What stocks to buy if markets correct? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

What stocks to buy if markets correct? 

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In this issue:
» Compact cars dominate the passenger vehicle market by far!
» IMF suggests China to cool down...
» What is the FM's plan to reduce fiscal deficit over time?
» Indian stocks down by 2.5% in the week gone by
» ...and more!

In continuation with yesterday's edition of the 5-Minute Wrap up - wherein we discussed what the key concern surrounding Indian stocks is at the moment, today's edition is written in attempt to help investors curb a possible panic situation.

We will be taking help of a gentleman named Tom Gayner to take this forward. While Tom Gayner may not be as well known as other key value investors across the world; but when it comes to his track record, it is very much up in the rankings. Mr. Gayner is the CIO and President at US Based Markel Corporation.

We came across an article wherein he spoke about the four-pronged approach to investing that he follows.

The four aspects he looks for in stocks include: 1) profitable businesses with good returns on capital; 2) managements with talent and integrity - with equal weightage given to both aspects; 3) good capital allocation skills; 4) and fair and reasonable prices.

Not a very unique approach you would think. Well... that may be true. But given the share market conditions at the moment, we thought it would be a good time to reiterate some factors that investors should focus on.

When asked to pick one of the above four, Mr. Gayner went with the third option i.e. good capital allocation skills. And as per him, nothing else even comes close!

Let us elaborate a bit more on this...

A company earning return on capital less than the opportunity costs (i.e. cost of equity) would be a business that would not fit in the "Buffett would buy" criteria. But... instead of ploughing back money into the business, if the management continued to payout a substantial portion of the earnings, that would not necessarily make it a poor investment idea.

On the flipside, for companies earning above average returns i.e. returns on capital well above their cost of capital, it would only make sense if such businesses would reinvest all of their earnings into the business and generate higher returns on that ploughed back capital. Essentially, this is where the power of compounding would come into picture; thereby allowing the money to work for you through investing in such businesses.

A classic example of such an investment is American Express. Shortly after the 'salad oil' scandal in 1963, shares of the company had declined by more than 40% over the next few months. However, given the quality of the business, it would definitely be one that Buffett would hold for a long time. Or as Mr. Gayner says, the prospects of American Express in present times continue to remain as bright as they were earlier - given that it is a play on rising affluence levels worldwide.

Nevertheless, the key takeaway here is that whether one had bought into the stock pre or post the scandal, the difference in the returns on a compounded basis over a long term period would be quite negligible when gauged today.

It may be noted that we are not indicating investors to go out and buy stocks of high quality companies right away - considering their high valuations. However, taking such an approach would be essential for investors over the long term. In India, the "quality" businesses may seem expensive at the moment. But the key here would be to purchase them are fair valuations - as they would rarely be available for cheap. But even if you were to buy into such a stock and if it declined after you purchased it, the 'power of compounding' aspect of such businesses would be the margin of safety to your investments.

What would be the best approach for investors given the possibility of overheated global stock markets? Let us know in the Equitymaster Club or share your comments below.

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01:40  Chart of the day
India traditionally has always been a market for small cars. This is in contrast to the developed countries of Europe and the US and for that matter even China where sedans and luxury segments dominate. Not that there is no demand for sedans and mid-sized cars in India. With the economy growth in the India in the last decade and the rise in incomes of the middle class, demand for bigger cars has increased. However, the small car segment has not lost out at all. Infact, this segment has only grown. This segment otherwise known as MMC (micro, mini and compact) has seen competition soar in recent times as automobile companies have looked to capitalise on this growing space. Maruti Suzuki is undoubtedly the market leader here but over the years has seen its market share slide as more players have entered the field and launched their models. The reasons why small and compact cars are doing so well in India are many. One is that these cars are affordable since most buyers finance purchases through loans. Second, is the question of space. Given that there is tremendous congestion in the country, it becomes easier to maneuver and manage compact cars at least for first time buyers. Hence, we believe that whatever the trends in the global auto market, in India there still remains considerable scope for the growth of the small and compact car segment.

Compact cars: India's preferred choice, by far!
MMC - Micro, mini and compact; SC - Super compact

The dragon nation is known for setting ambitious GDP growth targets and achieving them. And it has no qualms in resorting to stimulus measures in order to achieve its over the board targets. For instance, in FY14 it set a GDP growth target of 7.5%. However, weakening exports and cooling Indian property markets meant that growth could well fall short of the target. But doling out stimulus restored growth and put the economy back on track. Same was the situation in FY13 as well. A flurry of government measures saw China exceeding its target for that year.

However, for FY15, IMF is of the view that China should set itself a realistic goal and not resort to stimulus unless warranted. And the realistic figure could be 6.5-7%, well below its 2014 target. The reasoning behind IMF's view is the risk that the stimulus measure could pose in the form of high spending. And containing the same is a priority now.

We could not agree more. In the past, in order to achieve higher growth targets China resorted to heavy off-budget spending. Credit growth flourished as well. Excessive credit growth created a bubble like situation in property markets. This has put Chinese economy at grave risk. Hence, prudence lies in setting up a realistic growth figure and not resorting to stimulus just to maintain the tag of being the fastest growing economy.

Most major Western economies in the world are in deep fiscal trouble because the governments spent way beyond their means. This does not, by any mean, indicate that Indian policymakers have been prudent. They have been anything but that. And this is one of the key reasons why the economy is struggling to recover. This is why we were glad to hear some sane statements from our new Finance Minister Arun Jaitley recently.

We had mentioned yesterday that the FM plans to bring fiscal deficit to 4.1% in FY15 from 4.5% in FY14. That is indeed a big challenge given the current economic circumstances that the country is in. And the FM does admit the magnitude of the challenge. So how does he plan to achieve the fiscal deficit target? Will he increase taxes? The answer seems to be no. The new government is of the view that higher taxes tend to impede economic growth. As per Jaitley, taxes have to be rationalised to make Indian products globally competitive.

What he plans to focus more on is keeping expenditure under control. Because he is of the view that a government borrows and spends beyond its means, the future generations have to bear the brunt of it in the form of higher taxes. We quite agree with this point of view. So instead of raising taxes, Jaitley plans to rationalize subsidies to make sure that only the deserving, vulnerable sections of the country get its benefit. The government has proposed to bring down major subsidies from 2.2% of GDP in 2013-14 to 2.03% of GDP in the current fiscal. And then, it plans to further bring them down to 1.7% and 1.6% of GDP in FY16 and FY17 respectively. Well, we believe these are indeed positive signs. The only big question is: Will the Finance Minister walk the talk? This, we need to wait and watch.

In this world of ever increasing debt, the possibility of a default is always around the corner. And if the defaulter in question happens to be a sovereign government, then the result could be catastrophic. This is exactly what has happened in Argentina. The South American nation which has a long history of sovereign defaults has done it again. Back in 2001, the Argentina had defaulted on its foreign debt for the seventh time in its history, amounting to US$ 82 bn. In the restructuring exercise that followed, some of the country's creditors held out. They demanded that they be repaid in full. This group of creditors has now received a court order to that effect and this has triggered a fresh crisis. Argentina has refused to pay up. S&P has called it a 'selective default'. So what happens now?

As Argentina has been shut out of the global markets since 2001, there will be little impact felt immediately. However, the longer this saga drags on, the more nervous global markets will become. FIIs may not press the panic button just yet but if last minute negotiations do not result in a settlement, large outflows from the Indian markets cannot be ruled out. At such times, it is best if investors remain cautious and remain invested in companies with excellent fundamentals.

Share markets across the world continue to witness pressure from escalating tensions between the West and Russia over the Ukraine crisis. The sharp drop in the US markets on Thursday, and fear of US Federal Reserve increasing interest rates kept investors cautious. However, the overall weakness was somewhat reduced by positive performance in some of the Asian indices.

The US markets were on a cautious footing throughout the week in anticipation of weak economic data. The benchmark index suffered weekly loss of 2.8%, largest weekly loss since June 1, 2012. While some positive economic data on Friday helped to add back the momentum in the indices, however, the gains could not offset the week's losses.

Majority of European markets remained depressed. The markets in Germany and France were among the leading losers for the week. Disappointing manufacturing data of Eurozone countries have added more pressure on the European Central Bank. Indicating that the bank now needs to take more measures for further stimulus as rising deflationary risks could hamper its efforts to spur growth.

Among the Asian markets, China and Hong Kong markets were the leading gainers registering gains of approx 2.8% and 1.3% each. Strong manufacturing data kept markets upbeat in China. Manufacturing activity in China and other Asian countries gathered pace during the month of July, hinting at a revival in global trade.

Even the Indian stock markets ended the week on a weak note. Selling activity took toll on back of discouraging global cues and thus indices were, down by 2.5% for the week.

Performance during the week ended 1st August, 2014
Source: Yahoo finance, Equitymaster

04:55  Weekend investing mantra
"We want to be right on something that will work right now, not something that might work in the future" - Warren Buffett
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2 Responses to "What stocks to buy if markets correct?"

chandrabhan singh

Aug 4, 2014


Like (1)


Aug 2, 2014

I am averse to risk. Multitasking job which does not give anything to life. Being an doctor I prefer to use my money only for betterment of medical field. I can not trust any other advisor, because almost all the advisors in any sectors are looting my share of money by making so called word promise( MBA,s manipulation of business accounts). Cash and carry, or less luggage more comfort are best mantra of life.

Like (1)
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