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Should We Expect a Bigger Crash than China?

Jan 7, 2016

In this issue:
» Services space sees spurt in demand in Dec
» Delhi govt takes big step towards reform of its education sector
» ...and more!
0.00
Rahul Shah, Co-Head of Research

Imagine owning a company where it would take Rs 100 to replace all the assets on the balance sheet based on today's costs. Would you be willing to sell this company for the very same price? You probably would if the return was at an acceptable level.

Please note that we've valued the replacement cost of assets using current costs. This is different than book value. It is therefore the more logical yardstick to value a company.

An economist called James Tobin once wondered what would happen if he took into account the replacement cost of all the listed entities in an economy and compared that with the cumulative market caps of the very same firms. This exercise eventually gave rise to a famous ratio - Tobin's Q.

Tobin's Q is an important tool to understand where valuations stand at any point in time. If the stocks are trading at a huge premium to the replacement value of their assets, then they have to correct and trade somewhere close to replacement values. And if they are trading much lower than replacement values, then stocks have nowhere to go but up over the medium to long term.

The ratio has definite advantages over traditional measures of value such as price-to-earnings and book value. First, it does not try to make any future predictions at all. Second, it takes into account current replacement costs, not historical costs.

However, its utility lies more in understanding the valuations of the broader market rather than individual stocks.

Where does the ratio stand currently as far as the US markets are concerned? Not well. In fact, Mark Spitznagel has called it a ticking time bomb. He says US stocks are trading more than 40% higher than the replacement values of their asset and, therefore, markets should have already undergone a significant correction.

The fact that they haven't makes it even more dangerous as per Spitznagel. The longer the rally stretches, the further away the valuations will go with respect to replacement values and the bigger the crash will be.

I think the ratio also sheds light on why monetary easing hasn't worked so far. That there's a huge gap between market prices and replacement values indicates there hasn't been any huge capacity build up on the ground. All of the incremental money has gone into bidding up stock prices. It won't be long before reality catches up.

Unfortunately, replacement cost data in India remains sketchy, at least to our knowledge. Therefore, the right Q ratio values for Indian stocks as a whole will be difficult to come by.

Having said that, Indian investors could do well to stay prepared for a US market meltdown, which could lead to flight of capital from India and pave the way for value-conscious investors to find some decent bargains from a long-term perspective.

What do you think? Do you think Tobin's q looks like a reliable ratio to assess the broader valuations of stock markets? Let us know your comments or share your views in the Equitymaster Club.


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2.18 Chart of the day

The end of 2015 saw gloom for industrial India. As per an Economic Times report, India's core sector contracted 1.3% in November dragged down by sharp declines due to weak demand and imports. Production in sectors like steel, cement, crude and natural gas - all saw declines.

But even as manufacturing in the country has been seeing bad times, the services sector is seeing a spurt in business activity. As today's chart shows, service sector output in the country touched a 10 month high in December. The Nikkei Services Business Activity Index climbed to 53.6 during the month, compared with 50.1 in November. A reading above 50 on the index indicates an expansion.

While hotels, transport and storage services are still chugging along, the service economy's output has increased in financial intermediation and other services. The report also indicates that the improved demand environment has helped services companies increased their selling prices in December.

Services sector sees spurt in demand in December

3.18

Even as we investors remain obsessively focused on economic reforms, those are not the only ones that matter. There are other reforms that affect our development equally if not more.

One such area is education. And the Aam Aadmi Party led Delhi government has just made a very well-conceived and high impact reform on this front. It has decided to scrap all admission quotas from private schools except for economically weaker sections (EWS) in private schools. This puts 75% of total seats in the open category.

Quotas have long been rife in the vast majority of the Indian education system. Often these have been arbitrary and have only ended up being an excuse either to show preference to the powerful, or to take bribes. Take the 'management quota' for example. It is supposed to give you admission if you are recommended by a chief minister, education minister, judge, police commissioner, or by an income tax official.

The government's move, if implemented well, is sure to bring in a refreshing change to the education system. It will mean a thumbs up for a meritocracy, something that is so important to capitalism in the long-run.

4.48

The Indian stock markets were trading weak today on the back of sustained selling activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading down by around 470 points. Losses were led by realty and capital goods stocks. The declines seem to be fuelled by nervousness on the China front, with China's CSI 300 Index plunging 7.2% before trading was halted for the second time this week by circuit breakers. And with that, the CSI 300 index is already down 12% with just 7 days into the New Year.

4.56 Today's investment mantra

"Do not save what is left after spending, but spend what is left after saving" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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6 Responses to "Should We Expect a Bigger Crash than China?"

Satish Dabholkar

Jan 17, 2016

I wish to know How any one will value banking stock or IT industry stock?
Many time this type of theories crop up when market conditions are depressed.
The stocks are priced as per future expectation and ability of the companies which is supported by historical data.

Like 

Vamsi

Jan 10, 2016

Significance of Tobins ratios hold very true.. I agree to what all is said But intangibles such as brand value would also add to the current assets replacement costs, which I would think would be much more than the tangible assets..

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Sanjay Kamath

Jan 8, 2016

Good article. Wasn't aware of Tobin's Q, really informative and agree that it is the right ratio to consider (assuming we have correct data). If there was any approx number of India assets it would have helped.
Also the title of the article refers to China ... the content talks about US. There is no comparison with China.

Presume you are planning to use this ratio in your forthcoming recommendations/stock reports.

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Babu

Jan 7, 2016

I think Tobins Q may not be relevant for labor intensive companies such as services companies as investment are not upto the level as they are required in manufacturing/process industries. if this applied for labor rich services companies the replacement cost would be low as compared to market cap and hence ratio would be large indicating high valuation but in practice it may not be the case.

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sudhirseetharam

Jan 7, 2016

Yes there will be crash and I am expecting the sensex will come down and touch between 22500-23000, which I call it as market correction, fear correction, anticipated correction, China crash, Hydrogen explosion, Gulf war, Even the investors are feared whether to invest in MF, Gold, or Shares because of Market crash...Its a guess and I am sure the market will rise after correction...

Like 

Tirtharaj Khot

Jan 7, 2016

This concept is correct but with one rider as addition. Only the replacement costs and their valuation is not enough. What is required is a good management to make use of those assets, at whatever value they are valued. Therefore Good Management + lesser replacement value is a good formulae for the right buy.

Of course this is my persional opinion and discretion be exercise by those who would try to rely on this suggetsion.

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