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This Could Be the Biggest Risk in 2016... And It's Not China

Jan 5, 2016

In this issue:
» Largecaps: Are they attractive now?
» A shakeup is expected in the Indian e-commerce space
» and more!
00.00
Devanshu Sampat, Research analyst

The markets fell yesterday. The Sensex was down by about 538 points. Not a good start to the New Year at all. Mr. Market is skilled at surprising investors, and he did just that. Who could have imagined that trading would be suspended in China? We didn't expect it.

The Chinese market crash was blamed for the fall in the Indian markets. This was understandable. After all, China reported its fifth straight month of weak manufacturing data. The ban on selling shares by those holding more than 5% in a company will expire on Friday. This added to the worries.

But all this is old news. The transition from a manufacturing to a service/consumption economy will take time. And there will be many problems along the way. Growth will be slow. But the Chinese economy is not about to implode. The major risk to global markets, at least in 2016, lies in the Middle East.

It's surprising that most of the financial media hasn't flagged this as a key risk yet. But make no mistake: There will be far-reaching implications from the tensions in this region. Saudi Arabia cutting diplomatic relations with Iran is only the tip of the iceberg. The situation is so complex it's a challenge to keep up with events. But here's a quick and simplified roundup.

At the centre of the mess is Syria. It's in a full-blown civil war. The rebels (most but not all of them supported by the US) want to overthrow the government. They are supported by Turkey and Saudi Arabia. Russia and Iran are on the opposing side. Russia recently began bombing the rebels to support the Syrian government. Then there's ISIS. It holds huge territory and opposes both sides.

The situation is akin to a powder keg, which can go off at any time. It almost did go off when Turkey shot down a Russian fighter jet on 24 November. Thankfully, the situation did not escalate at that time. But the latest round of tensions has shown just how volatile the region is. The fallout is unpredictable.

Here's an example. Saudi Arabia and Iran are both members of OPEC. If the oil cartel were to split, what would happen to the price of crude? Will it go up because those opposed to the Saudis will cut production? Or will it go down because Iran will quickly scale up its massive dormant reserves? Questions like these can keep markets on tenterhooks.

So what should an investor do? As we have stated before, keep two things in mind. First, it pays to be aware of all types of risks that markets face. Events like these can cause volatility. Stocks in your portfolio can go down even though the companies themselves may not be impacted. If a company does have an exposure to this region, it would be wise to consider the geopolitical risk before investing.

Second, make friends with volatility. Such events can provide good buying opportunities. Yesterday, banking stocks were big losers on the bourses. But their business is not impacted by events in the Middle East or China. If a high quality stock falls due to panic selling, a long-term investor should seize the chance and buy.

We believe the Middle East could throw up a few negative surprises for the markets in 2016. But do keep an eye on fundamentally strong stocks you want to buy. The resulting volatility could give you a chance to make a great investment.

What do you think? Are you worried about the situation in the Middle East? Let us know your comments or share your views on the Equitymaster Club.


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02:25 Chart of the day

Rs 100 invested in each - the Sensex, the BSE-100 index and the BSE-Smallcap Index - a year ago would be worth Rs 92, 94 and 104 today respectively. So clearly, smallcaps have outperformed. The bluest of bluechips on the other hand have disappointed in the year gone by.

As per a report by the Economic Times, "Over 75% of the blue chips across sectors are trading below their five-year average price-to-earnings (PE) ratios." Today's chart of the day shows the difference in one-year forward valuations as compared to the average five-year valuations.

Largecaps: Attractive now?

As the data shows above, almost all of the bluechip companies highlighted are trading at valuations below their 5-year averages.

As we had mentioned earlier, the Sensex's fortunes largely rely on a handful of sectors. These include information technology, banking and finance, oil & gas and FMCG. These sectors have a weightage of about two-third in the index. As such, they would play a strong role in influencing the movement of the index going forward. This is why it becomes important to pick stocks individually rather than taking a call on market attractiveness by looking only at the index as a whole.

Not to mention that while on a P/E basis, the stocks above look attractive, two things should be kept in mind. First, the same valuations metric cannot be used across the board. Secondly, these valuations are based on forward earnings - which can be easily downgraded significantly in short periods, as was the case in the second half of 2015 when the earnings numbers started to disappoint market participants.

03.45

One of the headlines making rounds today includes Grofers (the app based delivery service) shutting operations in nine cities, scaling its operations back to 17 cities. This rough ride could possibly be a sign of how bumpy the road has gotten for the e-commerce space in recent times. No doubt, the opportunity is massive in the country as India is the largest English speaking market with about a third of the mobile phone users having access to the Internet on the go.

However, with aggressive bets and money poured in to expand operations, losses at these companies have been on the rise. Business Standard reports that Flipkart posted losses of Rs 20 bn in FY15, on revenues of about Rs 104 bn. Revenues and losses both trebled in the year. The case was worse for Snapdeal, which saw its losses expanding by five times in the same period.

Even in other avenues as the budget hotels, it seems that the top players are considering consolidation. With access to additional funds getting difficult and private equity players slowing their investments, this would be one way to go.

Talking about the current status of the Indian e-commerce market, Mohandas Pai (former CFO of Infosys) has this to say - "The market is set for a shake-out with slowing growth, greater competition, huge losses, bloated costs, a discounts-led consumer behaviour, tightened funding, greater compliance with taxes and tax issues. These companies need to contain their burn, focus on consumer loyalty and brand, reduce the mad focus on discounts and GMV, cut costs and improve productivity and demonstrate that e-commerce can be a truly viable business. The years 2016/17 will show us the winners and the large-scale casualties. But e-commerce is here to stay. It changed the retail industry irreversibly in 2015 and brought in greater efficiency and technology to India."

We are closely keeping track of developments in this space. The next year or two are bound to be interesting...

04.40

At the time of writing, the Indian equity markets were trading weak with the Sensex down by about 50 points or 0.2%. Stocks from the mid and small cap segments were however in favour today, with their representative indices up by 0.2% and 0.3% respectively. Banking and information technology stocks were trading weak, while those from the consumer durables and oil & gas spaces were in favour.

04.50 Today's investing Mantra

"We have all been taught that earning high rates of return requires taking on greater risks... If an investor can make virtually risk-free bets with outsized rewards, and keep making the bets over and over, the results are stunning." - Mohnish Pabrai

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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2 Responses to "This Could Be the Biggest Risk in 2016... And It's Not China"

mukesh

Jan 29, 2016

UK :- 52 $, USA :- 36$, Saudi and Iran :-10$...

No, there won't be all Muslim Gulf war but problem is costly producers ( UK:-52$, USA:-36$)cum consumers cannot stop pumping and importing at 30$ sooner enough , since the trade contracts are long term. I learnt that Saudis are floating tenders for new oil wells almost one per week. If economy of scales persists, production cost may be 7-8 $.
If consumers start posing demand price may rise.

Saudis made huge money 30$ to 140$ to 30$ but Iran is in serious need of cash. It would be interesting to see what happens in OPEC ....that's the battleground. They both have production cost 10$.

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Rohan

Jan 6, 2016

According to an article on seeking alpha - Chinese shares defied today's market trend to post gains after state media said that last summer's selling ban on major shareholders would remain in place until the government publishes new rules on such disposals.
The Ban on selling shares by those holding more than 5% in a company is going to be there and not to be lifted on this Friday.

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Equitymaster requests your view! Post a comment on "This Could Be the Biggest Risk in 2016... And It's Not China". Click here!
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