Can this crush the principles of 'value investing'?

Apr 26, 2013

In this issue:
» Is the US heading towards capital controls?
» Commercial banks may get a pie of government cash
» A strong case for rating upgrade for India?
» Alarming levels of unemployment across the world
» ...and more!

What are the thoughts that come to your mind when you think of value investing? Is it about buying cheap stocks? Is it buying stocks and holding them for a very long term? Is it to do with buying companies with fantastic fundamentals that are valued relatively cheap to their peers? Or is it about following the portfolios of legendary value investors and creating a similar one for yourself? Well, there is nothing wrong with either of these approaches. However, it could be dangerous to assume that using any one of these approaches without paying heed to the others could be rewarding.

We recently came across an article in Business Insider that had an interesting take on Value Investing. According to the author, technology companies could ring the death knell for value investing principles. Well, we would beg to differ. But before that allow us to explain the author's logic.

The 2007 valuations of technology and mobile communication giants Research in Motion (RIM) and Apple Inc are the basis of the Business Insider article. RIM was then trading at price to earnings multiple of 55 times. Apple was then just a computer company that had reinvented itself as an MP3 player company. Within two years, fundamentals of the companies changed dramatically. By December 2009, market share for Apple's iPhone as a percentage of US smart phone industry was 25%. Meanwhile, RIM's had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled RIM's PE multiple to around 17 times earnings. This according to the author was a precarious 'value trap' for value investors. Those who invested in RIM assuming that the valuations would pick up over time failed miserably. By 2011 RIM was trading at a PE multiple of 3.5 times earnings and its sales growth had stagnated. In 2012, the Blackberry maker posted a loss of US$ 847 m!

As is apparent, the author has assumed that value investing is about buying good companies cheap. However, not judging whether the good company will remain good for a very long time is the cardinal mistake here. Value investors have to not just evaluate past fundamentals. But the business model of the company has to be robust enough to face future headwinds as well. If this means letting go of few opportunities, one cannot be wiser. The business models of technology product companies that have very little long term visibility are prone to sustainability risk. That itself should be a red signal to value investors.

As Buffett himself has put it, he would rather err on the side of caution. In a letter to shareholders of Berkshire Hathaway in 1961 Buffett wrote "I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a "New Era" philosophy where trees really do grow to the sky."Hence, neither technology nor any other sun shine sector can dilute the principles of value investing. It is about how the investors put them into practice. Any doubts why not every value investor is Warren Buffett?

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 Chart of the day
With the US and China together controlling 33% of the global economy, investors cannot help but keep a close watch on their interdependence. For a de-growth in either can meaningfully impact the other at least in terms of value of overseas assets. A slowdown in the US for example does not leave China unhurt. This is because the oriental nation is one of the largest holders of US Treasuries. However, as against common perception, China will not be only victim of an American slowdown. As the chart shows, around 12% of the foreign owned assets in the US are held by the Chinese. Thus a major slowdown in the US is expected to have ripple effects across the world, rather than only in China.

Source: Pragmatic Capitalism

Paul Krugman is at it again. The Nobel Laureate has authored a lengthy discourse in a leading international daily supporting capital controls. And how does he support his stand? Well, he is of the view that the world was a lot safer place when capital controls were not in place. In fact, as per him free movement of capital across borders is only a recent phenomenon. And the result of this experiment has not been that great. He then pulls out a laundry list of countries affected by capital controls and goes on to conclude that these countries came face to face with crisis only because they gave unrestricted access to capital flows. And since such crises were few and far between when there were limits to cross border capital flows, we should move back to some sort of capital controls.

We believe that Mr Krugman seems to be confusing effect with cause. Swift capital outflows do not cause the crisis but is just a reaction to something according to us. The crises are caused by fiscal profligacy and policy of keeping interest rates way below real inflation levels. This in turn leads to asset bubbles, the deflation of which causes capital to move out of countries. Thus, before we address the issue of capital controls, we seriously need to look into interest rate policies and spending habits of Governments.

The Reserve Bank of India (RBI) has been cutting down the rates in recent times. It started with cutting the cash reserve ratio (CRR) rates and finally moved on to bring the benchmark rates down as well. At the same time the government has pumped in roughly Rs 1.32 trillion into the banking system. But the banks have still not cut their lending rates by a wide margin. The reason for this reluctance to cut rates is that despite the money floating around, banks are still facing a liquidity crunch. So much so that banks have actually borrowed Rs 1.6 trillion from the RBI to meet their daily cash needs. This borrowing is way above the RBI's comfort limit of Rs 600 bn. So it is little wonder that banks are not willing to cut down their lending rates.

To resolve this problem, the government plans to park its cash box with the commercial banks. Valued at almost Rs 1 trillion, this cash is currently held with the RBI. The government plans to auction these cash deposits soon. The RBI would decide the exact amount of cash that would be auctioned. Hopefully once this happens, the liquidity situation of the banks would be eased. We hope that the RBI sets adequate measures to ensure that this money does not find its way to high risk assets. For literally our country's savings are at stake.

The Japanese central bank recently unleashed a massive quantitative easing program. In simple parlance, money printing worth US$ 1.4 trillion! The Japanese Prime Minister believes money printing will end more than a decade of deflation, that is, falling prices. The money pumped will lead to inflation and this in turn would revive investments and spending in the economy. This is his plan to get the Japanese economy going.

This may appeal to some in theory. But we have always been extremely skeptical of such monetary policies. Such financial steroids have adverse long side-effects. The failure of the QE program in the US should have been a lesson.

But it seems such policies do benefit someone. No, it's not the economy. Not consumers. Not savers. Any guesses? The answer is investment banks! An article in Bloomberg notes that investment banks have been the biggest beneficiaries of the stimulus program. With stock and bond markets soaring, these banks are buzzing with activity.

This is not uncommon. The banks that were responsible for creating the 2008 financial crisis have been the biggest beneficiaries of all the bailout and stimulus programs that the US Fed initiated. And now it is Bank of Japan that seems to be following similar footsteps. Whose interests are policymakers really trying to protect? It doesn't seem too difficult a question.

The threat of a ratings downgrade has been hanging like a Damocles sword over the Indian economy. There were many reasons that led rating agencies such as S&P's and Fitch to consider a possible downgrade. Policy paralysis, corruption, lower economic growth were some of them. The Indian government since then has swung into action and announced a slew of reforms. Is this likely to change the perception of rating agencies As per an article on Firstpost, Economic Affairs Secretary Arvind Mayaram certainly thinks so. In fact, he opines global agencies will upgrade the country's sovereign rating. This is on the back of bold and tough decisions taken by government to contain fiscal deficit and promote growth. So far, among other things, the government has undertaken partial decontrol of diesel. It has also capped subsidised LPG cylinders, in a bid to check the rising subsidy bill. Further, FDI norms have been liberalised for various sectors. This includes multi-brand retail. But effective implementation will be the key. And this has not been particularly easy with many hurdles put forth by Opposition parties. Hence, whether India's rating will ultimately be upgraded is something that only time will tell.

Unemployment is a big problem for the world economy right now. Slowdown in the western world has rendered many jobless. Apart from this, lack of requisite skills and ever increasing population has compounded the unemployment problem in emerging markets. And in the recent times, this problem has gone from bad to worse. In fact, as per an article in Economist, the number of unemployed people in the world has reached a figure which is approximately equal to the US population!

So, is there a way to eradicate this problem? While the obvious solution would be to increase the growth rates it is hardly having any effect. For instance, it may be noted that even when growth rates were strong in some countries like Spain and Egypt, the unemployment rate was high. This highlights the problem with respect to inadequate skill sets and poor education systems. In short, the labor was unemployed as it was not fit for the job for the lack of necessary skill sets or requisite education. As such, it is necessary to re-vamp the education system and hone their skill sets. Also, reducing obstacles in establishing new start ups can help. For instance, getting licence for starting a new business can be made easier. This will enable the organisation to start its operations quickly and absorb the labor. If not, the government responsibility to provide temporary relief to these classes of people will increase especially in the developed world. And this will hurt their pockets deeply.

Profit booking in commodity and software heavyweights have kept the benchmark indices below the dotted line today. Backed by weak cues across Asian markets, the key indices in Indian equity markets failed to make any headway into the positive territory. The BSE Sensex was trading lower by around 152 points at the time of writing. Other major Asian markets closed mixed while markets in Europe opened in the red.

 Today's investing mantra
"Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: 'How many legs does a dog have if you call his tail a leg?' The answer: 'Four, because calling a tail a leg does not make it a leg'." - Warren Buffett

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2 Responses to "Can this crush the principles of 'value investing'?"


Apr 27, 2013

very interesting



Apr 26, 2013

Excellent sum up ! Though this 5 minute read will make me churn it for 50 minutes atleast !

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