Tuesday, July 26, 2016

What's driving markets - 2

"Make sure you never, never argue at night. You just lose a good night's sleep, and you can't settle anything until morning anyway."
—Rose Kennedy (American, 1890-1995)
Word for the day
Ambrosial (adj)
Exceptionally pleasing to taste or smell; especially delicious or fragrant. Worthy of Gods.
Malice towards none
The paranoid media is quick to brand all acts of individual violence as "terrorist attack".
Politicians are in a hurry to respond to "breaking news".
First random thought this morning
Many of my friends live in Mumbai. They all are good, except that they all suffer from a strong notion that unlike Mumbaikars, North Indians are gaudy, clumsy, and lack in commitment. Regardless that most of these friends actually have their roots in North India.
I watched two of my favorite 1970s Hindi movies (Chhoti Si Baat and Rajnigandha) this weekend. Both movies show visuals and life of Mumbai city extensively. It was indeed a simple and beautiful city back then.
Anybody who has visited the maximum city recently, would agree - it no longer is the city, it used to be. Place has changed, people have changed, so should the notions!

What's driving markets - 2

As mentioned last Friday (see here) a seed of worry is sprouting somewhere back at my mind. The more I strive to find the drivers of current equity rally, the more I get confused.
I do not see the current earnings or dividend yield sitting at the driver seat. It is therefore purely the PER re-rating that explains the current upsurge in equity prices.
As a broader benchmark, a conservative investor like me is usually comfortable with a PER between 10-20 for non-cyclical businesses. For cyclical commodity businesses the comfort would end in 8-10 band.
I do not like valuing asset heavy businesses with relatively longer and unpredictable revenue cycles on price to book (P/B) or replacement cost basis; because it goes against the principle of going concern. If at all these businesses might be valued at Net Realizable Value (NRV) for limited purposes of judging solvency conditions.
Evaluating financial stocks purely on the basis of net book value is also mostly not a good idea. It is important to consider the profitability and reliability of the book as such.
These days any query on corporate database would throw a long (ominously long) list of stocks trading at EV/EBIDTA ratio of over 20. (EV = Market capitalization plus Net Debt; and EBIDTA is broadly pre-tax cash earning). It is even more scary to read research reports early in the morning which find stocks with EV/EBIDTA ratio of 20+ as attractively valued.
In case you find this blabbering of mine too academic, I agree. Whenever I suffer from indecisiveness or I am confounded, I go back to text books in search of a solution.
In my view currently the following three are the primary drivers of equity prices in India:
(a)   Hope of material improvement in corporate earnings. Rise in public expenditure (both revenue and capital); hope of revival in rural consumption post good season of rains; lower cost of production (persistently lower global commodity prices, lower cost of funds, and improved productivity) and better realizations are some factors that are kindling this hope. Though not completely baseless, in my view hopes of 20%+ earnings growth in FY18-19 may not materialize. The prices may therefore have crossed over the line of reasonableness and heading towards the territory of bubbles.
(b)   Incessant flow of foreign funds. Negligible cost abundant availability od funds in developed economies is motivating many investors, traders and arbitrageurs, to look for opportunities in high yielding places like India. This trade I have seen many times before. Trust me, every time it had been ferocious. On the way up and on the way down. The upswing we are witnessing and enjoying. Please keep your seatbelts fastened for the descent, though it might be some time away.
(c)    The alternatives like gold, bonds, real estate are looking even worse.
 

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