ARE WE OVER-REACTING TO SUB-PRIME?

The sub-prime crisis is well and truly upon us. Institutions once considered infallible are toppling like nine pins. The key question is how badly will India be affected by this problem and are we showing the classical signs of a knee jerk recation?

The sub-prime crisis is of American and European origin and Indian markets are down much more than these markets even though directly we are the least affected. Our banking system is still extremely solid ( thanks to the RBI) and at worst a few private Indian banks with exposure to sub prime assets might suffer from losses which are just a fraction of their total assets. So the impact of the damage to the Indian economy would be basically on three fronts viz. drying up of flows to the capital markets, shortage of funds for corporates to borrow in order to meet their capital expenditures and reduction in orders to export driven industries.

Clearly the first one would not affect the fundamentals other than prevent companies from raising funds at hugely inflated valuations ( which was one of the reasons for the rise, remember Reliance Power). The second factor would be valid, but not to the extent projected, because a large number of companies have already expanded capacity and have their capex requirements tied up. Again the RBI is expected to do its bit by realeasing some of the throttle it had on the liquidity on the system, aided by a falling inflation rate. As far as reduced business to Indian exporters is concerned, they would face pressures to lower their prices in order to keep up sales, but in this they have the US Dollar on their side which has appreciated by almost 20 % from its lows against the INR. So even though India might face some collateral damage from the sub prime crisis, it is not expected to majorly impact the fundamentals of the economy and might indeed have some desirable side effects.

India being a net consumer of commodities would be the biggest beneficiary of the fall in prices. This would give a boost to sagging bottomlines. Not only that, Indian corporates could look at acquiring overseas companies at bargain prices due to the fall in share prices. This could help them to consolidate their position and quietly wait for the cycle to change. I believe that the current fall presents Indian investors with an incredible opportunity to buy stocks which are fundamentally sound but are beaten down without reason to such low valuations. If you look back a couple of years down the line, I think those who have the guts to buy today will not be regretting their decision.

IS 1 CRORE ENOUGH TO RETIRE ON? (II)

A pertinent comment on my last post about the feasibility of retiring on Rs.1 crore of savings, came from Manish. He raised the issue of whether Rs.75,000 per month of expenses is a realistic figure for someone preparing to retire on 1 cr.

I have considered the hypothetical figure of Rs.75000 per month of expenses inclusive of EMI payments on house, car etc. Secondly and more importantly the figure of Rs.75,000 p.m. takes into account the aspirational effect of living. Simply put it means that with time a person does not feel satisfied with his current status of consumption, but aspires for upgrades in terms of categories. As an example, our investor might well be happy with a sub-compact car at present. But when the time comes for replacing his current car, he might aspire for a mid size sedan. So even if his current expenses are lower than Rs.75,000, his aspiration for better products and a higher standard of living would keep on increasing his living costs beyond the projected inflation rate, thereby acting as a self induced super inflation.

This only goes to show that one cannot take one's current expenditure and scale it up by simply adjusting for inflation to arrive at a projected expenditure figure, but has to account for the intangible human need for a better standard of living, in calculating what he might require several years later. Our investor could well have an expenditure of Rs.50,000 p.m. at present, and he would be satisfied that he can do very well on a savings corpus of Rs.1 cr, but he has failed to account for the joker in the pack which could put paid to all his well laid plans. To account for this I have assumed the higher figure of Rs.75,000 in my working.

IS 1 CRORE ENOUGH TO RETIRE ON?

As more and more people are thinking of taking an early retirement, being sick of the hassles of participating in a never ending rat race, it automatically begs the question " what can be a sufficient corpus for retirement?" In this post I've tried to examine the feasibility of a couple with two kids retiring on their grand savings of Rs.1 crore.

Certain assumptions have been made in order to simplify matters. These are

1. Using a mix of debt and equity, the investor can earn a steady 12 % per annum after taxes over his life span.
   
2. Inflation grows at a steady 7 % per annum.
   
3. Monthly living expenses are Rs.75,000 at present.
   

From the above assumptions the investor will generate Rs.12 Lakhs in the first year and spend Rs.9 Lakhs. He will reinvest the balance 3 Lakhs at the same 12 %. Considering inflation and reinvestment of surpluses the situation at various time periods will look somewhat like this:

Year, Corpus Rs. (Crore), Annual Expenses Rs. (Lakhs)

Year 1, 1.03, 9.00

Year 5, 1.11, 11.02

Year 10, 1.05, 16.52

Year 12, 0.94, 18.90

Year 15, 0.59, 23.14

Year 18, Negative, 28.33

As we see from the above working, the investor would start eating into his capital from the 12^th year and from there on his capital would rapidly get eroded. Under the above conditions 1 crore would not be sufficient to last for even 20 years of retirement.

The result would be somewhat different if the figures in the assumption are tweaked somewhat, but what I would like to highlight is the corrosive effect of inflation on savings and its potential to destroy value without our realising it.

IS IT TIME TO PANIC?

 

 

Stock markets have done it yet again. They have managed to spread panic in the minds of not only traders but also longer term investors. People are worried about their investments and whether a further erosion of capital is on the cards. Frankly I don't know and I suspect neither does anyone else. But the fact remains that we are structurally in one of our strongest economic cycles ever and a projected GDP growth rate of 7 % (even by the worst estimates) is nothing to be scoffed at. It would do us good to take a step back from the mayhem in the markets and take an objective look at some of the factors in our favour and some against us.

Since crude oil prices have already cooled down significantly and are expected to come off still further, India is likely to be one of the biggest beneficiaries of this scenario. Besides having a psychological impact on the markets, it is expected to push down inflation further along its downward trend. Even if retail prices of fuel are not revised, industry would benefit from lower cost of industrial products derived from crude, such as plastics and organic chemicals. Also a decreasing rate of inflation would cause a lowering of interest rates thereby lowering cost of funds for corporate borrowers.

Similarly, commodities like Non Ferrous Metals are taking it on the chin. Prices of Aluminium, Nickel, Zinc and Copper are at their year lows. This augurs well for manufacturers of all products. It was observed from the first quarter results that though there was a robust growth in top line, the net profit margins of companies took a hit. This signifies that companies faced a rise in input costs although the growth drivers are still intact. Taking this argument further, if most commodities have already corrected and are in the process of moving lower, this pressure on margins due to cost pressures would ease and translate into higher profits in coming quarters.

Again a lot of emerging markets like Brazil and Russia are dependent on commodities for a major chunk of their GDP. If commodity prices should remain at their current lows, a lot of funds belonging to FII's would desert these markets and a logical destination would be India. In fact Indian stocks offer an excellent natural hedge against a correction in prices of commodities.

Since there is a crisis in the American housing industry, it follows that a lot of consumers are affected in the US. However Indian companies dependent on a growing Indian middle class and a huge Government expenditure on infrastructure would be relatively insulated from the effects of a US slowdown. And when the US economy does show signs of recovering, these are the businesses which will be the first to take off. A contrarian view on the effects of the US recession is worth considering. A natural offshoot of a slowing business cycle would be the tendency to cut costs. Costs can be cut by off shoring some of the activities to less expensive locations. Indian companies are well poised to take advantage of this fact due to their lower costs and aided in no small measure by a rapidly declining Rupee.

One of the negatives that are being projected is that sentiment would be affected leading to a drying up of foreign fund flows. This may or may not be true in the short term, but for investors with a longer horizon the fact still remains that India is one of the fastest growing economies in the world with a democratic structure, a strong consuming class, positive demographics in a large segment of the population under 25 years of age and having strong institutions. We need to remember that FII's were not doing us a favour by investing in our markets. They invest in places where they are likely to get the greatest returns for their investments. If India happens to be one such destination, then eventually they are bound to return with their money.

Valuations are now more reasonable with the PE ratio at around 15 times historical earnings for the Sensex. Therefore, if companies can manage a 15 % growth rate in earnings for the near future, we are trading at below fair valuations. In my opinion Indian markets deserve a premium over other emerging markets because of their size, growth rates and the potential of our economy.

Therefore in conclusion I would argue that longer term investors should not panic because analysts are predicting doomsday scenarios. These were the same guys who were predicting $ 200 levels for crude, when it was at $ 145. If an investor has selected stable, large cap companies for his portfolio, I believe that he should ignore day to day volatility and stick with his investments with the conviction that he owns great businesses in one of the fastest growing economies in the world and that sooner or later their value will be rediscovered by the markets.

PROFIT FROM THE AGRI BOOM - 5 (BANKS)

Since a larger agricultural output would result in more money in rural hands, Banks would stand to gain from this phenomenon in several ways. A higher rural income would translate into higher consumption of consumer durables like motorcycles, television sets and other white goods. This would in turn set off an increase in demand for loans from banks and other institutions. With banks being reluctant to give out loans for farming due to potential Government interference in form of farm loan waivers, the natural tendency would be to use income for financing farm needs in the form of seeds, fertilizers etc. and use bank loans to pay for other goods.

Also because the rural populace does not have access to advanced financial products like mutual funds, nor are they comfortable with investing in unfamiliar financial instruments, they tend to gravitate towards bank deposits as their means of investment. This way banks would get access to cheap funds via CASA (Current and Savings Accounts) which would reduce their cost of funds. Even fixed deposits are comparatively a cheaper source of funds for banks.

Those banks which have a wide rural reach are well poised to capture this opportunity. Since most of the rural population have a feeling of comfort and trust with PSU banks, they would prefer to bank with these. Also the fact that PSU Banks are available at extremely attractive valuations make them even better prospects for investment. They also have a history of giving out generous dividends, which serves to reinforce their investment potential for conservative investors. Among PSU Banks, Bank of Baroda, Bank of India and Canara Bank look like good value buys considering the hammering they have received because of notional mark to market losses on treasury holdings, arising out of rise in interest rates.

PROFIT FROM THE AGRI BOOM - 4 (FERTILISERS)

Fertiliser stocks have been largely shunned by investors, with some speculators intermittently trying to perk them up. Though these stocks are available at reasonable valuations and most of them offer great dividend yields, sensible longer term investors have been keeping away from them due to continued Government interference in the sector and lack of free pricing power.

Though the sector looks like it will never be completely free from Government meddling, some positives are emerging due to policy action recently.

Faced with an acute shortage of fertilisers, the government has recently announced a new policy whereby a company can import fertilisers and if it can leverage its international tie ups or contacts to import at a price lower than the notified price, it can keep the profits after sharing a portion with the Government.

Another positive is that the fertiliser secretary has assured that henceforth all subsidy payments will be in the form of cash and not bonds as has been the practise till now. Since these bonds were illiquid, most fertiliser companies were forced to sell these bonds at a huge discount to bridge their cash flow gaps. The result was that their bottom lines were negatively impacted. This is set to change with the subsidy being paid out in form of cash.

Since most of the fertiliser companies were dependent on Naphtha or other crude derivatives for meeting their huge energy needs, the crude price shock was adversely affecting profits. With supply of Natural Gas expected to start from KG Basin in October, 2008, these companies will now have access to cheaper fuel. As prices of fertilisers are administered, it will not have a major impact profit wise, since the subsidy will go down, but it will improve cash flow further. Again major fertiliser companies manufacture organic chemicals, which they can sell at market prices. The profitability on this account is likely to improve with the availability of gas.

Rashtriya Chemicals and Fertilisers (RCF) looks a promising bet in this space. Not only does it have a wide product portfolio but also aggressive expansion plans. It also manufactures a wide range of organic chemicals which are used in other industries. RCF has a huge property at Chembur in Mumbai which it wants to develop by constructing and letting out office and commercial space. It could prove to be a major beneficiary of all the above factors coupled with an upsurge in demand from agriculture.

PROFIT FROM THE AGRI BOOM -3 (AGRO CHEMICALS)

Agro Chemical stocks are likely to be the biggest beneficiaries of the upsurge in agricultural commodity prices. Since these products are directly used by farmers in their operations and there is no Government interference in the sector, companies in this line of business can command good pricing power.It makes sense to focus on companies involved in the crop protection business as well as in providing genetically modified seeds. Bayer Cropscience is one such company active in both these segments. It has a wide range of products in these areas as under:

Crop Protection

Insecticides
Fungicides
Herbicides
Seed Treatment
Plant Growth regulators

Environmental Science
Vector Control products
Pest Control products

Bioscience
Cotton Seeds
Rice seeds
Cereals and Oil seeds

Bayer is a research driven organization and relies upon the latest technologies for its products. It provides after sales technical backup to farmers, thereby imparting much needed education into the application and distribution of pesticides and benefits of genetically modified seeds.

It has a vast land bank at Kolshet in Thane of approximately 90 acres. It has indicated its intention of selling off this land in the past. The wide range of diverse products coupled with its technological superiority and the added incentive of potential extraordinary income from land sale make Bayer Cropscience a stock to look at in the agri business space.

PROFIT FROM THE AGRI BOOM - 2 (FMCG)

Since FMCG companies are expected to be major beneficiaries of the growth in rural incomes it makes sense to focus on those companies which look to conciously increase their rural footprint. ITC is one such company in my opinion. In this post, I shall concentrate on the business prospects only and ignore the financials.

ITC operates in various segments and has a diversified product profile.
1. Hotels
2. FMCG
Cigarettes
Foods
Retailing
Personal Care
Education and Stationery
Agarbattis
Safety Matches
3. Paper Boards and Packaging
4. Information Technology
5. Agri Business
Agri commodities
Leaf Tobacco

Out of the above businesses, FMCG and Agri Business would provide a major thrust in the rural space thus benefiting form the agricultural and rural boom.

The FMCG business has products in various segments and at various price points providing a vast choice to consumers from every strata of society. The distribution reach is already there due to their cigarette network with pan wallas and other small vendors. Therefore ITC can effectively leverage this reach to enhance the availability of its other FMCG products like soaps, personal care products, Bingo and other food products. Again with increase in income, consumers in the rural space could migrate from beedis to cigarettes providing additional revenues.

The Company's 'e-Choupal' initiative is enabling Indian agriculture significantly enhance its competitiveness by empowering Indian farmers through the power of the Internet. This transformational strategy, which has already become the subject matter of a case study at Harvard Business School, is expected to progressively create for ITC a huge rural distribution infrastructure, significantly enhancing the Company's marketing reach. e-Choupal reduces transaction costs through elimination of middle men and ensures that farmers get optimum realisations for their produce. This link with the farmers is beneficial for ITC, since it provides a continuous stable source of inputs for its various businesses like agri exports where it is a major player and its foods business like biscuits, chips and atta. Also ITC's retail stores get a captive buyer base from this segment of farmers who come to e-Choupal to transact their business.

The above factors put ITC in an enviable position to capitalise on the boom in the agricultural sector and since the stock is reasonably priced at current levels, the case for investment into it is all the more stronger. Investors with a 3 year horizon can look to buy the stock.

PROFIT FROM THE COMING AGRICULTURAL BOOM

Sectors having a dependence on agriculture could be outperformers to watch out for. With the rise in prices of global agro commodities, the Indian farmer tends to benefit to a large extent. This increased income in the rural hands could play a large role in driving consumption patterns across the space. Some of the sectors which stand to gain from this effect are:

1. FMCG : FMCG companies could benefit from increased spending patterns resulting from higher disposable incomes in the hands of the rural population. Investors would do well to concentrate on those companies which have invested large resources to establish their presence in rural areas.
   
2. Agrochemicals : A natural beneficiary of increased crop yields would be companies engaged in crop protection in the form of insecticides and pesticides. Also it would be interesting to watch out for stocks of businesses which produce genetically modified seeds which are resistant to various pests and provide higher farm yields.
   
3. Fertilizers : Fertilizers, which have not participated in the bull market could be major beneficiaries because of several factors now turning in their favour. The new fertilizer policy gives an incentive to companies which look to increase capacity. Again the recent news of the Government intending to provide subsidies to companies in the form of cash rather than bonds augurs well for this sector, because the bonds had then to be sold by the fertiliser companies at a discount. Then the expected gas from KG basin expected to commence by December 08 would reduce the dependence of these companies on expensive fuel.
   
4. Banks : As consumption increases, so would the demand for loans and other financial products catering to the rural space. Banks having an established presence in these areas would stand to gain from the trend. PSU Banks look particularly attractive, considering their reach in remote places and their established network of branches.
   
5. Logistics : As prices of agro commodities rise, so would the demand for storage and transportation of these with a view to minimizing losses resulting from lack of proper facilities for movement of these. With organized retail looking to expand their presence in the food and grocery business, logistic and cold chain providers would gain from an increased demand for their services.
   

In a future post I would discuss some of the dominant companies in each of the above sectors, which would stand to gain the most from the coming agri boom.

INFOSYS’ TAKEOVER OF AXON

Infosys' takeover of Axon for approximately 3300 cr signifies a major change in mindset of India's best software company. This shift augurs well for shareholders of Infosys, since not only is it getting an increased presence in the European markets, it is also cementing its position in the field of business consulting.

The valuation also looks fair at 20 times Axon's last year earnings and less than 2 times revenues, the earnings yield works to 5 %. Considering that Axon has been growing its revenues at 65 % compounded for several years is the proverbial icing on the cake. If such high growth rates can be sustained and enhanced due to the takeover, the acquisition makes even more sense and could prove to be a real winner for Infosys.

Consider also that the acquisition is being funded entirely through reserves and not through additional debt or equity. This improves the quality of Infosys' earnings since it boosts income from operations at the cost of other income.

The greatest positive is that Infosys has clearly taken on a strategy of aggressively boosting its revenues and profits, if need be at the cost of margins. It heralds the beginning of the 2^nd innings in the history of Infosys and with several factors like the exchange rate turning in its favour, Infosys looks like a great buy at current levels.

EQUITY V/S REAL ESTATE INVESTMENTS

Traditionally, Indian investors seem to prefer real estate over equity for their investments. I think the genesis of this attitude lies in the fact that equity markets are volatile and its fluctuations are available to investors on a real time basis. However real estate prices are also prone to severe cuts, though they are not so apparent in the short term and lack some of the advantages which equity investments have to offer:

Real Estate investments are necessarily made for the long term. Except speculators, no retail investor considers real estate for investment for a time horizon of less than 5 years. Now if the same attitude was displayed towards equities, investors would be a far happier lot. If investors bought fundamentally sound stocks and ignored their gyrations, I am sure that after 5 years, they would have made better returns on their investments than in realty. The problem is that we tend to evaluate stock market returns on a daily basis, while we give our real estate investments a far longer leash.

One can book partial profits in an equity investment if it has performed beyond expectations and still hold some stock for future profits. This flexibility is missing in realty investments. Due to this even if one feels that prices have moved ahead of fundamentals, one either has to sell the entire property or not at all. Also if funds need to be raised in an emergency, one can liquidate equity only to the extent required while retaining the balance.

An investor can invest in equity with relatively smaller amounts whereas in the case of realty it is often one of the largest holdings in one's portfolio. An investor can make use of scientifically proven methods like SIP/STP to build wealth bit by bit over the long term.

Liquidity is not an issue with equity investments (at least among the large cap companies). One can liquidate his investments fast and in a transparent manner, usually receiving the proceeds within 5 to 7 days. Anyone who has the experience of trying to sell a property will know the range of valuations bandied about and the innumerable people surveying the property before the transaction actually materialises.

Once purchased equities require no maintenance, while society outgoings are often extremely high , particularly in newer constructions in metro cities. To counter this real estate can yield returns if the property is let out, but advantage would be set off in future when the stock lending and borrowing mechanism becomes a reality, whereby investors would receive "rent" on their securities which they intend to hold for the long term. The dividend accruing on equities is yet another plus.

Tax breaks are often cited as being the rationale behind investing in residential property. But when the property is sold long term capital gains tax needs to be paid. Though there are no tax breaks at the time of investments in the case of equities, any gains from equities held for more than 1 year are completely tax free.

Of course, the above arguments are not valid for a person buying a property for residential or business use, but are intended to provoke a thought process in someone looking to buy property from a purely investment angle.

RELATIONSHIP BETWEEN SPORTS AND ECONOMIC PROGRESS

China won its first Olympic Gold in 1984. This also coincided with the point where their economy took off and reached its present heights. It has led me to wonder whether there is a relationship between excellence in sports and economic progress. If so, what message does this hold for India considering that they have just got their first individual gold medal in Beijing?

Does it indicate that this is the beginning of India's emergence as a sporting and economic super power? The ingredients all seem to be in place for this scenario playing out. It remains to be seen whether we manage to make the most of it or let the opportunity slip out of our hands yet again, as has happened so many times in the past.

In the Olympics as in life the difference between the winners and the also ran is often very small. So small that, bouts are decided on the basis of judges' decisions rather than outright victories on points. Races need computers to find which sportsperson got to the finish first. So also, when it comes to the question of economic progress India has demonstrated that it can manage to sustain GDP growth rates of 8 to 9% for a significant period of time. The real test lies in whether this can be upped to double digit levels. Though the gap between 9 and 10 may seem marginal, it could make all the difference when it comes to the effects on the ground level. This could be the difference between winning and losing.

One Gold and Two Bronzes may not seem like much to a country of India' size, but it could well be the catalyst to galvanize sleeping sports authorities into action. It could give a much needed confidence booster to our sports heroes who battle it out in spite of miserable living and training conditions. Similarly Indian corporate have gained the confidence to take on the world in spite of battling with an indifferent bureaucracy and inconsistent Government policies. Just as scientific training methods could propel Indian sports into a different league, access to cheap capital and proper infrastructure could make India Inc. world beaters.

Therefore, all our stake holders need to sit up and take notice, lest another opportunity pass us by. Conditions on the ground have to improve in every sphere, be it better nourishment and facilities for sportspersons, better means of farming for farmers, better infrastructure for businesses and more. The talent is already in place. Some changes are already visible. We need to give it that push so that it attains critical mass which, as China has demonstrated, is a prerequisite for success in any sphere.

RETURN OF THE SOFTWARE STOCKS

Software stocks are suddenly back in the limelight on the back of a stronger Dollar. As the dollar appreciates against major currencies and the Indian Rupee, it could provide a major boost to the bottom lines of IT companies. After lying low for more than 18 months, they could now emerge as the leaders of the next rally.

IT companies have already managed to take the US recession in their stride, as they have demonstrated by their Q1 results. They are expanding their market base by diversifying into Europe and Asia. India is also emerging as an important market with Infosys CEO claiming that margins are better on Government projects. Again their focus on products rather than contracts could become a source of steady revenue for these companies. Already Infosys' Finacle (Product for Banking services) is contributing more than 3% of its revenues.

The challenge for Indian IT companies is in moving away from a linear growth model where revenue growth is linked to growth in headcount. Revenue per employee for TCS is $ 51,320, Infosys is

$ 45,800 and for Wipro it is $ 41310. As against this global majors like Accenture have revenue per employee of $ 130,200. Therefore there is immense potential for the big 3 of Indian Software to substantially improve revenue without significantly raising the number of employees, by focussing on greater value addition.

Newer verticals like remote infrastructure management and bioinformatics hold great potential. These segments presently contribute very little to revenues, but going forward they could emerge as

major growth drivers, besides reducing dependence on traditional sectors like BFSI and telecom. Also the majors are trying to get into business consulting , which is a high margin business, though with limited success till now.

According to a report by research firm Gartner," Tata Consultancy Services (TCS), Infosys Technologies and Wipro Technologies will emerge as the nextgen IT service megavendors and threaten the reign of the current global majors—IBM, EDS and Accenture. These (Indian) vendors are increasingly being considered for strategic service deals, and will augment or, in some cases, replace today's acknowledged megavendors by revenue in this space by 2011.Top Indian IT firms have outperformed the megavendors by almost a 3:1 margin in growth rates, a Gartner report said. "The emerging megavendors have more than doubled their revenue in a four-year period, with the 2007 revenue being 2.6 times the 2004 revenue."

On the financials side Indian IT companies are now valued at PE ratios in the early 20'. These are historically low valuations notwithstanding their ethical managements and their business models. In fact, the PE ratios are similar to those witnessed during 2001 the worst of markets for these stocks, which indicates that markets are viewing the future prospects of these business as worse than those during the major crises like Y2K or 9/11 attacks.

To sum up, all the fundamental factors point to IT stocks being a great place to be in for an investor having a 1 year investment horizon. Of course, the clouds and worries are very much there, but without these, the stocks would not have been available at such low prices.

EFFECTS OF SIXTH PAY COMMISSION ON THE ECONOMY

The Union Cabinet on Thursday approved the recommendations of the Sixth Pay Commission thereby paving the way for higher wages for government employees.

"The cabinet has approved the pay commission report," Law Minister Hansraj Bhardwaj told reporters after a cabinet meeting.

The pay panel made its recommendations earlier in 2008 for salary increases for central government workers costing Rs 12561 crore ($2.9 billion) for the fiscal year 2008/09, plus Rs 18060 crore rupees in backpay to January 2006.

The cabinet set up a team of top civil servants to examine the recommendations.

Some analysts say the wage increases could derail govt's moves to tidy up its public finances and widen the federal fiscal deficit, which the government aims to limit to 2.5 per cent of gross domestic product in 2008/09, down from 3.1 per cent in 2007/08.

Another government panel said on Wednesday the budget deficit target for 2008/09 would be exceeded and serious fiscal risks were arising from growing off-budget liabilities estimated at 5 per cent of GDP.

The pay round comes roughly once a decade and the previous one in 1997 raised salaries for federal employees by nearly 40 percent, prompting many state governments to follow suit and blowing the combined state and federal deficit to nearly 10 per cent of GDP.

India is battling inflation of 12 per cent but economists said the pay round was unlikely to give prices a significant boost.

Highlights

1. Minimum wages to be Rs 10,000 per month.

2. 45 lakh employees to benefit from this hike which would take effect from January 2006

3 It will be paid in two installments: 40 % in FY 09 and rest 60% in FY 10.

 

Source : The Economic Times

 

The Negatives:

An already stretched Fiscal Deficit could worsen further, giving rise to downgrades by international rating agencies. However the Government could try to manage the situation by means like increased revenue from spectrum sale to telecom companies and by divestment of shares in PSU's to the public. Both these measures are on the anvil and could help the Government in bridging the gap between revenue and expenditure.

 

Inflation fires could be further stoked by more disposable income in the hands of the people. This should be more worrisome to a Government already battling high inflation and could lead to further tightening of liquidity by RBI.

 

The Positives:

More money in the hands of the people would result in more spending in malls and retail outlets, thereby giving a push to slagging demand in consumer durables and two wheelers.

 

Quality of employees in the public sector and administration would hopefully improve, because of higher pay packets. Public sector units would be able to better incentivise their employees and could hope to retain outperformers. The armed forces, which are facing a shortage of middle level personnel would be better placed to hire capable junior officers and other staff.

 

THE ART OF INVESTING

In my last post I had discussed the fundamental factors which an investor looks at in choosing a stock for investment. Apart from these an investor would do well to look at some intangibles which one cannot quantify in numbers, but play an equally important part in an investment decision. This theory was first propounded by Philip Fisher and further by Peter Lynch. Some of the factors to look at are:

1. How well the company's products are being received in the markets. This can be gauged by visiting some of its retail outlets or talking to retailers and dealers which stock the company's products. This can be useful in determining whether there is a strong brand loyalty which could prove invaluable in case the industry, in which the business operates, faces a downturn.
   
2. The R & D being carried out by the company. The annual report of the company gives the amount spent by it on R & D. Investors need to find out what percentage of sales is invested in R & D and also whether it is giving results. In case of Pharmaceutical companies, discovery of new drug molecules or new drug delivery mechanisms could herald huge future profits. In other cases investors could look at changes in products developed by the company and whether it is being innovative in introducing newer products or alternate packaging and if the company is keeping pace with competitors new launches.
   
3. Goodwill of the business among stake holders. Investors need to see whether the company is fair in its dealings with suppliers, dealers, employees and consumers and minority shareholders. Some businesses do extremely well on the financials, but are known for shady dealings and have a poor reputation in the markets. Investors would do well to stay away from such companies because the integrity of the management itself is suspect and therefore the excellent figures being reported may be manipulated.
   
4. Scalability of the business. Investors should look at the line of business and determine whether it holds the potential to scale up in terms of volumes. If, for instance, a business has excellent financials and scores well on other factors, but the nature of the business is such that it has a limited potential for expansion due to the fact that the market for its products is not very large, then investors would do well to not invest in the stock.
   
5. Board of Directors of the company. This could provide an important clue as to the authenticity of the published figures. If the company has eminent public figures on its board of directors, an investor is reassured that the probability of accounting jugglery is minimal.
   

A company may be assessed on the above factors by studying its annual report, talking to various stakeholders like its suppliers, retailers and employees. An important source of information would be the ex-employees of the organization who would be more willing to give out factual details. If a detailed examination is conducted based on the above factors coupled with the financials, the probability of losses for an investor would be low and could yield multi baggers in the long run.

 

VALUE INVESTING - BASICS

Value investing is an important tool in the arsenal of a fundamental investor. In simple terms it means buying a stock for much less than what an investor thinks it is worth. But how does a value investor decide the worth of the company under study? Given below is an explanation of some basic parameters to decide whether a business is undervalued or not. They are

1. PE ratio. This is the ratio of the market price of a stock to its earnings per share. It also the number of years the business will take to realise earnings equivalent to the current market price based on current earnings. For instance a business having a PE ratio of 10 would take 10 years before its earnings behind one share equals the market price of one share. This, of course, assumes that the company will keep on earning the same amount of profits every year. PE ratio, therefore indicates how expensive a company is based on current earnings. This is a useful indicator to compare companies in a similar line of business. Lower the PE ratio, cheaper is the stock. Naturally, PE comparisons cannot be carried out across industries, because some industries are given higher PE ratios due to their business dynamics.
2. Market Capitalisation. The market cap of a business is the number of shares outstanding multiplied by the price of each share. In short the market cap denotes the notional cost of buying the entire shares of the company. This parameter is useful in judging the relative attractiveness of a business as compared to other businesses in similar lines based on what value the market has assigned that business by way of market cap. For example a business in the consumer durable sector may be valued at significantly lower market cap than another consumer durable company. This would make it a value buy based on market capitalisation. For more on how to value a business based on market cap refer here.
3. Book Value. Book value is value of assets of the company behind every share. It represents the valuation of the stock based on its underlying assets rather than its earnings. If the market price of a stock is quoting at or below its book value, it means that the market does not think that the prospects of that company are bright and often indicates that the company that has become insolvent. However if the market price is below book value due to factors of a temporary nature, then this fact can be looked at by investors as a value proposition and can be used to buy into the stock with a holding perspective till the negative factors turn around.
4. Dividends. A value investor uses the dividend payouts as an important factor to determine undervaluation in a stock. If the dividend yield of a stock (i.e. the dividend per share divided by the market price) is high it indicates a higher degree of safety in times of adverse market conditions. Also important is to see what proportion of its earnings a company pays out in the form of dividends. For more on use of dividend yields referhere
5. Net current assets. Net current assets (NCA) are current assets minus current liabilities. If a business has high net current assets and the markets are assigning it a market cap near or below its NCA, it indicates a high degree of undervaluation. According to Benjamin Graham, the pioneer of value investing, investors cannot often go wrong in buying a business valued at or below NCA.

   The above are basic factors used by value investors in determining the relative underperformance of a stock. Of course, an investor also needs to go into the reasons as to why the market is giving a significantly lower valuation to a stock or an entire industry and whether it is justified in doing so before taking an investment decision.

   
   

CONTRARIAN INVESTING

Contrarian investing pays if you are a patient investor. We have numerous examples of how stocks which are out of favour with investors, but are fundamentally sound, have given handsome returns once the reasons behind their underperformance ease off.

Consider capital goods stocks in 2003. Stocks like BEML, BHEL, L&T and many others were available at a fraction of today’s prices. Investors’ who had the foresight and vision to invest in such stocks at that point would be having 15, 20 or even 100 baggers on their hands. The logic behind investing in such companies would have been that they were high quality companies backed by good managements and having solid assets on their books. They had pedigree, market standing and years of experience. It was simply a case for investing and simply waiting for the investment cycle to turn around.

And what did investors do? I know people who got tired of holding on to such stocks and sold off only to see markets reviving and stocks reaching the stratosphere. My argument is that for earning the highest returns, an investor needs to identify stocks which have been hammered to their lows, analyzing whether such low valuations are justified given the history, management quality, nature of the business, quality of assets, size of the business and future prospects. Then if the investor is convinced that the business is not going to disappear any time soon and simply awaits a change in the business cycle to see better days, go ahead and invest in it. Market volatility may yet take the stock price lower, but one should have conviction that the buy is backed by solid reasoning and not panic. Rather the fall could be used to buy more.

All evidence points to the fact that the world’s best and richest investors like Warren Buffet, Charlie Munger, Mohnish Pabrai, Rakesh Jhunjhunwala etc. have this philosophy at the core of their investment strategy. Each may his own variations on stock selection and valuation matrices, but the core strategy remains buy low and sell high. Contrarian investing is the only way you can follow this strategy. This strategy need not be applied only to a particular industry or stock, but to asset classes or markets as a whole. As described in a previous post, right now income and Gilt funds seem to be logical examples of contra investment as applied to debt investments.

Hitachi Results Update

Hitachi Home & Life Solutions (I) Ltd. Has delivered lackluster results for the first quarter.

Sales grew at a decent 25.36 % from 148.49 crore to 186.15 crore.
Other Income fell from 4.52 crore to 1.58 crore
Profit before tax remained flat at 20.96 crore compared to 20.49 crore.
Profit After Tax fell 8.75 % from 17.37 crore to 15.85 crore.

It seems that the company has been impacted by the rise in input costs particularly copper and plastics. We have to see how the company manages to handle these challenges from here on and whether it can continue to display the growth that it has shown in the past.

INCOME FUNDS - CONTRA BETS

Income and Gilt funds which have performed badly over the past three years could be attractive contrarian bets for medium term investors. Income funds predominantly invest in highly rated paper of reputed companies, with almost 80 % of their investments being in AAA bonds. Gilt funds predominantly invest in Government securities.

Bond funds have given the following lackluster performance over the past 3 years:

Medium term Bond Funds Sector Average 4.95 % 5.89 % 5.22 %
Long and Medium Term Gilt Funds Average 4.64 % 5.84 % 5.04 %

Returns are as on 25th July 08 and are for 1,2 and 3 years, annualized.

Since interest rates in the Indian economy have been steadily rising over the past year or so, most of these funds have underperformed. A majority of the holdings of these funds being long term in nature, they have been severely marked to market downwards and as a result their capital values have eroded.

However during the credit policy on the 29th of July, 08, the RBI governor has given some hints that interest rates have peaked. Since he expects inflation to remain at current levels for the near future and ease off to 7 % by March 09, barring major shocks in the form of a huge jump in international commodity prices, there should be no reason to increase interest rates any further. If inflation does start to cool off by the beginning of 09, due to various factors like slowing demand for commodities, higher base effect, effect of past monetary tightening etc., then interest rates should stabilize at current levels and then start to fall off. Again hints of a slowdown in the economy makes lowering of interest rates of prime importance.

This could result in a surge in bond prices with a consequent increase in the NAV’ of income and Gilt funds. In fact interest rates do not even have to actually fall, for bond prices to rise. Just an indication from various parameters that interest rates are likely to cool off is sufficient to trigger a rally in prices of bonds. Markets discount the event well in advance and as a result well before interest rates actually fall, bond prices would start to rise. Depending on the sharpness of the fall in interest rates, bonds could deliver handsome returns from present levels.

ICSA Q1 RESULTS UPDATE

I had posted on the attractiveness of ICSA (India) Ltd. in an earlier post.
It has reported encouraging results for the first quarter of FY 09.
Sales increased by 97 % from 122.63 crore to 241.50 crore (YOY)
PAT increased by 71.28 % from 23.92 crore to 40.97 crore (YOY)
The EPS for the quarter works out to 9.3.
The company paid taxes of Rs.14.14 crore for the quarter representing 25.65 % of the profits before tax.
In my opinion a high percentage of tax payout testifies to the genuineness of the reported figures as opposed to accounting jugglery and speaks well for the company.

FIXED MATURITY PLANS - BASICS

FMP's (Fixed Maturity Plans) are becoming increasingly popular among debt investors in recent times. Since conventional Income funds and Gilt funds are marked to market, in a scenario where interest rates are rising, these funds deliver low or even negative returns.

How does the mark to market concept work? If a mutual fund holds a debt security which gives 8 % per annum (coupon rate) payable yearly, it stands to receive Rs.8 by way of interest on Rs.100 invested. Now if the market rate of interest on bonds of similar tenure increases to 9 % an investor in these bonds would get Rs.9 for Rs.100 invested. The older bond gets less attractive and its price would have to be readjusted to reflect the new market reality. Since the coupon rate (8 %) is fixed, the price of the bond is adjusted to Rs.99 (approximately), so that an investor gets the same return whether he invests in the new bond or old. This is a simple example of a 1 year bond. In case of longer duration bonds the price of the bond is adjusted to reflect the notional loss in interest over the duration of the bond.

If interest rates fall in the market, then conversely, the older bonds would be more valuable and their prices would increase to more than their face value. This concept of adjusting the price of the bond to reflect the changing interest rate dynamics in the market is called marking to market. This is the reason why, presently income funds are suffering from poor returns in the current period of rising interest rates.

An investor holding the bonds to maturity would still receive his principle back along with the coupon rate. This is the concept on which FMP's work. Investors are locked into the scheme until its maturity and intermediate withdrawals are permitted with very high exit loads. So whether interest rates rise or fall in the markets, investors get more or less the indicated yield at the beginning of the scheme. This is a useful instrument for investors who need the security of returns above all else and are not willing to leave it to the vagaries of the market.

FMP's act like Fixed deposit schemes of banks but are more tax efficient due to their structure of not promising any returns. Because of this, the returns from long term FMP's (more than 1 year duration) are subject to capital gains tax, the rate of which is less than the income tax rate for individuals in the higher tax brackets. Again in case of shorter duration FMP' s the interest generated is paid out in form of dividends which are tax free in nature and a percentage is deducted towards dividend distribution tax. Dividend distribution tax rates also being lower than the income tax rates, investors in the higher tax bracket stand to benefit from short term plans.

FMP's have the disadvantage of being illiquid and any withdrawals before the completion of the scheme are permitted only with high exit loads. Therefore investors should only invest in FMP's if they are absolutely sure that they would not require the funds over the duration of the scheme.

SLOWDOWN IN COMMODITIES

Are we seeing the beginning of the end of the great commodity run? I feel that, though it is premature to write off commodities, they are certainly headed for a major fall. The reasons are not far to see;

A slowdown in the global economy is imminent. We are already seeing the signs in America and Europe. A demand drop poses a major threat to commodity prices, since demand has been a major driver of growth. The Chinese have contributed to the demand by their massive infrastructure build up for the Olympics. This is compounded by the fact that China has put on temporary freeze, all polluting industries like metals, chemicals, plastics. A significant cool off in demand is expected as the preparations for the Olympics near completion, coupled by increase in supplies once Chinese industries resume production.

The demand destruction could result in a major fall in commodity prices. Already crude oil has fallen about 18 % from its highs. A similar trend is seen in some non Ferrous metals, data for which is given below:

The data below gives the Commodity, Price on 2nd Jan 08, Year High and Price on 26th July,08.

Aluminium 2365 3291 2936
Copper 6665 9000 8258
Lead 2579 3459 2180
Nickel 26500 33250 19005
Zinc 2383 2825 1891
All prices are on London Metal Exchange, in US $ and per tonne.

Steel and plastics are still going strong and prices are buoyant in these items.
If commodities correct even moderately from current levels, it augurs well for Indian stocks, because we have witnessed a strong sales growth for the companies who have come out with results till now. Margins are under some pressure due to rise in input costs. If commodity prices come down, it could bring some cheer to the bottom lines of companies.

INVEST IN SAFE STOCKS

In the present market scenario, with volatility being the order of the day, I believe investors should stick to safe stocks with solid managements behind them. Even though some sectors have been beaten badly, investors would do well to not look at how much a stock has fallen from its highs, to base their investment decisions on.

It is important to differentiate between stocks and sectors where the losses are justified because something is basically wrong with their business models and those where the present drubbing is due to some temporary factors which are likely to ease out with time. Fundamentally sound stocks offer an incredible opportunity to buy at bargain basement levels and simply wait for fundamentals to reassert themselves.

In my opinion, there are enough indications for the real estate sector to be de rated by the markets. The main reason of course being that, the valuations of these stocks were NAV based. The NAV being the value of the land holdings of the company translated into potential for development. Since the companies decided their own NAV’s, this factor was open to various interpretations. Now with real estate prices crashing, the NAV has come down, though the extent of the fall is debatable. Again deals are not happening on the ground. Some sale is made at an inflated price and this is used as a benchmark to justify valuations of similar properties. The fact that the deal holds only a notional value is conveniently ignored.

Since most of the real estate companies listed on the stock exchanges are recent entrants, there are no parameters to judge their track records. In the absence of historical data by which to evaluate them, such stocks pose a significant risk on the downside. Though their prices may look extremely attractive when compared with the highs achieved by them, investors would do well to remember that a lot of tech companies fell to 10 % of their top valuations following the 2000 dot com bust.

A marked contrast are the PSU banks, many of them having decades of history and giving great dividend yields, now available for less than book value. I believe the reasons for the drubbing they have received are temporary in nature, as discussed in a detailed previous post on PSU bank stocks here.

Investors in this market need to have the conviction in the stocks they own, so as to ensure that they do not panic in case of a sudden fall. Hence they would do well to invest in businesses which have stood the test of time and which can be valued using simple and conventional methods.

ARE WE IN FOR BETTER TIMES?

What a difference a week makes! Around the same time last week we were surrounded by prophets of doom, who forecast levels of new lows for the Indian markets. Predictions ranged from 8500 to 12000 for the sensex. Any upside was said to be a technical bounce back, destined to be short lived.

Since then, the incumbent government has managed to hold on to power and the Finance minister is taking of unleashing a new wave of reforms. Prominent among them are banking, pension and insurance reforms, which could spur a new wave of foreign investments into the country. The nuclear deal shows the country in a positive light and promises good prospects for the few companies operating in related sectors.

Crude is finally taking it on the chin. From highs of $ 147/bbl to $ 125/bbl the cooling of crude oil represents a major plus for economies like India who depend largely on imports for their requirements. A further fall to $ 110/bbl is expected, though I suspect that once something which has gone up the way crude has, starts falling, it is unlikely to rest with a fall of just 20 % or so. This has been amply demonstrated by the fall in our stock markets since January and could also happen with crude.

Other commodities are likely to follow suit and this could act as a booster to the Indian economy. Again after the Olympics in September, a slowdown in imports from China is expected. Also on the supply side, a lot of chemical and other polluting industries which have been forced to stop production are going to resume their supplies.

The inflation front has delivered an unexpected bit of good news. Inflation growth has slowed down from 11.91 % to 11.89 %. Although the difference is marginal, the good news is that after many months, we are actually witnessing a slowdown in inflation. A cursory glance at the inflation numbers reveals that a large component of the inflation growth is the rise in prices of fruits and vegetables. Inflation contributed by manufactured goods has slowed down. This is a positive because fruits and vegetables induced inflation is seasonal in nature and could easily reverse with better rainfall.

Companies results are better than expected, though most analysts would say that they had expected results to be good, with the effects of the slowdown coming in only in the third or fourth quarter of this year.

Things have more or less worked out the way I had expected them to in a post last week titled "Where do we go from here". Although I will be the first to admit that I never expected all these factors to pan out so soon or all together. This is what has caused a tremendous rally in the markets and, though I could be wrong and all the above factors could suddenly reverse, indications are that we should recoup some of the lost ground.

VALUE BUY - HITACHI

Hitachi Home and Life Solutions (India), previously known as Amtrex Appliances is a leading manufacturer of window and split air conditioners.

The demand for its products is extremely strong considering the growing Indian middle class with its disposable income and the recent tendency to buy premium brands. In this context Hitachi's wide range of energy efficient products would place it at a considerable advantage in relation to its competitors. Its parentage and technological advancement should make it a product of choice among discerning consumers.

Hitachi also makes commercial and industrial air conditioners ranging from floor standing AC's, microprocessor controlled AC's, AC's for factory use and AC's for intelligent building cooling. With malls and modern residential complexes coming up at a rapid pace, this segment should witness high growth in the coming years. Hitachi also manufactures refrigerators and washing machines.

Financials:

For the year ended March 08, Hitachi clocked a turnover of Rs.446 cr and a PAT of Rs. 42 cr, giving an EPS of 18.40. PAT for the March 08 quarter was Rs.11.6 cr, a 100% growth over the March 07 quarter. The market price of the stock is Rs.145 as on date, giving it a PE ratio of 7.8. This appears undervalued considering the brand equity the company enjoys and the premium pricing its products command in the market.

The market capitalisation of the company is Rs.332 cr and the M Cap to sales ratio is 0.75. As against this Blue Star, operating in a similar segment has a PE ratio of 19 and a M Cap of Rs.3304 cr, with sales at Rs.2221 cr. The M Cap to Sales ratio for Blue Star is 1.5. Although Blue Star is more active in the commercial and industrial segment, Hitachi has taken steps to enter this market aggressively. The valuation gap between the two is wide, and Hitachi holds the potential to narrow down this gap.

Major risks are that Copper is a major input for air conditioner manufacturers and rising Copper prices could impact margins. Hitachi's products are priced higher than its competitors and in a recession consumers could downgrade to lower priced offerings.

 

THEORY OF REFLEXIVITY

The theory of Reflexivity propounded by George Soros, seeks to demonstrate that financial markets cannot discount the future correctly because, in certain cases, the behaviour of financial markets affect the so called fundamentals which they are supposed to reflect. It implies that financial markets do not merely discount the future; they help to shape it.

Therefore reflexivity is a self fulfilling prophecy which occurs when markets react to the expectations of its participants. A feedback loop occurs, wherein prices are driven by perceptions and the movement of prices help to reinforce expectations.

Consider the example of the Indian stock markets after its all time high in January, 2008. Once the markets started falling from its highs, investors, particularly FII' withdrew from the markets in large numbers. This caused stock prices to fall further. The fall in prices led to a perception among investors that markets were overheated. This in turn led to further selling in the markets, thus creating a feedback loop, where the prices were affected by investors' negative perceptions, which were in turn reinforced by falling market prices.

This selling and absence of fresh inflows by FII' led to the Rupee weakening against the Dollar, which resulted in inflation rising and interest rates going up. As a consequence, profitability of companies, which was projected to grow at 20 % on an average, started slowing down. Though not the only reason for slowing growth numbers, this example serves to illustrate how markets can influence fundamentals.

Soros contends that, "such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy." Conventional market theory acknowledges that all the available information is built into prices and current markets correctly discount the future. Soros thinks that this interpretation of the way markets operate is severely distorted . He works on the principle that whenever he takes a position, he does not automatically presume that the markets are wrong, but allows for the fact that he himself could be wrong on his call.

This article relies heavily on a speech made by George Soros on April 26, 1994 to the MIT Department of Economics World Economy Laboratory Conference Washington, D.C.

WHERE DO WE GO FROM HERE

With crude showing signs of cooling off, stock markets look poised for a rebound. It also depends on the vote of confidence scheduled for the 22nd and the inflation figures. In my opinion it’s a good time for long term investors with a time horizon of 2 years and above to go on a shopping spree.

Oil, which has been a major drag on the markets is projected to react to $100 to $110/bbl in the next six months. The reasons are slowing demand for gasoline in the US, the relatively lower growth in GDP projected by India and China and the comments of the King of Saudi Arabia seeking lower oil prices. If oil prices fall as expected, this would provide a huge boost to economies like India and consequently their stock markets. Since higher oil prices are already factored into current market levels, any positive news could act as a trigger.

On the political front, the exit of the left parties should act as a pleasant surprise for stock markets, only if the government survives the vote of confidence. In such a scenario, the Government would be free to aggressively push reforms in insurance and banking sectors. Moreover the disinvestment process of PSU’s would get a huge boost, bringing quality new issues to primary markets and increasing the depth and liquidity of our markets in addition to improving sentiment among battered investors. Also opening of the insurance sector would bring a flood of FDI into the economy, thereby strengthening the Rupee.

Inflation poses a huge risk to the markets, but again most of the bad news is built into prices. Though inflation is not expected to fall off any time soon, it is after six months that the higher base effect will kick in. Since, in India inflation is measured on a YOY basis, we are getting inflation figures compared with last year’s figures. Inflation was quite low at this time last year hence we are seeing disproportionately higher inflation growth figures. Also by this time we will see some of the measures taken by RBI to curb inflation take effect. Another positive would be the normal monsoon, at least till now, which would bring down the prices of food articles.

A caveat here is that any of the above scenarios not happening could act as a dampener. But in my view, current prices hold value for investors willing to wait it out and having the capacity to bear some potential pain in return for longer term capital growth.

A CASE FOR SIMPLICITY IN INVESTING

In a book, I recently read, the author gives the example of a person who turned this life savings of $ 2,000 into $ 1 Million by following a simple strategy. When the dividend yield of the Dow Jones Industrial average went up to 6 %, he put all this money into stocks. When it went below 3 %, he got out of stocks and put the realised amount into a savings bank account. It took him 30 years to achieve the above result, but still it is no mean feat. Though I am in no way advocating that investors follow this method, the fact remains that the techniques that make you the most money are often the most simple to execute.

 

If making money is the ultimate objective, why do we then follow exotic strategies in our hope of beating the markets in the short term? Could it be that the more we try to outwit the markets, the more we fail? I have tried to examine the reasons behind why people (including myself) go for complicated strategies in trying to outperform. One of the reasons is that we like to have our profits on a regular basis, rather like the coupon payout on a bond. We seek the regularity of bonds with the high returns of stocks. We hate the lumpiness of stock market returns as a result of which the maximum profits occur in short intervals with the markets either going down or sideways in the intervening periods. The fact that the profits made in the good years more than make up for the losses or opportunity cost of down years, tends to be neglected by us.

Another reason could be that we seek a sense of control. We feel the need for activity in the markets, thinking that if we do nothing, we are simply watching while opportunities pass us by and this creates a pressure on us to act. Comparisons with profits made by neighbours and acquaintances make us feel that we are being left behind, while others are raking it in. This psychology was at work in the bull ramp up till January, where most investors got carried away by stupendous returns made by active market players and were attracted to invest in stocks. To compound matters, most investment analysts were predicting still higher levels.

For some investors, outperforming markets is a matter of intellectual satisfaction. Everyone gets an ego boost when their trades turn out right. When we get things right a few times, we tend to feel that we have found Alladin's lamp. Only in retrospect do we realise that in the short term, markets are far smarter than us. I have seen a few experts claim that they can manage to outperform markets on a consistent basis, whatever the time horizon. I do not have the data to judge their claims, but I feel that for the average investor, the simpler the investment strategy, the higher will be the returns.

 

 

PSU BANK STOCKS

PSU Bank stocks are starting to look somewhat like the Indian cricket team after they ran into Mendis in the Asia Cup. Battered and bruised. But these stocks, currently out of favour could provide a mix of steady income and capital growth to investors' portfolios. Let's look at some reasons as to why PSU Banks are now discarded by the public.

1. It is felt that PSU Banks' profit margins would be eroded due to mark to market losses on their treasury holdings. While this is true, banks generally hold these bonds to their maturity. So while mark to market losses could dent their margins in the short run, these would provide above normal profits when interest rates cool off. Even if interest rates do not ease, these bonds would continue to provide interest at the coupon rates and on maturity the entire principal would be received by the bank.
2. Due to rising interest rates demand for loans would decrease. Again PSU banks are not aggressive in their approach to giving out loans to people. In fact this conservatism was said to be one of their drawbacks when the going was good. With the current scenario, where private sector banks are being downgraded because of NPA fears, PSU banks are relatively well insulated from NPA'. Though demand growth may slow down somewhat, PSU banks are well equipped to handle this because of their diverse clientele and their reach in rural areas. Since it is expected that agricultural growth will be better this year, PSU banks are well poised to capture a part of this growth to make up for demand slowdown from cities and corporate.
3. Rising interest rates would put margins under pressure, because of higher cost of funds. This would also work to the advantage of PSU banks because of their larger base of CASA (Current And Savings Accounts) deposits. Here banks have access to a large pool of funds at extremely cheap rates. This would partly offset the higher cost of funds, at which they borrow for term deposits and other longer term borrowings.

Now for some reasons, as to why PSU banks are excellent investment candidates at current levels.

1. Most of these banks are available at or below their book value. These businesses are not going to disappear from the Indian markets in a hurry. Then why give them such abysmally low valuations? Most of them own huge pieces of real estate, in prime locations. These are generally being carried on the books of the banks at cost price. So, if the treasury holdings of banks are marked to market, then the real estate should also reflect current market prices. If this is done then the disparity between book value and market price could widen further.
2. The current dividend yield on PSU bank stocks works out to anywhere between 4 to 6%. This is one category which offers the highest dividend amongst all the available sectors in India. Although, if profits decrease, the banks might lower dividends, but in the longer term they have a history of paying out a large portion of their profits in the form of dividends. So eventually the dividend payouts ought to revert to their mean. In fact the high dividend yields give investors some kind of protection against further sharp downsides in stock prices.
3. Most banks have modernised their operations, downsized excess staff and improved service levels. Gone are the days when they operated from dingy branches with grumpy clerks. The PSU banks of now are the match of their private counterparts in terms of ambience and ease of banking. Not only that, they also have a human interface for customers who are not comfortable with handling computers and ATM', unlike private banks.
4. PSU banks are being discounted at 4 to 5 times past year' earnings. Although earnings are expected to come down in the current year, as discussed above, this is likely to be a temporary phenomenon. Since markets have a tendency to discount the future by about 6 months, the stock prices of these banks could rise well before interest rates start easing.

Then again there are some intangible factors which work in favour of PSU banks. Customer loyalty is one of them. Then the low cost of operating accounts unlike private banks which charge customers for every small service. According to a Assocham survey in 2006, 60 % of Indian businessmen prefer PSU banks for sourcing credit cards and 80 % of them approach PSU banks for personal and educational loans. As mentioned above their rural reach, access to cheap funds via CASA and diverse client base give PSU banks an invaluable brand equity.

Future prospects include disinvestment by the Government, which could provide a real trigger to stock prices. Consolidation among banks is likely to take place in 2009, when several PSU banks are expected to merge to acquire size and financial muscle to take on foreign banks

Risks associated with PSU banks include Government interference in the form of farm loan waivers and tendencies to favour political constituencies through banks. Inability to face competition from foreign banks, which are expected to hit Indian markets due to opening up of the banking sector in 2009 could be a negative. Even the larger PSU banks are considered miniscule when compared to their global counterparts. This lack of size could hamper the growth of these banks. Lack of autonomy in incentivising employees to improve productivity and retention of key employees could be a concern.

VALUE BUY – AUROBINDO PHARMA

Aurobindo Pharma is a manufacturer of Active Pharmaceutical Ingredients (API'), formulations and intermediates, having a wide portfolio of products in various segments such as anti infectives, anti retrovirals, cardiovascular systems , CNS etc.

Strengths:

It has 5 units for manufacture of API' and 4 for manufacture of formulations, catering to regulated markets where norms relating to manufacture are extremely stringent. It has invested heavily in modernizing its plants to make them compliant with USFDA/European standards. This is a significant step in improving quality standards and would be beneficial to the company in the long run. A significant presence in US markets is accounted by a large number of approvals from the USFDA. In addition the company is in the process of filing for 30 more drug approvals in the coming years. Acquisition of Milmet Pharma (UK) and Prarmcin (Netherlands) has given it the required presence in major European markets. It has maintained its efforts to increase its presence in Europe by filing drug master files in various European countries. About 40 products are awaiting approval in various European countries, which could be a significant driver of revenues and profits going forward. In May 08 it has received 9 product approvals from MCC to market products in South Africa. It has now a total of 31 marketing authorisations approved by MCC.

Since the company manufactures a majority of the intermediates required for the manufacture of API', it has been relatively insulated from the cost pressures due to rising intermediate costs affecting a majority of its competitors. The company has focussed on diversifying its product portfolio by going into the formulations business, which is likely to impact bottom lines positively since formulations is typically a higher margin business as compared to API'.

Risks:

Prices of chemicals and intermediate inputs are on the rise due to the global commodities boom. This could have an adverse impact on the bottom line of the company.

The company operates in regulated markets of the US and Europe. Delays in the approval of drugs can have an effect on new launches thereby putting a constraint on the growth of the business. Also the quality parameters not only with respect to the final product, but also in the practices followed in their manufacture are very stringent, any slip ups can cause serious problems.

Financials:
For the year ended March 08, the company achieved sales of Rs.2234 crores, a growth of 19 % over the previous year.
Profits increased from Rs.229 cr. to Rs.290 cr. A growth of 27 %. However this was aided by an increase in other income from Rs.39 cr. To Rs.118 cr.
The EPS for the year stands at 53 giving a PE ratio of 5.5 at current prices. If other income is excluded, it gives an EPS from operations of 32.
The real undervaluation of this company is observed in its balance sheet. The company has Net Current Assets of Rs.1800 cr. as on 31.3.07. Against this the Market Capitalisation is just Rs.1500 cr. on date. This makes Aurobindo Pharma a real value buy.

IN DEFENSE OF FUND MANAGERS

There has been a lot of mutual fund bashing going on recently, with investors upset that fund managers have not been able to protect investors in the current downside. I am also guilty of criticizing these guys in a previous post. Everyone wants a scapegoat when things go wrong. But I now think we ought to take a relook at what went wrong with the decisions that fund managers made and were they entirely responsible for not saving investors from the terrible erosion in values that has taken place. I would not go so far as to say that there was nothing they could have done to protect investors, but given the circumstances it was extremely difficult to act any other way.

It has been said that funds did not take profits at higher levels. I think that, even though funds did book profits, by mandate an equity fund has to have a majority of its corpus in equity. Being in another asset class is not a call for a fund manager to take. When investors have given him the money to deploy in shares it means that they have studied the implications of having a portion of their assets invested in equity, with the associated risks. If investors had indeed wanted fund managers to periodically rebalance their portfolios, they should have invested in the various asset allocator mutual fund options in the markets or, opted for the dividend payout option. Let's face it, it was our greed that got us to invest in pure equity funds and not sell the units at higher levels.

Another point people make is that fund values have fallen more than the benchmark indices, which is quite true. But one has to realise that however diversified a fund might be, it's portfolio is still quite concentrated when one compares it to its benchmark index. The concentration may not be in the number of scrips held, they may be quite diversified but a large percentage of the fund's assets are concentrated in a few top holdings. Generally a large cap fund has about 45 to 50 % of its holdings in 10 stocks. This is exactly what enables an actively managed fund to outperform the indices when they go up. It is but natural that the converse should be expected to hold true on the way down. If the past 5 year track record of the top funds is compared with that of the indices, we find that the funds have hugely outperformed.

A criticism that I have also made in the past is that the fund managers were invested heavily in flavour of the month stocks like infrastructure and real estate. But as investors, our investment psyche is such that we generally look at how well funds have done over a 1 year period. We then invest in last year's better performers. In doing so, we do not allow fund managers to take a longer term call. If investors focussed on 3-5 years returns, I feel fund managers would be emboldened to avoid hot stocks which are overpriced and concentrate on value instead. Whichever way one looks at it, a fund has to have assets under management, to stay in the business. Assets can only be garnered by showing fantastic returns in the short term.

I have recently seen the concept of SIP' being attacked as not being a suitable investment strategy. I would like to differ on this. ICICI Prudential Growth Plan, not one of the top ranked funds, has given SIP returns of 18.57 % over a 3 year period and 29.60 % over a 5 year period. I have deliberately not included a top performing fund, in order to give readers an idea of the average fund returns. Returns are as on 31.05.08. Anyway, the best method of judging a SIP is when the markets have recovered after being down for a while. This is where the benefits of Rupee cost averaging works out. If the markets have fallen precipitously as they have done recently, investors do not get time to accumulate enough units at lower levels. The error in estimating the efficacy of this strategy is compounded when the lowest NAV' are used for calculating the returns. In my view SIP is an extremely efficient and simple way to create wealth in stock markets. If an investor sticks to his SIP plan, I am sure that when markets recover, he would be amply rewarded for his discipline and persistence.

The above does not in any way absolve fund managers from their duties as guardians of public wealth, but we, as investors, need to realise that they are after all human and are subject to the same failings as we are. They have done an admirable job in the past in beating market returns and can be expected to do so in future, if we allow them some leeway and time to get their act together again.

LESSONS FROM JAN 08

What percentage of the Indian investor population regrets not getting out at 21000? My guess would be 95 %. Even long term investors are shocked to see the value erosion in their portfolios now. Some of them are even thinking of cashing out, while they still have some profits left on the table. Panic is slowly creeping into the markets as stock values are rapidly eroded.

Looking back it seems that we all got too greedy. But aren't we doing the exact opposite right now by becoming too fearful? We felt that markets would never come down and miscellaneous analysts were egging us on by outdoing each other in predicting higher sensex levels. Some of us were afraid to sell thinking that we would miss out on the gains of tomorrow. The exact reverse is happening at the present moment. When so-called support levels are breached, analysts predict still lower levels. We are afraid that if we buy a stock today, tomorrow it will be available 5 % cheaper.

I am not saying we are at the bottom. I don't profess to know what the bottom is and am not interested in guessing. But I do know that valuations are attractive, just as they were stretched in January. Just like various theories were bandied about to justify high valuations, doomsday scenarios are being painted now.

One cannot sell at the exact top or buy at the bottom. We can take a call based on reasoned past and present indicators and a likely future scenario. Had someone taken a valuation call in December 07 and sold out at 18000, he would have seemed foolish initially as markets rallied another 12 % or so. But in hindsight his actions would have looked extremely wise. Similarly a purchase now might look foolhardy, but it is certain to pay off handsomely in the next 12 months. We need to learn lessons that history teaches us, if we are to profit from the folly of others.

ELLIOTT WAVE PRINCIPLE - BASICS

 

Even though I am a strong believer in a buy and hold strategy for the long term investor, I think investors who are more active in markets could look to ride the market cycles for greater profits. I have found the Elliott wave principle quite useful in predicting these cycles.

As anyone who has been in the stock markets long enough, knows fully well that markets follow cycles of boom and bust. Ralph N.Elliott, an American who worked in Mexico as a wireless operator, observed these cyclical movements of stock markets, by observing historical data of the indices while convalescing from a long illness in the 1930'. He postulated a principle that markets move in clearly identified waves over periods of time ranging from a couple of centuries down to movements in hours and minutes. Each wave can be subdivided into its component waves and each sub wave can be further subdivided and so on. This science is now known as fractals. Accordingly waves are classified from the "Grand Super Cycle" being the largest to the "Sub Minuette" being the smallest practically measurable wave.

As per the Elliott wave principle, an uptrend comprises of 5 waves, 3 up and 2 down. Each up wave is followed by a down wave. Up waves or impulse waves are labelled as Waves 1,3 and 5 and down waves or corrective waves are labelled as waves 2 and 4. Waves 1,3,5 comprise of 5 component waves each and waves 2, 4 comprise of 3 component waves each. At the completion of wave 5 a new market high is achieved. This is followed by a cycle of severe destruction comprising of 3 waves, which seek to erase most of the gains of the previous bull market. These three waves are labelled as A,B and C. Waves A and C, which are down waves each comprise of 5 component waves because the trend is now down. Wave B, which is an up wave comprises of 3 component waves.

The task before an investor is to identify the stage in the above cycles, which the market is presently in. Once this is correctly done, the investor can decide how the market is going to behave in the future and act accordingly. This can be particularly beneficial for longer term investors to decide when to liquidate their holdings or when not to enter the markets, so that they do not have to suffer the agony of seeing their portfolios diminish in value such as at the present moment. Also it prevents longer term investors from selling prematurely and thus not being able to capture the full extent of the bull run.

A drawback of this principle is that it calls for a lot of judgement on the part of the investor and has no rigid rules to go by. In fact this method is so flexible that different analysts can have different opinions on the present stage in the markets. But since markets do not follow any rules it seems only justified that any system which aims to predict market movements, similarly do not lend themselves to the rigidity of rules, but have an inherent flexibility to account for the vagaries of the markets. Therein lies the beauty of the Elliott Wave Principle, as it attempts to forecast market trends while at the same time is open to account for erratic market movements caused by sudden news flows, which cause a temporary aberration in the wave patterns.

MY TRADING SYSTEM

As you might have figured from my blog, I am basically a fundamental investor, though I reserve a small portion of my portfolio for trading (not day trading though, my typical investment period for a trade is about 30 days). My oservations on my trading experience are as follows.
1. It does make the whole process more exciting.
2. I use traditional charting methods like candlestick patterns, price patterns, moving avgs etc.
3. I am a long only trader. So no shorts & no F&O.
4. You can make money trading, but I don't know the sustainability of such returns since my fundamental investments have been over some time while I started trading only recently. However my trading returns till now have been positive.
5. Taking small losses and executing strict stop losses are the key to success. Easier said than done though.
6. I generally trade on the same stocks I hold in my fundamental portfolio. Thus I can save on STCG tax.
7. Whatever profits I make on trading I withdraw from the market. In case of losses I do not replenish my lost capital, but trade on the reduced capital.
8. I am not a compulsive trader. I buy whenever I feel comfortable and maintain inactivity if I get a bad feeling about the markets.
9. I generally try to guess the direction of the markets over a period of 2 -4 weeks and go long if I feel good about it. For instance I recently bought some Infosys. I already hold it in my long term portfolio. My logic is that Q1 results are expected to be good, and markets do not seem to have discounted this at current prices. So I am looking at an upside of about 15 % in about 2 weeks, while if it does not perform I will have some more of a good stock in my portfolio.

GARP INVESTING

GARP (Growth At a Reasonable Price) investing is an offshoot of the growth investing principles propounded by Philip Fisher and T Rowe Price. It involves identifying rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get rerated.

One of the leading practitioners of this investment style, Peter Lynch, often looked at businesses which manufactured products that he liked and used. An aspect of his investment style involved going to shopping malls with his family to check out the brands that were doing the best sales. Then he would research the companies that owned these brands and come up with options for investment.

An important aspect of GARP investing is the PEG ratio. This is the ratio of the PE multiple of the company to its average growth rate in EPS over a period of 3-5 years. For small companies that are growing rapidly, a PEG of 1 is considered suitable for investment in the Indian context. Here rapid growth rates are seen in a variety of businesses and an investor can find many companies quoting at PEG of 1 and below. Are all these companies good buys on the basis of GARP? To determine that, an investor needs to look at the sustainability of that growth. For example a company growing at 25 % per annum for the past three years and quoting at a PE ratio of 15 may be a buying candidate if an investor can satisfy himself that the business can sustain growth rates of at least 15% if not 25 % over the next few years.

How does an investor ascertain that? Therein lies the art element in investing. He looks at the business prospects of the industry in which the company is operating, the brands it owns, how well its products are doing in the markets, its loyalty among buyers, service track record, capacity additions it has planned and the quality of its management.

A risk in employing GARP investing is that high growth and low PE businesses are available mostly in the small and midcap space. By nature these companies do not have the staying power to overcome prolonged adverse market cycles. This risk can be mitigated to an extent by selecting companies which have been around for some length of time and have demonstrated their ability to weather difficult conditions. Large cap companies can be considered buying opportunities at a PEG of 1.25.

Let's try and apply this methodology to the BSE Sensex. The Sensex is expected to deliver earnings of 970 for FY 08-09. In the past the Sensex earnings have been growing at 25 % per annum. Since a slowdown is expected due to inflation, crude prices and other factors, let us assume that the Sensex will grow at 15 % in future. Since India is among the top five markets in terms of market cap in Asia, it is analogous to a large cap company. Therefore, it deserves a PEG of 1.25.

Price/Earnings/Growth = 1.25

Price (Sensex) = 1.25 x Growth x Earnings
= 1.25 x 15 x 970
= 18180
So, when various analysts say that India at a PE of 17 is expensive compared to other emerging countries, they fail to take the growth rates into account. PEG normalises the PE ratios by adjusting for growth.
Brazil's GDP growth rates for the past 6 years are given below:
2003 1 %
2004 -0.2 %
2005 5.1 %
2006 2.3 %
2007 3.7 %
2008 4.5 %
Average GDP growth over 6 years = 2.73 %
The PE ratio of Bovespa was 16.8 as on 31.05.08.
Brazil being a commodity driven economy, these growth rates are in an era of high commodity prices. Even in such conditions adverse to it India has clocked a GDP growth of 8 % over 6 years. What would happen if commodity prices were to correct, as is widely expected? Therein lies the genesis of my arguments that long term investors should buy Indian stocks at present levels.

WHAT ANALYSTS PREDICT & WHAT ACTUALLY HAPPENS

I would like to highlight an interesting post on rediff where three different analysts employing different prediction methods predict their levels for the sensex in the coming year. The predictions were made on Jan 7 2008. They went something like this:

1. Milind Karandikar - using Neowave theory - Sensex between 27000 to 39000 in the 1st half of 2008,

2.Devangshu Datta - using technical analysis - Nifty between 6600 to 7000 in six to eight months with a bottom of 5600 to 6100. Really?

3.Mukul Pal - using Elliott wave - Sensex not extending beyond 24000 in 2008. The closest of the lot, but still wrong by a long long way.

I would like to ask these gentlemen their views in the present context, but they have chosen to not display their respective e-mail id. They would probably be bearish now, taking refuge in some jargon or some hedging terms which they have been careful to qualify their projections with. Readers may judge the value of the predictions for themselves by reading the article here.Its very easy and popular to simply extrapolate the current trend and on that basis come up with fancy figures. The real test of an analyst is if he can go against the mood on the street AND end up being right. In that respect I admire people like Gul Tekchandani and Ramesh Damani who had the conviction to go against the popular mood and point out the risks, when markets were at their peaks. Some like Morgan Stanley have been screaming from the roof tops about overvaluations since the index was at 8000 and are delighted that their call has been proved right finally with the index at 21000! Some call, guys. Even a stopped clock is right twice in a day.

WHAT DO INVESTORS DO NOW?

So, finally the dreaded inflation number has crossed double digits. Not barely crossed it, but has done so by a considerable margin. Stock markets have expectedly crashed and analysts are screaming "the sky is falling". So what do you as an investor do now? It actually depends upon your timeframe for investment and your reasons for investing in stocks. If your goals are long term in nature such as planning for retirement or children' education, it makes little difference to you how the Sensex reacted today.

Just forget about the markets for a while. Sit back and take stock of the situation. OK, inflation is at 11 %. Did it jump from 6 % to 11 % overnight? No, it took about 6 months to do so. If inflation was increasing continuously for months and the trend is now continuing there is nothing strange about it. What is it that is so sacrosanct about the double digit inflation figure? I cannot believe that inflation at 9.9 % is OK, but at 10.1 % it is going to wreak havoc on the economy. I am not trying to make a case that inflation is good or that it will not affect the economy. What I am saying is that inflation is a fact and that the markets have already fallen by more than 30% from their peaks, simply discounts that fact.

Can markets fall further? Maybe. Will markets eventually rally? Certainly. Take a look at the positives. Since, even the worst case scenario for the economy paints GDP growth at 7 %, I see no reason to believe that we are in a recession. If the markets can consolidate at current levels, waiting for inflation to come down and interest rates to stabilize it may not be such a bad thing for investors. By now the froth is out of the system, speculative positions are low, IPO' are dead, the panwalla is no longer talking stocks. If you have cash waiting on the sidelines, the time to invest a portion of it has come. You could invest 25 % of your cash in high quality businesses, using this window of opportunity. There are plenty of opportunities available, where outstanding businesses are quoting at reasonable valuations. Even if you do not invest, it would be a mistake to panic and sell out now.

Advance tax numbers point to a significant growth in corporate taxes. This cannot happen without profits rising. Again the investments in capacity creation that India Inc. has made in the past few years are about to yield results as this capacity goes on stream. Again it is expected that inflation would come down somewhat as new farm yields hit the markets. I am in no way trying to make out that all is hunky dory with the economy. But it is not a doomsday scenario as many would have us believe. I am simply trying to bring a sense of sanity to the all round fear factor prevalent in the markets. Luckily the crash happened on a Friday. We have 2 days to put things in the proper perspective and then decide our course of action. An old wall street saying comes to mind " Buy when there is blood on the streets, even if it is yours".