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The Megatrend that is Not Money Making

Nov 11, 2014

In this issue:
» Is your 'growth stock' creating value?
» Indian corporates still waiting for 'Acche Din'
» Loose monetary policies will continue
» The CBI U-turn in Coalgate!
» and more....


00:00
 Chart of the day
 
Newspaper headlines are doing a great job of whetting investor appetite these days. Be it election results, cabinet expansion, reforms in the making, every headline is doing its bit to help the Sensex gather momentum. And even as the benchmark index sits pretty at life time highs, investors seem to be hardly worried about valuations.

Now ever since the election results were out in May, the stock market rally has been based on the premise that the economy will finally shake off the policy paralysis. Expectations that reforms will allow companies to grow at significantly higher rates have been factored into their valuations too. More so for smaller companies that can fetch better valuations as growth picks up. As a result, even as the Sensex is trading at trailing 12 month's price to earnings (P/E) multiple of around 19 times, the BSE Small Cap is richly valued at 37 times trailing P/E!

Why not invest in stocks when there is a fundamental improvement in terms of growth rate Well the trend of investing in growth stocks is undeniably lucrative in an economy like India. However the problem is that many investors are blindly following this trend of growth investing without realizing that not every fast growing company is creating wealth. In fact, a company that has very low margins and grows at a very fast rate by reinvesting capital in growth tends to destroy shareholder wealth rather than create it.

Global retailing giant Amazon is a classic example of a relentlessly fast-growing company whose revenues typically translate into relatively diminutive profits. This is because the company reinvests most of its enormous cash-flow into expanding its infrastructure and maintaining low prices. Investors hope that at some point in the future, Amazon can turn more profitable and reap enormous financial rewards. But, as Professor Damodaran has recently explained in his blog, high growth at the cost of margins can hardly create any moat. In fact the nature of retailing business is such (be it online or brick and mortar) that continuous plough back of capital for growth leave very little on the table for investors. So, investors hoping to strike gold by investing in such high growth sectors may be thoroughly disappointed if profits fail to show up even after a prolonged period.

Data from the BSE 100 group of companies shows that companies with wafer thin margins are the ones clocking the fastest growth rate. So if you were to select stocks based on solely the growth criteria without paying any heed to margins, the chances of losing money are much higher than creating wealth. In fact an investment in such stocks even over a long period of time tends to produce very disappointing results.

Growth at the expense of margins?

The growth investing trend, therefore, will work well, as long as the business you are investing into is generating enough profits and cash flow on a continuous basis. Else you are better off staying away from this Megatrend that is not really money making!

By the way, The India Letter team continues to meet companies across the board, so that we can select only the best of the lot with equally good growth and shareholder wealth creation potential.

Which are the other criteria that you would filter high growth companies on before investing in them? Let us know your comments or share your views in the Equitymaster Club.

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02:50
 
We have seen how growth at the expense of profitability is never a good idea. If we were to listen to the heads of large Indian corporates, growth seems to be the only thing on their minds. Take the example of the latest quarterly earnings season which is drawing to a close. The median sales growth (for the firms that have declared results) was a poor 10.5% YoY according to smartinvestor. Thus, the desire for growth is justified. However, it cannot come at the expense of the bottomline. The median net profit growth in the quarter was just 7.7% YoY. This is the slowest pace of profit growth since the post Lehman quarter in Oct-Dec 2008! Indian corporates are still waiting for their 'Acche Din'.

However, the stock markets are clearly not concerned. Stock prices have hit record highs in many sectors. In many cases, stocks have run up way ahead of the fundamentals. While investor sentiment in the markets has indeed picked up, investments in the real economy have not. Without fundamental changes on the ground, it will be difficult for the rally to sustain we believe. Economic growth will need to pick up if corporate profits have to see a rebound. To stimulate economic growth, decisive action will need to be taken to promote investments in key sectors like power, transportation, mining, manufacturing etc. If these reforms do not come quickly, the markets could be in for a reality check.

03:40
 
Now if economic growth is yet to pick up, why have the markets scaled life highs? The answer is simple: global liquidity. Six years of loose monetary policies have flooded the world with cheap money. With interest rates in the developed world at record lows; the money has ended up inflating asset prices. The Indian markets are just one example. However, some central bankers are now becoming wary of their own actions. At a conference in France a few days ago, the downsides of the easy money policies were discussed. We would have been delighted if common sense had prevailed but it was not to be.

While there were some sane voices, including Raghuram Rajan, the heads of major central banks still felt that loose monetary policy was justified. Though the US Fed has wound down QE for now, the Bank of Japan (BoJ) and the European Central Bank (ECB) are doing their best to avoid deflation. The desire for growth and higher prices has driven them to expand their stimulus plans. Some of this money will surely make its way to India. However, we caution investors against speculating based on foreign fund flows. When the Fed increases interest rates, global markets will have to brace for a lot of turbulence we believe.

04:05
 
On more than one occasion in the past we have written to you about why crony capitalism has been the biggest undoing for Indian economy over the past decade. And some of the largest Indian corporates are to be blamed for this. Do you remember reading about the CBI finding unaccounted cash worth Rs 250 m at Hindalco office, in December 2013? The instance was just a grim reminder of the unrestrained greed of corporates and politicians that has led to a breeding ground for corruption in the country!

The CBI reportedly closed the case later for lack of evidence. However, it seems that the investigating agency has made an epic U-turn and is set to pursue the case against the Birla group once again. Since the case is closely linked to the Coalgate scam, a meaningful closure with the wrongdoers being brought to book can create a precedent of sorts. At a time when India is looking to reform the economy to achieve growth on a sustainable basis, crony capitalism is the last thing that should be allowed to flourish.

04:40
 
In the meanwhile, the Indian stock markets pared their early gains in the post noon trading session. At the time of writing, BSE-Sensex was trading higher by 9 points. Sectoral indices were trading mixed with pharma and auto stocks being the biggest gainers. Stocks from IT and consumer durables were among the top losers. Asian stock markets were trading mixed with Japanese market leading the gains and Singapore market leading the losses.

04:55
 Today's investing mantra
"Speculation is most dangerous when it looks easiest." - Warren Buffett

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1 Responses to "The Megatrend that is Not Money Making"

C K VAIDYA

Nov 11, 2014

This comment is about today's 'Premium Edition' and HUL.
I think the relevant ratio is ROCE. HUL routinely reports ROCE numbers below its cost of capital. Such a company is actually destroying shareholders' wealth.

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