Do you know what would happen if all the depositors in a country go to withdraw their money from banks at about the same time? Well, under no intervention, the banking system will soon run out of funds and may even collapse. This is because banks keep only a part of depositors' money as cash and lend out the rest. Strange, isn't it? Well, there is one more unique feature of a modern day economy. And it has to do with the authority given to central banks. It seems they are the only entity that can print money. Thus, they have the ability to flood the system with cash as and when the need may be.
As though the economy wasn't a complex beast already. The above mentioned features certainly make it even more complicated. None more so than taking investment decisions we believe. Consider the low interest rate and a loose monetary environment for example. Here, it is very difficult to ascertain whether the excess money available in the system has come from genuine savings or because of pumping of money by the central bank which again has a multiplier effect courtesy the banking system. It turns out that on most occasions, it is the latter case that is more dominant.
However, businesses don't realise this. They borrow money and undertake projects in the hope that all the available money is real and here to stay. Steadily though, the reality begins to dawn on them. As loose monetary policy gives way to a tighter one, it occurs to them that not only the money is not there but the rates at which they previously borrowed have also become much steeper. The end result? Severe cash flow problems and even bankruptcy in cases where borrowings are on the much higher side.
This situation presents challenges for investors as well. When interest rates are low, it appears as if all the companies are doing well and growing at an impressive rate. In fact, the ones that continue to take on debt grow faster than the ones that don't as financial leverage plays it part. But once tightening happens, the wheat is certainly separated from chaff. It turns out that companies that were growing fast and taking on debt did not have real earnings after all. Their growth was a result of easy money policy by central banks rather than the one coming from some competitive advantage or productive improvements. Hence, it is very important that one avoids company loaded with debt for its earnings growth may not be real after all. A company that has a long track of growing without debt and also paying out part of it as dividends is certainly the one to look for.
As though the economy wasn't a complex beast already. The above mentioned features certainly make it even more complicated. None more so than taking investment decisions we believe. Consider the low interest rate and a loose monetary environment for example. Here, it is very difficult to ascertain whether the excess money available in the system has come from genuine savings or because of pumping of money by the central bank which again has a multiplier effect courtesy the banking system. It turns out that on most occasions, it is the latter case that is more dominant.
However, businesses don't realise this. They borrow money and undertake projects in the hope that all the available money is real and here to stay. Steadily though, the reality begins to dawn on them. As loose monetary policy gives way to a tighter one, it occurs to them that not only the money is not there but the rates at which they previously borrowed have also become much steeper. The end result? Severe cash flow problems and even bankruptcy in cases where borrowings are on the much higher side.
This situation presents challenges for investors as well. When interest rates are low, it appears as if all the companies are doing well and growing at an impressive rate. In fact, the ones that continue to take on debt grow faster than the ones that don't as financial leverage plays it part. But once tightening happens, the wheat is certainly separated from chaff. It turns out that companies that were growing fast and taking on debt did not have real earnings after all. Their growth was a result of easy money policy by central banks rather than the one coming from some competitive advantage or productive improvements. Hence, it is very important that one avoids company loaded with debt for its earnings growth may not be real after all. A company that has a long track of growing without debt and also paying out part of it as dividends is certainly the one to look for.
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