WHY STOCK MARKETS ARE NOT SPOOKED BY OIL

The single biggest factor influencing the global economy today are surging oil prices. Oil has risen from $ 20/bbl in 2002 to $ 130/bbl now. However this may not affect markets negatively and may in fact even be a bullish signal for stock markets going ahead.

The main reason touted for rising oil prices is the increasing demand for the commodity from growing economies. Therefore the very fact that oil prices are increasing means that the growth drivers are still intact. This is a very significant indicator for the future and it may be one of the reasons why, in spite of a surge in oil prices stock markets around the world are stable.

The second reason for the spiraling prices is the speculative element. Now if oil prices show some volatility on the downside, it could make the oil bulls run for cover. In turn this could trigger a sharper fall in prices intensified by speculators rushing to cover long positions.

The long term reason why oil cannot sustain current prices is that there are huge oil reserves in the form of oil shale, estimated at 2.6 trillion bbl. The only problem is that shale oil requires a different technology to convert into petroleum and new refineries have to be built. The cost of converting shale oil is estimated at $ 35/bbl. Now, as long as oil was in the $ 50/bbl range, this was a problem as it could slip back to less than $ 35 and render these refineries unviable. But at current prices investing in these technologies makes eminent sense and many companies are rushing to set up new plants.

Alternative technologies like wind power, solar power, nuclear energy are likely to get advanced as oil sustains its high prices. Also clean technologies being developed will ensure that demand for oil stops growing even though economies maintain their pace of growth.

When we combine all the above factors, it can be seen that oil is in a bubble zone presently. Whether the bubble goes on to assume larger proportions or deflates shortly remains to be seen. But deflate it will and stock markets across the world are picking up this signal well in advance, as markets have a habit of doing. This is the reason behind their surprising resilience.

REMEMBER THE PAST

Do you remember the stock markets in 2002? The whole world was recovering from the aftermath of the September 2001 attacks. Amidst all the gloom and doom, everyone and his uncle were advising you to sell stocks and get into good old fixed deposits. In fact people were talking as if markets would never rise again and any fresh investments made would fall even further. Further? Think about it now. In 2002, BSE Sensex was at 3200 levels. True, it may have gone down by a couple of hundred points more, but with the benefit of hindsight, just think how ridiculous that advise was.

So do not panic. Treat market falls as your friend. Remember the advise of Warren Buffet who said “ If you are in the market for buying apples and the price of apples were to suddenly fall, would you be happy or sad?” Think about buying stocks as you would about buying businesses. The same solid business that was available at Rs.500 a share barely 6 months ago is now being priced by the market at Rs.300 a share. Consider this. Everything about the business remains the same. Its growth rates, business prospects, quality of management – everything. Only you are getting it 40 % cheaper. In a few days it may fall another 10%. So what? It still remains a great business. If you can, buy more.

Remember, in spite of what the pessimists tell you India is still growing at 8%. Very few economies in the world can match that. Wages are increasing across categories. Millions of people are crossing over to middle class status every year. People are buying new homes, new cars and what not.

Do not let experts tell you that oil is at $ 132/bbl, so we must slow down. We may, but again we may not. We did not slow down when it went from $ 20/bbl to $ 130/bbl. And who knows, oil may come back to $80 levels before soon. These are the same experts who predicted that Indian IT companies would face rough weather because the Dollar had fallen against the Rupee and would fall still further to Rs.35 to the Dollar. And Infosys gained nearly 40 % in this period.

Therefore act with courage. Courage is not the absence of fear. Courage is the ability to act, to move ahead even when you are afraid. After you buy, even if markets fall further, remember the past. Markets have to recover at some point of time. And when they do so you will not only recoup your losses but overall your gains will far exceed interest earned on some stupid fixed deposit. Only remember to invest in quality. Do not buy simply because a stock has fallen sharply from its highs.

Don’t you think India will be a major economic power in the next 10 years? So make the most of that opportunity. Your chance is NOW.

DIVIDEND YIELD STOCKS FOR CONSERVATIVE INVESTORS

Investors who prefer stability in their portfolios and are not comfortable with stock market volatility can look at dividend yield stocks as an alternative to debt based instruments.

Suppose a stock with a face value of Rs.10 is quoting at Rs.100 and giving a dividend of 50% currently i.e. Rs.5 per share of face value Rs.10, then its dividend yield is 5 %. An investor in this stock receives Rs.5 by way of dividend, on every Rs.100 invested. At present dividends are tax free in India which makes it all the more attractive.

Now one might argue that 5 % is low as compared to 8 to 9 % returns available on debt instruments. But one needs to take into account the potential for capital appreciation, that is most likely to accrue over the long run, if the stock has been carefully selected to begin with.

Consider a business with a dividend yield of 5 %. Now take a simplistic scenario where this company is growing its profits at a steady 15 % per annum, year after year. It also keeps on increasing its dividend at the same rate. Now also assume that the market discounts the earnings of the company also at the same rate as on the date of investment. What would happen after 5 years? Growing at 15 % per annum, the profits of the company would double and its dividend will be now raised to twice the original. The initial investors who had got in at 5 % dividend yield would now find themselves earning dividends at 10 % of their principal invested.

Not only that, since the earnings have doubled, the market would now value his company at twice the original price. Therefore our investor stands to gain both ways. One, he is now getting dividends at more than the market rate for debt instruments and two, his original investment has appreciated by 100 %.

An added advantage of such stocks is that their dividend yield protects their market price from falling very much. For instance if the market price of a company with an initial dividend yield of 5 % fall by half, the new dividend yield now becomes 10% based on the current market price. This makes the stock attractive for many investors to buy, thus pushing the price upwards.

A caveat in this strategy being, that companies are not obliged to pay dividends. This entirely depends upon the business environment. If the company encounters a business slump, this strategy might fail. But the strategy is not designed to protect against adverse business conditions in the first place. It is designed to give stability to a portfolio in periods of stock market gyrations, with the basic fundamental attributes of the business staying intact.

Even this risk might be mitigated to an extent by selecting companies which have a consistent history of steadily increasing dividends over long periods of time. Several multinationals and PSU banks fit into this category. Another plus in selecting such companies is that, the very nature of their being profitable over many business cycles gives the investor added conviction in their business models.

This strategy can be used to invest a portion of their assets into equity by conservative investors while investing the balance into debt instruments. It may not give mind blowing returns but will impart a solidity to the investor’s portfolio with returns that at least beat inflation, while ensuring a good nights sleep.

USE OF MARKET CAPITALISATION IN VALUING STOCKS

Market Capitalisation (M Cap) of a company is defined as “ the number of outstanding shares multiplied by the market price of each share”. For instance a company having an issued capital consisting of 1,00,000 shares with each share valued at Rs.100 will have a M Cap of Rs.1 Crore. M Cap of a company changes every day with the change in its market price.

Companies in India are classified into three broad categories on basis of their M Cap.

Large cap companies having M Cap of more than 5000 crore.
Mid cap companies having M Cap between 500 to 5000 crore.
Small cap companies having M Cap of less than 500 crore.

Market cap gives the relative size and stability of a company as compared toother companies in the same industry. An investor can give due weightage to the M Cap of a company before judging its potential as an investment candidate. FII’ and other large investors usually favour large cap companies because of the liquidity they provide and their ability to invest large amounts in these companies without causing wide fluctuations in the price.

Another useful indicator in evaluating a company is its M Cap to sales ratio. This ratio indicates what value the market gives a company as a multiple of its sales. Generally 2.5 to 3 times of sales is considered to be fair valuation for a business, depending on what industry it is in and what is its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognized the value of that particular business and it can be considered as an investment candidate. Like all other ratios, M Cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint which the M Cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realize its potential.

A case in point is DTH services in India, where companies cannot be valued on basis of existing matrices like earnings, cash flow etc. because they are not generating any profits due to huge upfront investments in infrastructure. M Cap can be a useful parameter to value such companies, by taking into account their number of subscribers and checking what capitalization the market has given to companies with similar number of subscribers in developed nations. If there is a significant variation in M caps, such companies can be considered worthy of further investigation.

Serious fundamental investors should therefore look at the M Cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment candidates based on other parameters.

LOOK AT THE BIG PICTURE

When markets are down and everyone from television analysts to the man on the street are painting a doomsday scenario, it makes sense to step back and take a look at the larger picture.

Since its inception in 1979 has moved from a base of 100 to around 17,000 at present. The compounded annual growth rate works out to 19% p.a. It has been a roller coaster ride, as anyone who has been in the markets long enough will attest. Along the way many investors have been wiped out, many new investors have entered and old ones have given up on stock markets as a den of thieves and manipulators. (The word “investor” is used in the generic sense and includes both long and short term investors, day traders and speculators). But the ones who have made money are those that have stayed invested through market ups and downs.

So what lessons does history teach us:

1. In the long run stocks of superior companies have outperformed any other alternate investments.
2. Stocks bought without researching and analyzing the rationale behind the investment are almost certain to eventually lose money.
3. Concentration on any one sector should be avoided at all costs. Moderate diversification is the key to long term success in the markets.
4. Remaining invested in the markets is more important than timing the markets in the case of long term investors with clearly defined goals.
5. Compounding in the long run makes wealth grow exponentially.
6. Do not borrow to invest.
7. Invest in the markets what you are likely to not need for the next 3 years.

Although it is extremely difficult to keep your head when everyone else around you is losing theirs in a sharp market downturn, we have enough evidence to prove that is where investors have made the most money.

A good strategy would be to pick 5-6 good stocks, market leaders across various industries or diversified mutual funds and invest a fixed amount of money every month in purchasing shares or units. In a market downtrend this means buying shares of great companies at reasonable prices. The advantage of picking solid companies being that their very size and stability gives you the conviction to hold patiently and even buy more during volatile times.

The big picture tells us that in spite of major upheavals and calamities that have occurred in the past, stock markets have always bounced back and rewarded investors who have held on through the pain. Therefore learn from history and grow rich.

A 100 % EQUITY PORTFOLIO FOR RETIREMENT

Conventional logic has it that as people approach retirement, their asset allocation should move away from equity and into debt. For instance most financial advisors recommend that a portfolio of 70 % equity and 30 % debt should be rebalanced towards 40 % equity and 60 % debt as retirement approaches.

Take the case of a retired person with Rs.3000000 in savings and having a monthly expenditure of Rs.20000. If he puts the entire corpus into debt, currently at 8 % interest for Government schemes such as PPF, NSC and Post office deposits, he stands to make 240000 per annum, just about enough to see him through. But with inflation at 8 %, the purchasing power of Rs.240000 at the end of 5 years becomes Rs.158000. And this is considering the Government published inflation figures which are much lower than the real figures, as any shopper will testify. At some point our retired common man will be forced to eat into his capital if he is to maintain his original standard of living. Except among the very rich, ones standard of living cannot be preserved or increased without exposure to stocks.

Naturally how much you can invest in stocks depends on how soon you need the money. But consider a hypothetical Rs.1000000 invested in 3 ways for 10 years.
100 % invested in bonds.
50 % in bonds and 50 % in stocks.
100 % invested in stocks.
Assume bonds give 8 % per annum and stocks give an appreciation of 14 % per annum
(Historically in India the Sensex has appreciated 18 % per annum compounded annually since inception). Dividends accruing from stocks are ignored.

In case 1 at the end of 10 years the investor gets back his Rs.1000000 plus Rs.1160000 as interest. A total of Rs.2160000. In case 2 he ends up with a portfolio of Rs.2930000 and in case 3 his portfolio of stocks is worth Rs.3700000.

Now consider a case where the same principal of Rs.1000000 is invested and the investor requires a regular annual withdrawal of Rs.80000 for his expenses. If he invests the entire amount in 8 % bonds , at the end of 10 years he will be left only with his capital in hand even considering no inflation. On the other hand if he invests in a 100 % stock portfolio he could, after withdrawing the same Rs.80000 every year be left with Rs.2160000.

Agreed that stocks do not move up 14 % every year, year after year. So assume that the day after he invests the markets fall by 30 % and thereafter increase by 14 % every year. Even in this scenario, a principal of Rs.1000000 with a withdrawal rate of Rs.80000 per annum ends up with Rs.1050000 at the end of 10 years. This excludes dividends, and if a 1.5 % compounded dividend yield is considered, the returns would go up to Rs.1210000. This still beats buying the 8 % bond.

Investments in high dividend yield stocks would provide still better returns. Instead of a 1.5 % dividend yield, if an investor sets up a portfolio of stocks yielding 3 % dividend yield and growing at 14 % p.a. ( e.g. Many PSU banks and Fertilizer stocks are available in this range) for 10 years, with 30 % of his capital wiped out initially and a withdrawal rate of Rs.80000 per annum, he ends up with Rs.1392000.

Therefore investors would do well to relook at blind asset allocation formulae and instead question their utility against a 100 % stock portfolio.

ICSA (INDIA) LTD - A POTENTIAL MULTIBAGGER

What would you say if I told you about a company which is operating in two of the fastest growing sectors in India viz. Power and Oil & Gas, has seen sales grow 200 times in 5 years and profits grow 1400 times in that period. To top it its products enjoy patent protection and competitors if any are only in the unorganized sector.

ICSA (India) Ltd is one such company, having several patented products which are unique in preventing losses due to thefts and corrosion and these products have the potential to provide it with continuing revenues and profits for many years.

ICSA has a unique device for power monitoring and theft detection which is installed at junction boxes. It continuously monitors energy and sends signals to the base station. It also detects tampering and sends alerts to the control room. In addition it has products for intelligent automatic meter reading through wire and wireless communication. This aids power companies in billing customers without visiting the site. Another product is for remote street light control system whereby street lights can be controlled from remote locations by programming them to be switched on and off as per seasonal changes. It has a product for agricultural load management meant for supplying power to farmers during specified times during non peak hours.

Also the company is also involved in executing contracts for erection of small power distribution systems in rural areas.

The company has a range of products in pipeline applications. This product when installed in any pipeline (natural gas, water, oil) continuously monitors the pipeline with the help of intelligent cathodic protection system and notifies any abnormalities in the pipeline to the control room. It has entered into a strategic tie up with Oil India Ltd. To market this product in India and abroad, which testifies to the technical soundness of the product.

Because of the original and path breaking nature of these products, the company holds immense potential for sales and profits growth. Particularly so because transmission and distribution losses in India are currently at Rs.50,000 crores. In Budget 2008-09, the finance minister has provided Rs.800 crores under the Accelerated Power Development and Reforms Project (APDRP) aimed at reducing these losses. A proposal has been put up to set up a national fund for transmission and distribution reforms. These clearly indicate that reforming the power sector remains a priority for the Government and it is committed to bring down these losses from 35 to 40 % of power generated currently to 15 % in the 11th 5 year plan. Also power generation capacity is sought to be increased from 16000 MW now to 36000 MW by 2011. This presents a huge opportunity for contractors and suppliers in this sector.

ICSA is well place to capitalize upon the opportunities thrown up by aggressive investments not only in this sector but also in the oil and gas sector where Reliance is all set to commence its natural gas supplies to power and fertilizer plants.

Sales have grown from Rs.3.42 crore in FY 03 to Rs. 669 crore in FY 08. Net Profit has grown from Rs.0.09 crore in FY 03 to Rs. 126.5 crore in FY 08, yielding an EPS of 32.4 with the current market price discounting earnings by only 13 times for a company doubling its profits every year. The management has indicated confidence in sustaining 100% growth for the next 3 years, which their track record so far bears out.

Smart investors have already taken stakes in the company. Government of Singapore already holds 5 % in it. Goldman Sachs is an investor and so is Reliance Energy through its subsidiary and Tata group also has a stake. Long term investors with a time horizon of 3 years should consider investing into this stock with expectations of a 5 fold return during the period.

GOLD AS AN INVESTMENT OPTION

In the uncertain world of financial markets, gold looks to be an interesting hedging option which an investor can use to protect his portfolio from the wild swings in stock and bond prices. Some arguments are given below to make an investor look at gold with a view to diversifying and allocating a part of his assets to the precious commodity.

The basic argument for a higher price of gold hinges around its property as a store of value and a hedge against inflation. Inflation is a fact of life today and is going to be more so as we get further into 2008. So what options do Governments across the world have to control inflation? Interest rates can only be raised to a certain extent for fear of triggering a downward recessionary spiral in the economy. A case in point is the Japanese economy since 1990 a prime example of deflationary problems. Demand side inflation triggered by rising consumption of almost all primary articles is causing shortages and imbalances in virtually every commodity. Governments are importing inflation by protecting the value of the dollar against their own currencies so as to make their exports competitive.

Historically gold has done exceptionally well in such uncertain times. From December 1969 to December 1980, gold went from a low of $ 35 per ounce to nearly $ 850 per ounce. A gain of 2300 % in 12 years! A similar trend has been visible since the bull market in gold started in December 2000, when it rose from $ 250 per ounce to $ 850 as of now.

Plotting the graph of gold prices against time from December 1969 to December 1978 on one hand and from December 2000 to April 2008 on the other, reveals almost identical trend lines, an appreciation of 300 %. At this very point, in December 1978, nearly 8 years after the start of the bull market, gold prices suddenly took off from $ 200 per ounce reaching an astounding $ 700 per ounce in the next 24 months.

Since the current trend lines are very similar to those in the 1970’ it may be inferred that gold is headed a lot higher in the near future. On extrapolating the present graph to the one in the 1970’ a price of $ 2500 to $ 3000 per ounce looks quite possible in a span of 2 to 3 years. But why should we believe that history will repeat itself? Because all major indicators point to this very scenario playing out. Consider:

Oil rose from $ 2/bbl to $ 50/bbl from 1969 to 1981
Oil has risen from $ 15/bbl to $ 125/bbl from 2000 to 2008

US $ fell 50 % against Yen (1969 to 1981)
US $ has fallen 40 % against Euro (2000 to 2008)

Inflation shot up.

Current account deficits grew many times.

There are more fundamental reasons for the price of gold to increase further.

Gold reserves are limited, only a small number of major gold finds by the mining industry are being discovered.
Gold extraction and refining is an energy intensive process and since energy prices are increasing, so are the costs of gold mining. This is bound to reflect in the price of gold.
With purchasing power increasing in the hands of a resurgent middle class in India and China, demand for jewelry is going up giving a boost to the demand for gold.
Middle Eastern and Asian central banks flush with foreign exchange reserves from a booming economy, are looking to diversify away from US treasury bills into gold.
Gold ETF’ are becoming increasingly popular because they provide an easy and convenient way of investing in gold. This has led to increased demand from ETF’.

The way to super profits from gold may not be a one sided path. For instance when gold went up from $ 35 per ounce in 1969 to $ 850 per ounce in 1980, it suffered a sharp correction from December 1974 to august 1976 when it dipped sharply from $ 195 per ounce to $ 104 per ounce, before eventually regaining its path to new highs. Therefore, any sudden jerks should not deter serious investors, but any sharp downward movements should be looked upon as opportunities to accumulate.

There are 3 ways in which an investor can buy gold:

Physical gold in form of bars and coins. This is the least efficient way because of higher costs and problems in storage.
Gold Exchange Traded Funds (ETF’). The most convenient and transparent way because ETF’ are listed on stock exchanges providing ease of entry and exit.
Stocks of gold mining companies and mutual funds investing in these. A high risk high return strategy, because if price of gold goes up these stocks go up far more in percentage terms and vice versa.

Even though gold prices are highly volatile, the real value of gold lies not as a speculative investment but in its ability to provide a safe and steady means of protecting wealth and to improve risk adjusted returns for an investor.