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Should you be prepared for Chinese returns?

Jun 27, 2015

In this issue:
» India to surpass China in wealth creation?
» Is there a link between IT stocks and US manufacturing?
» Roundup on the markets
» ...and more!

2015 has so far turned out to be bit of a damp squib as far as the Indian stock markets are concerned. Particularly when compared to the robust gains in 2014. Indeed, against returns of 30% from the Sensex in 2014, the current calendar year has seen the Sensex up by a mere 1%.

One major reason for this has, of course, been the toning down of earnings expectations that had been unrealistic in the first place. As earnings growth of India Inc remained weak in the latest results season, FIIs began trimming their investments in the Indian stock markets. Hence, the bouts of corrections that we have been seeing in recent months. Now quite a few of these foreign investors moved their money from India to invest in the Chinese stock markets.

But is China any better? Now, among the emerging markets, the Chinese stock market has been the best performing having notched up gains of around 30% in 2015 so far. As reported in the Wall Street Journal, the rise in the last 12 months has been a mind boggling 106%.

And then this week, it all began to tumble. In the past one week, the Shanghai Composite index has fallen 19% from its 2015 peak. There have been several factors that led to this meltdown. One is the high amount of leverage as many investors are buying stocks with margin loans, or money borrowed from brokers. This is a practice that the Chinese government is now looking to curb.

The other more glaring factors are the valuations of the stocks themselves. The sheer pace at which stock markets have risen without any underlying fundamentals means that a steep correction hardly seems out of place. Indeed, an article in the Wall Street Journal has highlighted certain technology companies, which are trading at obscene valuations of around 600 times their past 12 months trailing earnings. Even brokers are making a case to buy stocks that are trading at more than 30 times forward earnings on grounds that China will continue to grow at a fast pace.

Can Indian stock markets then face the same fate? We thankfully do not have companies trading at silly valuations of 600 times earnings. But we do have many trading at more than 40 times earnings, which are not reasonable valuations by any yardstick.

Also, Indian stock markets continue to be influenced by FII flows. So global developments do play a role in impacting the markets even though the ground realities at home paint a different picture. This was quite evident during the 2008 global crisis when the correction in the Indian markets was massive even when the Indian economy was still cruising along at a healthy pace. So by that measure alone, a correction of the kind we have seen in the Chinese stock markets cannot be entirely ruled out as far as the Indian markets are concerned.

Which brings us back to the reality back home. Now, we do not doubt the India growth story. We for one strongly believed that the implementation of reforms was not something that was going to happen overnight and it would be a gradual process. Also, the current government is in the best position to make sure that key reforms make a difference to India's growth over the next decade.

But this alone cannot be the sole reason to invest in each and any stock akin to what the Chinese investors seem to be doing.

Each company ultimately is different and only those with strong business models, the ability to capitalize on growth and a visionary management at the helm will be able to rise above all others. But even then valuations will play an important role. And only those trading at reasonable valuations will ultimately be able to add on to shareholder wealth in the long term.

Will the Sensex see the same kind of correction like its Chinese counterpart? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
While there could be many who live below poverty line in China, the manufacturing boom in the country has resulted in sustained wealth creation in the past. It has helped alleviate poverty levels to some extent. As seen in the chart, China led the wealth creation graph amongst the APAC region (ex-Japan) during 2009-2013 with a compounded growth of 30%. Even in 2014, the growth of wealth in China was highest at 43.6%. However, its neighbor, India seems to be fast catching up on this wealth creation binge. If one BCG Global Wealth report is to be believed India is expected to surpass China in wealth creation over the next 5 years.

During 2014-2019, wealth in India is expected to compound at 21.5% as compared to 10.3% in China. If this growth expectation materializes it is certainly good news for India. However, proper distribution of this newly created wealth is even more important. If the new wealth gets created at the lower end of the income pyramid it shall help in alleviating poverty. However, if the new wealth creation happens at the higher end of the income pyramid, the rich will get richer. And there will be wealth concentration. While this may show a rosy picture from a wealth creation standpoint, it is not a good sign from a societal standpoint.

India to surpass China in wealth creation?

One sector that has seen good gains over the last few years has been the IT sector. Steady improvement in sales and margins has done wonders for many of the frontline IT stocks. Recently though these stocks of seem to have hit a road block. The IT index is down over 10% since March 2015. The reasons are not hard to find. Managements have found it difficult to meet the high expectations of analysts. Many of these firms are trying to deal with the rapidly changing environment with the advent of new digital technologies. This has resulted in margin pressures due to higher investments. Sales growth from their energy and telecom clients has also been under pressure.

To make matters worse, a recent report by Nomura claims there is a co-relation between Indian IT stocks and US manufacturing activity (as measured by the purchasing managers index or PMI)! As reported in the Mint, IT firms are impacted by US manufacturing activity (which includes outsourcing) with a lag of about 2-3 quarters. Thus, as the US PMI has turned down, more pain could be in store for IT stocks this year. We believe, it is important for investors to not be swayed by such short term concerns. Investing in Indian IT stocks should be done in the same way as it is with other sectors; i.e. with a clear long-term focus on the fundamentals of the business and the valuations of the stock.

It was a mixed week for global stock markets. The stock markets in China witnessed a sharp sell off (down 6.4%) for the week. The correction highlights the risks of stock market bubble in China on account of purchasing shares on margin or borrowed money from brokers. The decline was driven by managements and controlling shareholders selling massively into the rally.

US stocks ended the week in the red (down 0.6%). This was despite positive US economic data on existing and new homes sales and consumer spending on account of concerns regarding ongoing crisis in Greece. While the US GDP contracted by 0.2% during the quarter, the data was better than expected. The timing of higher US interest rates is likely to keep markets on edge.

The stock markets in France and Germany led the gains for the week (up 5.1% and 4.1% respectively) on accounts of some positive development, if not complete resolution regarding Greek crisis. As far as Greek debt crisis is concerned, 30th June is the deadline for a critical €1.54 bn debt repayment to the International Monetary Fund. Coming to Indian stock markets, the benchmark indices gained during the week shrugging off weak global cues as above average monsoons eased concerns regarding food inflation and supported hopes for further rate cut. The BSE-Sensex gained 1.8% over the week. S&P BSE Midcap and S&P BSE Smallcap indices also closed higher, up 1.9% and 1.7% respectively. All sectoral indices witnessed gains over the week with rate sensitive sectors witnessing maximum gains. The realty sector led the gains (up 6.5%) during the week.

Performance during the week ended June 26, 2015
Data source: Yahoo Finance

 Weekend investing mantra
"I have pledged - to you, the rating agencies and myself - to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow's obligations. When forced to choose, I will not trade even a night's sleep for the chance of extra profits" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst).

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1 Responses to "Should you be prepared for Chinese returns?"

RS Rathore

Jun 29, 2015

In fact, Greece is hardly willing to leave Euro & there does not seem any likelihood for European markets to improve any time during 2015. The Indian Markets will not follow the path of Chinese returns, but for the next two quarters Indian markets will be volatile because of global slow down & inevitable inhouse slow GDP Growth, which would take shape only with the passing t ime & typical FIIs activities, but 2016-17 should be a blooming financial year, when FIIs once again should make entry to Indian Market assuming as their Investment Heaven, because Indian Markets are greatly affected by FIIs activities.

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