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Are you switching to largecaps due to 'valuation gap'?

Feb 18, 2015

In this issue:
» China real estate prices begin correction?
» Debt levels worsening for some industry majors
» Is the art industry painting bubbles?
» and more....

Investors who burnt their fingers in the last bull run are being wary this time around. Not being sure whether the bull run will leave you richer or poorer is indeed a grave conundrum. Hence, not just the ones who have failed to create wealth with stocks but also new investors are looking for flight to safety this time around. Some are exiting stocks completely. Others are trying to buy stocks that still appear very cheap. And many are buying bluechip stocks as their valuations continue to look relatively lucrative compared to their midcap and smallcap peers.

Now, buying safe bluechips can be one of the best investment strategies across market cycles. However investors should not confuse the safety of bluechips with a discount in their valuations. The reason why the valuations of the benchmark BSE-Sensex pales against that of the BSE Mid Cap index and BSE Small Cap index is because a lot of the Sensex constituents have themselves shed premium valuations.

As you may have already guessed the list includes PSU banks, infrastructure and power companies, commodity companies and the like. The reason for these stocks to be trading at a discount is certainly based on the weakness of their fundamentals. And apart from few of these that look attractive and current valuations, investors have every reason to be wary of these bluechips too! Being large entities does not qualify them to be automatically safe. The large PSU banks may be cornering a big chunk of the banking market. However, their disproportionately large restructured assets have the potential to write off their networth. Hence it is not without reason that many such stocks are trading below book value.

Similarly companies in the commodity space that are unable to tide over the volatility in commodity prices or have limited growth visibility due to mining restraints are also not finding investor favour.

So while it is good for value investors to be greedy when others are fearful, you need to be sure that the valuations are indeed at a discount to intrinsic value. The valuations gap between large and midcap companies should not be the only reason to switch to the former. And as much as we recommend investors to have a majority of their portfolio allocated to safe bluechips, excessive exposure to fundamentally weak companies can pose grave risks.

Therefore our recommendation would be to evaluate even bluechips very carefully on case by case basis. As you would not want to be caught on the wrong foot while seeking safety for your portfolio.

Do you change your exposure to bluechips and smallcaps based on the valuation gap in the respective indices? Let us know your comments or share your views in the Equitymaster Club.

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Whether and how long will the liquidity driven uptrend in stock prices continue is anybody's guess. However, most investors continue to remain complacent about the possibility of a sharp correction once the liquidity evaporates. According to ex PIMCO chief and currently chief economic adviser at Allianz, Mohamed El-Erian, there is an illusion of liquidity in financial markets. On the ground, stricter regulations and fear of risk have already led banks and brokerage firms to cut down on their trading. However, the constant confirmation by central banks of the continuation of their money printing policies has kept markets on a high. And the day these central banks change their tone, assuming they will at some point of time, the illusion of liquidity will go away. Only the investors who have the most fundamentally sound businesses in their portfolios will stand to gain in such a scenario.

For long, there have been speculations about how there would be a prolonged slowdown in the Chinese real estate market. Some of the factors that have led to this included the over capacity situation, price declines as well as debt concerns which have been looming the sector for a while now. As reported by the Financial Times, prices in the big Chinese cities have declined by about 4.3% in the month of December 2014 as compared to last year. This is believed to be the largest drop since 2011.

While sales volumes increased in the same month (which many expect to be a turnaround factor for the sector) it seems this was largely driven by the interest rates cuts (first time in two years) in November combined with looser monetary policies. However, this trend is expected to be a temporary one as the supply outweighs the demand.

Further, the large debt levels continue to haunt the sector as well. It turns out that much of the property development in the nation has been funded through debt. And with the slowdown hitting the country, there is a high possibility of a debt bubble imploding in the dragon nation. What makes matters worse is that nearly a fourth of China's GDP is contributed by the property and related sectors.

We cannot help but compare this situation to what is happening in India. Unaffordable homes and lower sales volumes are factors that have lowered home sales volumes in recent years - leading to a huge build up on inventory. Inventory levels in India are at the multi-year highs. While simple economics would point towards price declines, it seems these laws do not apply to the Indian real estate market.

'Is investing an art?' is a question that has been discussed a lot. Another question that has debated a lot is whether 'art is an investment?' Well... since it would be difficult to arrive at an intrinsic value for art prices given the lack of cash flows that it can generate, essentially what it boils down to is the kind of value a buyer would be willing to pay for an art piece. As such, its value would be arrived at through the eye of the beholder.

But when one hears developments such as a certain painting going for about US$ 300 m or Rs 183 crore, it would only make one ponder on this subject all the more.

As put by economist Nouriel Roubini, there may be a bubble being painted in the art market, given the distortions that have been seen in recent times. In fact, Bill Bonner had recently written about this most expensive work of art ever sold and how the same is on the back of the absurdly low interest rates coupled with the massive credit bubble that the world is seeing. With over capacity being built across industries, such transaction only indicates how money moves to relatively fancier and risky asset classes during bubble peaks? So, is this another indication of us being in one at the current juncture?

  Chart of the day
From a bunch of charts printed by the Mint today, we found one chart to be quite interesting. That is of the rising debt to EBIDTA levels of large players across industries. This was part of the daily's summary on the bad debt situation in India and how some of the industries' debt levels have been on the rise and how they could possibly be a threat in the Indian banking space.

Debt levels worsen for large cos in these industries
I&C - Infrastructure and construction; figures are indicative

As you can see from the chart above, the situation is the worst amongst the infrastructure & construction sector, followed by the shipping companies. Power and real estate companies followed suit. From the perspective of the banking sector, major exposure to these sectors - where the leverage situations seem to be worsening - would only add to their stress. However, what may bring some amount of composure to the banking space is that profit levels of India Inc have been amongst the worst in recent years. With growth levels yet to pick up, banks can only hope (and hopefully learn from such situations) of better times ahead.

The Indian stock markets were trading firm today with the benchmark BSE Sensex trading higher by about 250 points (0.8%). Stocks from the consumer durables and capital goods spaces were the biggest gainers today. Most of the Asian stock markets ended the day on a firm note; stocks in Europe were trading firm at the time of writing.

 Today's investing mantra
"Our best ideas haven't done better than others' best ideas, but we've lost less. We've never gone two steps forward and then one step back - maybe just a fraction of a step back" - Warren Buffett

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

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Equitymaster requests your view! Post a comment on "Are you switching to largecaps due to 'valuation gap'?". Click here!

3 Responses to "Are you switching to largecaps due to 'valuation gap'?"

Sushila Singhal

Feb 18, 2015

Would like to switch but can't decide.


G S Apte

Feb 18, 2015

It would be a good idea to shift some portion of overvalued small/mid cap portfolio to large cap portfolio, provided that, those large caps are undervalued/fairly valued and having good fundamentals. Some investors are thinking that, PSU Banks are undervalued but considering the rising NPAs, those can not be considered as good investments, at this point of time.

Investors should be careful while selecting large caps, and large caps with strong fundamentals, high ROE/ROCE, good pricing power and good quality of management can be still considered for buying, after detail analysis.


rajesh mattapalli

Feb 18, 2015

I have been over the years reading your daily report and find that underlying, you are a bear.

Like (1)
Equitymaster requests your view! Post a comment on "Are you switching to largecaps due to 'valuation gap'?". Click here!
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