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70% Earnings Upside Extends Well Beyond Sensex

May 6, 2016

In this issue:
» Will the Bankruptcy Code solve the bad loan crisis?
» Is the government doing enough to revive the infra slowdown
» ...and more!
0:00
Tanushree Banerjee, Co-Head of Research

Buffett was half joking when he said...

  • If calculus or algebra were required to be a great investor, I'd have to go back to delivering newspapers.

But you would rather not assume Buffett shied away from using math to his advantage. In doing so, you would be dead wrong.

None other than Buffett's partner Charlie Munger attributed the secret of Buffett's success to his mathematical thinking abilities. He once wrote...

  • One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations.

Now, Buffett's genius lies in identifying companies with the strongest moats. But without some math he would have hardly come close to generating the kind of returns he did for Berkshire Hathaway.

And to tell you frankly, at Equitymaster, we have had the same experience with some good math over the last 20 years.

Take for instance the case of Tata Motors in December 2008. The stock had crashed to one sixth its price from the peak of January 2007. Worse still, the financial media was speculating on the possibility of its bankruptcy. The acquisition of Jaguar Land Rover was pronounced as its death knell.

We all know what happened since then. That the stock gained 700% since our buy recommendation in December 2008 was not only the result of business evaluation. Of course we knew the company had some moat. And was being steered by a good management. But what helped us take the risk was some basic math.

We did not look for comfort in Tata Motors' EPS in the next quarter. Rather we tried to see if the stock price justified the normalized earnings over few years. And that told us it was time to claim what no one was thinking of. When we claimed that the stock was set to be yet another multibagger, we must have looked like fools to everyone. But couple of years down the line we did have the last laugh.

Similar was the case with Hindustan Unilever in 2010. The stock had gone through a lost decade. Investors had made no money on the stock for as long as ten years! And there was little to suggest things were going to be very different in the next few years.

Again a little bit of math helped us here. The stock was so underpriced from its intrinsic value that taking a bet was worth it. Of course here too looking at the latest earnings performance would have taken us nowhere. But the little math told us that our chances were heavily skewed in favour of fetching phenomenal returns over the next decade.

If you recall, Rahul Shah recently claimed that the Sensex earnings could potentially have an upside of 70% in 3 years. This too is a claim that finds its logic in the mathematics of our earnings estimates. And rest assured that we try to reaffirm the claim against all kinds of possibilities.

Now Sensex has a heavy weightage of financial, IT and energy stocks. One can claim that the PSU banks, IT behemoths and oil companies may not sport the kind of growth we have estimated. Especially if they do not have sectoral trends in their favour.

But what are the chances of bluechips outside the Sensex doing well? There is good news here too.

Plenty of blue-chip stocks outside of the Sensex can fetch earnings growth in excess of 15% per year over the next three years. But if earnings were to grow at 15%, and if profit margins were to rise to their ten-year average of 11% from the current 9.6%, an EPS of Rs 100 can become Rs 174 by FY19. Which means an upside of 74%.

And at least for few stocks, if the earnings growth goes to 20%, the earnings could easily double from the current levels.

An EPS of Rs 100 three years hence would be........

BSE 100 3year Earnings CAGR
Profit margin 15% 20% 25% 30%
9.6% 152 173 195 220
10.8% 171 194 220 247
11.0% 174 198 224 252
12.7% 201 229 258 291

So the odds of fetching big returns from the best bluechips are certainly in your favour currently.

PS: My StockSelect team is already on the lookout for opportunities where bluechips in the Sensex and beyond it have high earnings growth possibilities. Expect more update on this in the next 30 days.

Do you agree that some basic mathematical thinking can fetch strong returns from stocks in the long term? Let us know your comments or share your views in the Equitymaster Club.


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2:32 Chart of the day

The much awaited Bankruptcy Code has finally been passed by the Lok Sabha. Once the bill becomes a law after clearance from the Rajya Sabha, it is expected to ease the liquidation process of a company for the recovery of dues. While this law will no doubt arm banks with a potent weapon in their fight against Non-Performing Assets (NPAs), it will still does not address the root cause of the malaise.

Public Sector Banks (PSBs) have been reeling under corporate NPAs that have ballooned in the past three years. As per information from the Finance Ministry, bad loans as a percentage of total loans to the corporate segment have surged from 3.5% in FY13 to 8.3% by the end of December 2015. But the state-run banks grew their corporate loan book by only 11.8% during this period.

This means that a large proportion of the loans extended by PSBs after the global financial crisis have gone sour. In their pursuit for growth, the PSBs threw caution to the wind and paid little attention to the underlying asset quality. However, the economic slowdown was the final wake-up call. It not only led to slowdown in credit offtake but also rising incidence of delay and default in loan payments. Another cause for alarm has been the sharp jump in wilful defaults in the country.

PSBs initially tried to push the problem under the carpet by resorting to restructuring measures. With slippages refusing to die down, the RBI finally cracked the whip and asked banks to recognise bad loans in the last two quarters of FY16. As a result, the proportion of bad loans in the banking system has escalated to multi-year high levels. While stringent laws of the land will act as deterrent for future defaulting entities, PSBs will also have to pull up their socks in the area of risk management to nip the coil in the bud itself.

PSU Banks burdened by corporate NPAs

 PSU Banks burdened by corporate NPAs


4:01

Apart from the bad loan rot, the slow pace of infrastructure projects has been troubling the policymakers in the country. Therefore, to address the problem of high cement prices so as to improve the viability of road and housing construction projects, the government is contemplating to revive the state-run loss-making or closed cement plants. The government is already in talks with Cement Corporation of India that has six non-operating cement plants.

But we believe that such ad-hoc measures do more harm than good. The government's efforts to bail out sick public sector enterprises actually work against their spirit of entrepreneurship and profit maximisation, pushing them further into losses and non-viability. Vivek Kaul in his article has analysed the reason why public sector companies are today saddled with huge accumulated losses.

Therefore, instead of wasting precious time and resources in running companies, the government should rather focus on its role of framing policies and creating the enabling environment for doing business in the country. The resulting healthy competition will not only optimise the business environment but expedite the execution of large projects in the country.

4:30

We don't make a claim to understand what the economists are saying. Simply because very little of it makes sense to us. Apart from the likes of the RBI governors, we try to keep a distance from the views of prominent economists. And it seems the problems with economists' silly assumptions are not small.

Here is what Tim Price, the Director of Investment at PFP Wealth Management in London wrote recently.

  • Perhaps CAPM's silliest assumption is that all investors are the same. It requires only a superficial acquaintance with the financial markets to know that this can hardly be the case. The financial markets are where sovereign wealth funds interact with private investors. The former can often be insensitive to price; the latter, never. Within the financial markets pension funds, with a theoretical investment horizon of decades, rub up against computer algorithms looking to front-run other investors by fractions of milliseconds.

Read more of it here...

4:45

After opening the day weak, Indian equity markets continued to trade below the dotted line. At the time of writing, BSE Sensex was trading lower by 58 points and NSE Nifty was trading down marginally. Mid cap stocks were trading higher by 0.38% whereas small cap stocks were trading in the red.

4:55 Today's investment mantra

"The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Madhu Gupta (Research Analyst).

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Equitymaster requests your view! Post a comment on "70% Earnings Upside Extends Well Beyond Sensex". Click here!

2 Responses to "70% Earnings Upside Extends Well Beyond Sensex"

Prashant

May 31, 2016

mathematically it makes sense!! :) Great years ahead if this turns true

Like 

Sonu

May 6, 2016

Hmmm...makes sense.

Like (1)
  
Equitymaster requests your view! Post a comment on "70% Earnings Upside Extends Well Beyond Sensex". Click here!
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