Can you profit from the mistake that shaved off 4% from India's GDP? - The 5 Minute WrapUp by Equitymaster
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Can you profit from the mistake that shaved off 4% from India's GDP?

Jun 26, 2015

In this issue:
» A risk to the Megatrends that you need to watch out for
» Will change in EPFO investments boost equities?
» Great Depression II in the making - Raghuram Rajan

"The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks." This is something Warren Buffett wrote in a letter to his shareholders in the year 1990.

The math is simple. When a business grows largely with the help of borrowed capital, every mistake multiplies the shareholder wealth destruction to the extent of the leverage. However, what is not easy, is to implement this learning when investing in financial entities. As we know, financial entities are in the business of borrowing and lending. Hence having leverage in their balance sheet is core to their operations. The minimal mistake in using the leverage therefore defines the credibility of the financial entity.

In India, over 70% of the financial sector is controlled (read majorly owned) by the government. Hence the dynamics of these businesses are governed by social as against commercial factors. And that is the reason the mistakes in using the leverage is oft repeated. In recent years, the mistakes in lending practices of government owned financial entities have dealt a heavy blow to the economy as a whole. Already at about Rs 4 trillion, the gross NPAs of Indian banks are currently amongst the highest in a decade. The lingering problem in the power sector is expected to add another half a trillion to their kitty of bad loans. And all put together these non recoverable loans have shaved off about 4% from India's potential GDP growth. What is worse is that these massive amounts are to be written off from the equity capital of these entities. The mistakes in bad lending and restructuring the already bad loans have therefore come at a heavy cost to shareholders.

So, as an investor how do such mistakes impact your investing strategy? Should you completely stay away from financial sector stocks? Well, that is certainly not the best approach. Despite his averseness to the business of banking, Wells Fargo, continues to remain one of the biggest holdings in Buffett's Berkshire portfolio. Apart from being one of the most profitable banks in the US, the entity offers comfort to Buffett because of the manner in which it handles leverage. By keeping away bad loans that erode capital, and ensuring that the capital is least vulnerable to trading profits, Wells Fargo has built its credibility in using leverage. So as an investor, the mistakes that financial entities in India have made, need to be part of your checklist when evaluating leveraged business.

Not just banks and financial entities, but even companies in metal, textiles and power sectors that carry heavy leverage on their books need to score well on the capital allocation front. More importantly, if you notice that an entire sector is trading at a discount due to investor pessimism about leverage, it may be a good time to hunt for the best bargains. Be it , , or banks, despite the inherently risky nature of these business, you will always find outliers. These will be companies that have the potential to enhance rather than destroy wealth with leverage. And it is with the checklist on buying leveraged companies that you can spot the Wells Fargo kind of entities for your portfolio.

So to profit from the massive NPA mistakes that Indian banks have committed, ensure that you stick to only those stocks that have a track record of preserving shareholder wealth across economic cycles.

Do you use a special checklist while evaluating companies with leverage for your portfolio? Let us know your comments or share your views in the Equitymaster Club.

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Speaking of mistakes, it is not just businesses with bad capital allocation that you need to watch out for. There could be some macro indicators as well that could point out to mistakes in your selection of stocks. Now, many of you would recollect that a discussion on Smart Cities was the focus of Equitymaster Conference 2015. We not just discussed whether the Smart City plan was feasible but also how it could give a major impetus to the economic Megatrends. Investing in high growth companies that could be the major beneficiaries of the Megatrends is the core underlying principle of The India Letter. Of course, the building of smart cities could unleash several Megatrends in the manufacturing and financial sectors. But the execution remains the key here. And as we had said then, the execution of the Smart City plan will have some teething problems. Allocating and managing resources, handling urbanization, skilling and employing labour are easier said than done. And although the government may want to earn brownie points from this endeavor as investors we would want to be wary about the mistakes in execution. So while we are closely following the Megatrends that could bolster corporate profitability, we world certainly not want to price in too much optimism in the valuations.

 Chart of the day
One of the biggest banes of the Indian stock market over the last many decades has been its major reliance on foreign money. Its ups-and-downs have been at the mercy of foreign capital, and the mood swings of the owners of that capital. There has just not been enough money domestic money in the equity markets to tilt that balance. Two pieces of good news however may now begin to remedy this.

The labour ministry has now allowed company run Provident Fund (PF) trusts to invest 5% to 15% of their incremental corpus in equity markets. Further, the Employees' Provident Fund Organisation (EPFO), which was earlier given the green signal for investing in equities, has now said that it will begin its investments from next month. It will start with 1% in July, and by the end of this financial year, will take it to 5% of its yearly investments. With the EPFO being one of the largest of its kind in the world, today's chart of the day shows just how big a role its funds could play in offering some stability to the Indian markets.

Bringing more weight to domestic equity investments

In what is reminiscent of the Great Depression of the 1930s, rather than creating growth, all countries around the globe are doing these days is shifting growth from one to another. This worrying view was expressed recently at a conference in London by none other than RBI governor Raghuram Rajan.

Indeed, he is of the view that the global economy may be slipping into problems similar to those during the Great Depression. And to prevent this he has asked central bankers from around the world to define the 'new rules of the game' - of what should be and what shouldn't be allowed in terms of central bank action. This is because many economies have now gotten into a sort of competitive devaluation of their currencies in a bid to gain an edge for their exports in international markets. Which may very well end up ensuring that no one is really better off in the larger scheme of things.

The Indian stock markets were trading weak today on the back of sustained selling activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading lower by around 70 points. Losses were largely seen in banking and capital goods stocks.

 Today's investing mantra
"You never get the high and you never get the low." - Walter Schloss

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

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