Have you met the dark side of P/E ratio yet?

Feb 9, 2012

In this issue:
» Are we on the brink of collapse of our money system?
» Gold could surprise most investors this year
» Nouriel Roubini turns bullish on stocks
» FM losing sleep over rising subsidy bill
» ...and more!

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How about a small query to begin with? What do you think the EPS growth of a firm will look like in sixth year if the same has grown by 20% each year for the first five years? Simple, isn't it? Applying basic common sense, one can easily conclude that growth in the sixth year too will be in the region of 20%. Well, if you answered along similar lines, let us tell you that your future as an equity analyst is indeed very bleak. This is because, what may sound common sensical in theory, could turn out to be absolutely absurd in real business world. In fact, factors like competition and law of diminishing returns will ensure that earnings growth revert to the mean. To put it another way, there is a greater chance that a firm that has enjoyed few years of strong earnings growth will either witness growth rate diminish or even turn negative.

However, this simple truth does not seem to have dawned upon Wall Street or the brokerage community. Most analysts in these places still attach great importance to the trend of earnings rather than try and work on the principles of mean reversion. Take the US stock markets for example. Quite a few experts are arguing that stocks seem to be a good deal currently because growing earnings are making price to earnings low by historical standards. Clearly, they totally seem to be missing a very important point. That the earnings in the price to earnings ratio are based on much higher net profit margins than average and hence, past evidence clearly suggest that margins as also earnings, have a strong chance of mean reverting. Therefore, stock prices will rise not because they are low in comparison to earnings. Instead, there is a greater chance that earnings will remain flat or even fall from the current levels.

So next time someone tells you that stock prices will rise because the market P/E is low as per historical standards, do not forget to see whether the earnings are normal as compared to the past trend or they are much higher and thus, ripe for a reversal. This alone can save you from a lot of wealth destruction we believe.

Do you think it is a good idea to use average earnings for calculating P/E ratio or simply the earnings of the past twelve months? Let us know your comments or post them on our Facebook page / Google+ page.

 Chart of the day
Today's chart of the day highlights how the skyscraper of India's GDP growth is likely to lose many of its floors in FY12. As per estimates by a Government firm, for the first time in three years, India's GDP could skid below the 7% growth mark in FY12. Interestingly, not long back, a lot of experts were talking about how India has reached a permanent new zone of 8%-9% growth and how this could usher in a new era of prosperity. It turns out, the economy was not resilient enough and much of the extra GDP growth was based more on liquidity than fundamentals. Clearly, the Government does have its task cut out if we have to go back to the era of 7%+ growth.

Source: Economictimes.com

An eminent columnist and writer by the name of Philip Coggan has shared some brilliant perspectives in his new book titled 'Paper Promises: Debt, Money, and the New World Order'. In his opinion, the current international monetary system is on the brink of collapse.

He puts forth an interesting thesis that economic history is a battle between debtors and creditors. Now, before delving further into this, let's understand the two basic functions of money. One, it is a means of exchange. Two, it is a store of value. And it is this second function over which the battle happens. On one hand, debtors want to expand the supply of money to give stimulus to economic activity. But this reduces the value of money. On the other hand, creditors want to guard the value of savings and thus try to restrict the supply of money. And it is this battle between the two that causes different monetary systems to rise and eventually collapse.

The problems of our times become clear in the light of this perspective. On one extreme, there is the US- the biggest debtor. It takes little to guess that China is at the other end. And the duel between these two economies will determine how the future monetary system would be. Does this indicate that the Chinese renminbi could replace the US dollar as the world's reserve currency? Well, this may not happen anytime soon. However, there are huge risks to the stability of the US dollar if it doesn't deal effectively with its debt problem. China, on the other hand, ranks poorly as far as transparency and trust in its legal system is concerned. So despite its growing might, it is still a long way before its currency can command global trust and acceptance.

With stocks zooming currently, have investors forgotten about the all important asset class - gold? John Embry, the Chief Investment Strategist at a US$ 10 bn fund is very bullish on the commodity. He even believes that the previous gold bull run of 36% will be obliterated this year. According to him, the global macro picture is just asking for you to go out and buy gold. The major economies of the world Japan, Europe and the US are all in a self created debt trap. There is no solution to this problem except to create more paper money. By doing so, these countries will inadvertently debase the value of their currencies to next to nothing. This is the best possible environment for assets like gold and silver. They are anchors for investors to hold onto in stormy times. We agree with Embry when he says that if you don't own gold and silver in this environment you are making a terrible mistake.

It is not just in fables that you come across naked emperors living under the myth of being well clothed. Looking around, you find plenty of officers being blissfully unaware of the messy state of affairs in their domain. It would not be wrong to reckon some of India's political bigwigs amongst them. Year after year, the Union Budget has been a medium for the incumbent government to secure votes through populist measures. Thanks to this, even the limited period subsidies never got divorced from fiscal planning.

Agriculture, export oriented and labour intensive sectors have been the maximum beneficiaries. None of their performances, have however, reflected the same. Fuel subsidies have not just been a burden on the government. Oil marketing companies have also bled right through the period. However, the government rarely showed any remorse for the deteriorating health of state finances. Until recently passing bills such as the one on Food Security were its top priority. It is only after the Reserve Bank of India (RBI) chose to make some blunt observations that the reality has drawn on policymakers. The Finance Minister has recently been quoted 'losing sleep' over the rising subsidy bill. This may well be a warning signal for the upcoming Budget. However, we believe that it will take more than one Budget to rectify the frivolous fiscal planning done all these years.

The main reason for working for any individual is the salary or the monetary reward that they get in a timely manner. But what happens when this benefit is not paid out to them? And the reason for this is to force them to perform better? Well, that is exactly what is happening to not 1 but 12,000 employees of about 12 loss making Public Sector Undertakings (PSUs). These employees are usually paid their salaries with a 6 month lag. Why? Because the government starts processing the proposal to pay out the salary 3 months after the last salary was paid. And then this proposal goes to the cabinet for approval. The entire process takes nearly six months. As these PSUs are quite small as compared to the likes of Air India (another loss making PSU), the employees do not have the option to go on a strike.

Apparently, the government feels this is an ideal way to put pressure on the employees to perform better and work out a revival plan for the PSU. We have heard of the carrot-stick approach being used by employers but this is one of the most ridiculous ways of going about things. If non performance has to be punished then even politicians should give up on their salaries. Why just torture the PSU employees in this manner? Such steps are appalling!

Of all the bearish economists in the world, Nouriel Roubini figures right there among the top. And he is called Dr. Doom not without reason. After all, he had been sounding alarm bells on the global economy much before the global financial crisis erupted. So when a bear begins to take a bullish view on the markets, people sit straight up and take notice. Roubini opines that recent actions by the Federal Reserve and European Central Bank will continue to make equities an attractive investment during the next few months.

But this rally may not last long. More likely it will fizzle in the second half of 2012. Interestingly, because of his bullish view, contrarian investors have taken this as a signal to sell. As far as US stocks are concerned, from a longer term perspective, we believe they are not bound to go anywhere much. Especially since growth has stagnated and the economy is saddled with so much debt that it is unable to bring down.

Meanwhile, after remaining in the negative zone right through the morning, indices in the Indian stock markets moved towards the positive territory with the Sensex trading nearly flat at the time of writing. Heavyweights like HDFC Bank and Tata Motors were the key stocks helping the index push forward. Other Asian indices however closed mixed today. Europe on the other hand has opened on a positive note.

 Today's Investing Mantra
"The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage." - Charlie Munger

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2 Responses to "Have you met the dark side of P/E ratio yet?"


Feb 9, 2012

It is always better to normalize the earnings before calculating the PE ratio. It may happen that the earning may due to some one time event or some legistilative changes in accounting reasons.

So normal earning should be taken to calculate the PE ratio.


Ramesh Wadhwa

Feb 9, 2012

To the best of my understanding devloped countries had been doing 2 things 1,selling their producs at exorbitant price to the global market and maintaing a very high standard of living Take the case of Japan small country but global presnce now China a very big country and global market ,giving tuff competition to all the countires in every field. 2nd thing which so called advance countires did they have been printing currecy and parking wherever possible ,sooner or later there will be no takers for their currency. This will lead serious global crises.What will happen to share market if these countires print currrency and buy shares in countires like India ?
Time is going to teach us new lessons.For today this much only.

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