A ratio most value investing gurus rely on - The 5 Minute WrapUp by Equitymaster
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A ratio most value investing gurus rely on 

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In this issue:
» Can gold go up 30% this year from current price?
» We were better off without NREGS, says a study
» Why is Mr Emerging market now bullish on US?
» Bill Gross finds US treasuries a safe haven
» ...and more!


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00:00
 
1999. Up until this year, we always thought that Warren Buffett was all about picking the right stocks and focusing on individual companies. But then something unusual happened. He, perhaps for the first time ever, came out in the open with his view on the general level of stock prices. And we are quite glad he did that because it led us to a very important ratio. What this ratio does is it measures the portion of a nation's GDP that ends up every year with the shareholders of American business. In other words, what is known as the corporate profits to GDP ratio.

The fact that Buffett uses this ratio to arrive at his views on the general market value does make it worth looking at. In fact, it is not just Buffett who finds this ratio of great practical utility. Jeremy Grantham, another famous value investor, also swears by it. And the reasons are not difficult to find. The nation's GDP should be carved up in such a way that all the stake holders viz. the Government, employees and shareholders who are entitled to a share of it are made better off. If shareholders end up getting more and more share of GDP every year, then there will come a point where either the Government or employees will intervene and make the profits come back to its long term mean. Besides, higher profits always attract competition and hence, this is another factor that will help in keeping profit margins down.

Thus, with these corrective mechanisms in place, is it any wonder that Jeremy Grantham calls profit margins the most mean-reverting series in finance. There's enough data to back these claims up. On a long term basis, corporate profits as a percentage of GDP in US have stayed remarkably consistent at around the 6% of GDP mark. There have been times when it has gone lower but has recovered lost ground in subsequent years. And there have been occasions when it has gone higher only to fall back over the next few years. As per reports, the present level of profits in US is around 70% higher than the historical average. And a lot of experts believe this is the main reason why US stocks would decline in the next few years.

Thus, in conclusion, using only market PE ratios to understand where markets are headed is a wrong way to approach the whole thing. Efforts also need to be made to understand where profit margins stand. If they are lower than historical averages there are chances that markets are attractive even if PE seems a bit elevated and vice versa. In fact, analysing whether profit margins of an individual company are below or above long term averages can also turn out to be an important indicator other than the PE ratio. Therefore, it's time you start you start taking seriously this simple yet very useful ratio if you haven't already.

Do you think studying corporate profits to GDP ratio will help you give an idea of overall market levels? Please share your comments or post them on our Facebook page / Google+ page

01:32  Chart of the day
 
The broader markets would have hardly budged over the last five years or so but that hasn't stopped few stocks from turning into multi baggers. Like the group of best performing small caps highlighted in today's chart of the day. Going up nearly 41x in the last five years, Symphony clearly leads the pack. However, investors would happily take even 15x returns like those given by the last name on the list. While we would not vouch for the fundamentals and management quality of each of these stocks, there is no doubt about the fact that attractive returns can be had even in sideways markets. Particularly if one focuses on companies with good competitive strengths and run by honest and capable management teams and invests for the long term. However, since for every company in the chart there will be many more that that failed to perform, one's exposure to such stocks should not be very high we believe.

Source: ACE Equity


02:06
 
After the recent decline in gold prices we saw a rush of people chasing the yellow metal. The recent fall in prices was viewed as an attractive buying opportunity by many. In fact, the surge in demand in the international markets was so huge that many were willing to pay a small premium to buy gold. In short, the general consensus was that prices are likely to rise and the correction was just an aberration. Now, this consensus has received a voice. And that too from a noted Indian billionaire jeweller. As per Mr T S Kalyanaraman, promoter of Kalyan Jewellers, gold price is likely to rise by as much as 29% by the end of December. He feels that current price levels will induce buying by fund managers as well as general public. This is likely to push gold prices to even higher levels. Also, the fact that India's overseas purchases are likely to jump by 36% YoY during the quarter ending June gives comfort that demand over the next few months is likely to remain strong.

Another important point that Mr Kalyanaraman highlighted is that the breakeven price for miners of gold is about US$ 1,250 per ounce. And the current price of gold is about US$ 1,400 per ounce. So, if prices fall further, miners would be reluctant to supply as their margins would come under stress. This should decrease the supply of gold thereby increasing prices. As such, even economic logic says that gold prices are at their bottom. And there is only one way where they could move from here which is up.

02:52
 
What does "emerging market" bring to your mind? The term, which became extremely popular in the previous decade, is almost synonymous with several fast growing developing economies. But a certain gentleman had spotted the idea as early as 30 years ago! Mr. Antoine van Agtmael was the man who coined this popular term.

Which is his favourite investment destination now? You may be surprised to hear that it is the US. As per him, the US is on its way towards an 'industrial revitalization'. What are his reasons? For one, rapidly increasing labour costs are weakening China's cost competitiveness. On the other hand, the US has some very strong advantages. Energy costs are declining on account of the cheap oil and natural gas from shale. Moreover, the US ranks much better China on the infrastructure front.

While we do agree with this gentleman on the factors highlighted above, he seems to have completely ignored the fact that the US has a massive debt burden to deal with. The US government has done nothing constructive to solve their fiscal problems. The economy has been recklessly put on a diet of monetary steroids. We believe that any major negative shock in such a situation could send the economy in complete disarray.

03:28
 
The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) was a well received plan. A step in the right direction towards uplifting the livelihoods of rural India! As stated on program's website, it was initiated to provide for the enhancement of livelihood security of rural households. This effort does sound like a good thing on part of the government. However, the Commission for Agricultural Costs and Prices (CACP) feels differently. Business Standard has reported that the CACP's discussion paper suggests that things could have been different. This it says so because growth in overall GDP, agriculture or construction seemingly tends to raise wages faster.

As such, if the Rs 2 trillion (since 2006) allocated towards MGNREGS had been spent towards such efforts - rural-urban construction or towards growth - rural households would have earned more. CACP's key argument is that the NREGS was not the main reason behind higher farm wages. Rather, it was the overall growth that led to the same. While it makes it difficult for one to gauge the argument, it does bring one question to our mind. Is this yet another plan gone wrong for the government?

04:01
 
Printing more money to settle the old debt is bad. It can only feed the vicious cycle. That is what we have learnt in the last few years of economic turmoil. However, it is this policy of Fed that Mr. Bill Gross, the cofounder of Pimco and manager of the world's largest Total Return bond fund might wish to continue. Gross is seeking refuge in US treasuries and has shifted a third of his assets to this class. The logic is hard to digest considering that the low interest rates and quantitative easing policies with no real growth are likely to fuel inflation, lead to higher interest rates and finally erosion in the value of bonds.

It is interesting to note here that it is his lack of optimism in other asset classes that is making the treasuries look greener. It is also about turn from a bearish stance in 2011 on US debt earlier that did not pay him well. He finds treasuries stable due to Fed policy and low inflation levels in the economy. So basically, he is counting on the fact that the US Government will keep printing money and keep interest rates low. And that none of these measures will lead to any economic recovery. However, we don't think that with no growth, high debt and huge fiscal deficit, US treasuries should be favoured from a long term perspective.

04:42
 
Meanwhile, Indian equity markets indices traded lacklustre today with the Sensex lower by around 80 points at the time of writing. Realty and banking stocks were seen exerting maximum selling pressure. Other Asian indices too traded weak and closed in the red today whereas Europe is trading in the positive currently.

04:52  Today's investing mantra
"There are all kinds of businesses that Charlie and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one, and that's what the individual investor should do" - Warren Buffett

  • Warren Buffett - The Value Investor
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    4 Responses to "A ratio most value investing gurus rely on"

    P.V.Ranganathan

    Apr 24, 2013

    This is an interesting concept but how can we ascertain this ratio over a period of time in India to be of any use to the investors?

    Like 

    sajith

    Apr 24, 2013

    What would happen to gold price if the existing stockpile come up for sale? Would the mining cost of gold still hold any relevance? Though highly unlikely that existing holdings come out for sale,it is still a point to ponder,theoretically at least!!

    Like 

    Shirish

    Apr 23, 2013

    Would love to know what is this ratio for India.

    Like 

    Mahesh Kumar

    Apr 23, 2013

    Hi Ajit, I would like to ask you the following question, since you are associated with EM and Quantum AMC.
    Which ivestment decision will you recommend for people who have no time/skill to invest in equity-
    Opt one or more services offered by EquityMaster like StockSelect, hidden treasure etc, or Invest in QuantumLTEquity Fund. While selecting stocks for QLTEF, does the team follow the same methods as that of selecting stocks for HiddenTreasure, stock select etc.

    Like 
      
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