Here's why IIP numbers don't matter in long run - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Here's why IIP numbers don't matter in long run 

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In this issue:
» Why bankers may remain unpopular...
» Will the US dollar survive the global gloom?
» China's accounting flaws open up an opportunity for India
» Indian insurance can do with better regulation
» and more!

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The famous economist John Maynard Keynes once said that in the long run, we are all dead. It appears that the most of the investment community and financial media seems to have taken this comment rather seriously. What else will explain their fascination behind employing an entire battalion of analysts and economists in order to study the short term impact of an economic event of note? The end result? Extremely volatile share price movements and swings of the magnitude of 20%-30% becoming a common occurrence.

But is this approach correct? Certainly not if one realizes where does the value of stocks really come from and their longevity. There cannot be any ambiguity with respect to the fact that stocks are worth the present value of future cash flows they will deliver to their owners. But do they have an expiry date? Well, individual stocks may decline and the business models behind them disappear altogether. But if considered together as a group, their duration is extremely long and the dividends they pay out do certainly grow with time.

Thus, if we assume, like the famous asset management firm GMO has done, that half of the returns from stock in a given year come from dividends and half from growth in dividends, it becomes clear that most of the value of stocks comes from cash flows in the distant future. This is because dividend in any year will only be a very small fraction of the overall value accumulated over a very long term horizon.

Well, we will spare you the math here but the broad conclusion that comes out is that the first 11 years of dividend account for only 25% of the value of stock market. Thus, even if dividends are a whopping 50% below the trend over a period of 10 years, the value of the stock market will come down only by 10%. Contrast this with the 30%-40% corrections that stock markets regularly witness over a small downward revision in earnings or dividends and one understands why the markets are so irrational.

It is extremely important to add that if India's GDP grows by 6% instead of 8%, this does not mean that India's capacity to grow GDP by 8% has been impaired completely. It is just that demand for goods and services has grown by 6%. Thus, when the demand returns, the economy will certainly be in a position to absorb the higher production needed. In view of this, whenever events like fall in industrial output, which we have demonstrated to have no sizeable impact on overall valuation of stocks lead to market panicking and pushing down value of stocks by 30%-40%, rational, long term investors can take advantage of the same. They will thus benefit from the attractive above trend returns that lie in waiting for them.

Do you think events like fall in industrial output could be thought of as good opportunity to benefit from India's long term story? Share your views with us or you can also comment on our Facebook page / Google+ page.

01:30  Chart of the day
As we saw, India may not face a huge long term threat from a temporary lull in its IIP numbers. But the topic of today's chart of the day can certainly have an impact on the structural trend of its GDP. As mentioned, despite nearly two decades of economic boom, the poor in the country have not benefited as the rich poor disparity has barely budged. In other words, most of the benefit of higher economic growth seems to have come to people who were already better off back then. Clearly, India's policymakers do have a lot of thinking to do in order to address this anomaly.

Source: LiveMint

Do bankers contribute anything to the economy? Bankers the world over have been a maligned lot simply because they had a key role to play in creating the global financial crisis in the first place. Most of them (especially those in investment banks) focused on 'financial engineering' and creating complex products rather than stress on the basic sound principles of banking. Huge amounts of money were pocketed as bonuses for profits generated. But the bubble burst (as it was bound to) and the rest they say is history. Recession, bloated debt, large scale unemployment have all hampered the developed world and threatened the health of the global economy. But bankers do not seem to have learnt a lesson.

Indeed, rich bankers can today be exposed as a huge drain on society costing it £8.4 for every £1 they produce. A study by think-tank the New Economics Foundation found that the average banker destroys £42 m a year in value while creating just £5 m. As a result of the credit crunch, most big banks had to be bailed out and this has been a heavy drain on the tax payers' money. This is in contrast to public sector workers such as nursery workers and bin men who are lowly paid but produce more value than what they earn as wages. As long as bankers continue to pocket big salaries without contributing much to the economy, they are going to be extremely unpopular not just with the government but also with the public.

A limping horse may still have a chance to win the race. How is that possible, you may ask. The answer is Einstein's theory of relativity. In a relative world, it does not matter if you are a bad horse as long as the other horses are in an even worse shape. Think of the global currencies and this analogy comes in pretty handy. With the limping horse we were referring to the US dollar. The greenback had everything going against it. Yet the US dollar has regained its safe haven status in recent times. How come? Because the Euro is in an even worse shape. Moreover, even China's growth has slowed down and many fear that the dragon economy is heading for a hard landing.

An economist by the name of Mr Gary Shilling even goes further to say that the US dollar would survive the global gloom and would continue to remain the primary international trading and reserve currency for decades. According to Mr Shilling, there are quite a many positives that the US economy has on its side such as its entrepreneurial bent, open economy, rapid productivity growth, superior technology and relatively open immigration. Besides these positives, the lack of alternatives to the greenback will aid its dominant global position.

Crouching Tiger Wounded Dragon', a modified title for the Academy Award winning Mandarin movie, has often been used to denote the one-upmanship of Indian economy to its Chinese counterpart. Although China has proven to be a difficult competitor in every aspect, investors often benchmark India's performance against the dragon economy. Of late reports about the Chinese GDP growth rate slowing down, banks accumulating huge NPAs and real estate bubble threatening to burst have diverted investor focus from the juggernaut.

The latest to catch their attention is accounting flaws in large Chinese firms. Auditors expressing concerns over the irregularities and falsification of financial records in Chinese firms have left a bad taste in investors' mouth. As a result, FIIs have turned to Indian markets for better returns than the near zero interest rates back home. That the Indian capital market regulator SEBI has adopted more stringent laws for accounting disclosure seem to have added to their confidence. Smaller Indian companies looking to get themselves listed on the exchanges are also keen to tap this opportunity. It is now for the government and India Inc to ensure that investors looking for long term opportunities here do not get disappointed. Else most of the BRIC story will be gone for good.

Should a regulatory body use its powers indiscriminately? Can it be partial and reverse its original stance? Well, this is exactly what the Insurance Regulatory and Development Authority (IRDA) seems to be doing. In 2009, Reliance General Insurance sold 3.5 lakh health insurance policies without informing IRDA. This is deemed illegal. When the regulatory body found out, it stated that it could levy a penalty of Rs 5 lakh per policy. This would amount to a whopping Rs 175 bn! However, realizing that this could very well sink Reliance General, this penalty was reduced to a mere fraction of the cost. Precisely Rs 2 m or 0.001% of the original. In another case with HDFC Ergo, instead of a maximum fine of Rs 68.5 m, a mere Rs 5 lakh was charged. The insurance sector is gearing up for big ticket IPOs next year. However such episodes provide very little comfort. The IRDA needs to really pull up its socks in terms of strong regulation of this important sector.

Meanwhile, indices in the Indian stock market have been hovering around the break even line with the BSE Sensex trading lower by around 25 points at the time of writing. Reliance and Infosys seem to be trying hard to keep the index from falling further.

04:57  Today's Investing Mantra
"Beware of geeks bearing formulas." - Warren Buffett
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5 Responses to "Here's why IIP numbers don't matter in long run"

M G Sharma

Dec 13, 2011

Dear ,
Really very interesting to read your articles all the time , always full of new knowledge . Bankers today are curse on the common investor & common public as taxpayers (direct Tax payers as well as indirect tax payers that means every body in every country , &on top of it they are treated as high profiled inteligentia. Greatest irony in todays financial & commercial world.



sunilkumar tejwani

Dec 13, 2011

partially agree with your views. but the bottom of the barrel is yet to come. technically speaking, we have yet to see further price damage in stock prices, then why to hurry for buying now? because the unforeseen negative factors are yet to be discounted, so let us wait for some more time to do bottom fishing at still more better prices. Further, one should do bottom fishing in well manged businesses and companies only, which are fundamentally strong and investor friendly.


Srikant Prathi

Dec 13, 2011

World over govts are running deficit budgets. Deficit budgets are run based on the hope that growth in tax and non tax Govt revenues (due to expansionary measures) would more than compensate for the increase in interest burden (because of bonds issued to sustain/ finance the dificit) on the country.

This has been the case when deficit reduced in boom years even if the percentage capital expenditure was far less than revenue expenditure of Indian government. The reduction in economic activity hampers our governments’ ability to sustain high interest payments which it owes on bonds and public money. Such macro stability concerns will effect companies operating in the country.

IIP numbers hence are a matter of deep concern. Bad numbers question India’s macroeconomic stability and her ability to sustain deficit budgets. Sustained growth with improvement in capital expenditure and cuts on revenue expenditure is probably the prudent way to cut deficits in long run.


anupam garg

Dec 13, 2011

either equitymaster is being completely irrational or i didn't understand the analysis

when we accept the fact tht current equity share prices r a reflection of the future cash flows...then please also accept the fact tht these future cash flows don't come out of thin air but are dependent on current scenario, which is negative in IIP & low on GDP

many a times predictions of 40k, or 30k level of sensex have been predicted for yr end of 2011...well, 2011 has ended & we r barely at half the predicted levels...y? coz of 2008 macroeconomic figures

yes, the companies will not vanish & yes, they will continue with dividends & capital returns but we shld b reasonable & cautious enough to expect rational figures based on current gloomy macro numbers


Abhay Dixit

Dec 13, 2011

IRDA has always worked like Insurance Companies' Association rather than a regulator. IRDA should be taken to court for not regulating miss-selling of ULIPs and commission structures. IRDA allowed day light robbery.

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