Brexit or Sensex 40,000? Channel Your Greed and Fear Right

In this issue:

» Brexit and Rexit fears overdone

» Brexit votes roils the global markets

» Management quality and our recent recommendation

» ....and more!

While writing this, we knew we have a busy day ahead. Brexit fears have come true. Markets are in panic mode. And stocks are crashing as if there is no tomorrow. Days of such extreme market volatility are few and far between. Therefore, it is all the more important for us to help you channel your greed and fear correctly. Getting it right on an occasion as rare as this could have a bearing on your portfolio for years and decades to come.

There is no denying that the Brexit and Rexit (Dr Rajan's exit) fears are overdone. Granted, these and other headwinds will keep the global economy and India's macro variables uncertain in the months to come. But stock markets have always endured such uncertainties. And the investors who have had the grit and courage to buy the best businesses during times of great uncertainty have had little to complain about.

To channel your greed and fear correctly, you must do your homework. Understand the direction of profitability of Indian businesses. Figure out how earnings could support the potential upside in stocks. Select the businesses that can withstand every economic, regulatory, and market vulnerability. And convince yourself that your greed is not misplaced. Having done so, no fear should stop you from buying stocks that can lay the foundation of your legacy portfolio.

To make your job easy, we have already done the math.

Our calculations tell us that there is an upside of about 70% in the earnings of top Indian businesses. Which means the Sensex could be perched as high as 40,000 in three to four years.

And the time to act on stocks that will lead this earnings surge is now.

Download our special report - Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave -to make the most of this rare opportunity.

Do you think that the Indian stock markets have overreacted to Brexit polls? Does the recent correction offer a good opportunity to long term investors? Let us know your comments or share your views in the Equitymaster Club.

01:50Chart of the day

Brexit poll outcome has sent the global markets on a wild descent. As you can see, all the major global markets have crashed. Talking about the Indian markets, as we write this, of the 2,717 companies being traded, 87% are in the red. Corporates, which have high exposure in the UK, have been impacted the most. However, we believe this is the time to not panic but make the most of the opportunity to pick good businesses at fair valuations.

Amidst this turmoil, gold has surged. Being an effective hedge against inflation, global and economic disruptions, this commodity offers a safe haven. It is for this reason we have always encouraged investors to include gold in their portfolio.

Gold Shines Post Brexit Polls

At Equitymaster, management quality strongly influences our views on stocks. We meet managements regularly. However, impressions can be quite subjective. So how does one assess management quality?

One way to get some insight is to track returns on capital and the management's approach to debt and cash. Our preference is for companies that have offer high returns on capital, avoid debt, and pay dividends.

Mind you, it's not just enough to have cash in the books. Remember Cairn India. Excess cash in the company was shifted to another group company at the expense of minority shareholders. The stock is still languishing, and deservedly so.

Too much cash can cloud the management's good sense. Often, it fuels management ambition and appetite for larger market share and topline growth. Discretion goes away. Margins and returns are sacrificed at the altar of growth ambitions. Managements of good repute are no exception to this folly. Tata Steel's acquisition of Corus is a case in point.

It helps little that even the analyst community cheers such capex and hardly ever learns its lesson. Be it real estate or commodities such steel and cement...a cardinal mistake has been to be optimistic about companies gearing up for topline growth through capex.

Companies on a capex spree are valued as if the benefits of capex have already begun to percolate through the business. It is too late by the time one realises that it was mindless capex itself that was the biggest undoing of the company's prospects.

It is critical to give 'supply analysis' its due. A focus on capacity utilisation and cash deployment can differentiate wealth creators from wealth destroyers.

We recently explained how capacity utilisation levels could impact the 70% upside in Sensex earnings. Here is what we wrote...

• Healthy levels of capacity utilisation are, however, necessary to make the Sensex upside a reality. Therefore, the most important data point that I will be tracking is the capacity utilisation of companies that have recently added capacity. We will be wary of businesses in sectors that are more likely to face overcapacity in the next few years.

Predicting the capex cycle is one thing. Benefitting from it is another. One can hardly get the timing of the capex cycle right every time. Few get lucky at it. So we don't even try.

An ideal recommendation for us, then, is one where the player has a dominant presence and where the core business does not run and grow on infused cash. It runs on autopilot. And it generates cash and pays it out as dividends.

It's not often one comes across such ideal recommendation. But this time we did. The latest Hidden Treasure recommendation is a small-cap company that boasts returns on capital over 40%, a dividend yield over 4%, and minimal debt on its balance sheet.

What's more, it's available at undemanding valuations. Investors who have such companies in their portfolio have little reasons to worry about Brexit, Rexit, monsoon vagaries, or any other short-term headwinds.

04:50 Investing mantra

"Buffett was asked why Berkshire Hathaway holds so much cash - never less than $20 billion - and he replied, "You never know when the phone will ring. "Charlie Munger