»5 Minute Wrap Up by Equitymaster

On This Day - 13 MAY 2011
Is cash no longer 'king'?

In this issue:
» Has the commodity bubble finally burst?
» Will the Microsoft-Skype deal benefit Indian entrepreneurs?
» Are high prices finally taken a toll on oil demand?
» Is Buffet's US$ 26 bn railroad acquisition finally paying off?
» ...and more!

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Every business is run with the aim of making profits to ensure returns for their owners. But, profits can be manipulated by making clever accounting adjustments. Positive cash flows, on the other hand is real. It is usually difficult for a company to wave a wand and magically generate cash. It has to come from the strength of its core business.

As you can expect successful companies generate piles of cash. They find themselves throwing up more cash than what they can attractively deploy. But, when this cash hoard runs into billions, investors start asking questions. European and US companies currently hold a total of around US$ 2 trillion in excess cash. They are under pressure from investors to distribute these accumulated mountains. Indian born, Infosys has also saved up US$ 3.8 bn over the years. But, instead of being an asset or a war chest, this cash pile has become a liability for the company. Jealously eying its bank balance, and high operating margins, clients are asking for lower billing rates from the tech major.

Companies like Infosys have one of two choices. They can either return the cash to shareholders or invest the money. Very often, companies are not able to find exciting enough opportunities to spend the cash. Rather than burning their fingers by making a hasty acquisition which may or may not generate returns, we are more in favour of the former.

But, some companies believe that distributing cash to shareholders is a bad reflection on management's ability to find profitable avenues for investment. We on the other had believe that companies should pay excess cash out to shareholders either through a share repurchase or through dividends. There is no fundamental difference in value created from either method. However, a share buyback offers a lot more flexibility to companies versus instating a higher dividend payout. When times turn bad, cutting dividends at a later date sends a negative signal to the market.

As an investor do you prefer the up-front benefits of dividends, or do would you prefer to offer your favourite company the flexibility of a share buyback?Share your comments with us or post your views on our facebook page.

 Chart of the day
Can India become one of the first countries in the world to truly go digital? Well, definitely not going by current standards. India, home to engineers and tech geeks has relatively few internet users. Only 7% of its population is connected to the internet, compared with 32% in China and 77% in the United States. But, we are forgetting a very important way to access the web. Mobile phones. As today's chart of the day shows, according to McKinsey India may bypass accessing the internet from computers and jump directly to mainly using their cell phones by 2015. Internet penetration is thus expected to increase five-fold, from 7% to 35%. Things are also falling nicely into place, with prices of handsets and costs of accessing the network going down. If this pans out as predicted, it would sidestep a number of hurdles relating to providing cheap internet access across a large, poor, country.

Data source: McKinsey Quarterly
Note: PCs stand for personal computers

Continuing with new technologies, for many of us, Skype has meant a paradigm shift in communication. You can leisurely talk for hours with loved ones staying in remote corners of the globe. And, while you merrily chat, a number of Indian entrepreneurs do business using the free call service.

Interestingly, Microsoft recently announced that it was acquiring Skype, the Luxembourg-based internet telephony provider for US$ 8.5 bn. In Indian rupees, it translates to about Rs 382 bn. That's a staggeringly huge amount considering the company is yet to make profits. The company has about 145 m users per month on average, out of which 9 m are paid users.

Experts are of the view that Microsoft has given a rich valuation to the company. This is a confirmation of the current trend where valuations of global tech deals have been steadily rising. Now, how do the Indian technology and e-commerce start-ups stand to gain from all this? The answer is that they can command better valuations too. Of course, India may not have start-ups of the stature of Facebook or Skype. Nonetheless, the trend will help them negotiate better and raise funds more easily.

Short term economic data can often lead to wrong interpretation of long term trends. Hence, monthly data on rise or fall of inflation or industrial output (IIP) needs to be taken with a pinch of salt. The market's reaction of short term variables does not come as a surprise to us. Every basis point (0.1%) change in food inflation or economic output tends to enthuse or disappoint short term investors. However, for those looking at long term trends these would be the most incorrect assumptions to factor in. Primarily due to the volatile nature of short term trends. Also markets often judge short term economic data based on consensus estimates. Any under or outperformance of the consensus estimates also have an impact on market sentiments. As we have cited in the past, neither the temporary slowdown in food inflation not the momentary pick up in IIP growth is of any consequence to us. The latest growth numbers for exports too cannot be construed as an indicator of the economy's strong long term potential. Hence we would rather stick to normalized long term trends than get swayed by short term variables for investing decisions. Hope you do that too!

Commodities across the board have seen a sharp fall in prices recently. Each class of commodities has seen decline for different reasons. So does it mean that the commodity bubble has finally burst? Will commodity prices continue to trend downwards? Legendary investor, Mark Mobius does not think so. He opines that the commodity prices would continue their upward trend in the times to come, on account of strong demand. This increase would be fuelled by emerging economies. Since the supply of these commodities would be insufficient to meet the demand, prices would continue to rise. However, thanks to speculators, they would remain volatile, as seen in recent times. Corrections like these actually present an excellent opportunity to buy commodities at lower prices.

Sticking with commodities, as per the latest International Energy Agency (IEA) report, demand for oil has started weakening. The o.4% global oil consumption growth for March 2011 has been the lowest year on year (YoY) increase since mid-2009. Demand in developed nations has also fallen by 2.8% YoY. Under these conditions; the agency foresees weak prospects for North America. It suits speculators to attribute the damp demand on onetime events like Easter holidays and the Japanese earthquake. But, are high prices finally taking a toll on consumption. IEA expects global demand growth to contract to less than half of levels seen last year.

So will a weak demand finally bring prices to sensible levels? While the agency expects prices to stay firm, we believe that the levels will be hard to sustain under a weak demand scenario. But there are caveats. If US decides to end tax breaks for oil and gas industry, it may stifle investment in new supply sources, pushing prices higher. As far as supply from OPEC is concerned, it will be better not to be optimistic.

Rewind to more than a year back. It was the time when US economy was in disarray, trying to pick up the pieces from the financial crisis. Consumer spending had also slowed down considerably. Then, like a bolt from the blue, came a rather bold announcement. Warren Buffett, one of the world's most successful investors, has chosen to splash out a rather princely sum of more than US$ 26 bn to buy out US' second largest railroad company, Burlington Northern Santa Fe. Buffett purists went red in the face. They wondered whether the wily old investor had finally lost it and reckoned that the investment was destined to fail. Certainly, Buffett is not the best investor in the world for nothing. More than a year later, he is the one who seems to be having the last laugh. Businessweek reports how Burlington's business has gone from strength to strength and how its CEO is embarking on a massive expansion plan. What more, dividends worth US$ 3.25 billion dollars will indeed be shipped to Buffett headquarters.

The investment has played out better than perhaps even Buffett would have imagined. US recovery has continued to strengthen and the huge unexpected jump in oil prices has also worked to Burlington's advantage. Besides, the company's CEO is now answerable only to Buffett and this has enabled him to take decisions in the long term interests of the firm. Thus, Burlington's recent improvements could only be an indicator of things to come. Don't be surprised if the firm scales much greater heights.

In the meanwhile, the Indian stock markets are trading firm backed by buying interest in heavyweights. At the time of writing, the benchmark BSE Sensex was trading higher by 360 points. All the sectors were trading in the positive led by FMCG and Banking. Asian markets were trading mixed with Singapore and China among the top gainers while Japan was on the losing end.

 Today's investing mantra
"As far as I am concerned, the stock market doesn't exist. It is only there as a reference to see if anybody is offering to do anything foolish." - Warren Buffett

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