When earnings guidance are taken too seriously...

Sep 4, 2010

In this issue:
» India's water resources may not support its growth
» Bankruptcy proof retirement savings
» Gold prices change the fate of gold mining in India
» 8% of Indians to live in slums
» ...and more!!

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Markets are more often fixated with the EPS (earnings per share) guidances offered by company managements during the earnings season. The guidance is generally an indication of just the next three to nine months performance. However, investors tend to take them rather seriously. And by doing so expose themselves to some grave risks.

Offering conservative guidance and then outperforming them comes easy to large companies during high growth periods. But investors mistake such outperformance as perennial. And in the bargain, end up paying high valuations for the same. Similarly, marginal underperformance during temporary slowdown often leads investors to lose faith in the business. This could rob them of a perfectly sound long term investment at even cheaper valuations.

But the risk of earnings guidance is even more profound in case of smaller or lesser known companies. Brokers hosting investor meets for lesser known companies during the result periods are commonplace. These typically serve as a platform for the companies to boast of unrealistic earnings estimates. The brokers in turn get a chance to popularize the stock in the street and generate more business. The only loser is the small investor who takes the guidance too seriously without checking more critical data points. And this, we fear, leads to most of them lose faith in stocks forever.

A good earnings season, like the one just gone by, is therefore a critical test for long term investors. It tests his or her ability to separate the wheat from the chaff. As also the ability to ignore near term promises and keep an eye on long term values.

 Chart of the day
As internet penetration grows so will the risks associated with it. What was initially meant to facilitate communication globally and free of charge has now turned into a threat. The ability of any individual to upload data or sell wares on the internet has limited the governments' and companies' ability to keep information under control. The recently released data by Google on the number of requests received from governments to remove content throws light on this. And as shown by today's chart, India leads the countries seeking control over content on the internet. However, ironically China which has been the most dismissive of independence of content on the internet does not feature on the list. Experts fear that such protectionism may defeat the purpose of the internet after all.

Data source: Economist
*Requests from the respective government to Google, YouTube

India is a country rich in water resources. We have rivers and vast coastlines. Water covers 10% of our surface area. Therefore, we are definitely self-sufficient in terms of water. Right? Well it won't be true for long. India has a huge population. It is doing everything to make itself self sufficient in terms of food. For this it is boosting agriculture - which uses water. India is also trying to boost industries to drive its economic growth. Again, the industries would need water. The harsh reality is that our water resources are inadequate to meet all these growing needs. There are steps that can be taken by the government like recycling of water, desalination of the coast, etc.

However, a big threat to our water is in the form of China. China has a larger population and much lesser water than what we do. Therefore, they are trying to take every possible step to claim the areas from where the rivers originate (like Tibet). This way they can build dams and store away the water but in the process cut the amount of water available to India. This is a serious political issue that can increase India's troubles in the future.

Another relief could be on its way for employees. Take the case of provident fund payments for instance. It is widely known that for these, there is an adequate mechanism to ensure that savings are protected. However, at present no such protection exists for gratuity payments. And so the government has proposed that Indian companies should create a separate fund for meeting gratuity payments of their employees. This is to ensure that retirement savings of employees are not wiped out in corporate bankruptcies. A fiasco like Satyam made the risk of such outcome seem even more real.

As opposed to the current 'pay as you go' policy, Indian companies will now have to set aside funds on a regular basis. This will ensure that even in the worst case scenario of a bankruptcy, employees will still be paid their dues. Gratuity is typically paid to an employee who has completed five years or more of continuous service in a particular organization. Indeed, this is a step in the right direction. However, whether the same will be converted into action remains to be seen.

Seems like nothing can stop gold prices from moving higher these days. And this hasn't gone unnoticed by gold miners in India. Gold mining activity has been severely limited in the country so far. That's because gold miners have hardly been able to make profits. Take the example of government owned Bharat Gold Mines Ltd (BGML). BGML was closed down in 2001, when the cost of extracting an ounce of gold became higher than its market price. But as per an Economic Times report, the precious metal has appreciated nearly five-fold since then. This has now made it viable for these companies to not only mine gold, but also make attractive margins in the process.

In fact, the Mines Ministry is now working with fervor to revive such state owned gold mining companies. Even the few private players in the country are now looking to step up their exploration activity and form international JVs to mine for the glimmering metal. Indeed, the proverbial gold rush has snowballed into a gold mining rush in India.

In 2009, President Pratibha Patil envisioned a slum free India in 5 years. A year after her statement, the problem has only intensified. In the past decade there has been a 23% increase in the slum population in cities. In fact, the slum population is expected to reach 93.1 m dwellers by 2011, according to latest census. This is nearly 8% of India's population.

Among states with the highest slum population, Maharashtra tops the charts with 18.2 m dwellers. UP is next with 10.9 m. Tamil Nadu takes third place with 8.6 m. Increased urbanisation, limited resources, and lack of space, and rapid city growth is only set to compound this problem. Sustained efforts need to go towards slum development and rehabilitation. Else the slum free dream will remain just that.

After witnessing a tough last week, stocks markets globally bounced back as the all the key markets ended on a strong note this week. Leading the pack of gainers were European markets, especially France and UK, buoyed by signs of economic recovery. Asian stocks too saw some action this week as Singapore, China and Japan reported weekly gains in the range of 1% to 2%. India's benchmark index, the BSE-Sensex was however, an underperformer this week, with gains of only 1.2%.

Data source: Yahoo Finance, Kitco

Amongst the key underperformers were the engineering and power stocks as their respective indices, the BSE-Capital Goods and BSE-Power indices ended the week with marginal gains. Midcap and smallcap stocks were in favour this week as the BSE-Midcap and BSE-Smallcap indices ended higher by 2.9% and 2.8% respectively.

 Weekend investing mantra
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money." - Warren Buffett

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3 Responses to "When earnings guidance are taken too seriously..."

ruchir shah

Sep 5, 2010

Content of the mail is good. Do appreciate if you can make stock specific recommendations for the comming week.


A.V.Krishna Murthy

Sep 4, 2010

Water This is the most important resourse we are wasting
Every year 90% of the rainfall is drained into the Sea.
We have to build big water reservoirs,canals,develop internal water transport after interconnecting the rivers & canals.Develop forestry.Let a separate Ministry
be formed.Otherwise we will be hit by global warming very badly. MY Kudos to Equitymaster for highlighting the topic



Sep 4, 2010

May I ask you,what short of research did you undergo beside looking at their 'cooked result' and earning guidance, before recommending CDIL two years earlier.
Most of us including me take it for granted that firms like you,before recommending ,at least visit their offices once.
But the fact is that we are beguile investors to be taken for ride be anyone.
This I say because even a little research beside looking at their site and earnings ,was enough to reveal their identity.


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