Should you buy a firm's assets or its earnings? - The 5 Minute WrapUp by Equitymaster
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Should you buy a firm's assets or its earnings?

Jul 18, 2013

In this issue:
» Modi v/s Kumar or Amartya Sen v/s Jagdish Bhagwati
» RBI more likely to hike rates than lower them
» Steel production capacity grows at slowest pace in 5 years
» Indians put nearly 2/3rd of personal savings in physical assets
» ....and more!

He has never possessed a computer and gets all his prices from the morning newspaper. Further, most of the financial data he wants is delivered to him by mail. Well, this statement does look straight from the 60s and 70s, isn't it? However, this is exactly how a gentleman named Walter Schloss used to invest till over a year back until he passed away. And how did he do with his investing? Well, he knocked the daylights out of market indices over a career spanning nearly 50 years. Little wonder, Warren Buffett used to refer to him as the super investor.

These were not his only quirks though. In fact, we believe that his biggest quirk had to do with the way he used to pick his stocks. As per him, one of the most important factors to make money in the stock market is buying assets at a discount rather than earnings!

Well, in a world loaded with PE investors and sophisticated DCF calculations, here is a super successful investor who is actually recommending valuing companies based on assets rather than earnings. Thus, it's important that some light be shed on this anomaly. As per Schloss, earnings can change dramatically in a short time but assets change slowly. Also, one has to know much more about a company if one buys earnings, he further added.

What this tells us is that Schloss had an absolutely first rate understanding about his circle of competence. And although its size would have been small, he knew exactly where its boundaries lay. You see, Schloss never tried to understand a company's operations intimately. Infact, he stayed totally away from managements too. Consequently, he did not invest in stocks under the assumptions that its earnings would rise.

Buying assets however does not require one to know which way earnings would go. The idea here is to buy at a significant discount to market value of assets and then to hope that over time, the gap between price and value is filled up. Earnings just don't come into the picture here. If they go up, well and good, but the entry price is not based on the same.

What investors can learn from people like Schloss and for that matter even Buffett is the art of knowing one's circle of competence extremely well. There are companies out there that lend themselves to both kinds of valuation i.e. asset based and earnings based. However what matters is how well do we know them so that we can arrive at a proper intrinsic value calculation of the stock. Understanding this one crucial factor can make a world of difference to one's investing track record we believe.

Do you prefer asset based valuation or earnings based? Please share your comments or post them on our Facebook page / Google+ page

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 Chart of the day
Can you take India's GDP up a few notches without making any investment or without any spending? Although it sounds improbable, it definitely can be done. And the answer to this is what today's chart of the day is all about. As highlighted, privatisation of public sector enterprises could well make this possible. The labor productivity in few of the sectors is appallingly low for public sector enterprises as compared to their private counterparts. In fact, in few of the sectors, even private sector labor productivity is a fraction of that existing in the US. While the data is few years old, it does a good job of showing how by simply improving the labor productivity of our public sector enterprises, we can raise the GDP per capita a significant deal. And the best way to achieve this would be by encouraging both privatisation as well as competition we believe.

Source: McKinsey Global Institute

Politics and economics are very intricately connected. No debate on either topic can be complete without the other. Economic ideologies have a significant influence on policy making. Even within our country, different states have taken to different development models. Which models have worked? Which ones have failed? Should government focus on economic growth? Or will building human capabilities lead to development? What are the ideological leanings of some leading economists? We came across an interesting article in the Economic Times that discusses some of these questions.

There are two main opposing economic camps. On the one end of the spectrum are Jagdish Bhagwati and Arvind Panagariya. Both are professors of economics at Columbia University. The duo is fully in favour of the development model adopted by Gujarat Chief Minister Narendra Modi. Growth and private entrepreneurship have been the primary development tools in the state. As per the two professors, growth is the single most important instrument of poverty alleviation.

On the other end of the ideology spectrum is well-known Nobel prize-winning economist Dr Amartya Sen. His leanings are more towards a state-driven development model with a focus on developing human capabilities. He has been a strong advocate of the Food Security Bill. In fact, he even suggested the government to take the ordinance route to pass the bill. But we do have some reservations about the merit of this bill. For one, it will put a huge burden on government finances. Secondly, the distribution system is very miserable and prone to extreme corruption.

Bond markets were the first to feel the tremor of RBI's U-turn in policy stance. But bonds are unlikely to be the only asset class feeling the near term pinch. The recent spurt in short term lending rates were essentially meant to make exchange rate speculations tougher. Moreover, the Reserve Bank of India (RBI) also wants to attract foreign funds to bridge the current account deficit (CAD). But what it also did was spook bond investors with the dramatic change in yield curve. For investors speculating on rate cut to invest in stock markets, there is no good news either. For the probability of RBI opting for a rate hike rather than a cut is even higher now.

This will not only impact corporate earnings in the near term, but also impact credit growth and asset quality. The good news is that all the measures bode well for India's long term economic outlook. And long term investors in equities have every reason to take cues from the RBI's track record of conservativeness and anti-inflation approach.

One of the prime drivers of India's GDP growth, the steel sector appears to be in a sorry state. Never mind the fact that a panel led by Prime Minister Manmohan Singh intends to take steel production to 300 m tonnes. For now, this looks like just a number when the reality is quite different. Indeed, as per an article in Business Standard, the government had set a target of 200 m tonnes by 2020. And this seems like quite a tall order now. There are several reasons for this. One is more medium term in nature. That is the slowdown in GDP growth and thereby steel consumption. But the critical problems are more of a structural nature. There is considerable uncertainty with respect to securing mining licenses and no clarity on how to take this forward. Disputes over land acquisition continue. Then there are environmental clearances to be obtained which take too much time.

As a result, from 60 m tonnes in FY08, steel production capacity in India increased to just 91 m tonnes in FY13. This is the slowest pace in five years. Foreign players who saw considerably opportunity in the Indian steel sector are struggling to make any impact as they have been unable to deal with this crippling bureaucracy. Indeed, players such as Posco and ArcelorMittal have pulled out of projects in India. It is a wonder that such apathy from the government is allowed to continue for so long. None of the targets that it sets have any meaning unless there is that commitment to meet them. The sooner it realises this, the better off the economy will be.

Indians typically have a savings mentality. They prefer to save for a rainy day. Ultimately these savings find their way into various asset classes. However, considering the recent slowdown concerns, paper assets are being shunned by many investors. In fact, as per Central Statistical Organization (CSO) nearly half of the country's savings are in physical assets. Physical assets comprise of realty, precious metals and the like. During the economic boom, investments in physical assets stood at 29.3%. However, due to recent slowdown worries, individuals have increasingly shifted their savings to physical assets. The share of household savings in physical assets is even higher. It may be noted that nearly 2/3rd of personal savings are in physical assets!

Higher share of investments in physical assets creates a capital scarcity for other sectors. This impacts the capex cycle as funding via debt and equity dries out since there are no takers for it. This in turn has impacted growth since capital flow in productive sectors has dried up.

Also, increasing share of investment in physical assets like real estate has created a bubble in the sector. Further, we know precious metals are non-productive with no yields. Yet people are flocking to park their money here for the safety of their capital. Why? Well, high inflation and slowing growth is keeping the investments in paper assets at bay. So, unless growth improves investment in physical assets will continue to rise.

Meanwhile, indices in the Indian stock market traded strong today with the Sensex higher by around 90 points at the time of writing. Stocks from realty and consumer durables sector were seen enjoying the maximum gains. Asian stock markets closed mixed today with Europe too trading in the same pattern.

 Today's investing mantra
"The highest stock market prices relative to intrinsic business value are given to companies whose managers have demonstrated their unwillingness to issue shares at any time on terms unfavorable to the owners of the business"- Warren Buffett

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5 Responses to "Should you buy a firm's assets or its earnings?"


Jul 18, 2013

Food Security Bill will not solve the real problem being faced by the poor of India. If Legislation alone could solve the problems, India would have been the best place on the planet Earth as India is, perhaps, the most legislated country. Alas! the truth is that we are a very poorly administered country and therein lies the rub.

Like (1)

Rajagopalan Ramesh

Jul 18, 2013

Principles of Value Investing are quite acceptable. Days are gone where strategies of asset based or earning based were once the basics of investing. Business, National and International economic dynamics are fast changing. Derivatives based on underlying securities offer plenty of specualtive opportunities equal to opportunities offered by wagers/ gambling. Share prices, among other things, move up and down depending on company-specific information or industry-based news or macro=economic parameters or global trends. If one watches a few scrips over a period of six months, one will fairly get an idea of market movements, how indiviudual scrips react, how one group of companies in the few industries move up while another is going down without any rationale though attempts are always made by experts to find out justifiable reasons attributable for rising and falling prices. Day trading has been very popular these days and it lures even small and medium size traders than investors.
Developing patience to reap benefits in the long-term looks out-of-place in the current context. As long as one gets to know the nuances of market movements along with movements of certain industries and company specific scrips, one has the chance to make money in the market.The intention is not to sound cynical about principles of investing.

Like (1)

Sundaravaradan S

Jul 18, 2013

Labour Productivity:
Yes. good statistics!
In the highly developed countries like USA, the cost of labor is High; hence, they resort to Automation of Labor, which initially increases cost of Goods & services.
We also need another Chart-of-the-day showing cost of providing Services in $ terms, for another angle to the one-sided Story!

Like (1)


Jul 18, 2013

the stocks of companies such as essar steel, sail, jindal vijay nagar steel, essar oil and a large number of stocks for that matter were quoting below Rs 10. and look where they reached after 2003-04. I later realised that a company with a large assest base and large facility will never disappear and will definitely turn around sooner or later. many investors dump a stock with one or two quarters of poor performance. look at ashok leyland for example. in my opinion, asset base is more important than earnings if the company is in the right sector and management is good.

Like (1)


Jul 18, 2013

Its a good idea to be look into, but in India i believe it wont work. For e.g look at MTNL or infact all PSU, the humongous amount of land and bldg in their balance sheet in prime areas and the value of their stock. Its been year we have been waiting when RCF will sell its Chembur property or MTNL will sell of its buildings. I fail to wonder why people are not buying such stocks at even 13-14 Rs.

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