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Would you rather lend than buy?

Apr 27, 2015

In this issue:
» Bond versus value investor
» IT behemoths log out of FY15 on a disappointing note
» Should you prefer a midcap portfolio over largecap?
» ...and more!

"I am a value investor." declared the octogenarian owner of a pawn shop, showcased in a recent episode of television series 'Pawn Stars'. The gentleman was contemplating giving out a loan against the security of an antique watch or buying it. But he wanted to make sure that the money he spent would be a lot less than the value of the watch. It was not the seriousness with which he declared himself to be a value investor that I found funny. But the fact that most lenders, corporate lenders to be more precise, do not think in this manner. I am not referring to the PSU banks who have lent to companies with poor cash flows. But to investors like you who invest in corporate bonds of listed companies.

Now, if you are a good lender, then you would want to make sure that the business to which you are lending money is worth a lot more than the loan. So even as a bond holder you would want to subscribe to bonds of companies that are AAA rated. In other words the cash flows of the company are sound enough to service your debt.

But when it comes to stocks, as an investor, you may end up ignoring a debt free company that is under valued, especially considering the potential of its cash flows.

Let me explain this to you with an example. Say the market capitalization of company A is less than Rs 500 crores. Since the company is debt free and has healthy cash flows it can easily raise Rs 500 crores via corporate bonds. So it can use its cash flows either to pay interest to bond holders or to pay dividends to equity shareholders. Now if the market continues to value the company below its debt servicing capacity, the management can easily sell the bonds, which can leave their equity ownership intact. Can they not? So the option for an investor is to subscribe to bonds of a company with healthy cash flows or to own a stake in it.

Here is the quote from Ben Graham's Intelligent Investor which describes what I have just explained:

"There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond with all the chances of large income and principal appreciation inherent in an equity share."

Thus margin of safety is something that does not come just from low PE multiples. But the balance sheet and cash flows of the company can offer what is called 'debt capacity bargains'. And in such cases investors must evaluate if they would be better off as bond holder or value investor for such stocks.

The reason I am highlighting this is because we are living in times when investors are all focused on earnings per share (EPS) and its growth. In doing so they may be ignoring some interesting bargains offered by companies with solid balance sheets and strong cash flows.

Where do you look for bargains other than the PE multiple of the companies you wish to invest in? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
Almost all of the business dailies carried stories of dull earnings sentiments today. As reported by the Business Standard, 100 odd companies that have reported results for the quarter ended March 2015 have seen their combined profits come down by 9% YoY; revenues on the other hand are down by about 16% YoY. With the information technology majors having come out with their results for the latest quarter, the talk of the town has been their dull performance and the shaky outlook provided by them; thereby setting a dull tone.

Today's chart of the day shows the past year trend in the revenue growth of the major four IT players - TCS, Infosys, Wipro and HCL Technologies.

A dull Q4 for the IT biggies

As you can see, the latest quarter was subdued for all, with dollar revenues coming in flat to marginally lower. While clients from sectors such as insurance, energy and telecom have been cutting down expenses - impacting players across the board - sentiments from other major sectors such as the BFSI space seem to have been mixed and subjective. But a trend that is common is of clients across regions (barring Asia Pacific) cutting down on their IT needs.

Further, the managements of the major IT firms believe that the competition scenario is changing too with the emergence of niche local/ regional players. The traditional IT services businesses are becoming more commoditized, with players finding it more and more difficult to maintain their pricing powers. Not to mention that they have not been able make a massive dent in the newer verticals yet, as they contribute to low to mid single percentage figures of their revenues.

What is the outlook? Well... the times ahead will be interesting considering that integration of the increased acquisition activity coupled with the annual salary revision which is underway in the ongoing quarter.

But according to our in-house IT analyst, it is not the earnings in the upcoming quarters that investors should be worried about. But the synergies and efficiency coming in from Infosys' acquisitions and Wipro's automation drive that could be the big game changers. And as long as the long term story remains intact the near term blips could be the very investing opportunities you should be looking out for.

Mid and smallcap stocks as represented by their respective indices - the S&P BSE Midcap and S&P BSE Smallcap indices - have done very well over the past year. As compared to the Sensex' one year gain of 21%, the two indices have returned as much as 44-48%. However, the same is not the case when the five year period returns are compared. It now seems that with the benchmark indices competing in terms of returns, investors are now confused as to where to put money - largecaps (due to the long term outperformance coupled with recent correction) or mid & smallcaps (given their short term outperformance).

Well, we would say that as an investor, you would be better off taking a call on their positions and prospective investments on a subjective basis. Factors such as valuations, earnings outlook, earnings quality, company's standing in the sector - essentially, factors to gauge the risk reward ratio - should be taken into consideration. Investors would also do well to gauge and understand what is priced into each stock. If the expectations are seemingly too high, staying away would not be a bad idea.

Above all, one should not get carried away by the market movements. Instead, the risk profile of the investor and the risk associated with the stock should be the deciding factor. If one cannot handle volatility, it would be best to stick to the stable businesses - irrespective of them being small, mid or largecap companies. Importantly, at no point of time should you ignore their asset allocation in stocks.

Persistent selling activity led the Indian markets to decline gradually as the day progressed. At the time of writing, the BSE-Sensex was trading lower by 180 points or 0.7%. Weakness was seen in stocks across the board with realty and pharmaceuticals leading the pack of losers. Asian markets ended the day on a mixed note. European markets too were trading mixed at the time of writing.

 Today's investing mantra
"Organised common (or uncommon) sense - very basic knowledge is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little. Part of [having uncommon sense] is being able to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don't clutter yourself." - Charlie Munger

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

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