Ring in the bad news - The 5 Minute WrapUp by Equitymaster
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Ring in the bad news

Jun 5, 2015

In this issue:
» No respite on stalled projects
» Why the rut in power sector runs deep...
» Are Mutual Funds supposed to behave like Venture capital funds?
» ...and more!

As proponents of value investing, the only thing that we constantly aspire to achieve at Equitymaster is reasonable accuracy in assumptions. The temptation to over pay for a stock based on market sentiments is not the demon for us. It is the inherent tendency to draw trends based on long term history that at times needs to be challenged.

Now since we recommend stocks based on the judgment of intrinsic value, we need to ensure that our assumptions for the business are not way off the mark. And it is not enough to understand the sector or speak to the management for this. We need to be sure that we can read between the lines when it comes to outlook and visions. For it is only here that we can spot the valuation gaps. As one of the best books on value investing authored by Thomas Phelps says, "Investors don't' pay different prices for the same thing. When they seem to be doing so they are paying like prices for different anticipations." So essentially every value investing tactic can go wrong if the assumption and anticipations are misplaced.

This is precisely the reason you will not find us recommending buys and sells every time a stock is in the limelight for good reason or bad. It is important to gauge whether our greed or fear for the stock has unknown biases. Expansions, acquisitions and buy backs do not always make the case for a good buy recommendation. Similarly, poor earnings, impeding regulatory mandates and macroeconomic hurdles cannot be the best reasons to sell a stock. And having a contrarian view to the markets at every instance can very well land us into value traps. Thus what we prefer to do instead is to evaluate every good and bad news from the perspective of whether it would make permanent change in the fundamentals of the company.

For instance, take the case of realty stocks that saw a massive correction in the past few days. This was in response to the RBI's stance on interest rates. The fact that most of the business are leveraged and create little wealth for investors in the long term is our premise for opinion on the stocks. And whether or not the RBI will make the borrowing cheaper by 0.25% or not does not warrant a change in our assumptions. Needless to say the sharp correction in the stocks does not make us salivate as value investors.

Similar is the case with fertilizer and FMCG stocks that are beginning to feel the jitters of below average monsoon predictions. Irrespective of the accuracy of the Met department's predictions, we do not intend to change the assumptions for the stocks based on a single monsoon.

Stocks have also been taken to the cleaners in recent days for poor earnings performance, regulatory overhang and anticipated slump in earnings. While their valuations are clouded by a temporary crisis of sorts, we would rather want to vet their prospects under the permanent change criteria.

Thus it is important to not react instinctively to a bad news. But it is important to ring in the bad news with the earnestness to evaluate whether it warrants any permanent change in your assumptions. And if your assumptions seem to be on the right track, every bad news could be an opportunity in value investing.

How do you react to bad news about stocks that you own or want to invest in? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Speaking of bad news there is plenty that continues to pour in on the economic front. One of the major reasons why India has not been able to achieve the growth potential is the delay in setting up of infrastructure. Stalled and abandoned projects that were backed by huge leverage literally brought India's PSU banks that were funding these to their knees. With Modi Government coming to power, all that was expected to change. A year has passed since the change of the regime at the centre. So are we doing any better now? First look at the data provided by Centre for Monitoring Indian Economy (CMIE) does not suggest so. As you can make out from the chart, the number of stalled and abandoned projects in 2014-15 have gone up. In fact, the number of abandoned and stalled projects has gone up by 46% and 6% year on year (YoY) respectively in this period which was majorly ruled by the BJP led Government. While one can blame the business owners for the rise in abandoned projects, the main reasons for stalled projects have been lack of clearances, financing issues and unfavorable market conditions.

However, as an article in Economic Times suggests, the comparison may not be fair. This is because the new Government came into power only in the end of the May 2014. Further, we believe, one cannot draw direct conclusions ignoring the legacy issues and mess that the previous government has left behind. On the positive side, the number of revived projects under the reign of new government has gone up by 35%. While drawing conclusions at this stage may be premature, what is obvious is that the expectations of the markets were indeed unreasonable, as further under scored by poor earnings season and correction in the markets.

A case of unreasonable expectations?

If there is one sector that is urgently and critically in need of reforms, it is power. On the power generation front, India has done quite well. Besides increasing the power generation capacity, the assurance of coal linkages has ensured that plants have not remained idle. The problem then is on the distribution side. And here one has to highlight the sorry state of state electricity boards (SEBs) . The latter come under the purview of state governments as a result of which SEBs have been the victims of populism. Subsidised power is distributed across varied interest groups rather than to those who actually need it. The other problem that SEBs face is power theft. All of this has then caused disarray in the finances of SEBs and piled on the debt on their books. Such lack of proper policies with respect to pricing means that SEBs do not have the means to purchase power from the power producers. This has then led to the plant load factor (PLF) or the utilisation of power producers to come down.

As reported in an article in the Mint, the PLF has dropped to a 15 year low of 65.1%. So it is quite critical that the problems on the distribution side are addressed. One such radical reform that makes sense to us is to open up distribution to the private sector. By allowing power to be priced as per market forces, the fortunes of the distribution side of the business will considerably ramp up. The other option could be a bailout of SEBs as has been done in the past, but we believe that bailouts only postpone the problem rather than solve it. Ultimately, power is critical for the growth of infrastructure and manufacturing industries and the sooner the government does something constructive about it, the better the Indian economy will be.

Up till now, we used to think that venture capital and mutual funds are two entirely different business models. And this because of the sharp difference in the ways in which they go about their investing. Venture capital is all about taking big, bold bets on business models that are still at a nascent stage and can go either ways in terms of their success. Therefore, the idea is to look for that one investment out of ten where one hits pay dirt, the 100-200 baggers if you will. Mutual funds on the other hand is all about investing in proven business models and compounding one's wealth at an acceptable rate.

An article in a leading daily however has made us rethink whether we have got the modus operandi of the two right. It has highlighted how in a bid to earn extra returns, mutual funds are placing bigger bets on privately held companies. This, they believe is likely to give them a head start in finding the next IPO star so that huge gains can be pocketed. Mind you, not all such investments are going to be successful. Well, we are not sure whether this a risk that's worth taking. The fund managers right now seem to be blinded by the upside on offer in such cases. But when the tide turns, there could be huge losses for the taking. Especially for companies which are commanding astronomical valuations just for the novelty factor while having no profitability to speak of. We hope better sense prevails.

After opening flat, the Indian stock markets climbed up sharply by mid-morning. At the time of writing, the BSE Sensex was trading higher by about 160 points (up 0.6%). All sectoral indices except banking were trading in the green with metal and FMCG stocks being the top gainers. The midcap and smallcap indices were also higher by 0.6% and 0.8% respectively. While the Asian stock markets indices closed a mixed bag, the European markets have opened in the red.

 Today's investing mantra
"Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst).

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1 Responses to "Ring in the bad news"

penugonda Prabhakar

Jun 6, 2015

I am Penugonda Prabhakar yesterday ring react thing others asking i am very sorry. I am investor also trading.

yours lovely
penugonda prabhakar

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