»5 Minute Wrap Up by Equitymaster

On This Day - 12 APRIL 2013
Be very careful with low P/E stocks!

In this issue:
» The reason why big banks must be downsized!
» This long term investor is bullish on India
» Is there a correlation between tax rates & debt levels?
» Current US stock rally could be heading the housing bubble way
» ...and more!

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After starting the year on a hopeful note, the Indian share markets have been on a declining trend for nearly 10 weeks. The extended slowdown in India, the shaky political situation and the uncertainty in the global economy have taken a toll on India Inc. In fact, close to 30% of the stocks listed on the BSE are now trading below their 2008 lows!

Being ardent practitioners of value investing, these are exciting times for us. Such gloomy times often throw up great buying opportunities for investors.

But wait... This does not mean you load up your portfolio with any 'seemingly' cheap stocks. Yes, 'seemingly' because stocks that appear cheap may not be so in reality.

Let's consider stocks with the lowest price to earnings (P/E) ratio. Given the bearish market scenario, there are several stocks that are available at low multiples. Some are even available at multiples of 1 or 2 times earnings. Theoretically speaking, this appears very lucrative.

Imagine a company with earnings per share of Rs 10 trading at a price of Rs 10. Was the company to give away all its earnings as dividends, your investments would be fully recovered right away. All the future earnings would be your capital gains!

Unfortunately, such situations exist only in theory. The real world is way different.

If ever we come across a stock that seems dirt cheap, we tend to become doubly cautious. Remember the famous words of Charlie Munger, "When you locate a bargain, you must ask, 'Why me, God? Why am I the only one who could find this bargain?"

There are several reasons that could have driven the P/E ratio so low. There could be issues of poor corporate governance and doubts over the integrity of the promoters. In some cases, the companies could be drowning under the weight of excessive leverage. In other cases, there could be adverse structural changes in the industry that could drastically affect future earnings. Changes in government regulations could also be one of the factors. The list could go on...

The point that we are trying to drive across is that be very careful when you invest in low P/E stocks. Do not get tempted by their apparent 'cheapness'. On the other hand, not all high P/E stocks may be expensive. The real intrinsic value of a business could only be found by researching the business model and management quality thoroughly.

Do you think it is safe to invest in low P/E stocks? Please share your comments or post them on our Facebook page / Google+ page

 Chart of the day
Ever since the 2008 financial crisis and the subsequent big bank bailouts, the future of too-big-to-fail institutions has been of topic of serious debate. Are these large financial institutions detrimental to the well-being of the economy? Should they be downsized into smaller, more manageable units?

Here is some more evidence on why it imperative to simplify these mammoth institutions. The chart of the day shows the numbers of subsidiaries of the six largest banks in the US before 2009 and at present. Together, these six banks had 27,748 subsidiaries. Though the number has fallen since the crisis, it still stands at 22,621. Such a complex maze of subsidiaries makes it very difficult for the financial authorities to regulate them.

Data source: Livemint

There are several reasons for investors to be jittery about emerging market equities. Indian stocks in particular are not inspiring much confidence. Earnings growth in the near term is bound to be muted. Economic variables are anything but inspiring. Policy reforms are unlikely to see the light of the day until next elections. In such a scenario, not just FIIs but even Indian investors are sitting on the sidelines. But make no mistake! For investors keeping a hawk eye on the long term returns from Indian equities, the market may not disappoint.

An interview with the CEO of a Norwegian sovereign wealth fund that we came across in the Economic Times today, assured us of this belief. Mr Yngve Slyngstad's fund manages US$ 720 bn of corpus and earned a return of 13.4% in 2012. Its India investment currently stands at just over US$ 4 bn, but is expected to grow at an accelerated rate. Mr Slyngstad believes that India's long term prospects are far from being dead. On the contrary the economy would actually thrive. The fund manager is not guided by short-term considerations. However, he is picky about the stocks he wants to invest in. Tobacco companies, ones using child labour, misusing natural resources and unethical ones cannot make it to his list.

We hope more long term fund managers and investors take cues from Mr Yngve Slyngstad's fund and his stock selection criteria.

Is there a relation between total taxes collected by a Government and the debt that it has? Well, an article in Businessinsider.com does seem to believe that there is a relation. For if you plot the OECD countries in terms of total taxes paid as a % of GDP, some sort of pattern does emerge. At the bottom of the list are countries like US and Japan that have lower levels of taxes as % of GDP and at the same time have high Government debt. Then there are of course the sick Euro zone nations like Spain and Portugal which too have high Government debt and collect lower taxes as % of GDP in comparison to other nations.

But what explains the fact that France has one of the highest rates but still runs a deficit? And Germany is lower than France but still has a budget that is balanced. So, there really isn't a strict co-relation we believe. And there shouldn't be any. For there are a lot of factors that determine the debt levels a Government has. And tax rates could be just one of them. Therefore, policymakers should not commit the mistake of trying to rein in debt by raising taxes. For one never knows whether it will have the intended effect. In fact, there is greater evidence that higher tax rates make recovery even more difficult and also make debt problems that much worse.

If history has taught us anything, it is that the asset bubbles during various periods of time have uncannily similar characteristics. So in 2006, there was the housing bubble. With so much cheap liquidity house prices were soaring at the time. Everyone wanted to jump on the bandwagon because they felt it was an opportunity not to be missed. Then came the subprime crisis and the rest is history.

The recent rally in the US stock markets is quite akin to the exuberance displayed before the housing crisis. Sam Zell, chairman of Equity Group Investments, certainly thinks so. Indeed, liquidity has surged because the US Fed has resorted to massive rounds of quantitative easing. However, the economy continues to remain in a poor shape and businesses are not investing much. The excess money is, thus, finding its way into the stock markets because no one knows what to do with so much money! And that is leading to the rally in the markets. Indeed, this in no way signals any kind of economic recovery. That is why the rally in the stock market can get dangerous because when the bubble bursts the repercussions could be quite severe.

Apart from growth prospects, favorable regulatory regime is a pre-requisite to attract foreign capital to any country. Both these factors go hand in hand. One without the presence of another does not help. But it seems that India is facing a situation where one of the factors is absent. Well, the long term growth prospects of the country are still intact. But regulatory hurdles are deterring foreign investors to invest in India. This opinion was also echoed by Mr Ravi Narain, who stepped down as CEO of NSE recently. He feels that there is a great deal of regulatory arbitrage between India and other countries. In other words, plethora of rules and regulations in India is discomforting foreign investors.

We agree with Mr Narain's opinion. Too many regulatory hindrances are impacting the inflow of foreign capital. General Anti Avoidance Rules (GAAR) or other outdated regulatory caps on sectoral investments are prime examples that. If such a situation continues investors might well prefer ease of investing in other countries over India's growth. After all, what is the point of high growth if they are not able to participate in it? They will obviously look out for other options. And if that happens, India will lose access to cheap foreign capital. While we agree that regulations are mandatory for a developing country like India, there is a very thin line between healthy protectionist policies and red tapism. And the government should know that.

In the meanwhile Indian equity markets have extended their losses and are trading at day's low. At the time of writing, the benchmark BSE Sensex was down by 286 points (-1.6%). IT and Realty stocks were the biggest losers while FMCG and Auto stocks were the biggest gainers. All the Asian stocks were trading weak led by China and Japan. The European markets also opened on a weak note.

 Today's investing mantra
"Organised common (or uncommon) sense - very basic knowledge is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little. Part of [having uncommon sense] is being able to tune out folly, as opposed to recognising wisdom. If you bat away many things, you don't clutter yourself." - Charlie Munger

  • Charlie Munger - Investing Lessons

    Editor's note: We are pleased to inform you that we have introduced a new section called 'What We're Reading'. Here, you can access some interesting articles across the web that we liked reading.

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