Ignore this valuation parameter at your own risk

Feb 16, 2012

In this issue:
» Big US banks must be broken up
» Indian bank NPAs are ringing an alarm
» Finally, some good news for the telecom sector
» Investors are fleeing mutual funds
» ...and more!

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 Chart of the day
What is the single most important parameter to consider before investing in a company? Without any doubt, it is the quality of management of the company. It is the people running the business who determine the fortune of the company. It comes as no surprise that legendary investor Warren Buffett lays great emphasis on the quality of leadership and management of a company before making any investments. But what qualities should one look for while evaluating the quality of management. A quote by the Oracle of Omaha comes in handy here: "In evaluating people, you look for three qualities: integrity, intelligence, and energy. And if you don't have the first, the other two will kill you." We believe that herein lay one of the most important lessons for value investors. A company that is not high on integrity is less likely to reward shareholders.

We came across an interesting article in The Economist. Taking the specific case of South Korea, it explains how corporate governance affects stock market valuations. Today's chart of the day shows 2012 forecasted price-to-earnings (P/E) ratio of benchmark stock market indices of some of the major Asian economies. It is apparent that KOSPI, the South Korean index, along with the Chinese index, has one of the lowest P/E ratios in the region.

Data source: The Economist

What could be the reason for such a low P/E of South Korea? Of course, it is partly attributable to the export-oriented national economic model, with a major exposure to cyclical industries. Also, South Korean companies typically have a lot of debt. But this is just one part of the story.

As it turns out, the main reason for low stock market valuations is poor corporate governance. The South Korean economy is dominated by chaebols, which are defined as large, conglomerate family-controlled firms that have strong ties with government agencies. The business practices of these firms are extremely shady and often to the detriment of small investors. These firms are notorious for engaging in immoral plots to pass over control to their own family members. Avoiding taxes, misusing company assets for the benefit of family members, awarding contracts to firms owned by family members are yet other features of these firms. You would be surprised to know that a company like Hyundai Motors was fined for giving US$ 1.4 bn of business to a company owned by the son of Hyundai's chairman, without any tendering.

So it is quite clear how vital a role qualitative factors like corporate governance play in stock valuations. In our own country, we have seen controversial stocks being severely penalised by investors. On the other hand, companies with high management integrity are often among the favourites. So the lesson is simple. Buy stocks with great fundamentals, but without comprising on management integrity.

Do you think corporate governance is an important factor in stock valuation? Share your comments with us or post your views on our Facebook page / Google+ page.

Thank God, the US Fed still has some sensible people in its ranks. Like this gentleman called Richard Fisher, a President with one of the branches of US Fed. Mr Fisher has argued, and rightly so, that downsizing the US banks over time into institutions that can be properly managed and regulated is the way to go. You see, the US takes immense pride in its capitalistic economic structure. But its banking system in recent times has not been subject to one its most important laws aka creative destruction. When the banks were in a hole bigger than anyone can imagine, the Government promptly stepped in. It prevented banks from collapsing under the pretext that they were too large and hence, could pose threat to the entire system if allowed to go bankrupt. In the end, it was the US taxpayer who had to pay a heavy price for bailing out the troubled banks. Thus, in order to bring a halt to this rather imbecile practice, it is imperative that banks be broken up so that only a handful of them do not bring the entire economy to its knees. Whether this will done is the million dollar question indeed?

Banking may be construed as a simple 3-6-3 job. That is the bankers give 3% interest on depositors' accounts, lend the depositors money at 6% interest and then are off to playing golf at 3 pm. But believe us the job is far from what it sounds. For inefficient lending and high operating costs can do a great deal of damage to a bank's operations. More so, to its net worth and shareholder returns. High costs and high NPAs can literally shave off equity from the banks books. That not just paralyses its ability to borrow but also to lend (due to low capital adequacy). Indian banks who managed to tide over the 2008 crisis thanks to prudent regulations are now facing some flak. Aggressive lending on some counters and restructuring of loans are now haunting their asset quality. The share of gross non-performing assets (NPAs) in the loan exposure of Indian banks has already double to near 8% in the latest fiscal. Rating agencies see the number moving up to 10% by March 2014. Meanwhile, banks are facing the pressure of provisions on their profits. All in all, the near term is unlikely to be favourable for banks that have not been rigid on quality assessment.

After a spate of bad news, the telecom sector has finally got a reason to cheer. The government has finally approved mergers between telecom companies with a combined market share of 35%. This is expected to finally lead to the much needed consolidation in the industry. The telecom sector has been grappling with heated competition for quite some time now. And consolidation is the need of the hour. The previous policy had also approved mergers between telecom companies but the rules were so rigid that nothing actually took place. The New Telecom Policy (NTP) is all set to change that. The NTP has also approved spectrum sharing, though this is restricted to the 2G spectrum as of now. The best news for the incumbent operators is that their licenses which come up for renewal in 2014 would be automatically renewed for a period of 10 years. However, the pricing for this is yet to be decided.

2011 was a dull year for the equity markets. As a result, many retail investors started redeeming their mutual fund (MF) investments. However, what is surprising is that the trend has continued in 2012 as well even when the markets have registered a steep rally in a matter of just few months. As per Securities and Exchange Board of India (SEBI) approximately 1 lakh accounts were closed in January alone. Attractive opportunities in the debt market (yield of 10-12%) have resulted in mass exodus of risk-averse investors. While most of the closures have been for sectoral/thematic funds, the most worrying factor is the discontinuance of Systematic Investment Plans (SIP). SIPs being long term products, investors have to be more patient with them. However, the current redemption trend suggests that investors are wary about the current rally in stock markets and are consequently trading for assured returns in debt instruments.

Chinese investors by the end of last year had unloaded US$ 32 bn worth of US Treasuries. Do they know something about the US that we don't? Not really. The move was prompted by the certainty that the US Fed will certainly go for another round of quantitative easing (QE3), though the Fed is yet to make any decision on this front. Further, the Fed has also made no secret that it would target mortgage securities to help drive rates lower and help the housing market. That is why the Chinese have been lapping up Agency bonds, which also include mortgage securities. Indeed, the strong buying in Agency bonds was five times the year's average. That, combined with purchases by US domestic banks, probably explains why the mortgage backed securities markets have been seeing price rises recently. So while any QE3 announcement will help Chinese investors record near term profits, for the US this move will not result in any meaningful gain as previous quantitative easing measures have proven.

In the meanwhile, the Indian stock markets slipped further into the red after opening the day on a weak note. At the time of writing, the BSE Sensex was down by 100 points (0.55%). Stocks in the metal and energy space were witnessing maximum losses. All stock markets in Asia closed the day on a negative note with Taiwan and Korea booking maximum losses.

 Today's Investing Mantra
"If calculus or algebra were required to be a great investor, I'd have to go back to delivering newspapers." - Warren Buffett

Click here to read our series on Lessons from Warren Buffett

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1 Responses to "Ignore this valuation parameter at your own risk"

Shashikant Nishant Sharma

Feb 17, 2012

There can be many parameter to decide the best investment opportunity but so far as I think investing in service industries give you more dividend in short term than in manufacturing sector. The service industry don't have to produce goods but make his reach to more customers and improving the quality of services. There is very low risk of making losses as investment has been made and only revenue expenditure is needed to keep the service delivery and expansion moving.
Shashikant Nishant Sharma
Urban Planner and Consultant
New Delhi

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