current environment even more challenging for VC’s , as they have to search for potential winners in a worsening economy.
• Due Diligence which was a forgotten art in the last 10 years or so will now come back in favour. Remember it’s the hard work that pays and not cheap imitations. It takes blood  , sweat and tears to find the real diamonds. The miner always holds the key.
• Technology itself will now be questioned for delivery. VC’s will realise that true value behind business is not just another technology but a valuable Enterprise Software product.
• Cyber security and Payment modulation platforms  are in demand. 
• Advanced due diligence with data and analytics will be key to identify new winners. Hence companies will need expert counsel to help them sell well to VC’s. 
• Disrupters will be favoured. Sources of disruption will be analysed.
• Companies will be forced to evaluate the ratio of profits -  Is it the product or the customers that are  bringing in the bulk of profits?
• It’s impossible to chase both growth and price. Growth will win the battle and must be prioritized. Growth can be monetised in a great manner in the long term for pricing, if short term greed is overlooked. 
• Too much competition between Investors in the last 10 years led to unreasonable price valuations. The same will now be reversed from 2020, as Due Diligence will take the driver seat and a more realistic approach will be worked in paper. 
• Investors are not immortals to identify the next big disrupters. Sound due diligence will help to understand the value of the product in the foreseeable future. Owners are good at doing the business, but lack art to sell themselves to VC’s.
• Companies have to come to the street and study the necessity of the bottom of the pyramid . There is no point in competing with the established businesses.  Always build a business around the bottom of the pyramid. 
• Investors know they are not lucky with all investments. Hence a deep analysis of Due Diligence will help the evaluate the risks and disruptions.
• Same goes for companies who don’t understand the needs of the investors and lack expertise to project the future of their own business. An expert analytical Due Diligence will help to create a biography of the business and present it to the Investors. It also means that the medium between the Investors and Companies are far more important, as they have the expertise to do ground level reality research and capture the facts in the Due Diligence report.
• There is competition between companies to attract capital. Dearth of experts will undermine the case of raising funds. Consultants that specialize in performing proper Due diligence should be considered by owners to build and  present a case for investment in a more formal way to Investors.                                                                                                                                                Due Diligence report  is more than numbers and graphs. It is a  realistic and practical look into the future of the Company and a roadmap to bring it to the market.

We at CAPITAISE take pride in conducting Due Diligence with our wealth of research, identify the hot spots, advise the owners, dig deep to find the disruption of the business and help companies come to the street to raise capital.