What to Expect in 2014 (And Beyond)

This outlook is being written a good 45 days later than when “What to Expect in 2013…” was written over a year ago. It is amazing how much can happen in that short time frame and can influence one’s view of the next year. If I let another 45 days pass I am sure there would be some things that would change. I believe the risks are to the upside on more positive news on the economy but at some point that news could affect Fed action.  Much of what could happen this coming year is influenced by what is going on in the energy sector. Middle East economies, of course, but also inflation, GDP growth, and geopolitical events will affect markets and the US economy specifically. These points will become clear as I spell out some of my expectations. Understand that these expectations follow the Byron Wien formula where I believe there is greater than a 50% chance they happen when the rest of the world may not agree. The “Expectations” are designed to stimulate thought. Some of them can relate directly to the securities markets, but some do not, and this year, a little whimsy. Hopefully, you can figure out which one that is. Let’s begin:

  1. After printing two 4% GDP quarters in 2013 and seeing a 1 percentage point drop in the unemployment rate, there is finally some recognition that, maybe, the Fed’s actions really did produce some stimulus. This could lead to self-sustaining growth in the US economy in 2014 with at least one more 4% print this year. Less noise from the crazies in Washington adds to business confidence and, ultimately, capital expenditures.
  2. Economic growth and job creation become more apparent with forecasts for a decline in the unemployment rate possibly approaching 6% before the end of the year. The Federal Reserve begins making noise about speeding up tapering and hints at reducing the time the Funds rate would remain anchored at its current level. This is in spite of limited evidence, at least early in the year, that the inflation rate is approaching the targeted 2% level. This ultimately has a dampening effect on the markets.
  3. We begin seeing some academic work and, of course, the pundits talking about an acceleration of the technological revolution making the case that low inflation or maybe even some signs of deflation are actually a good thing in this technologically driven environment. The low inflation picture is reinforced at the headline level by energy supplies expanding within the US, in the Middle East from Iraq and, ultimately, Iran. As other countries embrace fracking the potential for even more supply keeps downside pressure on energy prices.
  4. The negative elements on inflation, which are not sufficient to cause major concerns, come via erratic supply in soft commodities from continuation of drought in certain areas combined with weather abnormalities which, more and more, are blamed on climate change. As we get into the latter part of the year, the improving developed market economies combined with growth in Asia put some upward pressure on hard commodities. Investors must make the decision to invest in the extraction companies that have suffered from low prices or directly into the commodities themselves.
  5. The positive change in US trade balances from lower imports of energy combined with rising energy exports adds more than a percentage point to US GDP and reinforces the case for a strong dollar relative to almost every other currency except possibly the Chinese yuan. Asia shows growing signs of a currency war fueled by the impact of further weakening of the Japanese yen beginning to very seriously affect the export trade of its Asian competitors.  While this has a tendency to push up inflation rates in many of the Asian countries, the developed markets benefit from lower prices on many imported goods further softening their inflation rates.
  6. The impact of the currency wars raises questions about the stability of some of the emerging markets, particularly in Asia. There are also concerns about the pace of wage increases in these heretofore attractive locations for outsourcing. Manufacturing and some service corporations begin making different strategic decisions on the best places to locate manufacturing and processing centers.  The decisions are reinforced by a growing belief that technological advances will continue to allow capital to substitute for labor, or at least keep pressure on wages. More business activities find their way back into the developed countries of the world. China moves cautiously in the same direction, taking advantage of its own technological progress. It begins marketing itself as a technological leader as opposed to a low-cost labor market. This is not easy as China, at the same time, continues to push toward a more consumer-oriented society. Incomes have to rise and, politically, the population needs to be kept content. It will not be a smooth year for China.
  7. Coming elections in India point to a possible loss of leadership for the Congress party. Combined with continued economic difficulties and some strife associated with the potential leadership change, the country moves further down the path of being even less attractive for foreign direct investment. It loses another year to the relative growth of its Asian neighbors and finds itself participating in the currency wars as a possible way to salvage elements of growth.
  8. With the exception of Chile, Colombia, Mexico and Panama, the rest of Central and South America flounders. The US begins to pay more attention to its southern neighbors. Out of desperation, Argentina reaches a settlement on its outstanding debt and begins a focus on building its energy sector with some help from outside sources. A Menem-like regime change becomes a more likely political outcome.
  9. The changing energy picture outside the Middle East, combined with likely increased production out of Iraq and, ultimately, Iran, result in a change in the relative importance of Saudi Arabia and, to some extent, Israel. This could produce some positive movement in the Palestinian situation, and some changes in the relationships of Saudi Arabia with the rest of the Middle East and possibly Asia as the US becomes an even smaller market for its oil and an export competitor. On the other hand it raises the risk of some turmoil in the region as the power picture changes and attempts are made to preserve the old order in  a possibly military fashion.
  10. The fading newspaper industry surprises the street with its earnings in the early part of the year and benefits from contentious congressional races in the third and fourth quarters as well. The advertising related to Academy Award nominations and ultimately selections reaches new heights in print and social media. Studios advertise some small (but not cheap) movies to extremes to compete with some very high quality films and performances. We actually walked out of a couple of the most highly advertised ones. Aren’t two-page spreads a little extreme? Unfortunately, the correlation between the advertising and the nominations and awards becomes very direct leaving it up to the audiences to hopefully, make their own decisions after the fact. The quality and audience continue to rise for television productions and the associated delivery mechanisms for these performances leaving 3-D sequels and prequels to the movie industry. Can’t wait for “Inside Llewyn Davis Today–in IMax.”

So what does this all mean for the markets? I wish I knew. History says that the kind of equity market we had in the US in 2013 is usually followed by a decent year.  I don’t think it is that simple. We could see some re-allocation by institutions whose US equity portfolios have been pushed above their target percentages. At the same time, if we are beginning to return to a more normal relationship between earnings yields and fixed income yields, traditional debt doesn’t look that attractive. It may mean that markets outside the US are more attractive–maybe Europe and maybe some of the emerging markets if the currency is hedged out. There are some risk elements in the geopolitical situation. I think we will have to look harder for returns this year and the risks are high enough to look for some less correlated investments. I wouldn’t reduce my equity exposure, but I might change the mix.

We’ll have to see if another 45 days sets us up for totally different surprises. If nothing else I hope this has provided some food for thought.

I have some longer term expectations including a carryover from past years which, one of these days, will actually come to pass. I include these as additional repast for the brain. As has been the case since the millennium, the year will likely be more interesting than we anticipated.

  1. Contrary to normally quiet years during a transition of leadership, to some extent in reaction to some elements of an “Asian Spring” in the region, China takes further steps in response to a more activist populace upset with corruption, the environment, and some areas of economic stress. Externally, this includes significant acquisitions in other countries as well as the opening of manufacturing and service facilities where there is a receptive government. At home, R&D is accelerated, particularly in alternative energy, space and IT processing. Subsidies for hydrocarbons are reduced and an explicit carbon tax is put in place.
  2. As the US economy grows, corporations find qualified hires difficult to come by.  Enlightened corporations become educational institutions to provide skills and basic knowledge to a work force that has been idle and undereducated by the public systems. Corporations become much more vocal about creating paths to bring more immigrants into the US system, expanding visa programs and finding other mechanisms to add talented labor to the domestic pool. The tide shifts significantly on immigration issues. The skill match is aggravated by decisions on the part of some US corporations to bring business operations back into the States. Labor costs are rising elsewhere and the elements of control, rule of law, productivity, available feedstock and relative safety lead to better economics for manufacturing and service operations.
  3. Moore’s Law, driven primarily by Intel driving down the nanometer scale and introducing other innovations,  continues to march on. The use of Big Data becomes ubiquitous. This produces technological advances that enhance the opportunities in health care, manufacturing, extractive industries, media and services beyond even the imagination of some of the best speculative fiction writers. These advances, on balance, are positive but continue to raise concerns about the environment and quality of life and opportunity for those at the lower end of the economic and educational spectrum.
  4. Breakthroughs in stem cell research particularly led by work coming out of the New York Stem Cell Foundation change the nature of disease management and eradication and move general therapeutic advances away from animal models to direct testing on human cells. Targeted therapeutics driven by DNA analyses tied to narrower classes of patient recipients change the nature of drug and health delivery. It becomes apparent that the US FDA model is slowing the pace of US therapeutics development by the cost and time required to bring solutions to market. Much as financial services regulation was geared to the benefit of larger entities, it becomes clear that therapeutics development has been on the the same path. Change occurs in response to other countries moving more rapidly in bringing solutions to market.
  5. Away from continual ups and downs in financial assets as the world works its way through the hangover from the 2008-2012 financial crises, the general march of human progress is positive. I hope to be around to observe it. Maybe the breakthroughs suggested in the previous expectation will help that.

Jeff Bezos, the Washington Post and Content (which will get even better)

I have a different view from what’s out there thus far re where this acquisition will lead.  Much of the discussion to date about this very interesting acquisition is focused on the content and the risk it will change for the worse.  One would expect this from the media since that is what they focus on.   The discussion also seems to bring in the idea of Bezos wanting this property because of the leverage it will give him in Washington.  I don’t buy that.  Wired.com equated it to Bezos’ other “quixotic” ventures.  Everyone, naturally,  also keeps trying to tie this to Amazon.  I think that is only valid in looking at Bezos’ managerial approach, not what Amazon itself is.  Bezos has said the focus is on the reader–understanding what he/she is looking for and providing it.  That is consistent with understanding what the customers at Amazon are doing and providing them with more of what they most likely want. The Post is not going to look like Amazon, though.  The tie-in to Amazon represents a narrow focus on what he can do and, in my view, is likely to do.  I think Bezos is interested in learning who the readers are and their behaviors  and is prepared to do that with the high quality content of the Post.

I am not so sure he really wanted to buy the other paper properties, but I doubt that the Post Company wanted to be left with any.  I think his initial focus will be on reducing costs of the back office and not touching the content side.  He can do a better job than the current management was doing.   He certainly runs a lean shop at Amazon.  I think people are missing that the Post’s digital revenues must be running close to $100mm.  Graham does deserve some credit for that.   Bezos is buying a digital stream at 2 1/2 to 3 times revenues if you give no value to the $400mm of off-line revenues. That’s pretty cheap.  Henry Blodget pointed this out in his very well written piece on the acquisition.  I also think the Post is closer to breakeven than the last 12 months indicated, given the costs included on the pension side and termination costs.  The management didn’t have a solution  how to get the profits up,  was trapped by the experience of the last 7 years and the board didn’t have the patience.  The Post has been firing content creators without looking hard enough at other ways to reduce costs making use of technology that exists on that end.  As a public company the Post Company couldn’t risk more losses.  In an interview on the Post’s own digital website Graham said there were twelve bidders and Bezos was the highest bidder.  It will be interesting to see who the other bidders were, which is info that will likely make its way out over time.  Graham would likely have had to sell to the next highest bidder and who knows who that was. He got lucky with it being Bezos, who I think is prepared to preserve the content and figure out how to monetize it better.  I wonder if he would have been able to say that another buyer was as attuned to the “values” at the Post.  Interesting that the journalist employees were “sad.”   They should have been sad if there weren’t a sale.   If I were there I would be excited about what could happen.  I think their job security has just gone up.

Bezos wrote to the employees about inventing and experimenting.   This is the classic approach to trying to figure out what the right business model is.  As a private company the Post can do this without as much worry about the short term impact.  But, as I said, I don’t think the road to profitability is that long.  I believe the Post will likely be providing even higher quality content than it has been for a while.  I also think it will likely expand from the very specific approach to its local environs to something more global, which would move it toward a bigger audience. This will be interesting and fun to watch, and, of course, it will be well covered. The media industry is the most self referential of any I know. Anything related to media is always a big story. I am looking forward to following this one.

The Future of Capitalism (and Commission Sharing Arrangements)

Two weeks ago I attended an all day session, “The Future of Capitalism,” put together by the the World Economic Forum (WEF) and The Forum of Young Global Leaders, with a big attendance by and assist from the World Policy Institute. While this session was under Chatham House Rules so I can’t go into great detail, it is safe to say that the general thrust of a series of wide-ranging discussions was that, in its current form, Capitalism has yet to prove it can function in a sustainable manner on a planet approaching a population of 9 billion.  There was much discussion of what could or should happen–some naive, but most quite pragmatic with some actionable steps. My favorite actionable step  was to require that CEOs, in addition to preparing their annual report to shareholders, should prepare an annual report to their children and grandchildren, describing what they do and don’t do and why, in clear understandable language relevant to these inheritors of what one would hope to be a sustainable planet.

More recently I attended a meeting where some activities in the financial world were described that may have more immediate negative impact on the Future of Capitalism. This is where Commission Sharing Arrangements (CSAs) have relevance.  A CSA is an arrangement in the investment community whereby an institutional investor does a security transaction with a broker and directs that a portion of the commission on the trade be paid out to a third party.  The third party is typically a smaller specialized firm that has provided research services to the institution. The institution has chosen to do the trade with a particular broker, usually one of the ten largest  broad-based broker-dealers (BDs), because of the belief that the BD will provide better execution at a lower commission than if the trade were done with a smaller firm. The larger BD typically has broader reach and visibility to get a larger trade done, including use of electronic trading systems developed by the BD or more accessible to the BD. In addition, the larger BD is more likely to be willing and able to commit capital to complete a trade in the event that the market place doesn’t. CSAs, a variation on soft dollar payments, that now is used with smaller BDs,  have come into vogue over the last several years, with help from the larger BDs, and already account for upwards of 30% of all commission dollars generated by institutional investors.

The above is a long explanation of what may appear to be a minor thing happening to Capitalism, in contrast to the grand ideas that came out of a WEF meeting. In my view it is not minor and has significant unintended consequences. Historically, smaller BDs have been an important part of the capital allocation and capital raising functions of the financial markets. They have provided research on smaller companies, been a part of price discovery in the marketplace through their trading desks and provided investment banking services including IPOs and secondary offerings for these companies that typically could not command the attention of the larger BDs. As institutions have elected to pay for the research by check vs trades, the ability of the smaller BDs to service these small companies as investment bankers has become problematic.  As trading becomes more concentrated among the big guys the economics are forcing many of these companies out of the trading and capital raising function and lessening their ability to hire and retain high quality professionals. The larger BDs do not step into the breach to service smaller private and public companies because the economics just don’t justify it. Thus, the capital markets business becomes more concentrated among a smaller number of bigger players. In a way, it is Capitalism at work within the financial services industry where unfettered Capitalism leads to concentration into fewer entities and, ultimately, monopoly positions.

Unfortunately, it doesn’t stop there. Concentration in the capital markets affects the role of Capitalism in the broader non-financial world as well. The less apparent outcome of this concentration, is a stunting of the capital-raising function for private companies leading to more limited access to the public markets. It produces an approach by early-stage investors of less reliance on the public markets providing liquidity and more focus on the direct sale of a company. I see that working its way into the investment decision process by venture capitalists and others, and the subsequent strategic process around the growth of a small company. If the expected exit or liquidity event for the investor is a sale, that becomes a big part of the way capital is allocated to “grow” the company. It also appears to shorten expected time frames from start-up to potential liquidity. And, it leads to the creation of products as opposed to companies, with an eye on where the product would fit into the business of potential corporate buyers. It changes the nature of the skill sets at the investment banking firms from understanding and supporting functioning capital markets to advisory merger and acquisition talent. Finally, it has the insidious effect of leading to concentration and lack of innovation in the corporate world as well. A large company can survey the universe of start-ups and smaller companies and snap them up before they become a threat or to fill a gap in their skill sets or product offerings. It is no longer a “make or buy” decison. It is just a “buy” decision.  With lower odds of a smaller company ultimately getting liquidity and raising capital through the public markets, the focus internally becomes one of positioning the company for a sale to one of the behemoths in its industry. Once the acquisition takes place, I have seen, in many instances, the innovation pace slowing or in many cases just disappearing. In some instances it can actually add to the portfolio of products offered by the larger entity, but not always. Ultimately, concentration increases, stifling growth and innovation, and creating less-free markets. It then takes big government to “regulate” these entities to prevent the ultimate outcome of true capitalism–a monopoly position.

So we end up with big financial firms, big corporations and big government—most likely all too big to fail or change, but more dependent on each other for their raison d’etre and most likely less responsive to leaving a better world for their children and grandchildren.  It’s not a pretty picture. It’s not all because of Commission Sharing Arrangements, but the pace at which concentration is happening is accelerated by this small change in the way business is being done in the financial sector.

I was actually encouraged by the discussions at the WEF meeting and walked away with some hope that the upcoming generation of Young Global Leaders might actually find ways to get this right. But, the small changes which have big implications and are taking effect daily will make their job tougher.

The Facebook IPO: In my view it was quite successful

I don’t totally get the Sturm und Drang around the Facebook IPO.  There may prove to be some issues around disclosure, NASDAQ, stabilizing of price, and anything else someone wants to raise to support their own agenda.  However, I said yesterday on Bloomberg Hays Advantage that from the company’s point of view, this was a very successful IPO.  The company issued public stock against a set of governance issues that in many instances would not have allowed a “normal” company to face its shareholders with a straight face. The underwriting fees were at a discount to “normal” fees.  It basically got the near term high tick on the stock price. It was the third largest raise in the history of IPOs and put additional capital in the company’s coffers and provided more immediate liquidity for its private equity investors than one would ordinarily see on an initial offering. Even with the decline in the stock price, this company is being valued at around $60 Billion, significant multiples of revenues and earnings. Certainly, the senior executives are expecting to continue to build a company over a long time period and have the ability to control that build, given the degrees of freedom to do so without interference from their shareholders. Today’s price of the stock is of less concern to them.  The public shareholders can only vote by buying more stock or selling it. They have very limited say in the governance of the company. The 26 pages of risk factors in the S-1, the filing statement, clearly spelled that out.

From the underwriters’ perspective it doesn’t look as good.  Underwriting does involve taking risk. There is always an attempt by the underwriters to leave something on the table. It takes out a fair amount of their risk and makes room to exercise the “shoe” to sell more stock (and generate more fees) above the original offering amount. The demand appeared to be there, but with some pushing from the company, I am sure, the price and amount were raised, as was the risk.  The world of IPOs has changed though, given the increase in high-frequency trading and the increasing presence of hedge funds in the IPO process. While most companies would prefer to see their stock go into the hands of long-term investors, the underwriters have a client constituency that, implied or otherwise, expects to get significant participation in a hot IPO because of all the other business they do with the investment bank. In this instance there was also a decision made to put more of this stock into the hands of a less-informed individual investor. I would like to know how many of those individual investors actually read the S-1 before they made their decision to buy the stock.

In addition, the concept of being able to “stabilize” the price movements and trading action around an offering is almost non-existent. The dollars available in the market place to influence price movement overwhelm any amount of capital that the underwriters can put to work. In this instance, even the trading systems, as robust as they are, were not adequate to handle the 80 million shares that ultimately traded in the first thirty seconds after the stock was finally opened, much less the 570 million shares traded in the full day. This was a huge offering of shares of a company operating in a mode of creative destruction of legacy businesses with the volatility associated with that. Exciting, newsworthy, with more news to come over many years. I am most excited about the wealth creation that did occur for those who put their capital and their energy at risk in the creation and early funding of the company. Much of that capital will likely make its way back into the creation of other companies that will take advantage of the phenomena of increased processing speeds and the power of information control put into the hands of individuals. Very, very exciting!

Labor Market, Stock Market, The Economy, and Why the JOLTS Report is Both Good and Problematic

The labor market is fine, but there are some concerns (and opportunities). Listen to the podcast of a conversation with Bloomberg’s Kathleen Hays and Vonnie Quinn of “The Hays Advantage” on Bloomberg Radio from April 10, 2012. These two posts and a link will also provide some background: http://bit.ly/wfpykq , bit.ly/zAEswR , bit.ly/H9EBHo .

Download the podcast

The Economy, The Environment, Lessons Learned, Opportunities Today

A speech given to venture capitalists & entrepreneurs in India in December 2011

I am very pleased to be here today.  I come to India regularly for pleasure and for business although it is always a pleasure. What I plan to do is provide an economic and market context on what has happened in the United States trying to draw some parallels and contrasts to Asia – India specifically – and Europe. I will start with some history, review where we are today and then venture some guesses about where we may be going. I will relate that to what happened in the venture world historically, again to compare and contrast with what is happening here in India. I will then turn to the opportunities this presents. Several of you here today are investors, and your allocation to potential investments is made in an economic context regarding returns relative to risks. So lets start with economics.

Some history:  I am not sure that recent history provides one with the right context, so it may be helpful to look at a longer time span, which could provide a better perspective. I will give a caveat that “perspective” is an overused word. (As is “caveat” for that matter.) Jane Smiley, a great writer, may have been right when she had one of her protagonists define perspective as actually believing that two parallel lines meet.  Maybe you have to be an engineer to appreciate that. At any rate, this is my point of view and my sorting of the data and my perspective—one that is US centric, partly because it would be presumptuous for me to tell you about your own country, and partly because it represents a model that may be useful to understand.

I am not going to present a comprehensive picture of the economy and the markets. Instead, I will highlight a few points that I think have some relevance to investing today. Let’s start with GDP growth in the United States since World War II.

The US has had 12 recessions since the Second World War.  What is most interesting to me about this recession are 1) the year over year decline has been greater than any of the post-War recessions, 2) the rate of recovery compared to earlier recessions has not been as high, and 3) the official recession exceeded both the 81-82 and 73-75 recessions by a few months. In addition, we haven’t seen a 5% year-over-year GDP gain since late 1999.  High oil prices and Central Bank tightening were the primary causes of the other two lengthy recessions.  This latest one is much more of a financial crisis like a quarter of the 47 recessions the US has had in the last 220 years. Several of those financial recessions were substantially longer and in many cases deeper than what we have experienced thus far. In almost all cases the crises extended globally or even originated elsewhere in the world, primarily England. This crisis is certainly global. And has manifested itself serially from the US to Europe and is now affecting Asia, including India.

However, in the US, which was first to see the downturn, away from the construction market and its impact on economic activity, the rest of the US economy is actually doing well and is growing. And importantly, in my view, it may be approaching self-sustainability.  Profits have more than doubled from their lows in 08 and are 20% above their peak in 06.  In some ways the US securities market reflects this off of its lows generated by the fallout from the Lehman bankruptcy.

I am referring to the S&P Technology Sector, which while still way below its peak in the dotcom bubble is at levels seen in 1998 before the 18-month blow-off produced that final peak in March 2000.

This index is a reasonably good proxy for what has happened to overall values in the venture capital world in the US.  A caveat I would add though, is that while values have tracked one still has to be somewhat concerned about valuations.

The overall valuation in the US, while down, is still above the lowest Price/Earnings ratios that have been hit in the longer cycles of valuation in the market. One can come up with a variety of reasons why valuations may not go to previous lows experienced, but I have to say there were always a set of reasons why valuations could not go lower.   I think it is useful to look at valuations in the public markets, as history shows that private equity valuations tend to track public market valuations overall and by sector going in and coming out.

Valuations in India are not low by historical standards. This does translate into private equity valuations and does raise some points of caution.  It goes without saying, but I would make the point that the valuation one gets going into an investment may be one of the best determinants of the ultimate return.

Historically, the US is bouncing closer to the bottom of a price channel waiting for earnings growth or possibly further market declines to bring down the multiples a bit more. We can review how the US got to this point and where we are likely to go from here. This pattern does relate to what is happening globally.

It is a fairly simple picture. We overleveraged the economy to support consumption, which in turn has led to a very significant trade deficit, about half from overconsumption and about half from dependence on others for our hydrocarbons.  This is a US and European problem for the most part, but to some degree it exists here and in other parts of Asia as well. As we work our way out of this problem it will likely result in lower overall growth in the Western world for a number of years. Europe is likely to show negative numbers next year—maybe even this quarter.  I would point out though, that in the US, there are some positive indications. If one looks at total debt outstanding, the number has actually flattened, with government debt replacing private debt. The ratio of debt to GDP has fallen as well-still high but falling. US corporations have significant enterprise capacity if they only had the confidence and the opportunities for investment. They ultimately have to do something with their cash.  I would also make the point that US banks, in contrast to other banks around the world, are accumulating cash. Deposits are up. The Federal Reserve has bought paper from the banks, and the Europeans, South Americans and others believe that their liquid assets may be safer in US banks than their own. In addition, if the dollar stays where it is or weakens particularly against the Asian currencies we would move closer to values we saw during the 90’s.  A point I am making is that part of the growth in the 90’s in the US was fueled by a lower dollar than we have today.  From its low in 1988 the dollar marched up doubling in value over the next ten years and today is still 50% above that trough but in a recent decline.

However, China’s currency has been rising. On balance, I believe other Asian currencies will track China’s over the long run.

India’s currency tracked China’s earlier this decade but I think internal issues and some concern about the impact of the European problems have affected values more recently. I do believe in the long run, based on economics, the Rupee is likely to strengthen against the dollar. Internal issues, for example allowing for Foreign Direct Investment, could affect the timing and degree of strengthening as trade balances shift.

Looking at High Tech trade, which is a good proxy for some of the venture activity, aided to a measurable extent by the lower dollar and Moore’s law, the US had a positive trade balance annually in High Technology Products through the 90’s. Lots of factors have affected the numbers over time, but the net of it is the US went from roughly a $24 Billion annual surplus at the end of that decade to a $96 Billion annual deficit in 2010. I think the dollar has been an important factor. Looking at India specifically, overall, this year you will have about a $15 Billion annual trade surplus with the US. Actual exports have doubled in the last 5 years and will likely be $36 Billion this year. Venture-backed companies should be getting their piece of that.

I do believe in the long run, currency adjustment may be the most important factor in job growth in the US, and possibly Europe, reducing the labor arbitrage that now exists between the developing world and the developed world. This will require significant productivity improvement in the developing world to offset higher currency values.

It is unlikely the dollar gets back to the lower end of the 90’s level in a straight line any time soon, because, right now, given our relative growth and safety, we see capital continuing to flow in our direction adding some strength to the dollar. However, over the next decade or more, the dollar is likely to weaken, particularly against the Asian currencies.  As the dollar adjusts and the economy does show modest growth, the capital is there in the private sector to finance growth once there is some certainty about where it will come from and if the Europeans can deal with their deficits. Many of those dollars will make their way overseas seeking that growth and creating jobs, if local policies are supportive. Let’s also remember that while the US may be running a trade deficit in high tech products, it is exporting at a $288 Billion annual rate and importing at a $192 Billion rate.

And, in spite of its overall trade deficit with almost every country on the planet, the US still exported over $1.4 Trillion of goods. And not counting oil imports the US bought $1.8 Trillion of goods from the rest of the world. Indian corporations big and small, startups or established companies, can certainly take advantage of the demand that continues to exist in the US for products–and services as well.

While there is a risk that, given the political rhetoric, we could find ourselves aborting the recovery that is starting in the US and is likely to spread, logic or sanity should lead us to a different set of conclusions. This could set the stage for a very interesting investment environment. Globally, particularly in the faster growing developing world which I define as the BAICs not the BRICS—Brazil, Africa, India and China, infrastructure spend and total investment will continue to rise to meet the demands of the populace and the demands of the global marketplace for their products—both natural resources and manufactured goods and some services.  This is continuing to bring more individuals into the middle classes with their own set of demands and needs.

Brazil, India and China, as well as most of Africa have a long way to go before the mix of their economies comes anywhere close to the more mature world. But look at what is ahead.

If we look at a breakdown of GDP and employment by major sector—agriculture, industry, and services, for two developed world countries and three of the BAICs—I don’t have stats for all of Africa–, we will see that India, Brazil and china have a much higher percentage of GDP and employment in Agriculture. To make this a little clearer, let’s take Agriculture and compare the US, Germany and India. US agricultural output represents about 1.6% of GDP and employs 1% of the work force. Germany is at 1% of GDP and 2% of the workforce. India is at 18% of GDP but over 50% of the workforce is still employed in agriculture.  Today’s mix has some similarities to where the US was earlier in the 20th century, although with higher manufacturing and lower services.  China looks even more like the US at that time.  We are talking about large populations shifting from the agricultural sector to manufacturing and services over the next few decades. This carries with it some political risk and not necessarily a smooth transition. But, this also means on balance, growth. And I would make an important point: It is easier to innovate into growth than it is into replacement.

Growth requires a sense of urgency. Everything speeds up. One does not want to get left behind. There is also an opportunity to experiment and, of course, to fail. But growth covers up many sins and extends the runway to get it right. And, it usually results in multiple approaches to opportunities and problems. Let me elaborate further on this point–that it is easier to innovate into growth than replacement. The economics are different if, instead of simply taking away share from an established player, one is participating in an expanding market. Particularly, when it comes to plant and equipment, customers are making a different calculation if it is an expansion cost vs. a replacement cost. In any instance, replacement or expansion, I believe that most innovations relate to some form of productivity improvement. It is worth thinking about any venture investment in terms of productivity–whether in Social Media or cell phones where the productivity of connecting with others has been enhanced, diagnostics, medical outcomes, energy, agritech, measurement itself, or infrastructure.  When growth is uncertain or out on too far a horizon it becomes more difficult than it already is.  I think the best venture capitalists understand that, to some extent adding a vision that may see growth potential where others don’t. And, many of the best VC firms are on multiple continents having extended their reach to one or more of the BAICs, in particular, to take advantage of changing income levels and a growing consumer class; in other words investing into growth. Some would even say that innovation requires consumption growth. Successful innovation also requires the VC experience and a VC infrastructure as foundations.  I don’t totally accept what some are characterizing as the US exceptionalism, is that exceptional. And that other systems are not producing innovators. Not every engineering or science graduate–or dropout for that matter–in the US is an innovator. I have to believe that the distribution of potential innovators in any country is the same, and ultimately the infrastructure that permits that innovation will exist there as well. In some instances, it is already happening.

Asia and Europe combined are putting more venture capital to work than the US and have been since 2006. India and China are putting Rupees and Yuan to work at about 40% of the US rate. And the rest of Asia is quite vibrant as well.  What is lacking is both a long enough history of repeatable success, and the Tim Harford observation—Harford of the Financial Times–of the Galapagan Isolation vs. Corpocracy, as represented by Silicon Valley, Silicon Alley, the Silicon Wadi of Israel or the other pockets within the US and elsewhere that include investors with reach, experience and staying power; innovators with access; and flexible resources to execute. Harford’s analogy is that in the Galapagos, an ecosystem isolated from the rest of the world, different flora and fauna developed. He equates the ecosystems in parts of the venture world to this phenomenon.  You can go to the World Policy Institute website, www.worldpolicy.org, and look for the Journal issue entitled “Innovation,” to read more about this. This topic is included in an essay by Neal Stephenson, a great Science-Fiction writer and an unusual contributor to this kind of publication. He lays out some challenges for those of us who exist on the portal between the real world and those imagined. A fun and stimulating read.

Well, while Europe and Asia are increasing their venture investing, in the US the VC industry is going through a contraction, which is a good thing for returns—maybe not for the planet.

The number of funds raising capital is down and the number of investments being made is down. By the way, I want to thank my friends at Knightsbridge Advisers for several of the next slides. Knightsbridge is a fund of Venture Funds with a specific and very successful focus developed over a long period of time on the top quartile venture funds in the US, many of whom now reach into Asia specifically.

Historically, stronger returns have followed these contractions. Fund Raising is down to its historically low percentage of stock market capitalization and there is not a great inventory of what has been historically defined as early stage capital.  These are metrics that should be tracked in any market.

And, the top quartile, which has consisted of the same VC funds for many years with only few exceptions, has substantially outperformed the rest of the industry.  These firms are their own Galapagos.  There isn’t enough history here, in India, to determine all the entrants into that top quartile. Some firms are beginning to stand out, but we need a couple more cycles to really tell who has staying power. We may be hitting one of those cycles here right now.

This is an important point. As I said, growth can cover up many sins. To paraphrase Warren Buffet or Mark Twain–“you have to wait until the tide goes out to see who is not wearing a bathing suit.”

Having said that, this takes nothing away from the opportunity here in India, fueled by significant growth.

There is a very fertile environment here for Value Creation. I would highlight three sectors specifically for India. IT, Life Sciences and CleanTech, all in the context of infrastructure development and increasing awareness and demands from the populace for what they see elsewhere in the world.

It starts with the Internet and expands to mobile apps and cloud computing. And, it is driven by increasing processing speeds. We are still in early days regarding the ongoing impact of Moore’s Law. Three weeks ago I attended a three-day Intel Capital conference on the west coast. Duron, is in the Intel portfolio and I was fortunate enough to join our CEO, Ajay Awasthi, at the conference.  200 of Intel’s portfolio companies and 400 Intel managers and technologists attended the conference. Over half the companies were from outside the US. This was a very exciting and stimulating conference. Intel will invest in any company meeting its return criteria that will lead to more chips being sold—that covers the range from the technology around chips to social media.  The most important news though was when Paul Otellini, the CEO, stated that Intel has 10 years of clear visibility on Moore’s Law.  I think that means within 10 years, processing speeds on a single chip will be at least 64 times faster than they are today.  I am not sure we can imagine all the possibilities, but with a sense of certainty around that happening we get very close to Neal Stephenson’s and William Gibson’s worlds.

A big factor in India is bringing basic health care to a broader segment of the population. I think integrated delivery systems will be a part of the solution here. Ultimately, improving outcomes and taking advantage of the IT developments on the horizon will change the nature of health care and create real value for those who participate.

The need to drive both energy independence and cleaner renewable energy creates enormous opportunities. I don’t think India can wait for grid build-out to satisfy its needs. Much of the grid that does exist is aged and outmoded. A leap to models with distributed power and low power products offers many opportunities. This is my bias, but I truly believe that the need for innovation here is critical to the survival of the planet.

I think there are several other asset classes or sectors in which the venture community can participate that have growth characteristics.  Let me give you that broader characterization as we bring this to a close:

I start with Infrastructure. I think this could turn out to be a growth market in the US but will surely continue to be so here. And any innovation that contributes to the more productive movement of goods, services, people or information should find a market. Water also falls under infrastructure. There isn’t enough of it in the forms needed. Quality improvement and more efficient usage are two big opportunities. That leads us to Energy where there are enormous opportunities relating to the technologies being used and the productivity and efficiency of use, some of which I discussed already.

For India, we should include Agriculture or Agritech as its own category. This ties back into infrastructure, energy, water and life sciences, but should be listed here as its own. IT and Health Care are the two other big categories already discussed. Education is a difficult sector because of all the stakeholders who want a say in how the structure evolves, but one where technology can play a significant role and is very important in India. In some ways this sector also ties back into Energy as available and dependable clean power may be one of the most important factors in improving and broadening the educational map in this country. I put Financial Services and Hard Assets here as well as selectively attractive classes. . I list Global as a separate Asset Class, although every class listed can be considered global as well as domestic. The point this emphasizes is that the true growth opportunities involve solutions that extend beyond any domestic borders and truly allow one to be innovating into growth.  None of this is easy.  Persistent performance requires much more than capital and some smart people. It requires the ecosystems that in many cases have taken years to create. Investing beyond just getting Beta to getting real Alpha in any investment class requires patience and the full use of all the resources one can bring to bear. We are at an interesting stage where the nature of the venture industry may be returning to its previous core. I think it is a very exciting time for venture investing–not that it isn’t always exciting.

There are multiple opportunities across multiple sectors globally. Innovation is occurring and the pace is likely to accelerate. India is clearly innovating into a growth market in spite of near term concerns. Experienced Venture Capitalists can make a significant contribution. Smart capital can and should be choosy in this volatile global environment.    But maybe, if one is careful, the next decade may turn out to be a period of great investments with a great benefit to all humankind. Let us hope so.

Neuberger Berman’s Rivkin Discusses India Investments (Audio)

Jack Rivkin, director of the Neuberger Berman Mutual Funds, discusses investment and growth in technology in India. Rivkin talks to Bloomberg’s Kathleen Hays on “The Hays Advantage” on Bloomberg Radio.

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