Beware of this key factor while investing in stocks

Oct 13, 2012

In this issue:
» What Alcoa's forecasts tell about China
» Does junk rating mean much to India?
» This is where India has made rapid strides
» Shortage of people plagues construction sector
» ...and more!

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There have been instances in the past when many company managements have been lured by the prospect of 'attractive' businesses. In quite a few of these cases, the diversification had no relation whatsoever to the core operations. Further, there was no evidence that the management had any experience running such a business. But because it was successful in running its main business, it was under the illusion that it should have no problems running other kinds of businesses as well. And that many a time has led to its undoing.

One such company to earn this dubious distinction is none other than Deccan Chronicle. After boasting that it is the top team in the Indian Premier League (IPL) a few years back, it now faces the prospect of the termination of its team Deccan Chargers. This is after the company failed to provide a bank guarantee as stated by the High Court. The case of Deccan Chargers is a reminder of what investors need to be careful about while investing in such stocks. Indeed, the company management made injudicious investments in unrelated businesses where it hardly had much of an experience. And all was good until the core business kept supporting the cash needs of its loss making subsidiaries. But once the core business also started faltering a bit due to adverse economic environment, it started relying on short term debt to fund its long gestation subsidiaries. Ultimately, the company ran into serious cash flow problems as debt rollover became difficult and it all culminated into lenders coming knocking at the company's doors. Needless to say, the stock price took a heavy pounding.

We at Equitymaster were also wrong in realizing the shenanigans of the company rather late. That its investment in the long gestation cricketing venture will take the company debt to equity from 0.3 times in FY11 to an estimated 3.5 times currently was beyond our guess. And while we did advise investors to sell their holdings in the stock in early 2012, we admit that we should have done it much earlier.

So the important learning is not just pay attention to annual report details. But also pay very close attention to the business that the company is getting into or plans to invest in. Those diversifying into non-core businesses that too with the help of external funds should certainly be shied away from. Stressing on core competence and diligence is the only way to reducing the occurrence of bad eggs in one's portfolio.

Do you think that companies getting into unrelated businesses with the help of a debt are enough to cause alarm bells ringing? Please share your views or you can also comment on our Facebook page / Google+ page

 Chart of the day
The Economist pointed out that in the second quarter of 2012, the global economy grew at its slowest rate since the end of 2009. If one charts this trend over the past 10 years, China's contribution to the growth in world GDP has been steadily rising. This is hardly surprising given the stupendous growth that the dragon nation has witnessed over the years. In India's case the results have been mixed. Before the start of the financial crisis, its contribution to growth also inched upwards. Three consecutive years of 9% plus GDP growth certainly helped. But the growth path has gone a bit awry post that. Although the Indian economy came back strongly in FY10, the past several quarters has seen growth slow down on account of high inflation, fuel prices, interest rates and fiscal deficit.

Data Source: The Economist

With most major economies in trouble, we have always wondered whether the rise in prices of commodities is more cheap money driven. Or is there real demand out there? If Alcoa, the world's largest miner of bauxite and alumina refiner is to be believed, the former is more likely to be the case. The company is known for making detailed projections of aluminium demand across sectors and geographies. And the same is not looking good from a demand point of view. It has now turned sort of bearish on China, the key driver of commodity growth. The most notable, or rather stunning revision in Alcoa's forecasts has happened in the Chinese heavy trucks and trailers market. From a 3-8% growth in the beginning of the year, the sector is now expected to face a steep drop in the region of 18-21%. Not to forget the downward revisions in other important sectors as well.

Besides indicating demand for metals, Alcoa's forecasts also tell us something about the state of Chinese economy. It really seems to be going through tough times. And not only does this not augur well for China but also for the global economy we believe.

Junk rating. Do these two words mean as much to India as they do to Greece, Spain, Ireland or Italy? An article in Economist tries to answer this question. Now, as we have said earlier, it is not that rating agencies have a reputation for early warning signals. Their inability to rate junk mortgage papers in the US prior to subprime crisis has not done any good to their reputation. However, everytime they threaten India about a rating downgrade, investors get worried. This time the threat is grave enough. For a downgrade would mean 'junk' status for India.

But unlike the external debt burdened economies in Europe, India's liabilities are mostly domestic. The government bond market is dominated by local banks and insurance firms. These entities are perpetual buyers of government debt thanks to liquidity and solvency rules. The central bank too is a big buyer of government debt, irrespective of the rating. It in fact owns 18% of all government bonds, almost double the level of two years ago. Borrowing abroad for acquisitions etc is also not a problem for Indian firms. As Indian banks have a wide presence in overseas markets now.

But what about foreign investors looking to park money in India? Especially those looking to invest for the long term. It is this class of investors that seek some comfort from a better credit rating for India. And it is here that credible execution of proposed reforms will play its part. As per Economist the credit default premium for India is likely to stay higher than its BRIC peers. An investment grade credit rating will at least ensure the long term foreign money does not get diverted away from India.

Given how India is mired in red tape and corruption, the one perception that many have of our country is that things move too slowly. That is why the comments made by the Assistant Secretary of Commerce for International Trade, Michael Camunez are quite interesting. As per him, India has actually made rapid progress. He states that India and China are experiencing roughly 10 times the economic acceleration of Industrial Revolution.

Take the case of the Industrial Revolution. It began in the mid-1700s and took two centuries to gain full force. Indeed, Britain, the revolution's birthplace, required 150 years to double its economic output per person. In the US, this process took more than 50 years. By contrast, a century later, when China and India industrialised, the two nations doubled their GDP per capita in 12 and 16 years respectively. Again demographics have played a vital role in catapulting growth for both these emerging economies. For both of them, the economy began to take off with populations of roughly one billion each. For the US and Europe, this happened with a population of around 10 m. So clearly there is a considerable shift in terms of economic power. And both India and China could play a leading role in way the trade negotiations on a global scale shape up.

Until now, the construction industry was reeling under issues relating to project execution. Red tapism and environmental issues hampered the execution cycle of the industry. Now, just when there were signs of improvement on the execution front another trouble has resurfaced. It is in the form of labour shortage. It is believed that the construction industry is facing acute labour shortages these days. And social government schemes like Jawaharlal Nehru National Urban Renewal Mission (JNNURM) and National Rural Employment Guarantee Act (NREGA) are responsible for it. These schemes basically provide employment to the rural youth of India. As such, the demand for unskilled labour has increased considerably. But there is inadequate supply. This has resulted in increased labour costs by about 25%. It may be noted that construction is a labour intensive sector. So, the shortage of work force might further impact execution cycle. It seems like the woes of construction industry are not likely to die soon.

The week gone by was an unfavorable one for global markets given that investor sentiments turned negative over concerns relating to the global economy and its growth prospects. Stocks in Asia performed poorly with Japan which down by 3.7% over the previous week. The key concern was the country's decline in core machinery orders during the month of August this year. As for the US, the market decline was seemingly on the back of the beginning of the earning season with certain companies lowering growth forecasts on the back of demand from Asia slowing down. European markets also ended the week on a weak note.

The Indian markets ended the week lower by 1.4%. The markets performed poorly seemingly on the back of the beginning of the earning season as certain index heavyweights announced their results this week. There was also concern over the IMF lowering India's growth forecasts to 4.9% as compared to 6.1% predicted earlier. In fact, IMF is one in many entities which have lowered India's forecasted growth rates for the current year.

Source: Yahoo Finance

 Weekend Investing Mantra
"I have owned one stock since 1969, two since 1988 and one I started buying in 1986 or so. That's my portfolio. Six stocks. I once owned 17, but that was way too much." - Philip Fisher

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