What Buffett's favourite ratio tells about India in 2015? - The 5 Minute WrapUp by Equitymaster
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What Buffett's favourite ratio tells about India in 2015?

Dec 24, 2014

In this issue:
» Bubbles brewing in the SME space?
» What will central PSUs do with their Rs 2 trillion cash balance?
» Why China did a 'IMF' for Russia....
» Roundup on markets
» ...and more!

  Chart of the day
The market capitalization to GDP ratio is one of Buffett's favourite indicators of broader market value. And over the years we have realized how useful the ratio can be to study the relative valuations of markets across the world from time to time. Exactly a year back, we used the same ratio to point out to you that Indian stocks are looking very attractive! In fact, this is what we wrote.

"If one were to view valuations by this parameter, stocks look anything but expensive at the moment. At the end of FY08, the figure stood at about 106%, which indicated an overheated situation. Post the market decline, the figure fell close to 55% levels at the end of FY09. Going by the chart below, valuations picked up quickly thereafter. However, in recent years the ratio has moved lower. As of a couple of days ago, India's market cap to GDP ratio stood at about 64%, which is pretty much close to its thirteen year average."

So while we had no clue about the possible outcome of the upcoming general elections and did not wish to bet on it, one thing was written across the wall for us. That the valuations of Indian stocks offered sufficient margin of safety for investors to take long term bets. It would not be wrong to say that the electoral results offered the incremental momentum to Indian stocks. One that saw over 300 stocks make lifetime highs in the six months following election results. But the fundamentals and valuations of Indian companies in late 2013 did justify the upside to quite an extent.

Now the change in the market cap to GDP ratio for India, at about 14.6% in 2014, is the highest amongst global markets. So does this mean that Indian stocks are overvalued at current juncture? And whether 2015 will see any further upside in Indian stocks? Well, we once again take the help of Buffett's favourite ratio to answer that.

India's market cap to GDP ratio continues to remain below the world average despite the meteoric rise in 2014. And it is well below the ratios for developed economies like Japan and the US. Therefore with improvement in GDP growth, control over inflation and better earnings visibility for Indian corporates, there is no reason why the ratio cannot go up further in 2015.

But investors must realize that the foreign institutional investors (FIIs), who have had a big role to play in the rise in valuation of Indian stocks, are not looking at the economy in isolation. They are in fact constantly comparing the valuations of Indian stocks with other developing economies like China and Brazil. The fundamentals of Indian economy currently merit premium valuations given the instability in the other BRIC economies. However, a prolonged delay in reforms could make investors impatient and anxious about the upside in Indian stocks as well.

India's ratio moving closer to global average

2015 will therefore be critical for Indian companies to justify their valuations with earnings growth. Being able to do so with the help of necessary policy reforms will keep Indian stocks in investor favour. However, investors should not get complacent about valuations and ensure that they take some profits off the table whenever the opportunity seems ripe.

Do you think 2015 will see India's market cap to GDP ratio move higher? Let us know your comments or share your views in the Equitymaster Club.

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Any chance you heard of GCM Securities, Eco Friendly Food Processing Park or Esteem Bio Organic Food? Or for that matter Channel Nine Entertainment and HPC Bioscience? Well... our guess would be no.

But what if we told you these stocks were trading at valuations - as measured by price to earnings ratio (on FY14 profits) - in the range of 648 to 22,920 times! You read that right. It's not a typo.

It turns out that these stocks form part of the BSE SME IPO index, an index which allows SME business owners to raise capital for growth and expansion. The index constitutes of 82 companies at the moment. However, as reported by the Hindu Business Line, the above mentioned five companies contribute to nearly two-third of the Rs 100 bn market capitalization of the overall index. The average market cap of these businesses stands at Rs 12 bn or Rs 1,200 crores each, which is not a small size from any angle. However, the average revenue of these businesses stands at Rs 2.6 crores.

Something definitely doesn't seem right here...

Sure, while it would be expected that these business would grow quite fast - given their small base - one can roughly calculate the growth rates required to justify such valuations. Not to mention the relatively high amount of caution required towards investing in such businesses which do not provide sufficient information to make a sound long term investing decision.

Rs 2,000,000,000,000! This is the amount of cash and cash equivalents that the major central public sector companies were sitting on at the end of FY14; a figure similar to the previous year. In FY14, the companies' combined capex stood at Rs 1.2 trillion with another Rs 510 bn being amounts invested in projects under implementation.

As pointed out by the Business Standard, a large chunk of this cash resides with few entities, which make up a big chunk of the balance. Some of which include Coal India, ONGC, NMDC, and NTPC. As you can see, a good amount of these companies are involved in the commodity space; thus, with prices being volatile and on a declining trend, the possibility of a sharp jump in capex does seem less probable; at least in the short term. But does that mean, the excess cash will be paid out? Well... the odds here too seem minimal. While the government may try to push the PSUs to lead the investment cycle - with private companies following suit - it must be kept in mind that the payout ratios have been maintained while profits have been growing at a slower pace than the cash build up over the past five years. On an aggregate basis, PSUs have been thus relying on outside funds to maintain growth and capex levels.

At the same time, it must also be remembered that some of the amount paid out in recent years was also a function of the previous government taking desperate measures to lower its deficit levels. However, with the current data being seemingly better managed, whether the present government will take such measures too needs to be seen. In our view, given the strong position that the top PSUs are in and thus their cash generation capabilities - paying out the excess cash only makes sense - at a time when then environment for making large scale investment may not be very conducive.

1991 is still fresh in the minds of every economically aware Indian. Even for those who studied India's economic history much later, the IMF's role in bailing out India from the forex crisis of 1991 is one of the hallmarks. But it seems that in Russia the generations to come will thank a neighbouring country and not the IMF for bailing it out in times of crisis. And we are referring to none other than China! China's latest role in stepping on to IMF's shoes as the emergency lender may have come as a surprise to many. But there is no denying that its US$24 bn currency swap program, to help Russia weather the worst economic crisis since the 1998 default, gives it the status of lender of last resort. As China steps up its role of bailing out troubled economies with its financial might, it is also likely to have more say in global politics. And what we can say with some degree of certainty is that the US will have to do more in preserving the US dollar's reserve currency status now on.

After starting the day on a shaky note, the Indian markets were trading below the dotted line during the post noon trading session. At the time of writing, the BSE-Sensex was down by about 106 points or 0.4%. Stocks from the realty and metal spaces were in demand today, while those from the oil and gas and information technology spaces were the least preferred. As for global markets, Asian stocks were trading firm while European stocks were trading mixed.

Today's investing mantra
"Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid."- Warren Buffett

Editor's note: There will be no issue of The 5 Minute Wrapup on 25th December 2014. We wish our readers a Merry Christmas!

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

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Equitymaster requests your view! Post a comment on "What Buffett's favourite ratio tells about India in 2015?". Click here!

1 Responses to "What Buffett's favourite ratio tells about India in 2015?"

Dr. Atul Tiwar

Dec 24, 2014

I am never very optimistic about your views & principles published time to time as I know they may change up side down time to time seeing condition of market & misguides us often.
Post election you warned us that this rise in stock market is wave based & will settle down soon because fundamentals of companies have not changed & are still poor. But you failed tremendously as stock market never saw back there after.
Pain born by your call to sell Nucleus software has not subsided yet (You asked us to sell it on Rs 70-67 & we booked heavy losses but than it soared to 260/)
You again gave a call to sell "take solutions" (at around Rs 32?) & that forced me to do my own research & I held that. Result is there it jumped to Rs 54 + after your sell call).

So what I believe now- You people are good at theories, hypothesis & logic etc but when it comes to practical, you are average. You analyze the happening with appealing arguments but always when happenings are over. I love to read your articles as they are really good.
BUT We, as investors are not here to learn the economic principles of trading / investing or to details of various parameter you discuss with your selected stocks every month, but to earn profits.

Since share market is soaring now a days so almost all shares are going up & any stock could be selected with superficial research.

Now when stock market is swinging, you immediately changed your note from your post election article & started analyzing why Indian Market is attractive for FIIs forgetting what you said few months before.
It is that's why I have not opted for your latest research service because I hardly believe in your Algorithm analysis and all. God knows when you will deviate from your own analysis.

I am happy with services I am already availing. I know you will never find this article appropriate for posting & I too don't want to affect your business with this negative post but I want you to realize that you need to work more on outcomes than on academic analysis that are not included in our subjects of interests.

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Equitymaster requests your view! Post a comment on "What Buffett's favourite ratio tells about India in 2015?". Click here!
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