Buffett's favourite multiple on Indian stocks...

Jul 4, 2012

In this issue:
» Yet another skeleton tumbles out of global banks
» Ban on food exports soon to be passe
» Govt solicits VC funding for Indian pharma
» Debt ridden Indian realty cos. dole out generous dividends
» ...and more!

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 Chart of the day
'Irresistible' BRIC stocks! Thus screams the headlines in several business dailies today. The man making the fervent claim is none other than Jim O'Neill. Yes, the same gentleman who coined the term BRICs. The term may just be an abbreviation for top 4 emerging markets - Brazil, Russia, India and China. But over the years it has been the reference point for growth indicators and valuations. Not surprisingly, when the developed West is facing stagnation, BRICs are again the focal point. Not that these economies do not have problems of their own. But their strengths seem to far outweigh their weaknesses.

O'Neill's optimism about BRIC stocks and their potential to nearly double in 10 years stems from the valuation gap. That each of the BRIC nations has to catch up on its share of global market cap is understood. But the pace at which each one achieves this feat will determine returns for investors. Now, even the legendry Buffett has cited his favoritism for the market capitalization to GDP ratio. For India this ratio has gone up from around 93% in mid 2010 to around 120% in mid 2012. Way back in 2006 it was just 78%! That makes India's market cap to GDP multiple well above the median. Also, China which has long defeated India in terms of average long term GDP growth, has a lot more catch up to do. So putting things into perspective, a higher economic growth may not implicitly mean a higher market cap. Unlike in the US, the low penetration of financial products in emerging markets leads to a larger valuation gap in stock markets. True that Buffett's favourite yardstick is a good long term indicator. However, it can hardly be used accurately for comparative valuation across emerging economies.

Source: Goldman Sachs
Data at the end of May 2012

Thus instead of jumping headlong into Indian equities based on the potential of BRIC stock markets, it would be worthy to separate the wheat from the chaff. We would not like to take a guess on how soon will the Indian stock markets close in on the valuation gap in terms of share of global GDP. But what we are certain about is that few fundamentally robust companies will certainly get the valuations they deserve over time. And that is the 'valuation gap' that discerning investors must watch out for.

Do you think the market cap to GDP ratio is a good indicator of long term potential of stocks in India? Let us know your comments or post them on our our Facebook page / Google+ page.

Recently, another skeleton tumbled out of the western banking system (Or should we say what a leading portal said, the 'rotten' banking system?). Barclays, the financial institution at the centre of it all, was fined close to half a billion dollars. What more, the scam also led to the dethronement of Bob Diamond, the CEO of Barclays, virtually overnight. However, it will be naive to assume that in a system so interconnected, Barclays could be the lone casualty. There is a very high chance that other financial firms are also in connivance and hence, more drama is all but guaranteed.

You never know, string pulling at high places in order to prevent more heads from rolling must have already begun. In fact, as per the Wall Street Journal, lawyers for 16 banks have jointly filed in New York court seeking to dismiss antitrust allegations against them. We don't think their wish will be granted so soon. A lot of investigation still needs to be done. And this would certainly keep the prime suspects on tenterhooks we believe. Meanwhile, if this does not convince the powers that a major overhaul is needed, we don't quite fathom what will.

India is trying to revamp its international image. It wants to remove the tag of being an 'unreliable supplier' for the food grains market. The country has been imposing random bans on export of food grains in the past. Sometimes the ban is reasonable as it is in conjunction with the shortage in domestic supply. But most of the times the bans have not really resulted in an increase in domestic supply. Instead it has led to a disgruntled export sector and a worsening international image.

India now seeks to resolve this issue by working on a policy that would allow exporters to meet their export obligations. Even during times of domestic shortages, they would be able to meet their commitments. So how would the domestic shortage be taken care of? Well through imports. The policy appears to be one which would help raise India's credibility in the international markets. However, it would certainly mean that during times of shortage the domestic prices would spiral upwards. Hopefully, whatever policy the commerce ministry chalks out would keep this in mind. For if it doesn't then during years of shortage we would end up seeing price inflation spiral way out of proportion. While our international image would remain intact it would be at the cost of domestic misery.

The Indian Pharma sector has made a name for itself in the global generics space. At a time when only process patents were in force in the country, Indian pharma companies perfected the skill of 'reverse engineering'. This enabled them to make copycat versions of branded patented drugs and sell it in the domestic and semi regulated markets. Gradually generics began to gather pace in the US and Europe. Thus, Indian firms made sure to capitalise on this opportunity. However, in this process, not much has been done on the drug development front. No doubt research and development (R&D) is a high risk-high return affair. However, most of the global innovators have risen to the top based on the strength of their research pipelines. It has not been as simple for Indian firms due to lack of facilities and funding. That is probably why the government is considering forming a venture capital fund of Rs 20 bn to promote R&D in the pharmaceutical sector. India is the third largest producer of pharma products by volume and the industry is growing at a rate of 15-20% annually. So it is an important pharma market. Thus, efforts made by the government to bolster R&D augur well for the sector in the long run.

Emerging market stocks set off at a gallop since the beginning of 2012. Stocks in Brazil, Colombia, and India galloped ahead, increasing more than 10% within the first few weeks of the year. Even till today, the Sensex is up over 12.7% on a year to date (YTD) basis. By the end of April 2012, Colombia has the lead, followed closely by Thailand and the Philippines. The little known emerging stock markets are therefore catching a lot of eyeballs and investor attention.

The BRICs are expected to comprise 20% of the world economy in 2012 after growing more than four-fold in the past decade. However, their share of the world stock market has been shrinking. Their combined stock-market value has dropped to a three-year low of 16% of the total invested in equities. It is expected that some of the lesser known emerging markets may finally find their place under the sun.

The financial crisis of 2008 laid bare the huge risks posed by large US banks to the economy. It seemed that if the big banks were not salvaged it would expose the economy to systemic risk. But if the banks were bailed out by the US government, it would be a drain on the taxpayers' money. Either way, it seemed like choosing between the devil and the deep blue sea. In other words, too-big-to-fail institutions were big threats to the economy.

A response to this was the 2010 Dodd-Frank financial reform law. It required the large banks to prepare their "living wills". The "living will" would be a resolution plan that banks would adopt in times of crisis so as to deal with any adversity without taxpayer bailouts. Recently, the public portions of the "living wills" of nine large global banks were released by the US regulators. Though banks have assured that they would be able to make do without bailouts in case of insolvency, experts are not too enthused. They are doubtful about how hard regulators would push the banks for changes. Also, how useful can a hypothetical plan in the midst of a severe crisis? We are not too convinced about the credibility of these "living wills".

The real estate market is in a crisis of sorts. Most companies are debt ridden and volumes have also dried up due to increasing property prices. Thus, liquidity is the main issue within the sector. However, this has not prevented the real estate companies from dolling out liberal dividends. As per Economic times, 26 listed real estate companies having 50% or more of promoter holding have recommended aggregate dividend of Rs 7.2 bn during the year. And this is during times when they have no money to repay the debt! We understand that dividends have sentimental value. But when a company is debt ridden its prime objective should be to repay the debt rather than pay dividends. Thus, the current step raises further apprehensions about the ethical issues prevailing in the sector. It should be noted that since promoters are majority shareholders, dolling out liberal dividends effectively means the money is flowing back to them. Thus, surplus cash on the balance sheet is channelized ineffectively. On the other hand these very promoters are seen knocking the doors of banks for further loans. What an irony!

The indices in Indian stock markets had an uneventful outing today as they kept oscillating to either side of the dotted line, without making much inroad into the positive territory. Stocks from the commodity and auto sectors found some takers. At the time of writing, the BSE Sensex was trading 28 points above the dotted line. The indices in most other Asian markets closed marginally higher in today's trade. Those in Europe have also opened in the positive.

 Today's investing mantra
"In both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult." - Warren Buffett

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    Equitymaster requests your view! Post a comment on "Buffett's favourite multiple on Indian stocks...". Click here!

    2 Responses to "Buffett's favourite multiple on Indian stocks..."

    Low price stocks are mostly expensive

    Jul 6, 2012

    MIt seems that stocks selling for 30 or 40 rupees mostly don't rise in price
    as fast as stocks selling for 3000 or 4000 rupees. The "low" priced stocks
    are often disastrous investments. This is the trend, obviously not true in
    every case.
    M. Bersohn

    Like (1)

    sunilkumar tejwani

    Jul 4, 2012

    The least I say is Warren Buffet has lost his balance of mind. He is as much greedy and lunatic in today's world as is a roadside street smart fraudster.

    Like (2)
    Equitymaster requests your view! Post a comment on "Buffett's favourite multiple on Indian stocks...". Click here!