Beware of the Megatrend's False Alarms - The 5 Minute WrapUp by Equitymaster
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Beware of the Megatrend's False Alarms

May 29, 2015

In this issue:
» Variation in March quarter earnings performance
» The rut in the power sector
» Why no one in China is bothered about gap in fundamentals and valuations
» ...and more!

"How do you know if you have got the big picture right? Don't you need to consult an economist to figure out the complex changes in the economic environment?" asked a 5 Minute Wrapup reader recently. Knowing that I am not an economist, he was inquisitive and quite puzzled. He wanted to know what qualifies me to make comments on something as big picture as an economic Megatrend, through The India Letter.

Frankly, not having a qualified economist in the research team is something none of my team members regret. And given the track record of economists in predicting stock market disasters, I think we are better off without one. More so because what we want to do most is keep out all the noise about monthly changes in inflation, IIP, GDP and interest rates. And instead focus on getting the long term trend right in corporate earnings and management quality. For that the economist will be of little help.

Now when it comes to the big picture about Megatrends in The India Letter, it is hardly something an economist can conjure up with some heavy duty number crunching on the desktop. Instead it is a picture that is constantly evolving based on our on-the-ground interaction with company managements and visiting factories and offices across the country.

And this is precisely the reason why we believe that it is our process of selecting stocks based on the Megatrend that will help us get the big picture right. Rather than following a rosy big picture painted by financial newspapers, based on contracts awarded and policy plans made.

There is a key reason why everyone hoping to cash in on India's growth story based on news reports and economists' views may not succeed. And that is not every company that vies for the growth pie will create wealth for shareholders.

Take the case of the defence equipment deals that are up for grabs. I had recently written about these in The 5 Minute Wrapup and also spoke about it in a recent discussion on Megatrends

Companies vying for licenses to make military equipments range from those in the Tata and L&T groups to Tebma Shipyards, Chowgule and Co, Solar Industries, Modest Infrastructure and Titagarh Wagons. Not just that! As per Mint, among the applicants, is telecom infrastructure company Himachal Futuristic Communications. Readers would recall this company being famous for its outrageous bids for telecom licenses in the late 1990s. And who can forget its run-ins with the stock market regulator during the Ketan Parekh scam? Both are now behind the company, which is seeking an industrial license to make airplanes, weapons and ammunition!

Thus the pedigree of companies who are positioning themselves to be beneficiaries of the 'Make In India movement' is varied. And one needs to do a very thorough checked of not just the past financial track record but also the management quality before investing in them. More importantly investing based on the government's 'decisions' to award contracts could prove to be false alarms of the Megatrend, unless the execution is seamless.

Therefore while you should be following the pace of change in the unfolding of Megatrends, it is important to not act in haste. Neither should you buy the companies that are unlikely to create any shareholder wealth. Nor should you buy good companies at one go, without paying heed to valuations.

Do you invest in stocks based on the rosy big picture projected by the media? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Now, is not just the big picture but also the micro picture of quarterly earnings performance that you should carefully read into. The fact that the bottom-line of all companies forming part of the NSE Nifty index has halved in the March quarter of 2015 is worrying. But that is not to say that this quarter's performance is the best indication of the company's fundamental strength or weakness. One look at the companies that have posted the biggest rise and fall in net profits on YoY basis respectively shows that sectoral cyclicality has also had a big role to play in the performance . And hence the trend of change in profitability may be temporary. Hence investors should not get too carried away with the March quarter's performance and instead evaluate stocks on the basis of their long term performance.

Variation in earnings performance

India's power sector seems to be stuck in a rut. On one side, we have excess capacity situation, leading to not very encouraging financial health of the companies. Plus with, power distribution companies (discoms) continuing to bleed, payments are getting delayed and power off take is under pressure in the process. As reported by the Economic Times, generation companies' average plant load factor (capacity utilization ratio) stands at about 65%, the lowest figure seen in about a decade and a half.

On the other hand, new capacities are not coming up. No new projects have been announced in the past two years. Bids for UMPPs received are very dull response, given the unattractive bidding parameters. Given that setting up power plants takes a good number of years, concerns are more with India facing supply side issues in the future. The point of India having excess capacity gets ruled out, considering that the nation's per capita consumption is way below the world average. From that perspective, the prospects of the sector remain strong.

From the heydays of 2007-08, power sector stocks have been the least favoured over the past many years. But with valuations hovering around multiyear lows, we do believe there is a good amount of downside protection available. To participate in the sector, it would be best to stick with the leaders with a proven track record.

The loose monetary policies of the central banks in Europe, US and Japan have largely been responsible for the distortion in the behavior of the financial markets today. Indeed, stock prices have run up in these regions largely because of the excess liquidity. This is despite the fact that fundamentals are as weak as ever. So the reality is that there is a big disconnect between the stock markets and the economies when both should ideally move more or less in sync.

But the developed world is not the only one relying on liquidity doses. China is following in their footsteps as well. Indeed, it is a well known fact that the Chinese economy has slowed down. It is no longer growing at the rate that it did before the 2008 crisis. And yet the Chinese stock market has ignored this and has continued to notch gains. What more, the Chinese retail investor does not appear to be too concerned about the gap between fundamentals and valuations. These investors are of the view that as long as the government keeps introducing stimulus measures, stock prices will gain. So the fact the Chinese economy is not doing too well is of little concern to them. And so the investment in stocks has been driven by sentiments rather than sound logic.

This is quite dangerous we believe. Indeed, in India too, in the last one year, stock markets have rallied even when the Indian economy has yet to recover significantly. And here we would like to emphasize that Indian investors do not emulate their Chinese counterparts. Indeed, rather than investing based on government policies and sentiments, investors should instead focus on good quality stocks. And invest in them only if the valuations look reasonable and not because stock markets are generally going up.

After opening flat, the Indian stock markets climbed up sharply by mid-morning. At the time of writing, the BSE Sensex was trading higher by about 321 points (up 1.2%). All sectoral indices were trading in the green with banking, IT and pharma stocks being the top gainers. The midcap and smallcap indices were also higher by 1.5% and 1.2% respectively. While the Asian indices closed a mixed bag, the European markets have opened in the red.

 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

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

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1 Responses to "Beware of the Megatrend's False Alarms"

Krishna Kumar

May 30, 2015

Any one talking to me will never invest in equity. Indian corporates are more corrupt then political systems the rot is too deep. My father used to invest from 60s thru 90s he died after great scams of Harshad Mehta and Ketan Pareikh financially ruined him. The scamsters who were directors of vanishing companies are not traceable anymore Neither Ministry of corporate affairs , SEBI,BSEs or NSEs have list of directors of companies which vanished after making huge IPOs. They have not died . They have changed their identities and are continuing to operate in Markets. Stock market funds are used to divert public money to privately held companies and declare themselves as BIFR companies. Please do not misguide people in to investing in equities. I guarantee all power sector companies will go BIFR way or become defunct. When 60% of power is lost to theft or given away free how will investment return ever happen ?

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