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The silver lining to the Greece and China crises...

Jul 9, 2015

In this issue:
» After power, infra NPAs around the corner?
» Has the prosperity level of global middle class improved?
» An update on markets
» ...and more!

 Chart of the day
Imagine you had invested Rs 100 in a stock in 2004. You saw the stock go up to Rs 550 in 2007, come crashing down to Rs 160 in 2008, move up to Rs 340 by January 2015 and then sprint another 40% to touch Rs 480 within 6 months. Would you be worried about the impending correction after such a sharp run up?

Well, most investors who were invested in the Chinese benchmark index, which followed exactly this pattern, weren't! For they were too enamored by China's heavyweight position in the global economy!

In fact at the latest Berkshire Hathaway AGM even Buffett was asked if he would consider investing in China.. And this is what he had to say, "I would invest in China or any place else ... and I would apply exactly the same sort of principles".

So anybody who has put the sharp run up and the recent 30%+ correction in Chinese markets into historical and valuation perspective, is not shocked.

Similarly the crisis in Greece has also been building up for long. Running an economy perpetually on borrowed money is a challenge that central banks have yet to crack. And Greece may be the first casualty of the West's obsession to keep throwing more debt at a problem essentially of debt.

For you, neither Greece nor China crises may offer anything beyond a temporary opportunity to look for value in stocks. Hence these are not the kind of developments that you should focus all your attention on.

The silver lining to the Greece and China crisis is what is happening to commodity prices. And as we wrote in the latest issue of StockSelect. - The secret to investing in commodities is something that even big investors have yet to stumble upon!

Now, how are China and commodity investments related?

Well, China grew from consuming about 12% of the world's metals in 2000 to near 50% today. In commodities like iron ore, between 1998 through 2008, China's total demand rose more than five times. In steel, China grew to consume more than the US, Russia, India, Japan and Korea combined. The economy has also been a key driver of oil demand growth in the past decade. So any trend in commodity prices today is disproportionately weighed on what is happening to the Chinese economy.

Why China impacts commodity prices like no other economy...
Data source: Macquarie, USDA; *In 2013

The economic slowdown and debt bubble in China therefore sounds the red alert for commodity prices. Prices of commodities like iron ore have hit 5-6 year lows in recent days. And the correction is far from over!

Anyone looking at metal stocks from the PE perspective will find the multiple too high in coming quarters as earnings get depressed. However, the secret mantra to investing in commodities is - being fully in cash at the top of a commodity or a business cycle and being fully invested at the bottom of it. In other words, as commodity prices crash, the opportunity to invest in commodity producers will become ripe. The logic behind this principle is grounded in fundamentals of the commodity cycle. When commodity prices rise, new capacity comes in to take advantage of it. The trickle then eventually turns into a deluge to the extent that it starts putting pressure on prices. The falling prices in turn put pressure on the debt servicing capability of the players with the maximum being on the one with the most inefficient cost structure. Eventually the debt gets written off, the capacity starts declining and within few years, the cycle starts again.

So, while everyone else worries about what happens next to Grexit and China's stock markets, keep your eyes firmly fixed on the most fundamentally sound companies in the commodity space.

Do you invest in commodity stocks based on the cyclicality or PE multiples? Let us know your comments or share your views in the Equitymaster Club.

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With vast changes in the world economy over the last few years, one would have imagined that the prosperity levels of the global middle class would have risen. However, research by one organization known by the name of Pew Research reveals a completely different picture. As per its research, the global middle class has become poorer than previously thought.

Also, millions of people that have come out from poverty in the developing world due to growth in their respective economies are vulnerable to again submerge into poverty. This is quite shocking considering the fact that India & China, the two giants of the developing world, have seen prosperity levels rise. However, the progress in the other developing world is not that great. And hence for the global middle class to show rise in prosperity levels, other developing countries should start contributing.

We shall not get into debate as to what income levels constitute a middle income household but focus on the corporate repercussions here. If prosperity levels of middle income households have gotten worse, then discretionary spend will fall. As a result, companies that were betting heavily on increased spending by these households will have to go back to their drawing boards. Obviously, they will have to be more prudent in carrying out their expansion plans in geographies where they believed that the spending potential was huge.

When you borrow Rs 1 m from a bank it's your problem. However, when you borrow Rs 100 m from a bank, the bank is in problem. And the bigger problem arises when a bank lends more even after knowing that the debt servicing capability of the borrower has worsened. It is called axing your own foot and that is what some of the Indian banks are doing by lending money to ailing infrastructure companies.

About 5-6 listed infrastructure majors like GMR Group, GVK Group, Lanco etc are saddled with large debt. And with poor cash generating capability, they are selling their non-core assets and looking for other innovative ways to reduce their debt burden. However, that being insufficient, banks which have lent money to infrastructure companies are facing huge NPA risk. What is surprising is the fact that despite knowing that these infrastructure companies have stretched balance sheets, quite a few banks have sanctioned loan approvals to them. This indicates banks' willingness to lend more money to these companies.

We have always spoken how the Indian banking system is free from the plague that the US banking system had which ultimately led to the sub-prime crisis. While the regulatory mechanism in India is much better to avoid such kind of a large scale fiasco, we reckon banks have to be more vigilant in their lending practices. If not, the NPA risk in the banking system may rise considerably in the near future.

The Indian stock markets were trading in the red at the time of writing. While the BSE Sensex was down by 8 points, NSE-Nifty was down by 5 points. The Asian markets were trading mixed at the time of writing with China leading the pack of gainers. However, European stock markets also opened strong today.

 Today's investing mantra
"If past history was all that is needed to play the game of money, the richest people would be librarians" - Warren Buffett

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

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1 Responses to "The silver lining to the Greece and China crises..."

Tirtharaj Khot

Jul 9, 2015

Could not quite agree on the alert on NPA on lending to infrastructure sector. This is one sector which is most crucial for the growth of any economy and fuells many sectors within. Inherently, infrastructure sector needs lot of time to generate free income. Therefore it is not wise to say that lending should be stopped or be selcetively done to this sector just because banking will be affected. In any case the concept of NPA is a man made definition which can be genuinely tweaked to accommodate lending to infra and also not hit the banking due to NPA timeline definition.

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Equitymaster requests your view! Post a comment on "The silver lining to the Greece and China crises...". Click here!
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