Is optimism making you overpay for stocks? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Is optimism making you overpay for stocks? 

A  A  A
In this issue:
» A long way to go for a pick-up in the investment cycle
» What to expect from the RBI policy tomorrow?
» What is the biggest risk for the Indian markets?
» Why the US Fed might be falling behind the inflation curve...
» ...and more!

'Bull markets are born in pessimism, grow on skepticism, mature on optimism and end in euphoria'. These are the words of legendary value investor, Sir John Templeton. We believe truer words than these about bull markets haven't been spoken. As the Indian markets are currently in a bullish phase, it is pertinent to consider the above statement. What is the mood amongst investors at the moment? The pessimism seen last year has been left far behind. In fact, after the election results in May the mood has shifted. Investors who were skeptics have become optimistic with the relentless rise in stock prices. Rising valuations of stocks, many of them with questionable fundamentals, clearly reflects the optimism in the markets.

This is why we would like to sound out a word of caution here. There is a crying need to separate optimism from realism right now. Don't get us wrong. We hold no grudge against optimism. However, the fact remains that it is not conducive for picking stocks! As Warren Buffet once opined; 'It's optimism that is the enemy of the rational buyer'. As rational stock pickers, we could not agree more.

To see irrationality in action, one needs to look no further than the e-commerce craze. In every bull market we see at least one sector where valuations go for a toss. E-commerce seems to be in the spotlight this time around. The recent US listing of Chinese e-commerce giant Alibaba has captured investor's attention. Indian e-commerce firms have received over US$ 2 bn this year from private equity (P/E) firms. This despite the fact that none of them have turned profitable! Now this has been questioned by none other than Kishore Biyani, a pioneer of organized retail in India. We agree with Mr. Biyani that the amounts being poured into e-commerce firms are excessive. However, it is also true that he did not complain when stocks of brick and mortar retail stores got sky-high valuations in the last bull market.

The fact is that the e-commerce firms hold as much potential as brick and mortar firms. But these firms are still quite small and their business models haven't matured. Thus, the investment risk is best left to the private equity firms and venture capitalists right now. What is more important? It is the lessons that the Aam investor can learn.

First of all, it is not wise to overpay for stocks. Optimistic investors who brought retail stocks like Pantaloons, at high valuations, did not enjoy a good experience. Secondly, the fundamentals always matter. In fact, in the long run, it's the only thing that matters. Never forget that you are buying a part ownership of a business, even if you buy just one share. The return you get from the stock will be closely related to the cash that the business can profitably earn. So it pays to keep a close watch on the profitability, cash flows, debt levels and return ratios at all times. Lastly, investors should realise that markets will always behave in a similar manner. The craze may change from one sector to another but every bull market will follow the pattern outlined by John Templeton.

The Indian markets are most definitely in the optimistic phase right now. Just like all bull markets, this one too will end in euphoria. We do not know when this will happen but when it does, the worst stocks to own, will be the ones which were bid up too high without the profitability to show for it.

Do you believe that investors are getting carried away with the optimism in the markets? Let us know your comments or share your views in the Equitymaster Club.

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02:40  Chart of the day
The more we listen to Modi's speeches, the more we get convinced that the 'Acche Din' are indeed here. And while inspirational speeches are all good the 'Acche Din' for economy will only return if we kick-start the whole investment & capex cycle. For only then will we be able to produce more and create more wealth for our citizens. However, an article in a leading business daily has sort of thrown a spanner in our hopes. It has reasoned that it's not going to be easy to kick-start the investment cycle. And if stats are anything to go by, we can't help but agree. As per the article, new project announcement have slowed to a crawl and are now at a two year low and nearly half as compared to same period last year!

Besides, the investment projects that have been dropped have seen a steep 43% increase. All of this goes to show that while the intent of the new Government really seems to be in place, unless it transforms to action on the ground, not much is going to change. Thus, apart from launching big-bang programs like 'Make in India', it will also help if some archaic regulations which are really holding our economic progress back are really cut into and huge structural reforms be undertaken. Mind you, we've already lost enough time and cannot afford to lose more we believe.

When will the investment cycle pick-up?

Already on an overdrive, with positive cues about the economy pouring in, Indian markets are looking for excuses to move higher. And the anticipation is that the RBI will offer one such 'excuse' on September 30th. Well, the Indian central bank is hardly known to throw up surprises during Monetary Policy actions. In fact Governor Dr. Raghuram Rajan has been amply transparent in his policy stance so far. And going by the central bank's conservative track record, we do not expect any surprises this time as well. Least of all, to stoke the market's appetite! Falling crude oil prices and better rainfall in recent weeks may have tempered inflation risks in India. But they certainly do not guarantee sustainable low food inflation in the coming months.

The RBI is yet to see any concrete measure to keep price rises low on a sustainable basis. Hence, as far as lowering interest rates go, such measures will follow the government's actions to break the backbone of inflation. We do not think investors should invest on the basis of speculations about rate cuts ever! More so now when such speculations can prove to be dangerous in terms of valuations.

Madison Square turned into a Wankhede stadium when PM Narendra Modi addressed Indian diaspora yesterday. No doubt he is very popular in India. But even outside India he seems to be acquiring lot of admirers. No political leader has ever received such a grand welcome like PM Modi got in the US recently. What this says is the kind of expectations people have from him. He has established connect with his masses and people trust his delivery mechanism. This has created huge expectations from his government. So much so that noted economist, Jim O'Neill, considers Modi's failure to deliver as the biggest risk to the Indian stock markets now.

Most of us would have heard of political risk, monsoon risk, oil risk etc. But this is the first time we are hearing of an individual's delivery risk. This speaks volume about the leadership vacuum in India. In Modi, they find a leader with a solution. And considering the approach he has taken to revamp India with his missions on cleanliness and manufacturing, we feel he is on right track. However, as far as his delivery skills are concerned, the job will not be as easy as thought. Man managing a state and a country are two different things. Hope the results aren't!

The President of the Dallas Federal Reserve Bank, Richard Fisher has had no qualms to speak up against the Fed's policies (QE in particular) in the past. This time around, he believes that the country's Central Bank should be careful on not falling behind the curve on inflation given that the monetary policies work with a lag. This he says because he is seeing signs of higher wage inflation. The same is of course being accompanied by growth as well. According to him, the country's wounds have been healing. While his state has been witnessing strong growth in terms of employment, he is also seeing signs of wage inflation; the latter being the highest (gauged through surveys) since before the recession. Considering that such a trend would be the case across nations, he is therefore in favour of interest rate hikes to be 'sooner than expected'. However, it turns out that his colleagues do not share the same view - as they are concerned over such actions derailing the recovery.

All we can say is that Indian investors would do well to prepare for the volatility that is likely to hit the markets in the short to medium term. As per us, proper asset allocation along with some cash handy to take advantage of the situation would be a good way to do so.

In the meanwhile, the Indian stock markets are trading firm during the post noon trading session. At the time of writing, BSE-Sensex was trading higher by 48 points (+0.18%). Majority of the sectoral indices were trading in green with healthcare and IT sectors witnessing the maximum buying interest. Majority of the Asian indices were trading weak today led by Hong Kong and Taiwan. However, China and Korean markets were trading positive. European markets have opened on a weak note.

04:55  Today's investing mantra
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