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.