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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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It’s all complex, so what?

Posted by Muthu on June 2, 2013

I get few invites a week for joining Linkedin. As I’ve mentioned in the past, I’m not active in social network. So request you not to mistake me for not accepting invitations.

I’ve attended few workshops during the last one year on macro economics. I attend these seminars for few reasons; can learn some thing new, catch up with friends and nice way to pass time:-)

Attending these seminars gives an understanding how complex is functioning of an economy. Too many variables influence the outcome and it is rare for all these variables to be in the desired equilibrium. When government or central bank tries to influence a set of variables, another set goes haywire because the interconnection between them is complex and may work in the opposite instead of the desired direction.

Why I’m saying this?

There is an expectation set by these experts that while planning for a client all these macro economic variables need to be taken into account.

My opinion is that planning for an individual using complex macro economics is a recipe for disaster.  More the variables in a plan, more it is likely to go wrong. Though world is complex, accounting for these complexities is not only impossible, it also make the process error prone.  Economist and analysts gives forecast based on complex mathematical models with inputs from zillion variables. Still the outcome or accuracy of their forecasts is no way better than what an amateur can say based on some back of envelope calculations.

I would prefer a broad outlook based on understanding of some key variables rather than specific forecast based on complex excel models. The later one not only confuses the advisor but the client as well. There is no point in speaking a language which neither the speaker nor the listener understands:-) 

I would like to recommend two books for a simple and effective understanding of economics. 1) Economics in one lesson by Henry Hazlitt 2) The little book of economics: How the economy works in the real world? By Greg Ip.

Early this year I sent an email asking you to value an idly shop. There was enthusiastic response from you and I shared one way of valuing the same.

Valuation is a complex exercise because there are too many variables and their inter connectedness. There are various schools of thoughts as to how a company or business can be valued. Once you start reading these, you can get caught in a maze.

Like mentioned above, the funny part is that despite complexity, these methods can be vastly inaccurate and confusing.

There are thumb rules provided by Benjamin Graham which are easier to use for screening the potential stocks. For those of you who want to understand valuing a company in a simple way, I would recommend a 30 page book (yes it is only 30 pages) written by Frank M Singer, How to value a business?

I would rather have a simple approach and be inaccurate than having the same result with complex approach. The rate of error in the process is much less in the simple one.

Though I don’t make any predictions, let me explain below to give a view as to how my brain works, if and when it works:-) 

There has been lots of noise on Friday about lower GDP growth though it was on expected lines. The good news of fiscal deficit falling to 4.9% was lost in the din. We also don’t consider the difference between real and nominal growth. Only GDP is mentioned in real rate. The salary increments, prices, companies’ growth in earnings etc. is always mentioned in nominal terms. We use nominal rate for all practical purposes. Nominal rate is nothing but real rate plus inflation. 

If inflation is 7% and your increment is 4%, your salary has actually been reduced by 3%, though it the amount credited in the bank increases. Money illusion:-) 

Assuming inflation of 7% last year, the nominal GDP growth is 12% (7% inflation + 5% real). Usually the earnings of listed companies grow more than the nominal GDP rate of economy. I expect the nominal GDP growth rate to be in the same range with inflation decreasing and real growth increasing. 

So the earnings for Sensex can grow at 14% in the next 3 years. This year’s (FY14) earnings for Sensex is estimated at 1350. So at 20000 now, the Sensex is trading at 14.8 PE. Three years from now (FY 17), at the (nominal) earnings growth rate of 14%, the earnings may be at 2000. With the same PE level of 15 (which is not expensive), Sensex can cross 30000 and for example if the market is willing to provide a multiple of 20, it can even be 40,000. Normally PE expands when the growth cycle picks up and there is general optimism in the economy. What I’m saying may or may not happen. Earnings growth and multiples are influenced by many factors. But I do see a good growth compared to poor growth in the last 6 years, especially due to 2008 crisis. 

Economy, markets and almost everything in life is cyclical. Instead of asking why it is cyclical, it is better to accept the reality that for whatever reason, things are cyclical. We are in a position to similar to what we were in 2002-03. So we can afford to indulge in some optimism now.

Why we recommend even a debt product for long term is that though it is difficult to predict cycles, we are very confident that things are and would continue to be cyclical.

As I mentioned, the above future gazing is not to predict but to explain how my brain works.

The world is complex. So what? Let us have simple approach towards the complexity.

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