Multiply your wealth by 'holding dogs'... - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Multiply your wealth by 'holding dogs'... 

A  A  A
In this issue:
» The reason why Gujarat leads in manufacturing jobs
» Are bubbles and busts really bad?
» Is Goldman Sachs' optimism on PSU bank stocks valid?
» Here is why you should never write off investing in India...
» ...and more!

When you're investing in stocks what do you think is the real risk? If you were to go back the value investing philosophy espoused by Benjamin Graham and his protege Warren Buffett, the real risk in investing is the business risk. This is the reason why they have always emphasized on two key factors:
  1. Buying fundamentally sound businesses, and
  2. Buying them at bargain prices.
This approach makes sure that you avoid risky businesses and also do not get tempted to buy stocks that are trading at very lofty valuations. Hence, for value investors stock market volatility is a good thing. It throws up value buying opportunities from time to time.

But some economists tend to be obsessed with expounding complex theories; however removed they may be from reality. Take the Efficient Market Hypothesis (EMH) and the Modern Portfolio Theory (MPT). Both these theories have one simplistic assumption at their core: risk is defined by volatility. They took market fluctuations as a proxy for investment risk. This meant that more volatility would mean more risk.

How about factors such as business model, financial health, earnings, debt, etc.? For proponents of these theories, paying attention to these factors was a futile attempt because markets were perfectly rational and efficient. So every valid piece of information was already incorporated in the stock prices.

But we know from experience that this is not true most of the times. The mood of Mr Market often tends to swing between the extremes of optimism and pessimism. And this is what value investors aim to take advantage of. Buy when Mr Market is irrationally gloomy and sell when the opposite behaviour takes over.

Now here is something very interesting that you must make note of... Nobel laureate Eugene Fama who put forth the Efficient Market Hypothesis in the 1970s, confessed two decades later that there were some serious flaws in the theory. In 1992, he co-authored a paper on risk and return along with Kenneth French. The two economists had examined 9,500 stocks between 1963 and 1990. That's a pretty large sample size and a fair long time span. What were their findings? They found out that volatility had hardly any relation with stock returns. In simple parlance, it meant that taking higher risk, as defined by volatility, did not seem to result in higher returns. This was as good as saying that there were deep, fundamentals cracks in the Efficient Market Hypothesis and Modern Portfolio Theory that they had earlier championed.

So what is it that investors get rewarded for? In the words of Kenneth French, "What investors really get paid for is holding dogs."

What does 'holding dogs' mean? In their research, Fama and French discovered that stocks with lower price to earnings ratios and price to book ratios, as well as smaller market capitalisation companies provided the highest returns over time.

Ben Graham and David Dodd had penned down a very similar investing approach as early as 1934 in their investing classic Security Analysis. And has their value investing philosophy stood the test of time? There is absolutely no doubt about it. Investors who have followed their wisdom have been very handsomely rewarded.

Do you think investing in undervalued 'dogs' offers great wealth creation opportunities? If yes, then go ahead and read full details about this "niche" strategy that has the potential to help you select a series of winning microcap stock picks.

01:15  Chart of the day
There is no doubt that India needs to do a lot of ground work if it wants to become a manufacturing powerhouse a la China. That said, if one were to do a comparison among various Indian states, some of them have done quite well on this front, while others have significantly lagged behind. Why the difference? The answer lies in labour laws. Indeed, it is quite well known that India labour laws have been quite rigid. This is because employers do not have the flexibility to fire workers unless various conditions are met. Moreover, they have the wrath of the labour unions to contend with. Thus, it comes as no surprise that a report by Goldman Sachs and published in Firstbiz has highlighted that those states that are pro-employers have reported good manufacturing growth. This is as against those states that are pro-workers.

According to the report, Gujarat tops the list with an average employment of a little more than 350 per 1,000 people employed in manufacturing. This is between financial year 2004-05 and financial year 2011-2012 (April-May). In other words, states with flexible labour laws have reported higher increase in total factor productivity. Moreover, the younger set of workers prefers flexible job markets. This allows them to change jobs even if it means there is the likelihood of them being fired. Thus, it will be interesting to see how the new government will view this report and whether finally we will see some action in terms of reforming India's labour laws.

Gujarat Has Created Most Manufacturing Jobs

Who do you think is at the centre of an economy? The Government? The central bank? Or is it the consumer? Well, we'll go as far as saying that it is none of these but a business leader. Simply because it is the leader that takes judgement about the future and then deploys resources to convert them into finished products. In short, it is the oil that provides the much needed lubrication to the machine known as the economy. Now, do all the decisions that the business leaders take turn out to be right? Certainly not! There are times when these leaders turn extremely optimistic and then there are times when pessimism dominates.

As a matter of fact, everything else remaining constant, it is these tendencies of theirs that lead to booms and busts. And no matter how well informed these leaders are, it is almost impossible to prevent a boom or a bust from occurring from time to time. On the contrary, these are necessary elements of a well-functioning market since they provide the much needed cleansing process.

Booms and busts help weed out inefficient players and aid in setting the economic house in order. It is no wonder then that Nobel Laureate Robert Shiller feels that bubbles may not be all that bad, including those occurring in the financial markets. Shiller gave an example of the internet bubble. He argued that what it did was it generated a lot of start-ups, some of them foolish. Some of them failed but others survived. So is that a bad thing, he asks further. Well certainly not. And as we highlighted, we couldn't help but agree.

These companies are currently more valuable dead than alive. At least their valuations say so. So why then have the public sector banks in India not become value investors' favourites? Well there is more to it than their price to book value multiples which on an average is around 0.5 times. Investors looking at such stocks would commonly hope for a re-rating. In fact as per Financial Express, Goldman Sachs is of the view that stocks in PSU banking space are on the cusp of re-rating. The investment bank has rationalized that the election outcome and improvement in macroeconomic scenario will change the fortunes of the players. It appears that Goldman Sachs does not see the non-performing asset burden a meaningful risk to the sector. Or it believes that the election outcome could miraculously help the banks recover their bad loans. All said and done most of these banks are facing an acute pressure on their net worth. Most are likely to dilute equity to meet Basel III capital norms. And the low profitability coupled with equity dilution could only squeeze shareholder returns further. So according to us, investors would be better off not speculating on these stocks based on election optimism.

In FY08, there were four Indian companies that reported earnings in excess of US$ 1 bn. In the current year, the number is expected to touch eighteen. This is the count after keeping the rupee-dollar rate constant at current levels. If we take the dollar rate that was prevailing towards the end of FY08, then the count for FY08 would increase to thirteen. Given the slowdown in the Indian economy over the past few years, this is indeed a positive sign. As pointed out by Business Insider, thirteen out of the eighteen companies are likely to be private companies, as compared to three out of the four companies in FY08.

Taking a very broader view, this development does go on to indicate that one should not completely write off equities during difficult times. Sure, while there would be certain firms whose financial performances go for a toss, there are many who wiggle through and emerge stronger once the tough phase passes by. It is ideally such companies that investors should have as part of their portfolios. While one may argue that the past few years have been marked by inflation, rupee depreciation and commodity price increases - thereby providing strong tailwinds to certain sectors - we believe taking the approach of investing in high quality companies (those which are able to pass on prices and do so, in a profitable manner) would be a good enough margin of safety against all issues and concerns related to the volatile macro environment.

During the week gone by, global markets stood quite buoyant. The buoyancy in markets was boosted by the rise in world stocks on positive China remarks. The moderate sluggishness in US markets was primarily due to the harsh weather. That said, the steady US economic growth traction and the positive employment growth with improvement in labor market would prove encouraging for the US markets. The European markets witnessed healthy rally during the week gone on the back of expectations that the European Central Bank may ease the policy rates next week to support the fragile recovery. German and French markets inched higher by 2.6% and 1.8% respectively, as at the end of the week. The UK market was up by 0.9% for the week.

Asian markets got the much-needed boost with the upbeat US data and diminishing concerns over the Ukraine/Crimea crisis. Following a recent run of disappointing Chinese data, many economists expect China's growth missing the government's target of 7.5% this year in the absence of effective support measures. But the chances of Chinese stimulus remain. The Chinese markets were down by 0.3% for the week. But Japanese markets witnessed some momentum on account of economic recovery. The Japanese markets stood higher by 3.3% for the week gone by. Back home, the anticipation of positive outcome from the impending elections and the expectation of policy easing by the Reserve Bank of India (RBI) in light of lower inflationary pressures boosted the Indian markets during the week. Indian stock markets were up by 2.7% for the week.

Most of the sectoral indices ended in positive territory for the week ended 28st March with Power (up 6.8%), capital goods and banking (up 5.6% each) and metals (up 5.2%) being the biggest gainers. Pharma (down 1.8%) and IT (down 1.1%) were the losers for the week. Expectations that a new government will assume power at the centre and shall break policy deadlock has given a new fillip to Indian stock markets. Also, as inflation has shown signs of cooling down, there are expectations that the RBI may adopt a dovish approach. Therefore, expectations for economic reforms and faster decision making have revived confidence in India's growth story.

Performance during the week ended March 28th, 2014
Data source: Yahoo Finance

04:45  Weekend investing mantra
"The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective." - Warren Buffett
Today being a Saturday, there is no Premium edition being published. But you can always read our most recent issue here...
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1 Responses to "Multiply your wealth by 'holding dogs'..."


Mar 29, 2014

I agree that by adopting the age old principle of BUY LOW, SELL HIGH,together with good earning potential and good management you can create good sound portfolio over a period of time . To pass time and get some extra income/loss one can engage in trading and take advantage of volatility. SANKARAN VENKATARAMAN

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