At the outset, I have to say that this post is not motivated by any patriotic fervor. In fact, I have been extremely skeptical about the exaggerated claims of India’s emergence as an economic superpower. On many parameters, (share of world trade or per capita GDP for instance) we remain an economic minnow. However, like a prominent PE investor remarked in a conference that I recently attended – for India, God seems to be planning in lieu of the government (in his words, how else can you explain the fact that China and India both launched their family planning programs at the same time. They got it right, we got it wrong and we are left with one of the best demographic profiles in the world). Its in this context that I am inclined to say that the current global economic malaise may actually be a blessing in disguise for India.
First of all, lets recount the risks that any investor faces today. The two biggest questions on the top of every investor’s mind are – a) how much more downside remains in today’s already beaten down markets? and b) how long will it take for things to turn around? By all estimates, the answer to the first question is – maybe a little more (read 10%-15%). The EPS estimates for FY09 for the Sensex are around Rs 950. So, at current levels the Sensex is trading at around 10x PE(FY09). This versus a historical bottom of around 8x. I expect anywhere between 5-15% degrowth in EPS for FY10. That leaves the Sensex at a 11-12xPE(FY10). So, though we have lost a lot of ground, by FY10 levels, the market still doesn’t seem that cheap and indeed compared to some of the other emerging market peers, we trade at a premium. Therefore, there is some scope for further fall before markets bottom out.
Now, coming to the other important question of the expected time span for this bear market. In my opinion, this is where India is far better positioned to be first off the blocks on the path to recovery. If one considers the five major relevant economic blocks – US, EU, Japan, China and India, the former three are plagued by severe systemic issues (such as excessive leverage, low savings rate, inordinate consumption levels etc) that will take a long period of time to get resolved. Now, in comparison to China, India has some significant characteristics that will play in the latter’s favour. For starters, as is oft repeated, exports form a far smaller component of India’s GDP compared to China’s. Apart from this, India also has a lower operating leverage in comparison to China. China’s model has always been to build huge capacities, which worked very well in boom times, enabling it to attain economies of scale and enjoy great cost savings. However, in times like this, excess capacity can become a millstone around your neck and result in higher fixed costs. The fact that India is primarily a services led economy in contrast to China being a manufacturing economy also helps. The other areas where India scores over China are greater capital efficiency and also deeper management expertise in dealing with capital constrains of the kind we face today. (Merits to add here that the one area where China scores over India is its superior balance sheet (forex reserves and also budget surpluses), which afford it with the option of spending their way out of the crisis of the kind recently announced). Also, one of the key constraints, which has affected economic activity in the recent past, which is the shortage of credit should also get resolved in due course given the absence of any systemic problems. In fact, credit from domestic institutions has actually registered a 30% increase last quarter and it is the lack of availability of global credit, which has been the cause of paucity of capital. With the global credits slowly limping back to normal and also given the interest evinced by the debt FIIs in recently announced SEBI registrations, the availability of credit should improve with time. Finally, and this is the most important point – the falling commodity (esp. oil) prices are bound to have an immensely positive impact on our economy.
In sum, India doesn’t face systemic issues of the kind the developed economies face and in fact, the slowing consumption in the rest of the world and resulting demand destruction for commodities puts India in a good wicket for maintaining its relatively high rate of growth. Hence, there may be a case to make that if the demand for commodities and oil had continued to be what it was in the recent past, it could have imposed severe speed breaks on the Indian economy and therefore, the allusion to the remark earlier about God planning for India in lieu of the government.
In my next post, I plan to discuss some investing strategies in India for the next year or so. Stay tuned.

Like everyone else in the finance world (and actually elsewhere as well), I have been watching with obvious interest, the unfolding of events in the past few weeks. And needless to say, they have been quite discomforting. While I don’t have anything particularly positive or negative to say about the actions that the US Fed or other central bankers have been undertaking to mitigate the crisis (most of them were actually Hobson’s choices), I do however feel that this may be a case of postponing rather than solving the issues unless we are favored with some generous doses of luck.
Ever since the financial crisis began to unfurl, a few things have been happening. To begin with, there has been a flight of capital to safe assets, which has squeezed out all liquidity and credit in the system. This has led to a bizzare situation where from the threat of inflation a few weeks ago, the US is now staring at a sudden deflation in the economy. So, what has the fed done? - it has started pumping up money supply and inflating the economy to maintain the liquidity and keep the economic wheels turning. But there are a few things which will really work against this strategy in the long run.
First is the overhang of credit that the US carries from the past. The credit expansion in the recent past has been unprecedented and the total estimated debt in the US, which includes national and private debt is $53 trillion (thats nearly four times its GDP). With all the bad debts that the financial institutions are burdened with and with economic prospects looking dimmer and not brighter (which in turn will affect the repayment capacity of borrowers), banks and financial institutions are not going to start lending in a hurry. So, the credit unwinding process would be a long and gradual one and its not clear how the central banks can continue to shore up liquidity till then.
Second, the record capital account deficits that the US has been running already put the greenback on a weak turf and unleashing ever increasing amounts of dollars will most likely cause a precipitous drop in value of the dollar (both against other currencies and/or intrinsically) sooner or later. So, it is possible that we could see a sudden and steep rise in inflation at some point in time.
And finally, we have the worldwide commodity crunch and the ever increasing demand for resources that we are witnessing, which puts immense pressure on its prices. I realize that there have been various analyses floated on this topic, and I don’t claim to have researched this topic to any degree of rigour, but from all the reading I have done so far, its clear that the absolute demand for resources is growing at a far greater pace than the matching supply. This to me is really what could be the steepest hurdle in any path to recovery. If this were not the case the monetary measures that the central banks have been undertaking could have aided the healing process in which with increased liquidity and falling prices, demand would shore up and economy brought back on track. However, with the large nations/populations in the developing world (China, India, Middle East) consuming ever increasing amounts of resources, this process may not follow the same pattern that it has in the past, when the predominant consumers were only to be found in the developed world.
Therefore, I am not so convinced that the long term equities story still remains in tact (be it in India or elsewhere) and that, with every dip we should be buying equities. In fact, I’ll say that in the medium term, on account of the above mentioned factors, the underlying story for commodities is what looks extremely strong and if I were a hedge fund manager today, thats where I’d be putting my money especially in case there are dips in their prices. The only things that could impact that reasoning would be - technological advances like clean energy etc, which would ease the demand for resources or, massive discoveries of new sources of resources. Else, in the medium term (i.e. 5 year horizon) my recommendation would be - short equities & long commodities.

Some time back, I had posted about the shift in power in the media industry from content generators to content aggergators. That trend seems to be picking up steam and the content generation part of the value chain seems to be dying a death through thousand cuts. Nowhere else is this starker than the newspaper industry in the US, which is quickly sliding down the path to obscurity as it registered the supposedly sharpest ever fall in history during the first half of this year. I believe that other content industries such as the movie industry will also face some serious challenges going ahead on account of the following:
a. Surfeit of supply: According to this recent article just reported on WSJ, Hollywood has been hit by a glut of movies this year. In India as well, while there has been widespread welcoming of the institutionalization of the movie industry, one of the “negative” fallouts of this has been the huge quantums of capital being planned towards movie production including those by such large corporate houses as M&M and Reliance. One only hopes that the money and efforts will be judiciously utilized as much for better quality as an increased quantity of content and not just for the latter. Else, we could very well see supply far outstripping demand. Increased participation (in content production) of individuals/indie producers/ smaller media houses has also been another important factor in adding to the supply of content.
b. Backward integration by exhibitors: The other trend we are also witnessing is the moves by exhibitors such as multiplex and theater chain operators to get into movie production. I have personally evaluated a few such plans for potential investments. Again, although this is an understandable move by them (driven by need to tie in assured content that will fill their distribution ‘pipes’), this could again have the same consequences as those discussed above (in point a.).
c. Digitization and piracy: Digitization has the unfortunate concomitant effect of an increased ease of piracy. One of my Hong Kong teammates was mentioning to me as to how the HK film industry was virtually killed because of piracy (driven from mainland China). While surfing for something, I happened to bump into a Chinese website similar to Youtube thats a virtual online library of pirated Hollywood movies. The ease with which one can find and distribute pirated stuff is a major challenge that the media industry is grappling with.
In summary, its clear that we are moving from an era of a moderate supply of content where consumers paid for quality content to an era of an oversupply of easily accessible content where there’s little incentive for consumers to pay directly for content. This will be true of most forms of content, be they print, music or movies and hence, I believe that value will shift from the ability to generate content to ability to help consumers find the right content. This is not to say that content generators such as movie studios or television channels will completely disappear (after all there won’t be aggregators if there’s no content to aggregate). But, only that they will not be as highly valued as aggregators such Google.

Okay, that (I mean the title) was a ploy to catch your attention! Actually, this is the second part of my drivel on successful investing. Amongst the six factors for successful investing listed in my previous post, “insight” stands out from everything else in a distinct way in that it is “non procedural” as against the rest, which are “procedural”. Let me explain that.
In the study of logic, there are two approaches – deductive approach and inductive approach. In the former, there are tenets or premises, which are accepted as a given and conclusions are drawn on that basis. An inductive approach, on the other hand is the process of building a coherent thesis based on numerous observations (akin to a bottoms up analysis). For example, the reasoning – “All men are mortal. Joe is a man. Therefore, Joe is mortal” is a deductive line of reasoning since it is based on the *irreducible* premise that “All men are mortal”. On the other hand “I have only observed black crows and never observed a crow of any other colour. Therefore, all crows are black” is an inductive line of reasoning since the conclusion is drawn from a set of verifiable observations.
In acquiring knowledge, making decisions or drawing conclusions we constantly switch between the two above mentioned approaches. At any point in time, we have a built up repository of knowledge, which forms the basis for gaining new knowledge (deduction). We also constantly assimilate new information or data and use intelligent ways of interpreting that data (induction). We then either accept the conclusions and add that to our existing knowledge repository or we modify our knowledge with the new conclusions or we reject the new conclusions, if the result is counter intuitive to our existing set of beliefs (or the new line of reasoning isn’t appealing enough).
Now, how is all this related to investing or entrepreneurship? It has to do with the understanding of this concept of *insight*. So, what is this “insight”? It is a glimpse of reality that is granted to someone. It is typically not a result of a step by step analysis of observable facts. Rather it is a leap of understanding. A moment of epiphany, when something suddenly becomes clear. And in my opinion, true entrepreneurs at some point in time are bestowed with this insight. They visualize a reality that is not immediately obvious to others. They then go on to *act* on this vision of their reality. Strange as it my sound, this is true not only of entrepreneurship, but also other fields of endeavour such as science. To quote from a biography of Albert Einstein on his discovery of the theory of relativity – “He awoke one morning in great agitation as if, he said “a storm broke loose in my mind”. He described it as having finally tapped “God’s thoughts”. He and a colleague were trying to think — ‘Can we get another idea that will solve this problem?’ when Einstein said “Ideas come from God””. Similar such revelations have been recorded by other scientists, who were instrumental in engendering huge leaps in our understanding of certain subjects. Maxwell, the author of the famous eponymous equations on electromagnetism recounts a similar relevation, where he could visualize the existence of electromagnetic fields (which was till then an unknown concept). In the case of science, the practitioners i.e. the scientists, then give shape to their insight by actually describing their thesis in scientific language. Similarly, in the case of entrepreneurs, they do so by actually building out the business.
Here’s also where the art of VC investing comes in (and this took me some time to understand borne from my own attempts to fathom where I fit into the larger scheme of things). I’ve realized that the role of the investor is to use the tools of induction to not only evaluate and help articulate the insights of entrepreneurs, but also to separate true insights from mere pipe dreams. That’s also the reason that people with business analysis skills such as management consultants are valued in the PE/VC industry. Its because, that’s what they are very well trained to do – build bottoms up models from existing data to verify or reach key conclusions.
And here’s the final catch. It is entirely possible that the deductive and inductive approaches may finally yield completely divergent results. And, this is not just a personal opinion, but a conclusion arrived at from a field of study no less objective than pure science (theoretical physics to be precise). This is captured in the most famous puzzle of quantum mechanics called the double slit experiment for electrons. Here, deduction or direct observation indicates one eventuality (that the electron has passed through one of the slits) while the mathematical analysis indicates an entirely different one (that the electron is “distributed” between the two slits). To realize this means to realize the importance of striking a balance between the two approaches, and to develop the humility to accept the limitations of both. Entrepreneurs, to admit that what they may be chasing may not be true insight but a delusive mirage and therefore, would do well to heed to dispassionate evaluation of their plans by others. Equally well, investors to also realize that not every insight is amenable to rigorous analysis of the kind we ideally seek (Bessemer’s “anti portfolio” being an excellent case in point). And the art of discovering the magic potion with the ideal mix of analysis and insight is in my opinion, what successful investing is all about.

Taking off on my previous post on some ideas for industry specific funds, wanted to share my $0.02 of learning gathered in my (very) short history in the investment profession about some key success factors for successful investing.  Though these will be mostly applicable to PE investing, it could also be relevant to other forms of investing such as the public markets. In my next post, I will link these with some interesting concepts in human cognition and other ideas from pure science (which may come as a surprise to most readers).
1. Insight: This is perhaps the hardest skill to acquire (if it can ever be “acquired” at all) or even measure. Ultimately, it is also what differentiates a John Doerr or a Warren Buffet from other ordinary investors. Insight - the ability to visualize a reality that other mortals don’t normally possess. And it is distinct from all other success factors in a fundamental way, which will be further elaborated on in my next post.
2. Social capital: By this I refer to your people networks. It begins with something as basic as being connected with investment bankers and other agents, who will show you “deals” and opportunities. To make an investment, you need to learn about the opportunity in the first place - as simple as that. It could also extend to your ability to make relevant introductions to your portfolio companies (to potential employees, partners, customers etc.) post investment.

3. Industry knowledge: Have already discussed this at length in my previous post.
4. Brand of the investor: Everyone loves association with coveted brands, and entrepreneurs are no different. All things being equal, a tech entrepreneur would love to brag that he is a Mike Moritz investee or a KPCB portfolio co rather than that of a “lesser brand”. And its not only for ego’s sake that this is so. It also adds instant credibility to a startup, which is so essential for a variety of stuff such as - the ability to recruit talented employees to landing follow on investments to gaining traction with customers etc.
5. People skills: How often have we heard about the “chemistry” between investors and entrepreneurs. I could be the Albert Einstein equivalent of the VC industry. But, if I come across as a hard person to work with, companies wouldn’t like to partner with me. Period.
6. Luck: Finally, the greatest imponderable of them all. The X-Factor, the Midas touch, whatever you want to call it. It seems like an undeniable fact. On the other hand, may be, like they say - luck is the residue of design.

For a long time (in fact even before I joined the PE industry), I used to think about what’s the ideal strategy for making investments (especially PE/VC ones) to earn superior returns, and I had vaguely concluded that deep domain expertise in specific industries was perhaps the only way to beat the market. And a recently released study by BCG reaches the same conclusion. The report concludes that domain expertise and industry networks rather than financial engineering or fund structure is what differentiates top funds from the rest. Frankly, I am quite surprised that almost all funds define their investment criteria by stage and deal size and we haven’t witnessed that many “experiments” with industry specific funds which invest across stages and deal sizes.

In my opinion, immense information related synergies can be leveraged by having a portfolio of companies in a particular industry and this coupled with sound risk management systems can enable one to earn superior returns over time. For example, lets say a fund that’s focused on tech industry. It could take exposures on (say) innovative startups that are working on search and hedge that with an appropriate (long) position on the incumbent (publicly listed) leader - Google. Similar examples can be conjured for other industries such as pharma, biotech etc. In fact, I was talking to a PE investor some time back, who has done a few deals in the auto component sector both in PIPEs and private cos. He was saying that this offers an edge to them in two ways - a)it helps them validate the picture painted by entrepreneurs pitching to them by having their stories vetted by others in the industry (especially senior managers of other large cos) b)it enables them to gain credibility with entrepreneurs as well since they value the industry perspectives that they bring to the table. Given the plethora of PE funds that are operational and the competition for good deals, I’d guess that without such genuine differentiation that would enable a fund to a)earn a shot at good deals (most funds are not even in the reckoning for most deals) b)evaluate the opportunity better (owing to industry knowledge), and c)bid competitively without overpaying (owing to the value the entrepreneur sees in having the investor on board), it will be hard to sustain superior returns over long periods.
So, for any potential investors convinced with my above thesis and willing to part with their monies for trying out, I’d love to hear from you

Last week, there was an extremely interesting exchange of views on Microsoft’s search strategy between Tim O’Reilly and Michael Arrington. See:
http://radar.oreilly.com/archives/2008/05/microhoo-corporate-penis-envy.html
http://www.techcrunch.com/2008/05/25/the-importance-of-a-competitive-search-market/
http://radar.oreilly.com/archives/2008/05/why-search-competition-isnt-the-point.html
Tim seems to think that MS’s efforts are directed in the wrong direction since search as we now know it is essentially a “done deal”. On the other hand, Mike argues that Google is headed towards monopolizing search, which portends ill as far as internet related innovation is concerned and therefore, MS’s attempts to break into search should be welcome by all. I would say, I will have to go with Tim on this one, and here’s why.

One of the essential (almost mandatory) characteristics of an internet business model is - network effects, which means that the value of the service has to increase with increasing numbers of users participating in it (think of a telephone network). Prior to Google, it was not clear whether search would ever be successful in gaining network effects. However, amongst other things, one of Google’s greatest successes is that it has transformed search from individual one off interactions to an intelligent system that records every one of users’ actions and mines these data to constantly improve the search results. Therefore, for any keyword, if a particular result gets more clicks, it indicates that users find that more relevant, and this gets bumped up on the results list. Hence, every action performed by every user is incrementally beneficial to the system since it helps improve the results. Thats network effects for you.
Similarly, on the revenue front, Google’s Adsense program again has huge network effects working in its favour. The better the algorithms for matching content and text ads, the better will be the CPC yields. That will in turn attract more publishers to adopt the platform for monetizing content, which in turn will attract more advertisers. This enables Google to earn more, which it invests back into further ramp up of its search infrastructure (index, h/w etc), which further improves the results.
Thats the reason, I feel that Google has entered into a virtuos loop and its total dominance of search seems inexorable. I had a debate with Don Dodge (of MS) on this topic some time back (See: comments section of http://dondodge.typepad.com/the_next_big_thing/2007/05/why_1_of_search.html). That Google’s search marketshare has been growing forever proves my line of reasoning.
Therefore, I feel MS’s attempts such as its recently announced cash back offer is weak at best and doesn’t do anything to address the core issue. Like Tim argues, MS needs to fundamentally change the nature of search if they have any hope of gaining traction in this space rather than resort to superficial tactics such as the cash back scheme.

]]> http://arunuday.com/2008/05/30/on-microsofts-search-strategy/feed/ arunuday http://arunuday.com/2008/05/16/wheres-the-vmware-for-the-network/ http://arunuday.com/2008/05/16/wheres-the-vmware-for-the-network/#comments Fri, 16 May 2008 04:38:23 +0000 Arun Uday http://arunuday.wordpress.com/?p=75

I was reading a post by Henry Blodget on how Google’s search income is beginning to close in on MS’s revenues from Windows, which is unnerving the latter. In the comments section, there were many who remarked, “Why should MS feel threatened? After all, there is no connection between the two.” However, the fact of the matter is that there is a connection, and nobody realizes it better than MS (the aborted Microhoo endevaour is proof of that) . Ever since the internet exploded as a phenomenon, there have been various attempts to reduce the OS to a “plug-in that will sit below network applications” as Marc Andreessen put it when he set up Netscape. Netscape, Sun and now Google have all sweated it out in that direction. And, surely enough MS has squashed all such attempts. However, Google seems to have attained a position that seems most threatening of the lot for many reasons - a)They have amassed financial resources larger than any other challenger in the past b)they arguably have a better engineering team than MS c)they have a disruptive revenue model, which MS is yet to gain mastery over. In short, they have everything that it takes to launch a serious attack, and that they seem to be doing via Google Docs and the rest.
So, what would I do if I were Google? Try and build a VMWare for the network. Sub-optimal utilization of server resources was a long standing problem, which VMWare solved to gain rich dividends (enough to earn it the “IPO of the year” tag for 2007). Now multiply that problem by many orders of magnitude and that’s what you get with networks. For instance, take a large corporate network of a transnational company (like GE or Citigroup). Just imagine the redundancy of resources (computational and memory) they have across all the desktops they own globally. Indeed all of their PCs would be “sleeping” half the time when employees switch it off and go home. Think about what could happen when a US employee at the end of his day frees his resources only for an Indian employee to utilze them. The cost savings would be enormous. If Google were to successfully crack that problem and provide “local clouds” to enterprises (over which net apps such as Zoho, Google Apps etc would run), that would provide them with a platform which could potentially make the underlying OS irrelevant. Frankly, I do believe it won’t be too long before someone actually does it. The technology more or less exists (think SETI or any of the mutiple grid computing companies that are there) and the economic need definitely exists. Now, its just a question of who will make it happen (and I pray it not be MS).
 

Looks like the business world in the US  has taken a penchant for frenzied activity over the weekends.  If it was the Bear Stearns episode a few weekends back, it was the Microhoo - will they, won’t they saga unfolding in all its drama last weekend finally ending pretty unventfully with leaders of both companies calling off the deal and shooting out missives intended to give the impression that the outcome was in the best interest of its stakeholders after all.
And I should admit, I got this one wrong. Given MS’s dislike for being an also ran in any area of high priority for them, and Y!’s own trouble in getting its house in order, I had thought that there was no other choice, but for them to finally come together. I had dismissed the noises made by the managements of the two companies in the interim to be just posturing for valuation negotiations. And that indeed may still be the case.  In my assessment, the companies will probably keep the discussions going in the background (albeit quitely) and may just spring a surprise by announcing a deal some day when nobody was expecting one. The fact that the deal [fell apart] only on valuations (and even here, the gap doesn’t seem unbridgeable) indicates the willingness of both parties to have a discussion in principle.  However, there is a huge joker in the pack, and that is AOL.  If either MS or Y! decide to acquire AOL, all bets would be off.  Can’t wait to see how this game is going to unfold in the near future. Expect a whole lot of twists and turns in this tale before we get to the end.

One of the factors holding back entrepreneurial activity in India has been the lack of enough motivational success stories. An important turning point in the history of PE investing in India was the stupendous success of the Bharti Telecom investment by Warburg Pincus. The multiple times return on capital they earned made other foreign investors wake up and take note of the opportunity here. Similar stories are required in the VC world to rev up entrepreneurial and VC activity in our country. One of the common complaints we hear is the lack of early stage funding in India, though thats changed a lot in recent past with multiple seed and early stage funds coming in. Success breeds success, and in a myriad ways. Lack of enough hi-tech entrepreneuiral successes where startup employees have taken home large sums by way of stock options has also been a deterrant for others to sign up for startups. Hence, a handful of big successes is all that is required to seed the ecosystem of investors, entrepreneurs and also other contributors (read tech staff) to come together to start building great cos.
Therefore, this news item on  UTI’s blockbuster exit from Excelsoft augurs well for investors and entrepreneurs alike. Congrats to the UTI team!