»5 Minute Wrap Up by Equitymaster

On This Day - 22 FEBRUARY 2012
Why most value investors hate gold?

In this issue:
» The problem with dividend investing
» Look who is rooting for priority sector lending?
» The accounting change that can increase US debt by US$ 1.5 trillion
» Are India Inc's bad earnings days behind it?
» ...and more!

---------------------------------------- Have an enriching Saturday! ----------------------------------------

Can Europe find a solution to end the current economic crisis?

Will the new economic reforms drive the stock markets?

Are we paying a price for bad democracy?

Get answers for all such complex issues straight from Jawahir Mulraj.

Click here to sign up for J Mulraj's 'Straight From The Hip' e-letter! It's Free!---------------------------------------------------------------------------------------------------------------

We cannot emphasise enough the importance of Benjamin Graham and his teachings to a tribe of people known as value investors. It won't be too exaggerating a comment to make if we say that he is to value investing what theory of gravity is to Newton and relativity is to Einstein. There is one crucial difference though. Graham's framework cannot be called anywhere near as scientific as that of the other two gentlemen. In other words, Graham's works tend to reflect his own personal interpretation of the world around him rather than universal truths. And this bias of his perhaps tends to come out the clearest in his view on gold. It seems that Graham was of the opinion that absolutely no one can tell the future. Thus, in order to increase returns and reduce risk, investors should divide their portfolios between stock and bonds. This, after taking into consideration their relative valuations. Look into any truly long term chart and one would realise how prophetic Graham proved to be. The history is interspersed with periods where one asset class outperformed the other.

However, there seems to be one significant drawback in Graham's allocation. He does not seem to have suggested a framework for allocation when both stocks as well as bonds have stagnated or have a suffered a fall for a significant period of time. As far as the US market is concerned, this happened in the 1970s and again from 2001 till today. Thus, to earn any real return in these periods, it was imperative that investors look at some other asset class. Enter gold. It should be noted that it was exactly during these two periods mentioned above that gold's dream run took place. And this enabled it to act as a perfect option for the other two asset classes. Thus, we can safely argue that an ideal portfolio should have not two but three asset classes i.e. stocks, bond and gold.

Why on earth did Graham miss this fact? Well, it could be argued that he did not live long enough to witness the above two patterns with his own eyes. Besides, as economist David Galland points out, for most of Graham's adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Hence, he never witnessed a long enough period where gold performed way better than stocks and bonds.

Given how obsessed Graham's followers are with his theories, there is a chance that most value investors do not want to touch gold, even with an eight foot pole. And unfortunately, this tribe also includes super investor Warren Buffett, who has criticised gold time and again. But the fact remains that as long as Governments continue to pile up debt and debase their currencies, gold will remain a worthwhile investment option. It is as real as money can get and thus, should form at least 10%-12% of your total portfolio.

Do you think gold is an ideal investment option in your portfolio apart from bonds and stocks? Share your comments with us or post your views on our Facebook page / Google+ page.

 Chart of the day
Cushman & Wakefield, one of the world's renowned real estate consultants, has revealed in its latest report that for the first time in six years, Mumbai has fallen off the list of world's most expensive cities in terms of office rentals. In fact it fell significantly from 8th last year to 15th currently. As shown, Hong Kong, London and Tokyo emerged as the top three. Beijing and Sydney were the new entrants into the top 10.

Source: Zee news

People apply different criteria such as fundamental of the company, comparable valuations, dividend policy and quality of management to evaluate a company. There is a section of investors who mostly rely on dividend investing method. They attach prime importance to dividend yield to value a stock. No doubt, high dividend payout as well as high dividend yield speaks volume for any stock. However, one should not rely on this only for several reasons. What is the probability that the company would be paying high dividends in future as well? Sometimes, dividend yield itself could depict a wrong picture, especially in case of beaten down stock price. In addition to that, future dividend may not be able to cover for inflation as the company may not be distributing higher dividends, in line with inflations. And not to forget, a company can pay good dividends going forward only if it generates good profits in future. Hence, judging dividend history alone does not make much sense.

So what investors need to do? You need to define a set of investment criteria which can judge fundamentals, management quality and valuations in detail. This approach is certainly tedious but is perhaps the only way to do long term investments to generate healthy returns on your investment.

Subsidised loans. If you ask an Indian farmer, what his idea of the same is, very likely he will tell you 'free money'. The duty of Indian banks to prioritize lending to few sectors most often leads them to sacrifice margins. The priority sector lending is not just subsidized. For foreign and private sector entities, it also means buying out loan portfolios from the rural lenders. That too at a premium over the lending rate.

Priority sector lending mandate currently stands at 40% of overall loans. With such a high proportion, it has been the bane of contention for Indian banks for years. Few entities other than the PSUs have been complying with the same. For those that have complied fully, most of these loans have resulted in inferior asset quality. Hence the recent Reserve Bank of India (RBI) recommendation to keep the priority lending target at 40% has not gone well with banks. Of this, 15% is to be reserved for small and marginal farmers. We appreciate the social cause that the central bank is targeting through such mandate. But forcing banks to unduly risk their exposure may be hazardous for the economy. Especially, without proper recovery mechanism or collaterals in place.

In 2011, the Indian benchmark index saw a series of earnings downgrade due to rising interest rates, higher commodity prices and policy issues. However, if the current quarter results were anything to go by, it seems that the cycle reversal is just around the corner. While earnings for majority of the Sensex companies in the current quarter were in line with street estimates, many also surprised on the upside. There was a general improvement in margin due to decline in commodity prices. Easing monetary stance (cut in CRR) by the Reserve Bank of India (RBI) also gave confidence to the markets that cost of debt is likely to decline in the future. While policy risk still remains an overhang, the street is betting on earnings upgrade for a potential re-rating. However, we believe that apart from earnings, international crude prices and fiscal management will play a key role in determining where the markets head from here on.

Here's a change that will add US$ 1.5 trillion of debt to the balance sheets of the US leasing companies. The change is in the accounting standards. At present, the accounting standard on lease accounting allows companies to keep the leased assets off the balance sheet (for operating leases). Thus, there is no asset or liability created in such cases. The lease charges are accounted for as an operating expense. The new accounting standard seeks to change this. It would force companies to report the leased asset and the corresponding liability (in this case debt) on the balance sheets. As per a leading consultancy firm, this change would mean that nearly US$ 1.5 trillion would be added as debt for the leasing companies. At the same time, it would lead to increased costs to the tune of US$ 10.2 bn annually and an eventual loss of US$ 27.5 bn in the GDP. As a result, most companies and experts do not expect this rule to come up anytime soon. In our opinion the current standard is faulty to the extent that it allows companies to report lower liabilities. Leased assets are very much a part of the business of the company. And so is the liability that it needs to pay off over the period of the lease. Ignoring it does not make it go away. Companies have been allowed to continue with this practice till now. It is high time it was changed for the better.

Meanwhile, indices in the Indian stock markets were trading marginally below breakeven line at the time of writing. This, after starting the day on a positive note. The Sensex was trading around 10 points lower. Banking heavyweights like SBI and ICICI Bank were seen exerting the maximum downward pressure. While most Asian markets closed mixed today, Europe has opened mostly on a negative note.

 Today's Investing Mantra
"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.

Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement

Disclosure & Disclaimer: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. The Author does not hold any shares in the company/ies discussed in this document. Equitymaster may hold shares in the company/ies discussed in this document under any of its other services.

This document is confidential and is supplied to you for information purposes only. It should not (directly or indirectly) be reproduced, further distributed to any person or published, in whole or in part, for any purpose whatsoever, without the consent of Equitymaster.

This document is not directed to, or intended for display, downloading, printing, reproducing or for distribution to or use by, any person or entity, who is a citizen or resident or located in any locality, state, country or other jurisdiction, where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or what would subject Equitymaster or its affiliates to any registration or licensing requirement within such jurisdiction. If this document is sent or has reached any individual in such country, especially, USA, Canada or the European Union countries, the same may be ignored.

This document does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Our research recommendations are general in nature and available electronically to all kind of subscribers irrespective of subscribers' investment objectives and financial situation/risk profile. Before acting on any recommendation in this document, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. The price and value of the securities referred to in this material and the income from them may go down as well as up, and subscribers may realize losses on any investments. Past performance is not a guide for future performance, future returns are not guaranteed and a loss of original capital may occur. Information herein is believed to be reliable but Equitymaster and its affiliates do not warrant its completeness or accuracy. The views/opinions expressed are our current opinions as of the date appearing in the material and may be subject to change from time to time without notice. This document should not be construed as an offer to sell or solicitation of an offer to buy any security or asset in any jurisdiction. Equitymaster and its affiliates, its directors, analyst and employees will not be responsible for any loss or liability incurred to any person as a consequence of his or any other person on his behalf taking any decisions based on this document.

As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst) 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407