»5 Minute Wrap Up by Equitymaster

On This Day - 6 JUNE 2015
Is this all it takes to make a killing in stocks?

In this issue:
» Has the US job situation really improved?
» Banking sector's woes to worsen?
» Indian stocks: The worst performers this week
» ...and more!

00:00
It was not too long ago when companies were reporting a statement called the 'economic value addition (EVA) statement' in their annual reports. While most companies have stopped reporting the same now, this metric has hardly lost its relevance.

As defined on Investopedia, EVA is "a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).

The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)"

What this metric aims to estimate is the value a company creates in excess of the required rate of return expected by its shareholders.

As you would agree, people invest money in various instruments with the aim to maintain their purchasing power and improve the same over the long term. What would make sense for them is to beat the annual cost of increase in expenses (inflation per se).

The concept essentially remains the same for the corporate sector too. They have certain costs such as cost of debt and cost of equity that they aim to beat. If companies are able to do so, it only adds to their value; if they cannot, then it lowers the value of the business. If a company is able to deploy cash in a manner that beats the opportunity costs, it would be worth more. Add growth to it and the value only improves. And if a company is able to do both for long periods of time, it is pretty much a jack pot from an investor's perspective!

I thought it would be a good exercise to see whether this theory holds true.

With the help of our database tool, I pulled out the return on equity and D/E ratios for the entire universe (barring financials and banking businesses) for the decade ending 2010. The tool threw up a list of 1,829 companies. Thereafter, I only included those companies which had a minimum RoE of 15% (long term returns of the Sensex) in each of the financial year of this period. Further, I excluded companies which had D/E ratio of more than 1x in any one of the years of this period. The latter was done to avoid the possibility of RoEs being influenced by high debt on books.

A total of 42 companies met these criteria.

Then, I calculated the stock returns of these 42 companies in the past five years - i.e. from June 2010 to June 2015. I would like to point out here that this exercise does remove the factor of hindsight bias as the financial data is gauged for the period prior to calculating these returns.

The results here did pretty much surprise me! Out of these 42 companies, 40 of them beat the Sensex's returns of 9.4% per annum during this period. This is a success ratio of as high as 95%. The average returns of this group of stocks came in at a whopping 42% per annum!

And mind you, this was not really at a time when valuations of the Indian markets were depressed. In fact, the TTM valuations of the benchmark index five years ago stood at about 20x, higher than the current levels of about 19.3x. Even in terms of price to book value, the index five years ago was trading at a multiple of 3.4x as compared to the current multiple of 2.87x.

Here's a very apt quote by Charlie Munger that would well summarize this discussion - "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return-even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

Do you believe good investing can be as simple as investing only in businesses with consistent above average return ratios? Let us know your comments or share your views in the Equitymaster Club.

--- Advertisement ---
Is It Time To Be Greedy Or Fearful?

The stock markets have crashed and a number of stocks have taken a beating.

And now, many common investors feel it's better to stay away from stocks right now.

But what if we told you this could be an ideal time to get Greedy about stocks?

And not only that, what if we told you this is actually a wonderful opportunity to grab some very good stocks at bargain prices?

Yes, we've revealed details of 3 such stocks you could consider buying right away in our new special report... which you could obtain for absolutely FREE!

Click here for full details...

------------------------------


02:15
 Chart of the day
Do numbers ever tell the real story? Loads of statistics on economic data could not foresee or prevent the financial crises that still continue to haunt global economy. Ironically, the key economic policies are based on such data. One can imagine the mess that can follow if the picture portrayed is not correct.

Sometime back, it was new formula based GDP numbers of India that caused much controversy. Recently, this anomaly between the statistics and what could be the real situation was captured in case of reporting of US unemployment data. As per the US Labour Department, the unemployment rate was 5.5% in May. However, if one considers the metric used by Bureau of Labor Statistics to capture unemployment rate (known as U-6), it comes to 10.8% for May, almost double. What the latter captures is the unemployed, under employed and discouraged, which we believe makes more sense.

Is US unemployment scenario as good it seems?

Unemployment data reported by US Labour Department could be strong enough for Fed to hike rates soon. However, the IMF believes that could be premature, considering a fragile recovery! On the other hand, Mark Faber has something different to say. He is hardly bothered over the expected rate rise. The renowned editor and Publisher of Gloom, Boom and Doom compares US economy to a sinking ship and expects it may unleash another round of Quantitative Easing.

Whether it is a rate hike or Quantitative Easing in US, the impact on India is likely to be disturbing. The former can lead to the flight of foreign money thus rattling Indian markets. On the other hand, the latter can lead to too much of idle money chasing high return assets leading to a bubble across asset classes. So how can a common investor shield himself from such developments? We believe that one of the best ways to do so could be bottom up investing and asset diversification.

03:20
The prediction of the rain gods playing spoil sport for the second year running has got the banking sector really worried. Banks, particularly public sector banks, are already grappling with bad loans arising due to the slowdown. This coupled with the government's insistence on infusing capital in only the better managed banks has further stressed the balance sheets of a large number of banks. Therefore IMD's forecast of a below average monsoon this year is likely to further add to their woes.

Public sector banks are required to lend to the farming community at subsidized rates under the priority sector lending rules of RBI. Reportedly, Indian banks have a total farm loan outstanding of Rs 7.8 trillion as on April 2015. The farm loan target has been further hiked to Rs 8.5 trillion in the Union Budget 2015. But the possibility of crop failure in a drought year increases the risk of farm loans turning bad. This is especially true as the government steps up populist measures such as farm loan waiver and rescheduling of loans. While this might seem to be inevitable, statistics paint a different picture. Farm loans have been growing in double digits even as agricultural growth has been in low single-digits. Therefore instead of just focusing on providing funds, the government should help the farming community improve its crop yields through better and innovative cultivation techniques. Unless these real issues are addressed, the banking sector will continue to remain vulnerable to the vagaries of the weather.

04:10
Barring stock markets in China, majority of global indices were down for the week gone by. Uncertainty over the timing of rate hikes by the US Fed and worries about the negotiations between Greece and its creditors in the Eurozone kept markets on tenterhooks. It however does seem than better than expected US jobs data has increased chances of a Fed rate hike in September, despite the US economy contracting by 0.7% in the first quarter of the year. After hitting life highs just two weeks ago, the US markets have struggled for direction ever since Fed Chairperson Janet Yellen expressed her views that US markets were overvalued. Data shows that margin debt in the US stock markets have hit a record high of US$ 507 bn.

In Europe, the Eurozone-Greece negotiations have reached a crucial stage. There is still no clarity about the final outcome. Greece has already delayed one payment to its creditors as the negotiations continue. This uncertainty weighed down European markets this week.

Indian markets fared the worst this week after the RBI cut the benchmark repo rate by 0.25%. The markets were hoping for a larger cut. The RBI also stated that it had limited room to cut rates further due to concerns over a deficient monsoon.

Performance during the week ended June 5, 2015
Data source: Yahoo Finance


04:55
 Weekend investing mantra
"If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes" - Peter Lynch

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