Are Indian stocks as risky as their US counterparts?

Feb 21, 2013

In this issue:
» What leads to the poverty or the middle income trap?
» Taxing the super rich in India is not the answer
» Is the Euro crisis on its last legs?
» The next crisis in China could happen here
» ...and more!

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When it comes to valuation ratios, people cannot seem to think beyond the few obvious ones. They are most likely to talk about the P/E ratio, the P/BV ratio or the EV/EBITDA ratio at the most. However, there is a ratio out there which despite being one of the most effective ones is one of the most underused as per us. And this ratio answers to the name of P/S or the price to sales ratio of a stock. If you think carefully, in order to be successful at investing, one needs to value stocks based on causes and not results. And parameters like earnings and EBITDA are the results and not the causes. The cause is the business condition which then allows for sales. Earnings and EBITDA are what flows from sales and can't really stand on their own. Besides, sales are far more stable than earnings and thus, more reliable as per us.

Of course, even investing legends like Warren Buffett have not been heard tom-tomming the virtues of the price to sales ratio. And thus, its usefulness is lost on us. However, nothing could be further from the truth. Warren Buffett does in fact use the price to sales ratio. Only that he uses a much more macro version of the same. In fact, he calls this ratio probably the best single measure of where valuations stand at any given moment. The ratio is nothing but the total market cap of all the companies listed in an economy to that economy's GNP. As per Buffett, if this ratio is around the 70%-80% mark then buying stocks is likely to prove to be a profitable activity over the long term. But as it goes higher than 100%, the risk reward ratio of investing in stocks tilts more towards the risk side of things.

A write up on a financial portal talks about how in the US, this ratio crossed the 100% level recently and thus, put out a warning signal. What about India? Is the ratio high for India too? With India's GDP likely to come in just short of the Rs 100 trillion mark in FY13 and with its total BSE market cap currently at around Rs 70 trillion, the ratio has a comfortable value of 0.7x. This means that buying Indian equities at current levels is likely to work out well over the long term. Thus, while a correction threat looms over US equities, an Indian investor could do well to start building exposure to equities with a long term horizon in mind.

Do you think the market cap to GNP ratio is a good way of knowing when to start building positions in equities from a long term perspective? Share your views comments or post them on our Facebook page / Google+ page

 Chart of the day
Weak macro environment is taking its toll not just on economic growth but is also affecting labour productivity. As today's chart highlights, all the BRIC nations reported fall in productivity (measured by GDP per employed person) during the 2008-12 period as compared to the period of 2003-07. Just as in the case of GDP growth, India and China performed better than their other BRIC counterparts but their GDP per person employed falls well short of absolute levels in the US.

Data source: The Economist

Copycats more often than not do better than the innovators. At least when it comes to making quick bucks. But profits wither once the copycat products lose the novelty. Innovators on the other hand continue to whip the cream of the profits with newer inventions. This is not a takeaway from the rivalry between Apple and its competitors. On the contrary, this logic holds true even in case of rivalry amongst developed and developing nations.

Interestingly, even developing economies fall into the same 'traps' that copycat companies do. An article in Economist reveals that this could be either 'poverty trap' or 'middle income trap'. Poor countries follow the path of industrialization to get rich. But the convergence of economic virtues is not sustainable. For while the rich countries boast of the best technologies; the poor countries offer cheap manpower. As the economic gap narrows, so does the competitive edge of the weaker nations. And it is here that most developing countries get into a poverty trap. Even ones that do fairly well for a long time get into a middle income trap. China and India are classic examples of these. So unless and until the copycats strive to reckon themselves amongst innovators, their economic fortunes are stunted.

Is the Euro crisis really over? Well, the answer is not that easy. An immediate crisis may be averted, but the currency may not survive. And as long as the Euro remains unstable, the possibility of stress remains. One big positive however is the decline in interest-rate spreads between bonds issued by periphery countries and German bunds. The reason for the same is Germany's insistence to keep the union intact, the will of vulnerable countries to stick to creditor demands and various initiatives by the European Central Bank. But the euro-zone is like a bad marriage, with high stakes attached. The relationship is fragile and the cost of break-up is high. But how can this marriage turn into a good one? These countries need to return to economic health as soon as possible and introduce reforms that would make another disaster improbable. It's a tall task, but it's the only way to repair the damaged relationship.

With its fiscal deficit bloating, government is looking at various innovative ways to plug the same. One of them is to have a dual taxation structure for the two sections of the society. The two sections being - rich and poor. There has been a talk for quite some time in India that the super rich should pay more taxes. But does taxing the rich at higher rate really make sense? For that first we need to understand that different sources of income are taxed at different rates. And super rich and an average individual both have different sources of income. The modes of income for rich include capital gains from selling equity shares, mutual funds and property. While middle class population does have exposure to these asset classes, it is comparatively lower. They predominantly invest in fixed deposits and their primary source of income is salary. Now, let us have a look at how these incomes are taxed. Salary at the highest bracket is taxed at 30%. Income from FDs is clubbed to your marginal tax rate. Now compare this with nil long term capital gains tax rate (LTCG) on selling shares. Or 20% LTCG with indexation benefit that one pays on sale of property for that matter.

The point worth noting here is that the income sources of middle class individuals are taxed at higher rates than compared to rich class. This is income inequity in some sense. In order to move towards a more equitable income distribution model, rationalization of the existing taxation structure is necessary. In this way, government can extract more out of the rich without having the need for dual structure of taxation.

The slowdown in China hurt its banks. And that was natural because a large part of the credit given by the banks became more risky as the slowdown bit into the client industries. But the country did manage to weather the storm to a large extent. However it is still looking at a credit crisis. This time round it will not be the banks that would be hurt. This time the crisis in China could be more at the grassroots level or local.

The thing is that a lot of credit that floats around in China is through local lending. As per Business Standard only 37% of the total credit in 2012 was bank credit. The rest was all local. Companies, local people and even state governments rely more on these local lenders. Naturally as the size of the lender decreases, the risks surrounding the amount lent or that related to the borrower, also go up. As a result the risks in the system just go up as we move down the levels in the credit system. So if there is a crisis or default, the entire financial system would come crumbling down. What China needs to do is to increase financial inclusion by increasing the penetration of banking. Incidentally this is something that even India is working on. Hopefully the two countries take cues from each other's mistakes and restructure their systems soon.

In India, politicians and the government are always criticized for saying one thing and doing something else. But this now seems to be the case with the world's central bankers and governments as well. The likelihood of currency wars is a case in point. The Group of 20 (G20) nations in a communique have stated that they intend to move towards market determined exchange rates, which reflects underlying fundamentals. They will also look to avoid any misalignments in this regard. But according to the Wall Street Journal what this essentially means is that countries will continue to devalue their currencies as long as they do not explicitly state so.

All of this highlights the fact the most of these nations have become too used to easy and cheap money. As long as stock markets and other asset prices continue to rise, there is a general sense of well being. Once in a while, someone will point out the dangers of an asset bubble. But hardly anyone will be paying close attention. The US fed especially has been criticized for its stance of using 'domestic policy tools to advance domestic objectives.' This has only encouraged other countries to do the same, thereby raising the prospect of a currency war. Indeed, one really wonders whether any of them will realise the folly of their actions anytime soon.

Meanwhile, indices in the Indian equity markets are witnessing a strong bout of profit booking with the Sensex down by around 258 points at the time of writing. Stocks from metal and realty sectors were seen witnessing the maximum pressure. While all major Asian indices closed in the red, Europe is trading mixed currently

 Today's investing mantra
"In the financial markets, there is rarely anything new under the sun, but you can never say you've seen it all, and what you thought you would never see can clobber you." - Seth Klarman

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1 Responses to "Are Indian stocks as risky as their US counterparts?"

K C Shah

Feb 21, 2013

Political Leaders are Rich People Just look at the wealth Figure grow after 5 years as MP They should survey super Rich income source and if they find as you have mentioned of their income largely from LTCG and Dividend then Tax should be charged as per Original DTC Draft without any deduction Mr T K Arun has written IN ET dt 21Feb 2013 about charging Dividend and STCG and LTCG as per their Income Slab

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