Do these stocks deserve premium valuations? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Do these stocks deserve premium valuations? 

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In this issue:
» Why Munger believes Europe has made ghastly mistakes
» Investment banking has a muted future
» Indian PSUs not the only ones being milked
» Will low inflation data prompt interest rate cuts?
» ...and more!

Blue chip stocks are revered for being the market makers, innovators and trend setters in their respective sectors. It is not unnatural for these stocks to be the biggest gainers of an uptrend in demand in the sector. With their large market shares and established brands, most enjoy reasonable pricing power. Their business models have much wider moats than their smaller peers. The consistent flow of information from the management of these companies, whether or not relevant to their long term performance, also offers comfort to some investors. Needless to say investors are easily lured into paying a premium for blue chip stocks.

There is nothing wrong in valuing few stocks at a premium to their peers, if they deserve it. But the mistake that investors often make is paying a premium with myopic view of fundamentals. Take the instance of Indian companies making foreign acquisitions between 2007 and 2009. Their ability to raise funds at cheap rates overseas was no logic for Indian blue chips to make expensive acquisitions. Corus (Tata Steel), Orient Express (Indian Hotels), Novelis (Hindalco) and Repower (Suzlon) turned out to be bitter pills for the parent companies. Each of these companies risked their shareholder returns to make expensive investments. Eventually most of the investments were impaired and the losses of the foreign subsidiaries eroded the profits of the parent entity as well. As per an article in Economic Times, Indian Hotels' attempt to buy out Orient Express was snubbed by the bankers several times. This was after the company wrote down its investment in the Bermuda based hospitality company by nearly 80%! In Suzlon's case, the huge debt burden to buy Repower got the company in the throes of bankruptcy!

Rest assured these were not one-off cases. Several profitable blue chip stocks have a history of squandering share holder wealth. Diversifying into unrelated business, taking risky exposures to derivatives etc, investing in loss making subsidiaries, over paying for brands are just few of their follies. Being in the business long enough too has not prevented the managements from making cardinal mistakes.

Thus investors would do well to dispel the notion that all blue chip stocks are safe to invest in, at any price. For that matter even the ones that have been safe for long should also be evaluated on a regular basis on the risk parameters. Else you could end up paying for a premium for companies that take shareholder returns for granted.

Do you think the blue chip stocks that take shareholder returns for granted deserve premium valuations? Please share your comments or post them on our Facebook page / Google+ page

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01:35  Chart of the day
We recently came across an article in Moneynews articulating why billionaire investors like Buffett and Soros are no longer bullish on the consumption story. The veteran value investor has been very disappointed off late with the performance of American FMCG giants like Johnson & Johnson, Procter & Gamble and Kraft Foods. However, with 70% of the US economy being dependent on consumer spending, Buffett's apparent lack of faith in these companies' future prospects is worrisome. Hence we decided to check if the trend is similar in Asia. As data from a report released by consultancy firm PricewaterhouseCoopers (PwC) shows, the growth trend is definitely slowing even in the Asian region. However, for countries housing the world's largest population groups, India and China, the growth in FMCG demand will continue to be a multiple of that in the developed world.

Source: PricewaterhouseCoopers

The Euro zone is suffering one of the worst crises in history. There are news reports saying that things are stabilizing. But there are an equal number of articles, if not more, that talk of how bad things are in the region. Unemployment is at a record high. Prices have slumped. Countries are taking on austerity measures but almost no one has shown any solid signs of improvement. In the opinion of Charlie Munger, Europe has made ghastly mistakes. And these mistakes are related to policy. He feels that Europe's biggest mistake was to accept Greece as a part of the Euro zone. Its economy is just not the perfect fit for the zone's overall strategy. Therefore all measures that the Eurozone and ECB are taking would only muddle through. We completely agree with Munger on this. In order to survive the zone needs to take harsh decisions. But instead it has resorted to printing money. And by the looks of it this cheap money is not really helping anyone. All it is doing is to postpone the crisis. But eventually it will come back and hit them. Crisis has to be resolved. It cannot be postponed to another date.

It's a well known fact that the financial innovations, a brainchild of investment banking industry (IB) were at the heart of financial crisis that struck us few years back and still continues to haunt us. That the returns are directly proportional to risk was taken too literally by the IB industry. And the result was an overgrown asset bubble, bigger than the size of real economy backing it, and hence doomed to bust.

As the global economy still remains crisis struck, will new lessons be learnt? Well, as an article in The Economist points out, the irrational growth in IB industry is likely to be held back on account of cyclical and structural changes. The cyclical factors include a slowdown in the global economic growth and trade. The same has led to less appetite for risk, something on which IB industry thrived. Even if the cycle reverses, there are structural changes likely to keep IB industry in check. The wave of new banking regulations are likely to limit the gambles played by investment bankers. With stricter norms, the size of bank balance sheets is likely to remain in check. Hence, the IB industry is unlikely to witness the growth it enjoyed in the past. However, we hope it will have a stable future which is more important.

We have often highlighted how the Indian government has been the biggest threat to the PSUs (Public Sector Undertakings). It has often put its own agenda before the financial well-being of the firm. And this has resulted in numerous loss making PSUs. On the other hand, the government losses no chance to milk profit making PSUs. As a result, listed PSUs often trade at a discount to their private sector peers.

But if you thought this situation was unique to India, you'd be highly mistaken. After the collapse of mortgage firms Freddie Mac and Fannie Mae, the US government had taken over the two firms. The government infused about US$ 187 bn and acquired special preferred shares in these two entities.

Ideally, the government should concede control of these firms once their financial health recovers. And allow them to play by the market forces by returning them to the private sector. As per an article in Barron's, the US government is not willing to do so. It is sucking away their capital and profits and keeping them perpetually weak. In fact, the government could rake in good returns if it takes these two firms public, through an IPO. But it chooses to do otherwise.

The root problem in all such cases is political agendas taking priority over economic logic. This is why we often suggest investors to be careful while investing in PSUs.

Misuse of confidential customer data remains one of the biggest concerns in the digital world. Bloomberg is the licensee for the most widely used terminals in financial institutions. However the company has been in the news recently for all the wrong reasons! It has been at the receiving end of complaints over its journalists having access to sensitive data of the terminal users. The users include central banks from across the world. With data - such as private messages as well as trading activity - of such clients being available to reporters, it could put the markets in frenzy in case of leakage. In fact, it is believed that the company's journalists have had access to such data since the 1990s. Central banks from across the world - including the Bank of England, the People's Bank of China, and European Central Bank - are quite agitated and are looking at resolving the potential data confidentiality issues with the company.

After three years of staying consistently high, wholesale price index (WPI) finally fell below 5% in April 2013. This means that inflation is now within the comfort zone of the Reserve Bank of India (RBI). Inflation so far had been a big headache for the central bank. As a result of which it was not comfortable cutting interest rates. This is even when economic growth had considerably slowed down. With this latest piece of development, there are once again increased hopes that the central bank will bite the bullet and cut rates in its next monetary policy meeting. With commodity prices easing, there was some breather on the food inflation front as well. This slumped to 6.1% from 8.7% a month ago. Similar was the case with non-food manufacturing inflation, which slowed to 2.8% in April from 3.5% a month ago. This is after the international prices of iron ore and steel dropped. However, a lot will depend on how this trend pans out in the coming months. Further, the consumer price inflation data will also play an important role in determining the central bank's further actions.

Buying interest in banking, commodity and auto stocks have helped Indian indices make a strong recovery after yesterday's correction. Backed by positive cues across Asian equity markets, the key indices in Indian equity markets have retained the momentum since the start of the session. The BSE Sensex was trading higher by around 471 points at the time of writing. Other major Asian markets closed in the positive while markets in Europe opened higher.

04:50  Today's investing mantra
"A business or stock is not an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." - Warren Buffett

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    2 Responses to "Do these stocks deserve premium valuations?"


    May 15, 2013

    I agree that these stocks do not deserve premium valuation.
    1. Tata Steel have bought the foreign inventure when the world market was at the peak.
    2. Indian Hotels have also acquired foreign assets not at correct price.
    3. Suzlon was over ambitious when they acquired the German venture, with the result that they are burdened with heavy debt, which will take decades to clear the debt & come into black. But I am confident about success in this case.

    Like (1)

    Borkar M.R.

    May 15, 2013

    Sir, I beg to differ with u when "u say Govt's own agenda". It is individual politician's agenda that is pushed forward. In his previous Avatar as FM (if I correctly remeber) Mr. Chidambaram wanted banks to consolidate (in 4/5 big ones). What would have happened if that was in place when 2008 melt-down took place? The schemes are floated with only one aim "to secure the Chair. What happens in practice is one thing.
    Long Live Poor Indians

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