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A Letter to our Subscribers - Views on News from Equitymaster
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  • Jun 8, 2006

    A Letter to our Subscribers

    As an investor, the last one-month must have been a difficult period. While the decline has forced to experts to debate whether we have entered into a 'bear phase', we continue to believe that investors should use this decline to one's advantage and start investing in equities for the long-term.

    As always (this has been the case in the past as well), we are not going to involve ourselves in predicting when the stock markets will rebound and at what levels. We continue to believe that it is difficult to first, predict index levels and secondly, time the market perfectly.

    What we can do is assert that in the long-term, the stock price of any company will reflect the long-term growth in earnings and cash flows. The ability to generate profits depends largely on the capability of the management to guide the company safely through ups and downs.

    Following our review on the StockSelect and Midcap Select recommendations, we have received many emails from subscribers about future strategies, our view on the stock market, whether one should buy more into the decline or exit. The update does indicate that many of our recommendations have fallen faster than the decline witnessed in the Sensex. But does the fall warrant a re-look at fundamentals? We do not think so, for the following reasons.

    1. Interest rates - But is it new?
      Perhaps, one of the major concerns that are attributed to the recent decline in stock market is the possible increase in interest rates. We have been telling investors that interest rates in India will rise since the last six to eight months. We have also factored in such an assumption in our earnings estimates (in the form of higher rate of interest on loans).

      Secondly, we have exercised caution as far as topline growth prospects of sectors like banking, automobiles (and related sectors) and cement. For instance, as compared to the 'consensus' estimate of a 8% and 20% growth in CV and motorcycle volume growth in FY07, our estimates reflect a 5% and 12% CAGR in demand FY07.

      Thirdly, when prices are going up (i.e. inflation), margins of corporates will come under pressure. Our margin outlook across sectors (particularly banking) has been negative for more than six months.

      Fourthly, any increase in interest rate has a negative impact on equities as an asset class. This is because on a relative basis, debt instruments gain in attractiveness.

      Overall, we believe that we have been cautious as far as the earning growth prospects of companies under our research coverage are concerned.

    2. Valuations:
      We attributed the primary reason for the sharp decline in stock price to valuations retreating back to the mean. Just because Holcim paid a premium for the acquisition of stake in Gujarat Ambuja (enterprise value per tonne of close to US$ 200 per tonne), investors were buying into cement at EV per tonne of over US$ 150. All this while, we had a Sell view on the sector as a whole and continue to remain cautious even after the decline (largely due to valuations).

      Taking another example of engineering, a fund manager from a MNC fund house told us that BHEL and ABB (at around Rs 2,800 or thereabouts) warrant similar P/E multiple like Infosys and Wipro because of visibility in earnings! We had a Sell view on most of the engineering stocks and after the fall, some look attractive from a long-term standpoint.

      As far as valuations are concerned, we believe that our valuation band across sectors is among the lowest, not because we want to be cautious but we recognize the fact that a bull market or a bear market does not alter the fundamentals of a sector. Having said that, we recognize the fact that in the case of few companies, our estimates were higher as compared to the actual performance, necessitating a downgrade in our earnings estimates (Arvind Mills). Rests assure that we will continue to keep the downside risk in perspective before looking at the upside potential.

    What is our outlook?
    At 2,748, the NSE-Nifty is trading at a price to earnings multiple of 15.3 times trailing twelve months earnings. Assuming a 12% growth per annum in net profit of Nifty Fifty companies over the next two years, the NSE Nifty is trading at a price to earnings multiple of 12.2 times. This, we find relatively attractive from a long-term perspective.

    To conclude:

    1. We continue to remain bullish on the long-term. We suggest that subscriber invest in stocks, which we have recommended in the last six months for the long-term.

    2. Volatility may persists. But again, if one invests in the right stock for the long-term, why bother about day-to-day price movements?

    Happy investing!

    Team Equitymaster



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