Thanks to Graham, We Spotted This 'Big Billion Bubble' Beforehand

Aug 1, 2016

In this issue:
» Corporate profitability: The road ahead
» Automation wave to hit IT jobs
» Market roundup
» ...and more!
Ankit Shah, Research analyst

I have been a great admirer of Warren Buffett and his investment philosophy since I read The Warren Buffett Way as a teenager. I liked Ben Graham too, but I must admit that my first attempt at reading The Intelligent Investor was somewhat unsuccessful. I couldn't get past the first 60 pages or so. The dry text couldn't keep my racing teenage mind glued for long.

I owe most of what I know about the Father of Value Investing to my mentor, Rahul Shah. Rahul has studied Graham in great depth, even pouring over Graham's lesser-known research papers.

Rahul's foresight and prudence has often steered us clear of high-risk, money-losing investing ideas. He doesn't talk a lot. But when he does, he makes it count. And he often quotes the people he admires most.

I recall a discussion a couple of years ago on the ecommerce industry when Rahul pulled out this Graham quote:

  • Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

It is this highly grounded approach to investing that helps us avoid the itch to chase growth at any cost.

And it's why we were able to spot this 'Big Billion Bubble' well in advance.

I'm referring India's leading ecommerce giant, Flipkart, in particular...and the massive valuation bubble in the Indian ecommerce industry in general.

Over the past few years, Indian ecommerce startups have taken the retail industry by storm. I'm sure many of you now buy 'stuff' at the click of a button.

At the forefront of this ecommerce revolution has been home-grown retailer Flipkart.

Until last year, this bubble had been inflating at a phenomenal pace. In a nutshell, this is how the story unfolded:

Venture capitalists and private equity investors pumped in money. With this money, Flipkart offered huge discounts on merchandise. People love discounts. This led to an astronomical jump in sales. Investors got excited by the growth story. More investors formed a beeline to invest in this growth story. Flipkart's valuations begin to skyrocket. This positive feedback loop played out till Flipkart's valuations reached dizzying levels.

At its peak valuation last year, Flipkart was valued at US$15.2 billion. At that level, it became one of the most valued companies in India. Had it been listed, it would have had sizeable weightage in the BSE Sensex.

But throughout this frenzy, we were highly skeptical of this growth story. In fact, our warning signals were sounding as early as two years ago. Here's what we said in The 5 Minute WrapUp on 31 July 2014:

  • ...Flipkart seems to be a success story written too early. While it does have the advantage of fastest growing market, the same comes with a challenge of tough competition. The next day announcement by Amazon to invest additional US$2 billion in India is a stern reminder of the same. With no significant competitive advantage, no assurance of customer loyalty, huge competition from experienced players like Amazon, Snapdeal, eBay, etc, no significant entry barriers for players with deep pockets, and expected price wars, scaling up from here will come with its own set of challenges. In fact, we will not be surprised if the market matures before the company tastes profits. And post that, for such firms, one cannot ignore the huge risks to earnings.

All businesses built on extreme optimism have to face their day of reckoning. And that day has been playing out for Flipkart for some months.

We saw clear signs of trouble at the ecommerce giant in May when it postponed the joining date of its fresh IIM MBAs recruits by six months.

And then last Friday came news that Flipkart would lay off a few hundred employees. The company played down the news saying it was 'business as usual', but that's hard to believe.

For some months now, Flipkart has been facing funding issues. No investors have been willing to invest in the company at its preferred valuation of US$15 billion. In fact, several investors have started to write down Flipkart's valuation.

As a recent article in Livemint reports, global asset manager T Rowe Price Group Inc has lowered the value of its stake in Flipkart twice this year...first, by 15% in April and by another 20% recently. That's a 32% crash from its peak valuation!

What happened to Flipkart? What's going wrong?

Well, in our view, this is 'business as usual' in an industry that is based on an aggressive discounting model. Our big-picture editor, Vivek Kaul, not one to mince words, called the Indian ecommerce a Ponzi scheme.

Some people seem to think prudence is old-fashioned and no longer a recipe for high returns. For them, the only way to market-beating returns is to enter new emerging trends and high-risk zones.

But that's not true. The phenomenal success of our Microcap Millionaire service is proof.

Rahul based this service on some simple rules that Graham laid out and some qualitative criteria of his own.

The service recently hit the 100% returns mark for the first time since its launch in February 2014. This is way, way ahead of the Sensex's 37% during the same period. In fact, Microcap Millionaires even outperformed the 86% returns of the BSE Small-Cap index during the same period.

So, yes, we believe prudence not only saves you from unwarranted risks, but also offers handsome returns if coupled with a sound strategy.

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03:00 Chart of the day

The earnings season for quarter ended June 2016 is on. For 300-odd companies that have announced results so far, the picture looks bright. As an article in Economic Times suggests, on a year on year basis, the adjusted bottomline for these companies has grown 11.6% YoY. After a long period of slowdown in demand, a revival seems to be in sight as suggested by topline growth for second quarter in a row. Lower raw material cost and interest cost have boosted operational performance.

But hold on. This is just the trailer. A lot of companies are yet to announce their June quarter results. And with a bulk of these companies belonging to IT sector, it will make little sense to extrapolate this trend.

Initial Earning Trends: Too Early to Cheer

That said, it is not quarterly earnings we are focusing on. We are looking at the long term picture - two three years from now. And we are optimistic. Reason - the conventional logic of mean reversion that even investing gurus like Warren Buffett and Jeremy Graham believe in.

As Rahul Shah suggests...

  • Enough corrective measures are in place to ensure that corporate profitability stays neither too low nor too high. There is always a reversion to the mean.

Rahul has applied this profit margin indicator in Indian context. And has come up with very interesting results.

The aggregate data he pulled for Nifty companies suggests that profit margins were at a ten-year low at the end of FY15. Even if they were to rise to the average of the last ten years, not immediately, but three years out, the upside would be close to 70%.

Now one need not throw caution to the winds. As Tanushree Banerjee, the editor of Stock Select suggests, there are several moving parts to rise in corporate earnings. One of them being capacity utilization levels, which Tanushree and her team are tracking very closely. If you are interested to know more about the companies that have caught Tanushree's attention, do read this special report - Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave that is still available for download.

Do you think the quarter ended June 2016 could mark a turnaround in corporate profitability? Let us know your comments or share your views in the Equitymaster Club.


Man v/s machine - the debate is getting more relevant day by day as we come across the news of how automation is shaving off jobs. And if you thought this was applicable only for manufacturing/agricultural sector, you need to listen to TV Mohandas Pai, the former CFO and HR Head at Infosys.

As reported in an article in Business Standard, he expects around 25,000 jobs to be shaved off every year in the IT sector, a majority of this at the middle management level. Hiring is expected to come further down by 10% for the entry level jobs.

For a young nation, it's a threat we can no longer afford to ignore. Vivek Kaul has some interesting points to make in this regard. In a recent edition of Vivek Kaul's Diary, he points out the fallacy of the demographic dividend and forces us to question this much hyped competitive advantage as compared to other nations.


After opening the day firm, Indian indices slipped into the negative territory during the post-noon trading session. Sectoral indices are trading on a mixed note with stocks from the IT and auto sectors leading the gains. capital goods and banking stocks are however trading in the red.

The BSE Sensex is trading lower by 59 points (down 0.2%) and the NSE Nifty is trading lower 11 points (down 0.1%). The BSE Mid Cap index is trading up 0.1% while the BSE Small Cap index is trading flat.

04:50 Investing mantra

"After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers." - Warren Buffett

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