»5 Minute Wrap Up by Equitymaster

On This Day - 18 AUGUST 2011
Do you see 'value' in the most valuable firms?

In this issue:
» FIIs get weaned off P-notes
» Who holds the maximum gold after the RBI?
» Midsized IT companies go shopping
» The Euro threat for the US Fed
» ...and more!

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Sometimes the most complicated lessons in life can be drawn from the simplest rituals in our day to day life. Take shopping for utilities in a supermarket for example. The items that have the most conspicuous displays certainly catch our attention first. The fact that fellow customers are buying a certain product also lures us to try them out. But what excites us the most are the stuff on sale! The fact that the underlying value of the product could be more than the sale price tends to have the maximum influence on our buying decisions. Any reason why the same should not be the case with our investing decisions as well? Especially since long term investments having higher embedded value can fetch supernormal returns. That too for much longer than the utilities can last.

What brought us to this discussion was the media coverage on Coal India topping Reliance Industries as the 'most valuable company' on the bourses. For the uninitiated, here most valuable means the company with the highest market capitalization. Prior to October 2006, the crown belonged to energy major ONGC. IT majors TCS and Infosys are the others in the reckoning of the top 5 on the benchmark indices.

Investors often mistake the term 'most valuable' as one offering most value. Stocks with highest market capitalization may certainly have the virtue of being very liquid. Also being bluechips they may have wide media coverage. But whether their fundamentals and long term prospects offer reasonable long term upside is a different story altogether. That is something investors need to study carefully before arriving at a conclusion. More importantly whether the valuations have any margin of safety will determine if the stock is on sale. Only then can investors find any value in the most valuable companies.

We are certainly big fans of safe bluechip stocks. But we prefer to stick to the "ones offering the most value" rather than the "most valuable ones". We would advise investors to do the same.

Do you invest in stocks purely based on market cap or weightage on the Sensex? Let us know your comments or post them on our Facebook page.

 Chart of the day
Indians and Chinese are considered to be amongst the best savers in the world thanks to consistently high proportion of savings despite a growing GDP (Gross Domestic Product). Interestingly, the proportion of investments in India is set to overtake savings (as a percentage of GDP) in the next decade. While this is a natural progression for a developing economy, it could also mean better financial inclusion and higher financial literacy in the economy.

Data source: OECD, CMIE

Are the fickle FIIs having a change of heart? They certainly seem to be if the recent data is anything to go by. As per a leading financial daily, the value of participatory notes as a share of assets under custody of FIIs fell to a low of 14% in July. The same stood at a high of 19% in the month of May. However, this is only one part of the story. The reduction in share of participatory notes has come at a time when FIIs were net buyers of equities by Rs 80 bn during the same month of July. What this could imply is that rather than taking the route of participatory notes, quite a few FIIs want to directly invest in India by registering themselves with the regulator. Participatory notes, it should be noted, are generally used by hedge funds that do not take a long term view of things and exit any time. In short, they are short term investors and known to create volatility in the markets. Thus, it is a heartening sign if share of these notes is coming down at the same time the direct investments are going up. However, it is early days yet and we may have to wait for some more time before passing any judgement.

In terms of official gold reserves India ranks 10th in the world with about 550 tonnes. That's the quantity of gold that the Reserve Bank of India holds. Now consider the fact that the country's top three non-banking financial companies (NBFCs) together hold about 220 tonnes of the precious yellow metal. However, there is a difference that must be noted. The RBI owns the gold reserves, whereas the NBFCs hold gold as collateral against the loans they give to borrowers. Most of this gold given as collateral is in the form of jewellery. The interesting part is that these NBFCs are expecting to grow at a whopping rate of 50-60% over the next few years. If that happens, their gold holdings will be at the same level as that of RBI.

A number of large Indian corporates including the Tatas, M&M, ADAG, AV Birla Group and L&T have expressed interest to enter the banking space in the past. Others such as Indiabulls, Shriram Finance, Religare and Srei have also shown keenness in entering the sector. But while the debate of whether corporate houses should be granted banking licenses goes on, the Finance Ministry aims to bar industrial houses conducting business in four sectors, from being given banking licenses. One of them, not surprisingly, is real estate. And very rightly so, we believe. The rationale is that the finance ministry does not want to extend licenses to sectors that could manipulate the system. And given the large scale corruption that prevails in the real estate space, it only seems right that it not be allowed to dabble in the banking space. Only then can the government ensure that the sanctity of banking in India remains intact.

The recent downturn in the global stock markets has presented an opportunity to the intelligent investors. This opportunity is to pick up fundamentally sound stocks at cheaper valuations. This is an opportunity not just for individual investors but also for companies. Especially cash-rich companies like those in the Indian IT space. Several mid-sized IT companies have gone shopping and have acquired companies in the global arena. Companies like NIIT Technologies have used this correction as an opportunity to expand their global footprint by acquiring companies like Proyecta which gives them a foothold in Spain. However, even at such times, the larger IT companies continue to shy away from acquisitions. It is not that they do not have the cash for it. In fact they have plenty of cash. But it is simply their over-cautious approach towards acquisitions. It is right to be cautious for a wrongful acquisition could prove to be fatal for a company. But being extra-conservative may not be the right approach either. For such bargain opportunities do not last forever.

Having recently suffered the blow of a ratings downgrade, the US has now got a fresh issue to cope with. The latest worry claiming its attention is the possibility that US banking system may be engulfed by a debt crisis induced from Europe. If the fears come true, it will be a perfect setting for another global financial crisis, worse than the previous one.

As per the action plan, Fed is digging deep to know whether the US arms of European banks have easy access to funds to conduct their day today business in the country. The efforts are to prevent the European banks that are facing funding issues from siphoning funds out of their US arms. The European banks are now under pressure to convert their US business into self financed organizations. This will help to contain any crisis at the parent level, thus insulating US arms.

In the recent past, funding of foreign banks was hardly an issue. The latter mopped up huge cash piles, thanks to the dollars flooding the markets under Quantitative Easing measure. However, in the last few weeks, such reserves have diminished. What is bothering Fed is the speed at which funding can reverse direction when funding options cease in the times of a crisis.

Looks like the there is no end to the penalties US will have to pay for bad policy measures taken in the past. It should learn its lessons and handle the current crisis in a way that does not leave any scope for a backfire in the future.

Taking cues from peers across Asia, the Indian indices started close to the dotted line and nosedived into the negative territory today. Backed by selling pressure in realty, commodity and FMCG stocks, the benchmark indices in the Indian stock market languished in the red for most of the session. At the time of writing, the BSE Sensex was trading lower by 230 points. Most other Asian markets also closed lower. Europe has also opened on a negative note.

 Today's investing mantra
"People who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run." - Benjamin Graham & David Dodd

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