One valuation signal investors should watch out for - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

One valuation signal investors should watch out for 

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In this issue:
» Mergers & acquisitions making a comeback, investors beware
» Real estate IPOs waiting for better markets
» Now a super group for financial stability
» Water shortage holding India back
» ...and more!!

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When economic conditions become tough all around, one's first reaction is to hold on to your cash. And when things turn around for the better, one feels more comfortable in going shopping. Companies are no different. In the aftermath of the financial meltdown, they stockpiled as much cash as they could. With the growing belief that the worst of the storm has passed by, companies are beginning to use the cash.

As per the Wall Street Journal, the cash levels in leading US companies is up by almost 31% from a year ago. And not surprisingly, the all-cash acquisitions in the first two months this year have shot by more than 100% YoY. Although many companies are looking at dividends and buybacks, their favourite outlet of excess cash is mergers and acquisitions. In our view, a flurry of mergers is a signal retail investors should watch out for. The reason is simple. It is only when the 'animal spirits' of companies are high and financial markets conducive, that we see a rash of acquisitions. After all, it often requires the top management of companies to fully invest their egos behind such moves.

As investors have seen in the last several years, strong merger and acquisition activity thrives in an environment of over optimism. And valuations start moving northwards. Our advice to investors is to always insulate themselves from such a climate and focus on well-managed companies at reasonable valuations.

00:52  Chart of the day

Note: At factor cost at FY00 prices
Source: Central Statistical Organisation

India was one of the first countries to shake off the economic slump following the global financial meltdown. And as per the advance estimate numbers for FY10, this recovery was quite broad based. As the chart of the day shows, seven out of the eight sectors show a growth rate of 6.5% or higher. As anticipated, the exception is agriculture which is expected to decline by 0.2% YoY due to the poor monsoons last year. Such differences in growth rates have caused a structural change in the Indian economy. The share of agriculture in GDP has declined gradually from 19% in FY05 to 15% in FY10. During this time, the share of industry has remained the same at about 28 %, while that of services has gone up from 53% in FY05 to 57% in FY10.

Speaking of acquisitions, a business daily reports that 2010 may well be the year when Indian companies snap up foreign assets in record numbers. After a rather sedate January, February has seen a slew of outbound deals what with companies like <>Renuka Sugar and <>Religare getting into the thick of action. Then there is the much talked about deal by <>Bharti, which is almost certain to take over Zain Telecom's African assets. Had it not been for a rejection by the company's board, LyondellBasell could well have been another on a long list of trophy acquisitions. However, investment bankers may not be complaining. The pipeline of outbound M&A is far from dry and they are going to have their hands full this year, a welcome break from the barren days of 2009.

It should be noted that with confidence returning and with asset prices also surging from their bottoms witnessed in the previous year, sellers appear keener to talk and negotiate. Furthermore, with liquidity situation also improving, buyers know that funding for the deals may be more forthcoming than before. However, buyers can go overboard at their own peril. Indian companies could do well to remember that making acquisitions by taking on too much debt may not be a very good idea. For if an unexpected weakness in business environment does show itself up, it could make servicing debts a very difficult affair. Investors too need to take cognizance of this fact and attempt to steer clear of companies that make leveraged acquisitions.

The queue of realty companies wanting to come up with their own IPOs seems to be getting longer. A business daily pegs the number of such companies at 7. They've received the approvals from SEBI. But, quite evidently, not from Mr. Market yet. This is understandable as all companies would like to get the best possible valuation during their IPOs. Better valuations for the promoter of a company would translate into him having to sell less of his share in the company. Now which promoter wouldn't want that? But doing this is only possible when investors are sanguine and optimistic. The recent volatility in the market has taken away from general investor optimism, which is usually the highest when easy profits have been made in the stock market for some time. Thus, these companies are holding back their IPOs despite having all approvals in place. All said and done, it would be perhaps most important for investors to note that an environment that is better for a seller, has to logically be that much worse for a buyer.

Being TBTF (Too Big To Fail) is risky. Not if you know that the government will in most cases be willing to bail you out. Very recently testifying before the TARP committee, Citigroup chief Vikram Pandit showed a similar attitude. Not mincing his words in a show of gratitude to American taxpayers for bailing out the once beleaguered bank, Pandit showed little determination to break up the entity. Replying to a TARP committee question on why Citigroup still chooses to remain big in size, Pandit clarified that being small is not the solution to avoiding risk. The same requires better regulation. Pandit also justified saying that Citi had sold 30% of its consolidated business in the last year that were un-related to core banking. And that it would keep its size to only what would be required to serve its clients. Whatever maybe Citigroup's logic to not reduce its balance sheet size, we believe that tax payers, be it in the US or anywhere else, will be wary of the TBTF bailout proposition after the American experience.

After the crisis, financial stability has assumed importance like never before. As compared to the developed world, India emerged relatively unscathed from the crisis. However, the severity of the crisis is still fresh in the minds of the governments across the world including India. Plus there has been an increased tendency towards having independent agencies outside the central bank for ensuring financial stability. And so there will be a Financial Stability and Development Council (FSDC) set up, which will be headed by the Finance Minister Pranab Mukherjee. Heads of all financial sector regulators such as RBI, SEBI, insurance regulator IRDA and pension regulator PFRDA will be members of FSDC. Forming a council is all very fine. But the real issue here would be whether it will do any better than the RBI in averting the crisis. In fact, the RBI's prudent policies have been one of the many reasons that prevented India from dealing with the fate meted out to the rich world.

What is it that is holding India back from becoming an agri super power? According to the legendary commodity investor Jim Rogers, it is water. While India has all the natural resources in terms of land, soil and weather, lack of proper irrigation facilities and government regulations are acting as barriers for increasing agriculture output. In fact according to Jim Rogers, addressing water shortage should be a higher priority than inflation. With a fast growing population, food security should be of grave importance to India. We recently witnessed how a subpar monsoon can play havoc with the country's food output. We hope that the government has woken up to the harsh realities facing the country and takes steps to ensure that water is available to farmers. However, we are also keeping our fingers crossed that the monsoon this year turns out to be normal.

Meanwhile, the Indian markets witnessed a volatile trading session today after a firm start. Amidst choppy trade, the BSE-Sensex was down by about 20 points at the time of writing. Profit booking in stocks from the banking, auto and IT sectors made the benchmark indices pare almost all of their opening gains. However, realty, capital goods and healthcare stocks managed to garner investors' interest. The Indian indices were the only losers in Asia, while Europe has opened in the green.

04:56  Today's investing mantra
"A good business will retain its value in real terms over time no matter what governments do to currency." - Warren Buffett
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4 Responses to "One valuation signal investors should watch out for"


Mar 5, 2010

RBI's prudent policies have been one of the many reasons that prevented India from dealing with the fate... Financial crisis meted out to the rich world.



Mar 5, 2010

I found some pieces of sound advice in today's wrap-up titled "One valuation signal investors should watch out for". In my candid opinion,your well-considered views: "Strong merger and acquisition activity thrives in an environment of over optimism. And valuations start moving northwards. Our advice to investors is to always insulate themselves from such a climate and focus on well-managed companies at reasonable valuations" are worth their weight in gold. Yet another statement which impressed me most was "All said and done, it would be perhaps most important for investors to note that an environment that is better for a seller, has to logically be that much worse for a buyer". To be frank, they are quotable quotes which will hold good in any kind of situation.



Mar 5, 2010

How does one refer to the Bharti-Zain deal in context to your article?


manish nagrecha

Mar 5, 2010

Jim Rogers, addressing water shortage

It is very correct. Gujrat is example..Becuase of higher focus in irrigation gujrat`s GDP of agriculture is more then 10% since last few year against above 11% growth of gujrat

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