Focus on the earnings and not on the 'bulls and bears' - The 5 Minute WrapUp by Equitymaster
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Focus on the earnings and not on the 'bulls and bears'

Oct 27, 2014

In this issue:
» No 'Acche Din' for corporates in 2QFY15
» FM calls for a rate cut!
» Can this one measure revive the power sector?
» The US economy and stock markets are out of sync
» And more!

Most of us have heard the terms 'bull markets' and 'bear markets'. These two terms were coined in the US many decades ago. They have come to signify major up and down moves in the stock markets. Many pundits spend a lot of time trying to figure out when these moves will happen and when they will end. Is this really a worthy exercise? We don't think so. Let us look at the experience of the previous bull market of 2003-08. Let's say that you had invested Rs 10,000 in the Sensex on 25th April 2003. At the peak of the bull market on 08th January 2008, your investment would have been worth Rs 71,385! That's a growth of a staggering 614% in less than 5 years. Mind you, this is just the index we are talking about. Individual stocks were up a lot more.

But the question is; how could you have known this in advance? Also, could you have known in advance about the carnage that would follow later that year? The answer is no. It's just not possible to predict bull and bear markets. In August 2013, when the Sensex was trading at around 18,000 levels, pessimism was at its peak. Not many were willing to trust the markets with their hard earned money. Yet, the markets are up about 50% since then and every pundit now believes that we are in a long term bull market! So if predicting the bull and bear markets in advance is not possible; how do we go about making the best use of them?

We believe that only sustained earnings growth can lead to long term wealth creation. Instead of worrying about the markets, it is better to focus on the earnings potential of the business. Think about it this way. If a business has a decent competitive advantage and earns a return on capital that is well above its cost of capital; then in the long run, even a moderate growth in earnings will create a lot of wealth for shareholders. The same applies to the entire market as well. The period between 2003 and 2008 was marked by a big pick up in earnings. As global liquidity was ample during this time, it was natural for the stock market to rally.

However, the important thing to note is that without the growth in earnings, no amount of liquidity will be able to drive markets for long. This is why long term investors like us, prefer to focus on the sustainability of the earnings potential. Even the sustainability of the current bull market will be determined solely on the basis of the expected pick-up in growth. If the government continues on the path of reforms, then the future is indeed bright for the markets.

According to us, the economic reforms can unleash what we call a 'Golden Decade Megatrend' in the Indian economy. The Megatrend will play a key role in unlocking the potential for sustainable high earnings growth. If global factors remain conducive, there is no reason why this bull market cannot sustain. So how do you take advantage of this possibility? We think 'The India Letter' can certainly be the answer. If you haven't signed up for The India Letter yet, we strongly recommend that you do so now.

What do you think is the best way to deal with the 'bulls and the bears'? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Q2 earnings for India Inc are trickling in steadily. However, if the trend so far is any indication, looks like there's still some time for 'Acche Din' to show themselves in the numbers. As per a leading daily, at 14%, the operating profits of a sample of 185 companies have risen at the slowest pace in the last five quarters on a YoY basis. What more, even sales growth and net profit growth displayed similar trends. However, to be fair September quarter last year had seen the currency depreciation to the extent of more than 5%. The same this time though stood at a lot less 2.5%. Consequently, the earnings of exporters are impacted to that extent.

Anyways, no one was hoping the new Government would come with some sort of a magic wand. The policy measures will take indeed take some time to make their presence felt in the numbers. Besides with India's macros further taking a turn for the better due to the crude price correction, the next few quarters would be the ones to watch out for according to us.

Growth yet to pick up

The new Finance Minister seems to have done a good job of identifying problems with the economy. However, when it comes to finding solutions, he seems to be taking the beaten track! According to Mr. Jaitley, low credit offtake and tepid performance of the manufacturing sector are inhibiting the growth potential of the economy. And like his predecessor, he has lost no time in blaming the RBI's conservative monetary policy for this. In an interview to Times of India, Mr. Jaitley has accused banks of adopting 'defensive banking', thanks to their NPA burden. He even assured a nudge to the chiefs of PSU banks to lend more aggressively. But his key solution to stimulating growth in the economy seems to be cutting down interest rates. Well, given the problem of bad lending in PSU banks, lowering interest rates will only defer the NPA problem and not resolve it. And as far as the RBI's monetary policy is concerned, the same continues to keep a hawk eye on inflation. Unless and until Dr Rajan is convinced of tackling the inflation problem effectively, we doubt he will relent on interest rates. So instead of waiting for the RBI to stoke growth with interest rates, Mr. Jaitley will be better off taking some firm steps himself. Some key reforms in manufacturing and power sectors can be the panacea for India's staid GDP growth.

The power sector was in a state of limbo for ages under the UPA regime due to poor fuel management practices. While the NDA's decision to auction coal blocks will bring in more transparency, it remains to be seen whether it shall really address the scarcity issue. The fact that there is a huge divergence in domestic and imported fuel (coal, natural gas etc), prices was one of the reasons why some power plants remained idle. Operating at a higher priced imported fuel was not feasible for all power companies. Hence, plants that were not in a position to secure domestic supplies stood un-operational. However, it seems that the government may go in for pooling to revive such power stations. 91,000 MW of combined capacity may get a lease of life if pooling indeed sees the light of the day.

But what exactly is pooling? It means that the cheaper domestic fuel is allowed to be blended with the costly imported fuel to average out the final price. The blended fuel is then used as feedstock to generate power. In the absence of pooling, only priority sectors were able to secure fuel at cheap prices. Other sectors had to import fuel which was costly. This put power production in limbo as producers were apprehensive of importing costlier fuel when the power prices were regulated. We reckon pooling is the best option to break this deadlock. And we hope the government takes decision in this regards soon.

Stock markets are not mirrors of the existing economic situation in a country. The action on the markets is forward looking. There is time lag between what the markets price in and the same to reflect in the economy. This is why we see the markets rising even when the economy is in a lull. But markets are not always right in what they anticipate. And when that dichotomy between economic realities and market expectations widens too much, we see sharp adjustments in the markets.

Take the US stock markets. They have witnessed one of the most powerful bull markets in history for almost six years. Ironically, this coincided with the weakest economic recovery since World War II. From March 2009 through June 2014, the S&P 500 has increased 4.7% a quarter. That's about five times faster than GDP growth. The gap between growth in stock prices and GDP has been the biggest since at least 1947. So unless the US economy shows a solid revival, the stock markets could be looking at a sharp correction.

In the meanwhile, the Indian stock markets pared early gains and slipped in the red in the post noon trading session. At the time of writing, BSE-Sensex was trading lower by 5 points. Sectoral indices were trading mixed with realty and oil and gas being the biggest losers. Stocks from capital goods and banking were among the leading gainers. Majority of the Asian stock markets were trading in the red led by Indonesia and Hong Kong. But the Japanese index was trading positive. European markets have opened the day on a positive note.

 Today's investing mantra
"I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business." - Warren Buffett

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1 Responses to "Focus on the earnings and not on the 'bulls and bears'"

Satish S Dabholkar

Oct 28, 2014

What is the impact of weakness in economy of USA and European countries on our megarend.Pl also guide us for Quantitative easing programme of Federal Bank .

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