Is the share price a liar or an honest gentleman?
(Mar 12, 2015)
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In this issue:
» What's Jhunjhunwala's view on e-commerce boom?
» Government downing shutters on loss making PSUs
» Bad debts in PSU banks creates a record
» ...and more!
The year 1984. The occasion? The celebration of the 50th Anniversary of Security Analysis, the classic text authored by Benjamin Graham and David Dodd. Ironically, the very same platform used to celebrate the book's success was now being used to question its credentials. Talks had started doing the rounds whether the methods outlined in the book were past its 'use by' date and hence had become totally irrelevant. After all, those were the times of a brilliant new theory in finance called the Efficient Market Hypothesis (EMH). And at its core was a principle that was diametrically opposite to what Graham had based his entire book on.
The EMH was of the view that just like a thorough gentleman, the share prices gave out the right information at all times and therefore, it is next to impossible to beat the market. And any investor who manages to beat the markets over the long term is merely lucky and there is no skill involved. In other words, don't try to analyse the stocks too much. You might as well ask a monkey to select stocks for you by throwing darts and you would get the same result.
Benjamin Graham as you all know took a view completely opposite to this. As a matter of fact he viewed share prices and the broader market as manic depressive guys whose price quotations often vacillated between two extremes. In other words, at times the share prices would be too euphoric. And on other occasions, extremely pessimistic. A rational investor therefore can take advantage of this by buying when the share prices are taking too dim a view of things and selling when they are too optimistic. So in effect, it is totally possible to beat the markets by employing a certain level of skill and rationality.
So which side are you on? As far as the great investor Warren Buffett was concerned, there was virtually no competition at all. He belonged to the Graham school of thought hands down. And during the same celebration of Graham's classic text, went about systematically destroying the myth that markets are efficient. He put forth a simple argument. He mentioned nine super investors who had all beaten the market over a considerably long period of time. Now, as per EMH, this could be pure luck because out of a nation of 225 million Americans, there will of course be a handful that will end up beating the markets.
But Buffett was not done yet. What if, he asked, all of these nine investors practiced the same investment principles as espoused by Benjamin Graham? Now, this can't be put down to pure luck, isn't it? If most of the new cancer cases in a country come from the same village, it certainly calls for checking the water the village drinks. Similarly, if a lot of investors who outperform the market follow the same Graham principles, the principles do hold merit. And it is these principles that Buffett was totally convinced about. In other words, as per him a share price is mostly a liar and does not reflect the true value. And investors from schools like Graham and Dodd High School can successfully exploit gaps between price and value.
If you are still not convinced, let's recall a very vivid incident from the Indian stock markets. The IPO of Reliance Power from a few years back. The issue was quite audacious we should say, with the company seeking to raise in excess of Rs 100 bn, making it one of the biggest IPOs to hit the Indian market. And investors were seen falling over each other in order to subscribe to the issue. Their excitement was fuelled not only by the record highs on the Sensex, but by investment bankers and analysts who literally whipped up a frenzy in explaining the merits of the issue. All this for a company that had not earned even a rupee in revenue at the time of going for the IPO.
However, our objective assessment had an entirely different story to tell. It told us that the company was on shaky grounds. Not only was there no underlying business to figure out the valuations but the issue too was excessively priced we felt. Therefore, rather than go with the herd, we preferred to go by the numbers and we recommended our subscribers against investing in the issue.
To cut a long story short, the IPO turned into a colossal failure and precious savings of thousands of small investors got eroded. So much for the markets knowing everything and the price being truthful!
Mind you examples like this are galore. There indeed are a lot of pricing anomalies that one can take advantage of from time to time. Market tops and bottoms especially are the periods where these irrationalities can be seen in their full glory. As a matter of fact, quite a lot of our track record across our services like ValuePro could be attributed to following the Graham and Buffett school of thought as far as market prices are concerned.
To conclude, while investing it would pay to share the sentiment of a famous investor called John Burbank who's very fond of declaring that 'Price is a liar'.
What do you think? Do you think you think it's better to treat the share price as a liar and make it your servant instead of your guide? Let us know your comments or share your views in the Equitymaster Club.
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The eternal bull on stocks, Rakesh Jhunjhunwala, fondly known as Warren Buffett of India, is known for his humour and satirical quotes. However, very few people know that he is quite outright too when it comes to presenting his opinions. One such instance came to the fore when he was being interviewed recently and got questioned on the e-commerce boom. Not only did he say that the current boom may end as the dot com burst did, he raised questions on the business model of Flipkart! Now, this is an e-commerce giant which has been able to attract billions of dollars in funding from the so called PE funds which are supposedly smart.
Hence, questioning its business model sounded naive for an investor like him. However, his question was genuine and did not reflect sarcasm.
Ability to generate profits is what seemed to be needling Jhunjhunwala. For the uninitiated, most of the e-commerce firms are currently burning cash and running into huge losses including Flipkart. Their focus is simply to increase volumes and grab market share.
And hence the question he posed was how will e-commerce firms turn themselves into profits? For your information, as per the data available from registrar of companies and quoted in a leading business daily, Flipkart earns 10-12% on the merchandise it sells. However, the cost of handling these goods itself is 15% odd. This makes the company a loss making proposition.
If it cuts the discounts to turn profitable, volumes may go down and impact its business. And this it may never do. Remember, the reason why people buy from e-commerce companies is because products there are cheap and available at a click of a mouse. If the pricing moat itself erodes, e-commerce firms will be at par with other brick and mortar firms.
Thus, on the face of it, profitability and growth appear to be north and south poles for e-commerce firms. May be investor rationality is currently clouded by the growth blanket and this needs to be lifted to get a clearer picture.
Though investors may have lost rationality when it comes to valuing e-commerce firms, government seems to have gained some when it comes managing PSUs. Just recently, government stated that some 5 loss making PSUs will be shut down. This is a landmark decision by the Indian government. Until now it was nursing these PSUs but it was evident that some day it had to take this call as sustainability was proving to be a big question mark.
To be quite honest we feel that government has taken the right decision to do away with managing these sick PSUs. In the first place, it shouldn't be in the business of managing businesses. That's because, all its decisions are not taken with keeping profits in mind. Secondly, quite a few PSUs lack talent and are embroiled in bureaucracy.
Roping in talent from outside and giving them a freehand is one way to come out of the mess the government is currently in. The other option is to shut out /sell and get out completely. With the Modi government choosing to do the latter for sick units, it would be interesting to see what it does with the listed profitable PSUs like BHEL, SAIL, Coal India etc.
It's a fact well known that the bad debt situation across the PSU banking system is certainly in a bad state. Today's chart of the day makes an attempt to put the magnitude of this problem in some kind of perspective. As the chart highlights, gross NPAs as a percent of total advances has reached a 10-year high and ruled at 5.64% if the data for the current financial year and up to December 2014 is anything to go by.
The last time the bad debts were so high was back in the year 2004-05. What's alarming is the fact that the bad debts have risen steadily during the current financial year led by sluggish economic growth and the uncertain nature of the global economy. However, it does look as if there's some help on offer with the government offering to set up six new debt recovery tribunals and the clearing of quite a few of the big ticket projects that are stalled.
Bad debts in PSU banks create new record
*Up to Dec 2014
The Indian stock markets are trading strong today. At the time of writing, the BSE-Sensex was trading up by around 215 points, while the NSE-Nifty was up by 59 points. Gains were largely seen in power and FMCG stocks. Most Asian markets were also trading in the green at the time of writing. European stock markets, however, opened mixed today.
"Investing in yourself is the best thing you can do. Anything that improves your own talents; nobody can tax it or take it away from you. They can run up huge deficits and the dollar can become worth far less. You can have all kinds of things happen. But if you've got talent yourself, and you've maximised your talent, you've got a tremendous asset that can return ten-fold" - Warren Buffett
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