The magic formula for finding good stocks

Dec 15, 2011

In this issue:
» This is perhaps the only bubble left, says Jim Rogers
» Even Pakistan is better than India Inc when it comes to dividends
» The sector that created the most wealth for investors
» OPEC sets a new production limit
» ...and more!
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What names come to mind when we talk about remarkable long term track records in finance? Warren Buffett? Peter Lynch? Benjamin Graham? How about a gentleman called John Maynard Keynes. Of course, most of us know him as one the most influential economists this side of the 20th century. But what has also emerged is the fact that he can easily boast of a fantastic investment track record alongside the other greats in the field.

So, what was Keynes' secret sauce when it came to investing? There were quite a few we believe. But we will make what we feel the most important one as the focus of this write up. Keynes observed back in the 1930s that stock markets exert a great deal of influence on the rate of investments by companies. As per him, there is no sense in building a new firm from scratch at a cost greater than that at which a similar existing enterprise can be purchased from the stock market. Similarly, the temptation to invest large amounts on a project cannot be avoided if the project can be floated on the exchange at an immediate profit.

This is a powerful concept indeed. And old as it may seem, we believe its relevance has not worn out one bit even today. Clearly, there is no point in building say a cement company from scratch if it costs Rs 5,000 per ton whereas the same is available at Rs 2,500 per ton on the stock market. One would certainly buy the stock than set up a cement plant. Alternatively, if a project that's worth Rs 100 m is fetching a price of Rs 300 m on the exchange, the owners are likely to go all out and list themselves on the exchange at the earliest. This perhaps explains why many infra and real estate companies fell over each other for their IPO listings few years back. They were indeed getting a lot of bang for their investment bucks as the market was valuing them much higher than the total investments they had made. In fact, try as much as you can and you will still not be able to come up with a more eloquent explanation of why stock market bubbles happen.

A situation of perhaps the opposite kind seems to be facing investors currently. Markets are way off their peaks and chances are very high indeed that you may bump into a firm that can be bought from the stock markets at less than what it would cost to build it from scratch.

Do you think the idea of buying stocks at cost well below their replacement value works very well in the long run? Please give your views or you can also share them on our Facebook page / Google+ page.

 Chart of the day
Despite the hammering they received in 2007-08, it won't be wrong to call the previous decade the decade of commodities. As today's chart of the day shows, India appears to have failed to encash off the trend. The share of the country's mining sector in its total GDP remained a low 1.2% right through the decade. Contrast this with the jump witnessed by Australia, China and Brazil and we realize that a good deal of investments needs to be still made in India's mining sector for its share to go up.

Source: Ministry of mines

It seems that the volatile energy situation around the world has made its case with the biggest cartel of oil producing nations - OPEC. The members have finally come to a compromise, agreeing to the new and upward revised limit of 30 million barrels per day for the first time in three years. With this, the current production limits running already near three year highs get legitimized, thus vindicating Saudi Arabia (that is already producing 25% more than earlier quota) against the price hawks - Iran, Algeria and Venezuela. The price hawks were opposed to raising outputs to command better pricing.

However, the decision is incomplete. This is because while the aggregate limit for all 12 nations is fixed till June end, there has been no word on the individual members' production limits. This leaves lot of room for violation of self set limits, especially when Libya strikes back with full production. The possible fault lines for the crackdown are already visible as Saudi Arabia has suggested its supplies will not move in line with supplies by other OPEC members but market demand. This is a strong indicator that there will be a leakage above the new limit, disappointing OPEC's price hawks that want to maintain at least US$ 100 per barrel. Overall, even if the production limits are breached, it will be a reason to celebrate for non OPEC as it will keep inventories at healthy levels and keep oil prices tamed.

If we were to tell you as to which is the largest wealth creator in recent years, you may express surprise. It is none other than the currently beaten down financials sector. The sector managed to increase its share of the total wealth created by the stock markets. As per the 16th annual wealth creation study (2006-2011) carried out by a leading brokerage, financials have increased their share of wealth from 12% in FY06 to 24% in FY11. One of the big reasons for this is that the period under study saw the financial sector booming with increased credit flow and loan growth. The slowdown in the sector actually started after that. And in recent times, it has been gripped by the fears that NPAs from other sectors would hurt their profitability. Nevertheless, the numbers do add to the feel good factor at least for those investors who have managed to make handsome gains by holding on to the financial stocks over the period under study.

It is no longer about real estate, stocks or gold. These assets have already passed the stage that is called 'bubble territory'. But there is yet another asset class that according to veteran commodity investor Jim Rogers is amongst the few bubbles left in the world. And this asset class is likely to be the worst hit by the US Fed's irrational quantitative easing programme. This asset answers to the name of US government bonds. These papers have found their calling ever since the US decided that the best way to keep the liquidity tap open is by printing currencies. But Rogers believes that the time is ripe for investors to go short on US government bonds. In fact he believes that investors planning to buy US papers at the current stage would be making a 'terrible mistake'. In recent days the flight of dollars from emerging markets, especially India, has been backed by the FIIs' appetite for investing in safe haven dollar denominated papers. We hope that Rogers' claim that the same would be an unwise decision serves as an eye opener for long term investors at least.

Stock prices are extremely volatile. They keep going up and down all the time. So there could be times when your portfolio would be in the green, while on other times it could be in the red. Both profits and losses are notional unless you book them. The only real income in that case is dividends. No wonder the minority shareholders value dividends so much. But how does India Inc fare as far as dividend payouts (Total dividend/ Net profit) are concerned? Not very encouraging as per a recent study by a leading financial services firm. In fact, among a list of 17 countries, India is the worst performer with an average dividend payout of just 24%. On the other hand, countries like China, Brazil and Pakistan have an average dividend payout of 26%, 40% and 49% respectively. Even the 24% payout is not as good as it looks. Of the 2,100 profit-making companies for 2010-11 that were included in the survey, 942 companies have an average payout of mere 5%. Another 400 companies have an average payout of just 15%. So it is because of a few companies that pay upwards of 40% that the average payout stands at 24%. There is little doubt why Indian minority shareholders are not amongst the happy lot.

Meanwhile, indices in the Indian stock markets continued with their poor run with the BSE Sensex trading lower by 130 points at the time of writing. Heavyweights like Infosys and Bharti Airtel were seen adding the maximum selling pressure. All the other Asian indices also closed in the negative today. Europe too has opened on a negative note.

 Today's Investing Mantra
"Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company's owners are slim at best". - Charlie Munger

Click here to read our series on 'Lessons from Charlie Munger'

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5 Responses to "The magic formula for finding good stocks"


Dec 28, 2011

All these concepts are relevant only to global markets as there are very few companies owned by promoters. In Indian context it is totally irrelevant as promoter's holding is always more than 50%. Therefore, as a minority shareholder you won't get anything otherthan a bulky annual report.



Dec 27, 2011

The magic formula for finding good stocks



Dec 26, 2011

In fact, this is the principle followed by the legendary Sir John Templeton. When the inflation is high, the replacement cost beomes still higher, and the stocks become more attractive.


madhav k.apte

Dec 15, 2011

Assets need to be efficiently used & cheaper old might not confirm to this. Costlier new are at times for ulterior motive of getting kick backs by promoters.
Company law must provide for some minimum of net profit % for dividends, & future fund needs should be met as new requirements of business for which dividend enriched holders would willingly come forward


Bharat Shah

Dec 15, 2011

It is not always so. When you acquire a company, lots of baggage comes along. Of much detriment is the cultural differences between an acquirer & the acquired. The failure of many M&A projects & also acquiring of a company is because of such hidden problems.
This is not to say that this is a wrong way of operating. If there is maturity and complmentarity then it can be a success story.
Greenfield project gives you the advantage of creating your culture, freedom to use newer technology and being more in sync with the times. Yes, Capital Cost may be a major impediment.

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