Are we missing on this important investment signal? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Are we missing on this important investment signal? 

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In this issue:
» Is the India growth story dead?
» What went wrong with emerging markets?
» India to surpass China as coal power
» Will Asian crisis repeat itself?
» and more....

In simple words value investing is the art of buying stocks at a discount to its intrinsic value. It's akin to buying something that is worth Rs 100 for Rs 50. The idea is that there can be periods of time when irrationality and emotion, rather than fundamentals will drive stock prices. And such periods, of excessive greed or fear, could last for months, if not years. But sooner or later rationality is bound to return to the market. Leading to stock markets eventually valuing companies based on what they are actually worth.

However if you have been investing for a while you will know that there are several stocks which are fundamentally good but the prices never ever reflect their true value. One may label such stocks as value traps where the intrinsic value is never reflected in the stock price. This could make you question your entire investment process. You would wonder is there something that you did wrong. Or more accurately, was there something else that you should have done to avoid this trap?

We recently had an interview with Professor Aswath Damodaran of Stern School of Business and asked him this very same question. His reply to this was that there is an important part of the process that most value investors tend to miss out on. This is accounting for the pricing process in the markets.

As per him there are two things that investors need to do. The first is of course finding stocks that are fundamentally sound, have a robust management, are capable of earning & delivering high returns and are available cheap. The next step is to check why these stocks are trading cheap. And this second step is what most investors tend to miss out on. The stock could be trading cheap just because of an anomaly in the market. Or it could be simply because it is an out of favor stock with the major institutional investors. Or it could be because the markets are missing out on the major catalysts that would drive prices in the future. In all such cases, the mispricing is nothing but a short term phenomenon and sooner or later the prices should correct to reflect the intrinsic value.

But if the stock is trading cheap because of some structural issue like regulatory framework or lack of a sound succession plan, etc then this is more of a long term thing which may never really rectify itself. And such stocks end up becoming value traps. So what investors need to do is to essentially add this pricing process into their screens when they are screening for cheap stocks. This means they need to question why a particular stock is trading cheap. It may make the process of investing slightly longer, but would prevent investors from getting stuck in a value trap.

Do you think it makes sense to include the pricing screen in your investment process? Please share your comments or post them on our Facebook page / Google+ page

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01:15  Chart of the day
The Reserve Bank of India (RBI) has flagged a major risk to the Indian financial system. This comes in the form of external risk. And the reason for this is the rising quantum of external debt particularly short term debt. As per the RBI, India's external debt has gone up to US$ 390 bn which is about 21% of our GDP. Of this 44.2% is short term in nature which needs to be repaid over the next one year. The recent decline in Rupee has made the situation even worse because the amount of rupees required to pay back the debt goes up due to the currency depreciation. This debt burden makes India exceedingly vulnerable to any external sector shocks.

Source: The Mint

Do you recall a gentleman named Raj Krishna? Well, if you don't then it pays to know that he is the very same guy who coined the term 'Hindu rate of growth' to describe our languid economy at a time when there were high growth rates happening in other Asian countries. Over the past few years though, this term was all but forgotten. By growing consistently at 8-9% we became the toast of the world.

And just as we were thinking that we had rid ourselves of this term for good, it is making a quiet comeback. An article in Firstpost has laid out a strong case in favour of why we're headed down the same path again. And we couldn't help but agree. Everywhere one looks one sees gross imbalances and distortions. None bigger than the twin deficits of fiscal and current account, a glaring example of how we seem to be spending beyond our means year in and year out. Then there is the high CPI inflation which a high income disparity country like India can really ill afford.

However, the worst is yet to come we believe. Rather than alleviating these problems, policy makers seem to be only worsening them with populist measures like MGNREGA and now the food security bill. If this wasn't enough, we now have the rise in gas prices which would fuel inflation further. Thus, with such an environment around us, even the most ardent of Indian supporters would not want to stick their necks out and declare that we could shortly revert to the 8% growth trajectory. Indeed, few big bang reforms and we could well be out of our current state. But after what has happened in recent years there's very little hope left even on this front.

Emerging markets at one point in time were must have's in any global investment manager's portfolio. However, recently these markets have underperformed the developed ones. While some may say that it was dearth of liquidity there is something more to it. In the case of emerging markets, it was government ownership. It may be noted that most emerging markets lack privatization. Most companies in these markets are government owned. Government ownership means that there are various kinds of restrictions on these companies. They do not operate in a free market. In other words, their actions are controlled by the government to some extent. And for government, profit is not the sole motto. Hence, sometimes these companies have to bear the burden for the overall good of the society. Now, earlier when there was abundant liquidity in the market investors ignored the profitability aspect of these companies. Thus, they bid up the prices of all emerging market companies. But now with dearth of liquidity publically owned government companies have taken a beating. Investors are worried about their profitability and interference by the government. At the same time private enterprises have been relatively stable. This suggests that with drying liquidity focus has shifted to capitalism now. Unless emerging market governments relent and bring private ownership foreign investors will continue to stay on the sidelines. This is especially true when there is dearth of liquidity and investors are careful about putting their money which is very much the situation now.

Scarcity of fuel, predominantly coal, has been one of the biggest black holes for Indian power sector. However, with the resolution of deadlock between power producers and coal suppliers, the demand for coal has surged. And nobody other than the international suppliers of imported coal to India are happier about this. As per an article in Mint, India is currently consuming more coal now than it has done in the past 3 decades. India is set to eclipse China as the top importer of power station coal by 2014. As Asia's second-biggest energy consumer, India's coal consumption grew by 10.2% in 2012. Both China and the US have imported lesser coal in the past two years. China is reducing its dependence on imported coal with more domestic mining. The US meanwhile is trying to rely on shale gas. Plus economic slowdown in the West and China has impacted demand for imported coal as well. Further large economies are increasingly using cleaner fuels like natural gas to produce electricity and reduce carbon emissions. Thus while the country's power sector continues to rely on imported coal for the time being, it remains to be seen if it can make the shift to gas over time.

Considerable volatility in the Chinese financial markets has sparked fears of a big crisis in the making. Probably bigger than Asia's 1997 financial crisis. But as per an article in Bloomberg, Frederic Neumann, head of Asian economics research at HSBC Plc thinks otherwise. He opines that the differences far outweigh the similarities. The 1997 Asian crisis was largely the result of a forex crisis in countries such as Thailand and South Korea. They were forced to devalue their currencies and this sparked off a recession. Having burn their fingers badly, Asian economies since then have been cautious. That is why one big difference is that most of these countries now have sufficient current account surpluses. Thus, there is enough cushion in the event that outflows take place. Second, in 1997, most of the debt was dollar denominated. Thus when the currencies devalued, the debt service costs ballooned. This is not the case now as most debt now is denominated in local currency. In addition to this, banking systems also appear more robust, with better regulatory systems, higher capital buffers and lower loan-to-deposit rates. That does not mean that there are no worrying signs. In 1997, debt was mostly on the books of corporates. But today, it is the households, small businesses and government entities that have more debt. However, even if a 1997 type crisis may not be on the cards, there are still worrying signals in some of the Asian economies most notably China. And the governments would do well to make sure that these issues do not get out of control.

Majority of the major global stock markets recovered during the week as the Fed tried to quell fears of the pullback in quantitative easing. The New York Federal Reserve Bank President hinted that the asset purchases would increase aggressively in the event of lower than expected recovery in the economy and labour markets. Japan (up 3.4%) was clearly the outperformer, as positive economic data pointed to a steady pick-up in the Japanese economy. India (up 3.3%) and Hong Kong (up 2.7%) were the other indices leading the pack of gainers.

The US stock market ended marginally positive (up 0.8%) over the week. The European stock markets too regained lost ground. The stock markets in France & Germany were up by 2.2% each and the UK stock market ended 1.6% higher over the week. All the major Asian stock markets also ended the week in positive territory. However, China registered a steep fall of 4.5% on worries of a tight liquidity in the banking system that has led to soaring money market interest rates.

The Indian equity markets closed the week on a strong footing with the shares in the oil & gas and IT leading the gainers. The BSE-Sensex was up by 3.3%. The gains were also bolstered the by improvement in the current account deficit in the March 2013 quarter.

Source: Cnnfn, Yahoo finance, Equitymaster

04:55  Weekend investing mantra
"Price is what you pay; value is what you get." - Ben Graham
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2 Responses to "Are we missing on this important investment signal?"

Kapil Khanna

Jul 5, 2013

How does Equitymaster plan to screen for value traps in their recommendations? It should be part of Equitymaster Risk Analysis or Risk matrix. And what about a stock becoming a value trap after a BUY recommendation? Unless there is some agile tracking and reporting in place the SELL call will be late and losses not minimized. Please think about this.


Tarun V. Duggal

Jun 29, 2013

Giving a title "Is the India growth story dead?" is being very harsh. No individual should have the right of making such statements on a forum.
Any country goes through ups and downs. We should learn to underplay some situations when the country is going thru some tough times. Its good to be honest but not always necessary to be blumt.

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