The risk that can quickly take your stock to zero! - The 5 Minute WrapUp by Equitymaster
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The risk that can quickly take your stock to zero!

Dec 13, 2014

In this issue:
» Returns from upstream oil companies sink after fall in crude prices
» Dr Rajan proposes his version of 'Make In India'
» What as per Dr Rajan should be the true role of any regulator?
» ...and more!

If we remember it correctly, Warren Buffett and Charlie Munger were once asked as to why they have not considered investing outside the US in a major way. This at a time when other international markets were performing superbly and handing investors great returns.

Munger in his typical style opined that their intention was to not be the number one in terms of returns earned. They would rather invest in something they know and earn good market beating returns over the long term. Whether someone is earning greater returns than them is inconsequential as far as they are concerned.

Munger and Buffett were aware that investing outside one's geography of comfort has its own perils. Then again it is not just about doing bottom up investing. It is essentially taking a call on the economic, political and social environment of the country.

Some may of course dismiss this as a small observation. However, its enormity is something we recently witnessed firsthand.

As a matter of fact we will go to the extent of saying that don't pay proper attention to this factor and you may well see your favourite stock go all the way down to zero. Like it happened with a company we recommended to our subscribers a few years back.

When considered in isolation, the business of rose cut farming looks innocuous enough. On the contrary, as long as mankind will continue to express love and offer condolences, the business will keep flourishing. It is with this very intention; we recommended a stock that was amongst the world's largest sellers of roses to our subscribers way back in 2008. And while our subscribers did manage to exit the stock with a profit, it has hit rock bottom since then.

The last time we saw, the stock was down 94% from our recommendation price and with absolutely no recovery in sight. What happened? How did the rose wither away? Well, if only the management would have taken Munger and Buffett's advice seriously. In a mad rush for expansion, it made the mistake of going outside of its geography of comfort. And if this was not enough, it chose a region as unstable and volatile as the continent of Africa!

Consequently, it didn't take long for the chickens of this error to come home roosting. First, its diversification in agriculture suffered a huge jolt when floods ravaged the crops. And then came the allegations of land grab. The agony piled on further when the company had a human rights case slapped on it. The last we heard, the management was considering delisting the stock and thus get rid it of its misery.

Really, there can't be a better case study on the perils of having a bulk of your revenues coming from a region not particularly conducive for doing business. The business can of course flourish for some time. But in places where the odds are so heavily stacked against you, the entire enterprise can crumbling down in no time. This lesson becomes even more pertinent now than ever what with many Indian companies venturing beyond domestic shores and trying to establish global presence without taking the country specific risks into account.

As for us, amongst the most important questions we ask before we recommend a stock is whether a sizeable chunk of the company's revenues come from hostile and unstable regions like the countries in the African continent? If the answer is yes, it could well make sense to give the stock a miss.

Do geopolitical risks figure prominently in your stock picking process? What do you think? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
We just saw what could be the risk if one moves outside of his/her geography to invest without taking country specific risks into account. However, apart from such geographical risks even oil price risk can hurt stock returns. While the former can be hedged by investing domestically the latter cannot be diversified. It is the risk you have to bear while investing in equities as crude price movement has a direct bearing on stock returns. And you can do nothing to control crude prices.

However, with crude prices sinking every day this risk seems to have ebbed for the time being but not before hurting the returns of upstream oil companies. As can be seen in today' chart, GAIL India has been the biggest loser since November 01 after crude prices started sliding which fuelled margin concerns. Other oil producing companies too have lost ground considerably since then. Being oil producers, a fall in crude price hurts their realizations and hence profits. As an example, as per an article in Mint every US$1 drop in crude price erodes Rs 8 bn in topline and about Rs 4.5-4.75 bn in bottomline for ONGC! So, unless the crude prices rebound from here on margins and returns of upstream companies will remain under pressure.

Upstream oil companies bleed amidst fall in crude prices

A fall in crude price and Prime Minister Modi's reformist approach has certainly proved to be a sanjeevani for India. Various measures like the Swachh Bharat, Jana Dhana Yojana and Make in India introduced by the PM have changed investor sentiments and laid a new background for a fresh start.

As far as the PMs 'Make in India' campaign is concerned we have written numerous times that it will be an important driver in terms of bolstering manufacturing in the country. And at the same time give a big push to GDP growth. But will this be enough? Dr Rajan, the governor of RBI, does not think so. And he has some compelling points to make. The PM's intention is to make India a strong global manufacturing hub. But according to Dr Rajan, the compulsion to bolster exports should not be at the cost of ignoring domestic demand. In other words, Dr Rajan believes that the focus should also be on the mantra 'Make for India'. China is a classic example of how the global manufacturing model does not always work. Given the prolonged slowdown in the global economy, the dragon nation has also slowed down. And it is only now that the Chinese government is working towards emphasizing domestic demand.

For India, inflation so far has been a big headache. Thus, while domestic demand is very much there, the government needs to ensure that there are no supply side shocks. This will ensure that headline inflation stays within acceptable levels. Further, Dr Rajan also is of the view that domestic demand must be financed responsibly through internal accruals as well savings. We agree that Dr Rajan has made some very strong points. As long as global demand remains weak, Modi's idea of a global manufacturing hub will not really deliver much. Ensuring that demand in India is catered through ramp up in production is more likely to yield the desired results.

Have you ever seen someone piled on with incessant pressure while doing his job? With people from various quarters constantly second guessing him, asking why he isn't doing what they think he should do? Well, such is exactly the predicament of a certain Raghuram Rajan these days. The clamour for a rate cut has been constant and forceful. And few have lost an opportunity to express their displeasure at the lack of a cut in interest rates. So much so that Rajan, the governor of the RBI, recently retorted by saying that the role of regulators is not to boost the Sensex. He further went on to expound that to ensure financial stability; regulators have to sometimes go against popular sentiment. This is because their most important goal, by far, is to make sure that the underlying fundamentals of the economy and its financial systems are sound enough for sustainable growth. Wise words indeed we would say. We draw a lot of comfort from the fact that the person in charge of India's central bank so fiercely guards the independence of his convictions.

After rallying for several weeks, global markets witnessed a sharp reversal this week. Worries about global growth were clearly evident. With crude falling to a new 5 year low below US$ 63 per barrel, markets are now factoring the possibility of weaker than expected global demand. Despite positive economic data from the US, markets remained jittery. Japan's third quarter GDP contraction is believed to be worse than initially reported at -1.9% and China's economy continued to remain sluggish due to falling consumer demand.

In Europe, the German economy showed increasing signs of weakness as the nation's October trade data revealed that exports and imports fell by 0.5% and 3.1% respectively. There were also concerns surrounding the future of Greece in the Euro as presidential elections have been called in the country.

After hitting a life high just last week, the benchmark Dow Jones Industrial average (DJIA) in the US ended the week lower by 3.8%. Back home in India, the BSE Sensex ended the week lower by 3.9%.

Performance during the week ended December 12, 2014
Data Source: Equitymaster & Yahoo Finance

 Weekend investing mantra
"There are huge advantages for an individual to get into a position where you make a few great investments and just sit back, you're paying less to brokers, you're listening to less nonsense." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi.

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3 Responses to "The risk that can quickly take your stock to zero!"


Dec 15, 2014

Dr.Rajan and RBI are not criticized by anyone for any other actions.RBI has done well in all other spheres. The only area is monetary Policy. RBI was increasing Repo Rates with much alacrity when Inflation was going up. But, these Rate Increases did not have an Iota of beneficial effect on the Inflation. This fact needs to be recognized. Inflation has started coming down due to various extraneous factors unrelated to Rates now. Government also is very seriously tackling Inflation. In last 3-4 years, we have seen that repo rate increases had no beneficial effect on Inflation. But, these increases adversely affected Growth. These are facts we all know.India cannot afford to retard its growth for so many years. RBI can try to fuel growth and employment by a significant Rate Cut. While Rates did not affect Inflation, they can work wonders for Growth. This is the point.This is what the present FM and also the previous FM have highlighted to RBI. RBI has of course done well in holding Rupee value and in many other matters.



Dec 13, 2014

PM's Make-in-India is to attract huge foreign Capital to usher in a Global- Brand for India! And it is not simply Export-Oriented. It is a strategy for Job-creation and skill-Development.


Dr HA!

Dec 13, 2014

This is with reference to the concepts of MAKE IN INDIA by our PM and MAKE FOR INDIA by our RBI Governor. Each of the concepts works and effective during particular time periods. Hence why not combine these two and have a holistic concept calling it as MAKE IN INDIA FOR INDIA. For example, product needs of our people first and the excess can be exported. Usually, the export oriented products require heavy subsidy and added to that the income earned has to be tax exempted. This tells on our economy and also shortage of certain products required here in India become costlier day by day leading to inflation. Hope our netas like our PM, FM and others and
professionals like RBI Governor,successful industrialists and others join together to have MAKE IN INDIA FOR INDIA become effective.

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