The dilemma of the investor: Buy or Sell? - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
The dilemma of the investor: Buy or Sell? A  A  A
PRINTER FRIENDLY | ARCHIVES
28 NOVEMBER 2011


With the Indian stock market stuck in a rut and threatening to head to September 2008 levels, investors will not be blamed for asking the question: Buy now - or run away?

Graph 1: Falling down or surging up? The BSE 30 Index, January. 2005 to November 2011
Source: Bloomberg

The Rupee does a bungee jump!

To make matters worse, the Indian Rupee has taken a beating. It has lost -14% in 3 months and there is talk that it could lose a further 10%. For foreign investors already facing a -23% decline in the BSE-30 Index since January 1, 2011 the weak Indian Rupee means that the value of their US Dollar (or even Euro) investment has depleted further. With these losses will the foreign investor stay - or jump out?

Graph 2: The yo-yo of the Indian Rupee, January 2008 to November 2011
Source: Bloomberg

In January 2011, the 10 year Government of India bond was yielding 7.7% and the Indian Rupee was at Rs 39.50 per US Dollar. The Lehman bankruptcy in September 2008 saw a global "risk-aversion" - everyone ran home to the safety of mother! At that time, the Indian Rupee declined to the INR 51 levels. The 10-year government paper was yielding 6.5% as the RBI reduced interest rates to keep economic activity alive. Today, the RBI has increased interest rates and the 10-year Indian government debt yield is 8.8%. The INR, though, has plummeted to a new all-time low against the USD. Is the foreign currency market signalling a crisis? Maybe the Euro is about to break up. And everyone wants to return home to mother once again and wait till there is more clarity in the investment world!

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The stock markets - and Pawar - get a slap in the face

The stock markets, meanwhile, are hostage to bad news and have remained under pressure because:

  1. Inflation within India remains at 9% and the government keeps on saying that it should decline. And, logically, it should. The global economy is not in good shape and demand for raw materials in general should decline. This means that the prices of many products - including oil - should decline. The increase in prices of food products in India is being attributed to a change in consumption habits. As people get wealthier, they want to eat more proteins (meats and pulses) and fruits. The prices of these products will continue to increase till the farmers respond by producing more. Or systems and infrastructure is in place to make perishable products last longer. No one knows when that is likely to happen.

  2. With high inflation comes the persistent increase in interest rates. Seeing the government sleeping at the wheel (no reforms to increase the supply side for any product or service, including agriculture), the RBI has been left the single-handed task of trying to curb demand. Hence, the persistent increase in interest rates. So there is a slow-down in demand for cars, homes, and consumer goods - much of which tends to be financed by loans. But talk to companies in the 2-wheeler, soaps, shampoos, and clothing businesses and they don't see demand declining. In fact, rural India is buzzing.

  3. The revelation of the corruption scandals since July 2010 - Adarsh, 2G spectrum, Commonwealth Games, coal mines, gas fields, iron ore - has slowed down decision making. With the practice of granting of wealth to a few at the cost of the national exchequer increasingly under scrutiny via some courageous RTI filings, the investment by companies has slowed down. If the hard-working industrialists don't get the iron ore mines they want for free based on a few phone calls - how can they invest in all the machinery and trucks to dig out the iron ore! So, the capex numbers are down and everyone is worried. They need not be. Theft is decreasing and the country will be richer for it - the industrialist who wants the iron ore mine will now have to pay a higher price for it. And there will need to be a greater sensitivity for displaced labourers or messing around with the environment. Meanwhile, there are companies who are investing to meet the growing consumer demand. Even the small retailers, faced with a change in the FDI rules, are upgrading their stores and their services.

  4. And politics is looking a little messy again. The Congress is leaderless and rudderless. Worse, the Congress remains arrogant in its dealing with any differing view. The BJP. Meanwhile, is running out of ideas and unable to provide a credible alternative - burning an FDI compliant shop will not help India and rath yatras are merely symbolic of the dark ages. Till the anger against corruption is taken seriously and Anna Hazare is not seen as a proxy of the RSS, slapping politicians may become a national habit. And for those in Congress who blamed the Sharad Power Slap on the BJP, it showed - once more - how disconnected the Congress is from reality. There are enough "fans of Congress" who would like to take the corrupt to task - irrespective of party lines.

  5. Globally, the US and European economies are a write-off for the next 5 years. The willingness to take on excessive debt to satisfy current consumption (or military adventures) has been the main reason for the decline of the western economies. The cost of honouring the promises of good medical benefits and a comfortable life to retired employees cannot be met (Table 1). While the US government debt is pegged at some USD 14 trillion, private estimates put the total liabilities (including the pensioners) at over USD 40 trillion. With a GDP of USD 15 trillion and a savings rate that is less than 5% even in these distressed times, and assuming an ability to repay USD 750 billion every year with their savings of 5%, the US will take decades to pay down its debt. There is no way that the US can make good on its promises. Neither can Portugal, Ireland, Italy, Greece, or Spain (the PIIGS). That is why a "strong US Dollar" and a "weak INR" is absurd and flies against the face of rational thinking. For now, the ability of the US government to print more notes that the world wishes to buy will save it. That may change tomorrow. The buyers of US government bonds and currency notes know that they are buying a product with suspect inherent value.
Table 1: PIIGS on the wing - and India not flying with them
Country Per capita income
USD
Govt debt per capita
USD
Debt / Income
%
Greece 27,652 41,462 150%
Ireland 45,601 32,307 71%
Iceland 38,620 62,261 161%
Italy 34,721 41,790 120%
Portugal 21,851 20,537 94%
Spain 31,391 19,067 61%
USA 47,263 31,101 66%
India 1,272 464 36%
Source: Quantum Advisors, IMF

For those worried that the Indian stock markets are in a meltdown, to really understand what a meltdown is, look at what has happened to stock markets in the PIIGS (Table 2). India has had a relatively small "correction" because, as listed above, things have certainly been tough within India - and the uncertain global environment has not helped. But India is not in any sort of crisis.

Table 2: Now that is a meltdown...
Country Peak level of stocks Current level Decline since peak
Greece 5,335 690 -87.1%
Ireland 9,981 2,566 -74.3%
Iceland 8,174 573 -93.0%
Italy 44,364 14,738 -66.8%
Portugal 13,702 5,374 -60.8%
Spain 15,946 8,125 -49.0%
USA 1,565 1,193 -23.8%
India 21,005 15,946 -24.1%
Source: Bloomberg

Investors buy the earnings

Investors buy (or sell) the earnings. Traders buy (or sell) the news flow.

I have little advice for traders since I don't really track global - or local - markets on a minute-by-minute or even hourly basis. But for investors, I will continue to offer the comfort that India's GDP is growing well and will stay above 7% per annum for the next decade based on a vibrancy that is not dependent on the support of government. Yes, the Indian economy could grow by 8% or 10% but for that we need political parties that shed their arrogance and really work for the country. But, that is not likely, so let's not waste time over that hope!

And where there is growth in the economy, there is growth in earnings.

Despite all this bad news and slow down and high interest rates, the operating profits of the BSE 200 companies (excluding the financial firms) increased by 14% for the six-month period April to September 2011. True, this was lower than the profit growth of 19% registered in the April to September 2010 period. But recognise that this 14% growth in operating profit was in a relatively slowing economy with high prices of raw materials.

But while profit growth is decent, the price of an Indian asset - including the shares of companies listed on the domestic stock markets - will be determined by foreign flows. Domestic Indians have maintained their buying at USD 1 billion - too small to influence the direction of share prices. For the 11 months of this year the foreign inflows are around USD 0.5 billion. For the same period in CY 2010, the FII inflows were USD 25 billion. FII's - spooked by global uncertainty - are staying home and not making the "risky" bet of investing in India. The US debt was downgraded on August 5th and, yet, the US Dollar and the US government bonds have been the best-performing asset classes to own for these past 3 months (Table 3). Gold, which every investor must own in their portfolio, has been muted.

Table: 3: The wisdom of the markets as USD does better than gold.
The asset class or equity % change from August 5 to November 23, 2011 (in USD)
US 10 Year Treasury Bond +6.4%
S&P 500, USA -2.4%
FTSE 100, UK -5.8%
DAX, Germany -17.9%
MSCI World -7.9%
MSCI Emerging Markets Index -14.4%
IBOV, Brazil -11.1%
SHCOMP, China -7.5%
BSE-30,India -22.4%
RTSI$, Russia -20.80%
Oil, WTI (USD/barrel) +10.7%
Gold (USD/ounce) +1.7%
Silver (USD/ounce) -17.3%
USD Currency Index +6.1%
INR / USD -14.0%
Source: Bloomberg

Waiting for the pension flows

The markets are currently in "trading mode" driven more by fear and less by greed. Long term fundamentals are being ignored and short term fears and prejudices have taken over. In a rational world, investors would follow the trend of long term earnings. Based on the outlook for growth and earnings, India would be allocated more capital, the western world - and US government bonds - would be allocated less.

But any move in share prices will, unfortunately, be dependent on foreign flows. Over the past few months we have met long term pension investors who see the India opportunity, but they have been quicker to commit to China. Pension funds in the developed world have over USD 15 trillion of assets. They need to earn at least 7% annual returns in USD to ensure that they can meet their pension liabilities. Over the past 30 years the BSE-30 Index has generated some 15% annual average returns in USD. If these pensions were to allocate 1% of their corpus to India, that would amount to USD 120 billion. If they were to spread their investments over ten years, that would amount to USD 10 billion every year. On average, foreign investors have invested some USD 10 billion every year since 2003 (see Table 4). And very little of what has come in is pension money.

Table 4: Foreign "investors" stay on the sidelines in CY 2011.
Period Net foreign Activity (US$ m) Net Local Fund Activity (US$ m) Total (US$ m) Change in BSE-30 TRI in that Period (% USD)
CY 2003 6,628 88 6,716 86.3%
CY 2004 8,669 -253 8,416 23.1%
CY 2005 10,707 3,049 13,756 42.2%
CY 2006 8,106 3,413 11,519 53.3%
CY 2007 17,655 3,222 20,877 68.5%
CY 2008 -11,974 2,501 -9,473 60.7%
CY 2009 17,458 -1,132 16,326 89.7%
CY 2010 29,362 -6,049 23,313 23.7%
Cumulative 86,611 4,839 91,450 676.9%
Oct-11 347 -75 272 7.8%
YTD 2011 398 1,083 1,481 -20.1%
Source: www.Sebi.gov.in

Graph 3: QE2 and inflation: now you buy me, now you don't (BSE-30 Index from July 1, 2010 to October 30, 2011)
Source: Bloomberg

For investors, building a portfolio, my recommendation remains to keep buying - recognising the impact of weak inflows on the prices of Indian shares. Please remember that markets can turn on a dime. Sentiment - for better or for worse - can change overnight. Fear can quickly turn into greed. On March 6, 2009 the world went into a "green shoots" mode and everyone suddenly turned bullish on stock markets globally. That was only 6 months after the bankruptcy of Lehman. True, we have not yet seen the declared bankruptcy of the PIIGS or of the US as yet. So there may still be the torture of uncertainty ahead. But that is something for the trader to worry about, not the investor.

There is no fundamental change in the earnings direction of Indian companies as a universe. There is no flaw in the argument that foreign money will come into India - the unknown is the timing. There needs to be a clear understanding that the trigger of any share price movement is a function of foreign flows.

Accepting this fact, in the final analysis, every investor must identify his or her risk taking ability: a portfolio allocation decision - how much money to invest in the stock markets and how much "downside" pain can they endure by seeing all the gloom and doom and red numbers on the business TV channels (my solution: switch off the TV channels). There will be - and there has been - downside pain. Markets can fall suddenly - it is not easy to see your initial investment of Rs 100,000 in a mutual fund lose 25% of its value in a year! But an investor would not panic and would check the facts: on earnings and on flows. These are the reasons behind any potential rise in share prices.

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A combination of earnings growth and foreign inflows could see the market surge. A 28,500 Index level by July 2012 may sound lofty from where we are. It is. To get to those levels - as has been qualified before - will require two things:

  1. earnings growth to continue - so far there has been some slowdown in growth but no decline; and

  2. it will require the foreign flows to surge as they did in CY 2009 (so far there is no sign of that!).
Graph 4: The earnings of the BSE-30 Index have grown
Source: Bloomberg

Graph 5: Earnings and money flows have caused the BSE-30 Index to rise...most of the time.
Source: Bloomberg

Graph 6: The market has to "catch up" to earnings
Source: Bloomberg

Graph 7: The BSE-30 Index could reach 28,500 by July 2012, based on a combination of earnings and money flows
Source: Bloomberg

Would I be upset - or wrong - if the 28,000 level was not breached in 8 months?

Wrong, yes; but upset, no. Not if the reason for the failure to reach was lack of foreign flows.

As long as there is visibility of earnings growth in Indian companies, I am investing in the stock markets via equity mutual funds. I continue to have a portfolio that includes gold. And I have kept aside money for many months of monthly family and living maintenance to tide me over tough times.

When I reap the reward of my investment in equity mutual funds is an unknown - that is what the traders with a really short term time horizon will worry about. Investors stay invested for the long haul as long as there risk-return needs and their personal situation of an immediate need for money have not changed.

And by the way, if you are buying shares with a "target" of 28,000 on the BSE 30 Index by July, 2012, then you are not an investor - but a trader! Because, if earnings keep growing - and I use the estimates of the hundreds of research analysts here - there is a case for the Index and share prices to keep doubling every 6 or 7 years! The only reason I would exit the stock market - or change my portfolio mix - would be if the outlook on earnings changed, if the markets got "expensive", or if I had a need for the money invested.

Till then, I am an investor. With no useful advice for the traders!


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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.


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11 Responses to "The dilemma of the investor: Buy or Sell?"

Rasesh Choksi

Dec 4, 2011

Dear Ajit,

Thanks for the good article.

I am missing one thing here - corelation between US markets and Indian market. Refer "The Daily Reckoning" and writing by John Mauldin, Harry S Dent. Global economies are expected to face recession or very slow growth over the next decade - Europe, US, Japan. China is expected to see moderate growth. With global markets falling, it will be difficult for Indian markets to rise. Writers mentioned above predict at least 50% fall for US market from current levels. Why do U not recommend to wait for such an opportunity?

Thank you.

Regards,

Rasesh

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krishnan

Dec 1, 2011

Dear sir,The country is facing very difficult situation.
Every party,every socity and media is having their own agenda.Take FDI bill on retail which is for city having a population 10,00000 and the state Govt have to give licence.Deapite that Media,political parties civil socities spreading misinformation and call for banth from village level to Parlimentcausing loss to exchequer.To couter the entry of coke we introduced 77
where is it now.Pl analise the State of PUNJAB where corprates have taken retail business.Now the producer the consumer gets correct price.
To prevent the corruption the civil socity movement is weicome. But their behavier is dangerous to democracy.
Contrlling inflation is difficult overnight. Consumption is more than supply due to change in income.
Increasing Agri production is the onlyway which depends upon various factors.For instace anyone get a car loan of Rs.5 lakhs over phone but getting an Agri loan for Rs.5000/- is very difficult.The media reports sucide of farmers only but not the way get the loan.
The media should focus more on villages and
Agriculture and Educate people giving correct picture on every issues.

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LS Ullal

Nov 30, 2011

Lucid analysis! Stay invested is the mantra for Indian equity investors.

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DK

Nov 29, 2011

You are right on the mark again! Unfortunately, not many people really understand this honest truth, and give in to the same irrational behaviour that is displayed by these foreign institutional investors. Thank you for showing the light.

Like 

Raman

Nov 29, 2011

Great, encouraging. Simply superb to keep the mood up.

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Mahesh Shah

Nov 29, 2011

You have expressed the very naked truth on current state of affairs, concerning to our country. You must keep on and inform the nation.

Like 

CHETAN

Nov 29, 2011

People are ready to wait 6 years (currently) for an NSC to mature and receive just 1.60 time the amount invested (that too is taxable), but once they enter the stock market, they want their money doubled in a short period of time. If these people park their money into the market for that period of time, they would earn stupendous return. This write should be published in the newspapers. Its actually worth that.

Like 

Shailendra

Nov 29, 2011

I am appreciator of articles by you. However, I appreciate more the catchy titles...the article are indeed well drafted, studied and in depth giving detailed analysis... would be nice if certain articles can give very straight forward- lets come to the point- answers to the article titles... many times readers has to read it completely and gets lost...I can understand its not so easy...but tel us Shall we Buy or sell...in one word!...

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Riz

Nov 28, 2011

Nice article

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Madhu

Nov 28, 2011

Dear Ajit

That was sane sane advise. At a time where gloom and doom pervades, this was needed !

rgds

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