Vijay Kumar Gaba: November 2017

Thursday, November 30, 2017

Outlook for 2018 - 1

Thought for the day

"I would like to be remembered as someone who did the best she could with the talent she had."

—J. K. Rowling (English, 1965-)

Word for the day

Benevolence (n)

Desire to do good to others; goodwill; charitableness

Malice towards none

A CM of a state, who happens to be an ex IRS officer, calls certain action of IT department a political vendetta.

I do not know who is on the right side in this case.

But whosoever it is, the one on the wrong side should not go unpunished, if we want people to respect institutions.

First random thought this morning

As per popular sayings a diamond cuts the diamond, steel cuts the steel, venom cures the venom and lion defeats lion, so on and so forth.

Our politicians have taken these adages too seriously. They are trying to counter false propaganda of their opponents by even bigger lies.

The mud-slinging match between them is no longer funny. The sight has rather become repugnant.

A revolution would be in order here. Any correction may not work.

Outlook for 2018 - 1

The Economic Intelligence Unit (EIU) of The Economist released its outlook for global economy and industries for 2018.

In general the economic outlook is cautious. EIU believes that "global economic conditions will not be bad—although not quite as good as in 2017".

A summary of the global economic outlook of EIU is reproduced below:

"The global economy has been at its healthiest for some time in 2017, but this will prove a fleeting state. Inflation will pick up and central banks will begin to tighten somewhat more aggressively. The European Central Bank (ECB) will start to taper its quantitative easing in 2018. Moreover, political risk is at its highest level for years: there is long-term policy uncertainty in the US, little clarity on Brexit negotiations in the EU, and North Korea is flexing its muscles. Global GDP growth will thus tail off slightly in 2018, to 2.7% at market exchange rates.

The non-OECD world will manage to grow by 4.4%, while the expansion among OECD countries will slow gently to 2%. The US economy will grow by 2.2%, a level that is fast becoming the new normal. The greatest shadow of unpredictability hangs over the world’s largest economy. Donald Trump is an erratic leader, making him a difficult ally at home (for his fellow Republicans) and abroad. This will give the US’s rivals, including Russia and China, the chance to extend their influence.

Still, the debt-laden Chinese economy will slow to 5.8% in 2018, marking a steeper decline compared with recent years. The slowdown will be policy-induced, however, so the credit bubble will deflate rather than burst. Countries such as Australia, Chile and Mongolia, which export non-oil commodities to China, will also feel the chill.

Higher oil demand in Asia and OPEC members’ willingness to extend a supply agreement into 2018 will at least offer some support to oil prices, which will rise to US$59/barrel, from an estimated US$55/barrel in 2017. In oil-dependent Russia, structural weaknesses will dampen economic growth, and The Economist Intelligence Unit does not expect significant reforms before the presidential election in March 2018.

In Europe, political risks will again be in evidence, but the biggest challenge for the euro zone will come from the economy, given the underperformance of markets in southern Europe, such as Italy and Greece. Higher borrowing costs in the US, China and Europe will also temper global growth—another reason why it will fall a touch in 2018."

EIU has also made some very interesting forecast about the likely trend in six key industrial sectors. I shall be discussing these forecast and my views on that tomorrow.

Wednesday, November 29, 2017

Driver of rally suffer from fatigue

Thought for the day

"It is our choices... that show what we truly are, far more than our abilities."

—J. K. Rowling (English, 1965-)

Word for the day

Complicit (adj)

Choosing to be involved in an illegal or questionable act, especially with others; having complicity.

Malice towards none

There is no Punjabi pride working for Virat Kohli. Who will root for a Bharat Ratna for him?

First random thought this morning

Nothing could be more unfortunate that the fact that after 70yrs of independence from alien rule, we are still debating who, how, when and where should sing the National Anthem.

The courts of law, already saddled with millions of pending cases, are busy hearing these mostly frivolous cases and passing some ridiculous orders. State administrations have to force students, and even older citizens to sing the Anthem, and stand up when singing.

Don't you think, this is one of the three major failures of our political establishment in post independence era, besides failure to eradicate manual scavenging and prevent female infanticide.

Driver of rally suffer from fatigue

The current bull market in Indian equities, that started in August 2013, is mostly driven by macroeconomic improvements and political changes.

The twin deficit situation improved materially. Interest rates fell over 200bps. RBI successfully targeted inflation and tamed it effectively. INR decline was arrested and forex reserves improved significantly. Change in political leadership led to improvement in sentiments and confidence. Some key pending economic reforms like GST, regulator for real estate sector, modern bankruptcy law, have been implemented.

The upmove has been strongly supported by abundant liquidity in the global financial system, declining domestic investment demand and poor real estate market.

The corporate earnings though have not shown any encouraging trend in past four years.

All these driver of the current bull market in India appear fatigued now. For example—

(a) The current account deficit improvement that started with drastic steps taken by the then new RBI governor and the then Finance Minister working in tandem, has peaked at 0.7% of GDP a few months back and is forecast to deteriorate to 1.75% by 2020. Higher energy import bill and lower export growth are primary reasons for the deterioration.

(b) The gross fiscal deficit of the central government is peaking in range of 3-3.5% of GDP. It is highly unlikely to improve any further from here. To the contrary there is a strong case for it to deteriorate in next couple of years as we approach the next general election.

(d) The chances of any further cut in interest rates appear dim. Bond yields have risen sharply over past few weeks. INRUSD also likely bottomed close to Rs64/USD.

(e) The global flow look uncertain as central bankers in the developed world look to contract their respective balance sheets.

(f) The popularity of political leadership is at the peak. The improvement in sentiment and confidence of businesses and consumer seems to be peaking close to decade high level.

(g) Investment demand continues to struggle.

(h) The impact of wage hike post implementation of 7th pay commission and OROP has been mostly factored. The implementation by PSUs and state governments may occur over next 12months.

(i) Earning downgrades continue, though at a slower pace. But given that the consensus is estimating a 25-30% earnings growth over next one and a half year, the disappointment is more likely there.

Tuesday, November 28, 2017

Bull markets are all same, or are they?

Thought for the day

"Youth cannot know how age thinks and feels. But old men are guilty if they forget what it was to be young."

—J. K. Rowling (English, 1965-)

Word for the day

Hearth (n)

Home, Fireside

The floor of a fireplace, usually of stone, brick, etc., often extending a short distance into a room.

Malice towards none

Controversy over Padmavati is not yet settled and an MLA and former minister in Bihar, hs threatens the Deputy CM, and the Deputy CM had to shift the venue of his Son's wedding.

"Law & Order"— is anyone bothered?

First random thought this morning

Last week I had the opportunity to interact with school children of a government school in a small town of UP. While I was sharing my experiences and thoughts with intermediate students, a young teacher raised a question. She asked, "why do we celebrate achievements of Indians living abroad, like Satya Nadella, Sundar Pichai et. al. These individuals indubitably have done very well for themselves. But what have they done for the country. And for that matter why are we celebrating an Indian girl winning Miss World title. The girls who won this title in past, have not really done anything for the country or countrymen to feel proud about, unless you want to feel proud over Priyanka Chopra playing a role in an English TV serial?"

As the question was fired out of blue, I could not answer this young lady. But I do want to satisfy her inquisition. May I seek your help!

Bull markets are all same, or are they?

In my view, most human being are naturally inclined towards positivity, progress, and prosperity. The cynics and skeptics are usually in abysmal minority. Celebrating rise in asset prices causing increase in wealth hence is a natural human reaction.

Bull markets are therefore usually welcome. The up cycles in real asset prices are mostly celebrated uniformly. However, the bull market in financial assets are fiercely contested, almost always. The current instance is no different. The reasons could be varied and justified. But that is not the point I want to discuss here. My point is limited to analyze the current bull market in India to optimize my returns on my investment portfolio.

In my view, though most bull markets in equities look the same from 35k feet, a closer look would reveal a different set of drivers in each case. It is important to note because it is the fatigue of these driver that eventually causes the reversal in price trends.

For example, the key driver of previous bull market in Indian equities (2003-2007) was the surge in credit. An unprecedented investment cycle was unleashed by easy credit.

Asian Financial crisis and successive poor monsoon resulted in economic growth plummeting in 1997-2003 to an average of 5.4 per cent. Economic sanctions post 1998 nuclear tests also played their role. The government responded with fiscal compromises and massive economic reforms. The government gave away its control over key sectors like roads, coal, energy, telecom, ports, airports and opened multiple areas for FDI. Implementation of VAT at state levels and expansion of Service Tax augmented the revenue considerably.

Consequently, fiscal discipline was restored after FY03, with the next five years up to FY08 witnessing a major reduction in the combined fiscal deficit from 9.3% of GDP in FY03 to a then record low of 4.7% in FY08. Lower fiscal deficits led to materially lower interest rates, which promoted higher investment and growth, which, in turn, increased revenues and thus further reduced deficits. Economic growth soared to record highs to average 8.7% during 2003-08.

The equity market celebrated its best bull market in history with Nifty rising from a low of 920 in April 2003 to a high of 6357 in January 2008 a 7x rise in less than five years, regardless of the most popular PM losing elections.

The market faltered when fiscal discipline was set aside in FY09 (combined deficit @ 10.6%) and the easy credit (rates begin to rise and NPA begin to build up) and freedom to operate to infra developers (scams in telecom, coal, real estate, roads) that drove the market started to falter. Global financial crisis pushed the markets deeper into abyss. The house of cards collapsed, with an unusually large number of infra builders losing over 80% of their market value and lenders left to collect the debris....to continue tomorrow

Thursday, November 23, 2017

Market Cap to GDP

Thought for the day

"There is no less invention in aptly applying a thought found in a book, than in being the first author of the thought."

—Pierre Bayle (French, 1647-1706)

Word for the day

Nonbook (n)

A book without artistic or literary merit or substance, especially one that has been developed primarily to exploit a fad or make a profit quickly.

Malice towards none

Regardless of the outcome of controversy around Padmavati movie, one thing is certain that 10yr hence the legend of Padmavati will have a face and that will be of Deepika Padukone, much the same way as Anarkali is imagined as Madhubala!

First random thought this morning

I can confidently say that movies inspire a lot of people in India, and may be elsewhere also. The inspirations people derive from movies vary from fashion, career choices, relationship management, political choices, crime ideas, and even life changing idea, e.g., committing or not committing suicide, etc

What I understand from media reports, the case of a young girl that unfortunately died of dengue in a Gurugram corporate hospital is very similar to what was shown in a 2015 Hindi movie starring Akshay Kumar.

I am not sure whether the movie was inspired by some real life instance (s), or the Hospital's conduct is inspired from the movie. Regardless, there is a case for implementing serious reforms in the healthcare sector.

Market Cap to GDP

One of the most popular data point used by the market participants to justify (or otherwise) the current market level is GDP to Market Capitalization ratio.

The latest argument in this context is that the last bull market peaked at 103% Market Cap to GDP ratio. The current ratio being 87%, there is still scope for market to move higher.

I have never fully understood the rationale behind applying this criterion to equity markets, especially Indian markets, for the following reasons.

(a) This argument assumes near perfect correlation between economic growth and stock market performance. This assumption may not be correct in most circumstances.

(b) This argument completely ignores the rise in private equity investments. In Indian context for example, the equity investment in self owned enterprise and home equity has risen sharply in past one decade, as compared to the decade prior to that. Besides, the size of unlisted private businesses has increased significantly. Factor in the estimated market value of Amazon India, Vodafone India, PayTM, FlipKart, Honda India, Hyundai India, LG India, Samsung India, Apple India, etc. and you will find this ratio running much higher than what the chart below shows.

(c) The rise in market cap purely due to PE re-rating due to excess liquidity or other reasons, may not actually represent any improvement in underlying economic fundamentals.

(d) The equity valuations of stressed companies and lenders to these companies may not be adequately reflecting the realizable value of assets and future business potential

Wednesday, November 22, 2017

Been there seen that

Thought for the day

"Properly speaking, history is nothing but the crimes and misfortunes of the human race."

—Pierre Bayle (French, 1647-1706)

Word for the day

Deontology (n)

Ethics, especially that branch dealing with duty, moral obligation, and right action.

Malice towards none

Some analysts are suggesting that Gujarat election outcome would be critical for stock market.

I would like to know how and why?

First random thought this morning

Fringes are playing some interesting roles in Indian politics.

The right wing fringes are distracting peoples' attention from core issues and indulging them in frivolities like Love Jihad, Beef, Padmavati, et. al.

The left wing itself is at the fringe. Nonetheless its fringes are busy in protecting the freedom of expression of Indians. They believe the only way to protect FoE is to make sure that only they are allowed to speak.

The centrist-socialist fringes are busy in cracking sickening jokes on social media so that they can make Rahul Gandhi look like a towering statesman.

Been there seen that

As mentioned yesterday (see here) a seed of worry is sprouting somewhere back of my mind. The more I strive to find the drivers of current equity rally, the more I get confused.

The rally was driven initially by macro improvements. But now most of the macro improvement seems to have peaked, and FY19 may actually see some of the macros like twin deficit and inflation may actually deteriorate.

2QFY18 has shown lots of promise for earnings improvement. But even after factoring in the rather optimistic growth forecast for FY19, the current valuations look stretched, leaving no margin for error whatsoever.

As a broader benchmark, under the current interest rate and inflation expectation scenario, a conservative investor like me would be comfortable with a PER between 15-25 for non-cyclical businesses. For cyclical commodity businesses the comfort would end in 8-10 band.

I am still not be comfortable 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 earnings before interest, depreciation and tax). 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) and hope of revival in rural consumption are primary factors that are kindling this hope. Though not completely baseless, in my view hopes of 20%+ earnings growth in FY19 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 domestic funds. Still low equity exposure of domestic investors, even after a significant rise in recent months, is motivating many investors and traders.

This time the argument is that demonetization of currency and GST have lead to material contraction in the cash economy. A large part of the household and private sector savings that were out of the formal financial markets is bound to find its way into the financial market, mostly into publicly listed equities.

This trade I have seen in early 1989-1992, mid 1994-1996, 1998-2001, and then in 2004-2008.

Every time there was an argument of structural changes in the market that would sustain the households' interest in equity investment. In early 1990s it was opening of capital markets and beginning of private mutual fund industry. In mid 1990s it was bank recapitalization, restructuring of UTI, flood of new IPOs, in late 1990s it was ESOPs and our engineers returning with bagful of dollars, and a decade back it was cheap credit, FDI reforms, tax reforms and all that.

Unfortunately, on all previous occasions, 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, even if you can't see it around the street corner yet.

On valuations there is another rather strange argument is being relied upon heavily.

Many analysts and fund managers have argued that the current PE ratio of Sensex is much below the peaks seen in previous bull markets, and therefore, the market is nowhere close to a bubble territory.

I have two comments to make on this.

1. Since 1990, every subsequent bull market has peaked at a lower PE ratio as compared to the immediately preceding bull market.

2. The average life expectancy in India is close to 70yrs. Does it mean that people below 60yrs of age need not take care of their health as they are not likely to die anytime soon!

What if markets peaked at 25x PE ratio last time. Does it mean that they cannot correct from 20x level this time?

There are other arguments like Market Capitalization to GDP Ratio.

I would be sharing my thoughts on that in subsequent posts.

Tuesday, November 21, 2017

Valuations - Starting from the end

Thought for the day

"It is pure illusion to think that an opinion that passes down from century to century, from generation to generation, may not be entirely false."

—Pierre Bayle (French, 1647-1706)

Word for the day

Macaronic (adj)

Composed of a mixture of languages.

Malice towards none

Has the government erred in not marking the birth centenary of former Prime Minister Mrs. Indira Gandhi?

First random thought this morning

LKA build BJP from almost zero to a force to reckon with. NaMo has strengthened this force materially. But one thing that has confounded many is why LKA could not achieve what NaMo has.

I think I have solve at least first stage of the puzzle.

LKA mobilized millions in the name of Ram temple, but never tried to channelize the mob into a positive force working for betterment of life. Whereas NaMo mobilized millions of youth the name of corruption and has shown intent to channelize them into a positive force to work for clean India, self reliant India, self employed India, etc. This positive intent has made all the difference.

Karni Sena might have a lesson to learn here.

Valuations - Starting from the end

In past bull markets I have seen many analysts reengineering their valuation arguments. Instead of arriving at the fair value of a stock through the conventional earnings, cash flows and replacement value arguments, they would seek to apply innovative and fancy valuation criteria like foot falls (for retail stores), eye balls (for ecommerce portals), price to growth or PEG (for IT start ups), NAV per share (for real estate developers) etc. to justify the current market price (CMP). In this case CMP becomes the starting point of analysis.

I can see a similar trend emerging in the current market environment also.

In conventional sense, the return on the investment in publically traded equity is a function of 3 factors (a) earnings growth; (b) changes in price earnings (PE) ratio and (c) dividend.

The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; (e) resource availability (raw material, labor, capital, managerial bandwidth etc.), etc.

The price earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value which an investor is paying today. Principally, an acceptable PER for a company's stock is defined by (a) the return on equity (RoE) a company is able to generate on sustainable basis and (b) the growth rate of earnings that could be achieved on sustainable basis. A company that could generate higher RoE consistently and is likely to grow faster, should be assigned a higher PER as compared to the ones which generate lower RoE or has low or highly cyclical earnings growth.

A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny. Sometime the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometime, PER changes (re-rates) due to relative forces, e.g., rise of PER in comparable foreign markets or change in return profile of alternative assets like bonds, gold, real estate etc. This is usually unsustainable and therefore a short term phenomenon. Many times, demand-supply mismatch in publically traded equities also drives re-rating of PER (excess liquidity chasing few stocks and vice versa). This is again usually a short term phenomenon.

Sustainable rise in dividend yield is generally a sign of stable profitability growth (P&L improvement) and strong financial position (B/S improvement) and stronger cash flows. In some cases however it could reflect stagnation in growth.....to continue tomorrow

Friday, November 17, 2017

Mood of markets - divergent views

Thought for the day

"Do you know because I tell you so, or do you know, do you know."

—Gertrude Stein (American, 1874-1946)

Word for the day

Attenuate (v)

To weaken or reduce in force, intensity, effect, quantity, or value, e.g., to attenuate desire.

Malice towards none

Those clamoring for Rajput pride and opposing #Padmavati may please do something to stop female infanticide and incest that plagues their society and makes life hell for millions of living Rajasthani women.

First random thought this morning

There is section of people who is accusing judiciary and regulators for over enthusiasm and activism. Their grouse is that judiciary is overstepping its jurisdiction and may even be infringing the legislative and executive territory.

The point is how did our system reach this stage. It is clearly the failure and corruption of the legislative and executive that is driving this trend.

For example, if executive and legislature were proactive in checking the menace of pollution, why would NGT be needed at first place, and even if constituted, why would it need to pass some seemingly ridiculous orders!

Mood of markets - divergent views

In past few weeks, I have read a number of research reports and market analysis. I have also heard the views of a number of fund managers and investment strategists. Unfortunately, I have not been able to decipher much from all this. Admittedly, my prejudices could be major culprit here. Therefore, I would not like to burden my readers with my conclusions based on the views and opinions of experts.

I would however like to share some guideposts that may help readers form their own judgment about the current mood of markets.

I find that there are two distinct camps of analysts and fund managers:

(a) First camp comprises of those who have seen the exuberance that preceded the last global financial crisis (GFC) and also the melt down that followed it. Experts in this group have seen high growth, full employment, rising interest rates and double digit inflation, Lehman collapse, Merrill Lynch sale and General Motors at brink of bankruptcy. These experts were stress tested for 1930s type of global depression conditions. Many of these also completed the cycle of million dollar bonuses to no pay hike for 5-6yrs. Many of these navigated through GFC adroitly and manage to grow their stature. While others sank with the market but have staged a comeback, but with bruised egos and diminished stature. Most important, experts in this group have experienced asset price falling 50-80% in a matter of one year, from a all blue sky scenario.

(b) The second camp comprises of young people in their late 20s or early 30s, who started their investment career post GFC. These bright guys have mostly worked in 'whatever it takes" and environment, characterized by abundant liquidity, near zero interest rate, very low inflation, low growth that is acceptable as "new normal". The people in this group have only seen asset prices rising steadily while energy prices declined by more than 50%. The belief seems to be that events like Greece default, Brexit, China slowing down from 9%+ growth trajectory to 6%+ growth trajectory, major emerging economies like Russia and Brazil struggling for growth, and India growing at much slower pace are minor aberrations and asset prices have only one direction to move and that is north.

The stance and arguments extended by both the groups are obviously contrasting. Though fund managers from both the groups might be fully invested, the asset allocation and sector preferences do vary materially. Emerging Markets Debt, Gold, US Treasury, Euro, Japan, Chinese mid and small caps, Bitcoins, Frontier Markets etc. are some of the major divergences among the these two groups of experts.

Another stark difference is seen in the valuation argument, especially for equities. While the first group mostly sticks to the conventional valuation matrix, the second group is innovating methods that would justify the current price....more on this next week.

Thursday, November 16, 2017

Judging mood of market

Thought for the day

"The nineteenth century believed in science but the twentieth century does not."

—Gertrude Stein (American, 1874-1946)

Word for the day

Pneumatic (adj)

Of or relating to air, gases, or wind

Malice towards none

Rahul Gandhi - The Alchemist.

RaGa never fails to amaze us with revelation of his new side everyday!

First random thought this morning

Sometimes I find it very unfair. Price of a publicly traded equity share can rise infinitely. But it can fall only 100%.

The history of stock market therefore is dominated only by the winners. No one bothers to remember the stocks which lost 100% of their value. Even if these losers outnumber the winners by 100:1.

Judging mood of market

In the past 17 odd weeks, since Nifty first touched 10K level, the simple average traded value of Nifty has been 10064. The value will be lower if we take the volume weighted average. In this period market breadth has remained decisively negative. The net institutional flows (DII and FPI combined) have been mostly neutral in past 4months.

In period from July to October over Rs220bn have been invested in domestic equity mutual fund schemes through systematic investment plans (SIPs). The current monthly run rate for equity SIP flows is over Rs56bn/month.

This is the period when some significant economic events have taken place, the most notable being implementation of GST. The investors and businesses had been waiting eagerly for this event for past many years. Besides, implementation of new Bankruptcy code and announcement of a comprehensive plan to recapitalize beleaguered public sector lenders are being widely acclaimed as transformational events for Indian economy.

Two sets of quarterly results have been announced in this period. The general consensus amongst analysts and fund managers (at least going by their public utterances) appears to be that earnings for corporate India have bottomed out and a sharp recovery in imminent. Many reputable global fund managers and investment strategist who had turned their back on Indian equities have turned bullish on India in this period.

In the period between July and now, INR has weakened vs USD by almost 1.5%; benchmark yields have jumped up by almost 10%; RBI has cut policy rates once by 25bps and inflation has jumped higher by 200bps.

However, after scaling the mount 10K in last week of July 2017, Nifty has literally gone nowhere, despite much excitement and enthusiasm.

The moot point is weather the markets are still assimilating the changes and may make a move up after consolidating for few months; or market has already assimilated the changes and decided that rally since February 2016 is overdone and a correction would be in order....to continue