"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.
(c) The alternatives like gold, bonds, real estate are still looking
worse.
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.
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