Can you buy safe stocks when Buffett indicator is revisiting 'bubble' days? - The 5 Minute WrapUp by Equitymaster
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Can you buy safe stocks when Buffett indicator is revisiting 'bubble' days?

Nov 7, 2014

In this issue:
»  Where India stands on Mcap to GDP ratio
» Falling commodity prices: A double edged sword
» Will India be able to take on the baton from China?
» ...and more!

Let us put things in perspective first. In 2001, in an interview to Fortune magazine, Buffett said "Market capitalisation to GDP is probably the best single measure of where valuations stand at any given moment." What was the ratio for the US then? 154%! The highest that the economy has ever seen till date. It is therefore understandable that such valuations were stumbling blocks for investors like Buffett. And therefore he cautioned investors looking to buy into stocks even when markets were quoting obscene premiums. In 2008, the market cap to GDP ratio in the US went closer to 115%. The sharp correction that followed was logical in hindsight. And at 125% currently, the ratio is higher than that seen during the housing bubble days.

So Buffett's best single measure is certainly a yardstick investors need to keep in mind when looking for margin of safety in valuations. But buying safe stocks is not just about buying them cheap. In fact investors are often misled into believing that stocks that are 'safe' to buy are only the low priced ones. Investors also believe that buying stocks sporting the lowest PE multiples or those that are at 52 week lows will keep their portfolio safe. This market cap to GDP ratio can be quite a handicap for investors looking to buy safe stocks.

Now consider the market cap to GDP ratio for India in 2002-03, 26%. The valuations were mouth watering to say the least. However, not every stock bought at even such valuations, fetched attractive returns. Investment in bluechip stocks like L&T, Voltas, Titan in 2002-2003 fetched returns like 3,311%, 2,740% and 6407% respectively over a period of 10 years. However, at the same time, stocks like VSNL, IPCL, Unitech, Oriental Bank eventually eroded all investor wealth during this period. Thus apart from valuations, it was the robust business models of companies like Titan and L&T that allowed investors to get rich with safe stocks.

Therefore, instead of looking only at the broader market valuations, investors need to look for safety in the business model of individual stocks. Business with strong moats, a long track record of surviving several economic cycles, robust management and healthy balance sheet should give you the confidence of safety. Typically bluechip stocks are the ones to sport most of these characteristics. Moreover by virtue of their long track record, these stocks give investors a fairly good judgment of the management quality and revenue visibility. And hence the ability to value them based on long term trends.

Do you think a high Market cap to GDP ratio should dissuade investors from looking for safe stocks? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Now, if the market cap to GDP ratio in the US is worrying you, here is a breather. The ratio for India is currently at least 20% below the 2008 highs. Yes, despite the sharp run up in stock prices, the Market cap to GDP ratio for India at the end of September 2014, stood well below the danger mark of 100%. In fact at 83.5% the ratio is still 12-15% lower than the FY10 levels. This not just assures investors of the upside in valuations but also comfort about the fact that growth in corporate profitability and GDP may continue to keep the ratio healthy.

Hence investors looking for opportunities to buy must look for safety in fundamentals first and then go on to decide when to buy them based on the stock's valuations and the Market cap to GDP at any point of time.

India's position on the Buffett indicator

And while the equity market is busy touching dizzying new highs, the commodity market seems to be in a tail-spin. Oil prices are the lowest in four years. Iron ore has seen a whopping 43% slide this year. Coal has been on the decline. Even food prices haven't been spared by this commodity bear run.

But it's not as if we are complaining. Indeed, lower commodity prices will do a good job of cooling down inflation, an enemy the RBI has found to be implacable. They will also mean lower raw material costs for the many manufacturing companies which have grown hoarse crying about how commodity prices have been playing havoc with their bottomlines over the last couple of years. In fact this is good news even for companies from the metal processing and power sectors. Nevertheless, where all of these players will gain, there are others that stand to lose.

All producers of commodities, from farmers to miners to oil explorers and refiners, are seeing red. The spiraling prices have had many of them doing a recheck on their costs and breakeven levels. This includes the likes of ONGC. As per reports, unless the company gets a realization of $65 per barrel of oil, it will be difficult for ONGC to even make profits!

One of the biggest sources of this dullness in commodity prices is China and its decreasing appetite for commodities going forward. While the dragon nation has been growing at a blistering pace for years, it is now showing definite signs of slowdown. And that is why the India versus China story is gathering steam. A Megatrend investing opportunity in India could be in the making if India defeats China in its own game, manufacturing.

One recent woe for China has been the minimum wage rate in the country, which has been growing at double digit rates. A Bloomberg report estimates that while the hourly labor cost in India for manufacturing averages 92 cents, this figure stands as high as US$ 3.52 in China. However, so far this advantage that India has in terms of labour costs has been getting overshadowed by the terrible infrastructure in the country. This has made many an investor reluctant to invest in India. But this might soon be set for a change. Prime minster Modi's high pitched campaign to show that his government is going all out in making India a place conducive for large scale manufacturing has indeed caught a lot of attention.

In fact, even renowned economist Nouriel Roubini has been quick to point out that with the right reforms, India's GDP growth rate may actually exceed that of China as early as 2016. "So for the first time ever the tortoise becomes the hare and the hare becomes the tortoise", quipped Roubini recently.

The government is already at work as far as this big sore point for investors - terrible infrastructure - is concerned. The Economic Times reports that the Highway Ministry has called a meeting with all the top banks to discuss ways to step up lending to infrastructure projects. This could be just what is needed to revive the interest of financial institutions in highway projects. For wary of projects running into trouble over lack of environment clearances and problems of land acquisition, banks have taken a back seat as far as funding such projects is concerned.

In the current financial year alone, 9 of 11 PPP (public private partnership) projects did not get a single bid. This cannot be so, especially if India has to take on the baton of world's manufacturing hub from China. Highways are the arteries of an activity like manufacturing. So it is heartening to see the government take the right initial steps towards course correcting where it matters the most.

In the meanwhile, the Indian stock markets continued to languish in the red post noon trading session. At the time of writing, BSE-Sensex was trading lower by 55 points. Sectoral indices were trading mixed with pharma and realty being the biggest gainers. Asian stock markets were trading mixed with Japanese market leading the gains and Hong Kong market leading the losses.

 Today's investing mantra
"Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee and Taha Merchant.

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2 Responses to "Can you buy safe stocks when Buffett indicator is revisiting 'bubble' days?"

Russy Master

Nov 8, 2014

As on date (Nov 2014), what's the GDP / M.Cap ratio for India?



Nov 8, 2014

Very well reserached, scientific article. Kudos to you Mr.Dayal.

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