|»5 Minute Wrap Up by Equitymaster|
On This Day - 26 APRIL 2013
Can this crush the principles of 'value investing'?
In this issue:
We recently came across an article in Business Insider that had an interesting take on Value Investing. According to the author, technology companies could ring the death knell for value investing principles. Well, we would beg to differ. But before that allow us to explain the author's logic.
The 2007 valuations of technology and mobile communication giants Research in Motion (RIM) and Apple Inc are the basis of the Business Insider article. RIM was then trading at price to earnings multiple of 55 times. Apple was then just a computer company that had reinvented itself as an MP3 player company. Within two years, fundamentals of the companies changed dramatically. By December 2009, market share for Apple's iPhone as a percentage of US smart phone industry was 25%. Meanwhile, RIM's had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled RIM's PE multiple to around 17 times earnings. This according to the author was a precarious 'value trap' for value investors. Those who invested in RIM assuming that the valuations would pick up over time failed miserably. By 2011 RIM was trading at a PE multiple of 3.5 times earnings and its sales growth had stagnated. In 2012, the Blackberry maker posted a loss of US$ 847 m!
As is apparent, the author has assumed that value investing is about buying good companies cheap. However, not judging whether the good company will remain good for a very long time is the cardinal mistake here. Value investors have to not just evaluate past fundamentals. But the business model of the company has to be robust enough to face future headwinds as well. If this means letting go of few opportunities, one cannot be wiser. The business models of technology product companies that have very little long term visibility are prone to sustainability risk. That itself should be a red signal to value investors.
As Buffett himself has put it, he would rather err on the side of caution. In a letter to shareholders of Berkshire Hathaway in 1961 Buffett wrote "I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a "New Era" philosophy where trees really do grow to the sky."Hence, neither technology nor any other sun shine sector can dilute the principles of value investing. It is about how the investors put them into practice. Any doubts why not every value investor is Warren Buffett?
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We believe that Mr Krugman seems to be confusing effect with cause. Swift capital outflows do not cause the crisis but is just a reaction to something according to us. The crises are caused by fiscal profligacy and policy of keeping interest rates way below real inflation levels. This in turn leads to asset bubbles, the deflation of which causes capital to move out of countries. Thus, before we address the issue of capital controls, we seriously need to look into interest rate policies and spending habits of Governments.
To resolve this problem, the government plans to park its cash box with the commercial banks. Valued at almost Rs 1 trillion, this cash is currently held with the RBI. The government plans to auction these cash deposits soon. The RBI would decide the exact amount of cash that would be auctioned. Hopefully once this happens, the liquidity situation of the banks would be eased. We hope that the RBI sets adequate measures to ensure that this money does not find its way to high risk assets. For literally our country's savings are at stake.
This may appeal to some in theory. But we have always been extremely skeptical of such monetary policies. Such financial steroids have adverse long side-effects. The failure of the QE program in the US should have been a lesson.
But it seems such policies do benefit someone. No, it's not the economy. Not consumers. Not savers. Any guesses? The answer is investment banks! An article in Bloomberg notes that investment banks have been the biggest beneficiaries of the stimulus program. With stock and bond markets soaring, these banks are buzzing with activity.
This is not uncommon. The banks that were responsible for creating the 2008 financial crisis have been the biggest beneficiaries of all the bailout and stimulus programs that the US Fed initiated. And now it is Bank of Japan that seems to be following similar footsteps. Whose interests are policymakers really trying to protect? It doesn't seem too difficult a question.
So, is there a way to eradicate this problem? While the obvious solution would be to increase the growth rates it is hardly having any effect. For instance, it may be noted that even when growth rates were strong in some countries like Spain and Egypt, the unemployment rate was high. This highlights the problem with respect to inadequate skill sets and poor education systems. In short, the labor was unemployed as it was not fit for the job for the lack of necessary skill sets or requisite education. As such, it is necessary to re-vamp the education system and hone their skill sets. Also, reducing obstacles in establishing new start ups can help. For instance, getting licence for starting a new business can be made easier. This will enable the organisation to start its operations quickly and absorb the labor. If not, the government responsibility to provide temporary relief to these classes of people will increase especially in the developed world. And this will hurt their pockets deeply.
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