Some food for thought
"A demagogue is a person with whom we disagree as to which
gang should mismanage the country."
—Don Marquis (American Poet, 1878-1937)
Word for the day
Demagogue (n)
A person, especially an orator or political leader, who gains
power and popularity by arousing the emotions, passions, and prejudices of the
people.
First thought this morning
Founder of Cafe Coffee Day (CCD) succumbed to the pressure and
decided to take the extreme step. This is a sad moment for many like me who had
a truly good time enjoying coffee with friends in CCD.
In CCD, V. G. Siddhartha (VGS) created a brilliant institution.
However, somehow I am finding the obituaries, comments and reactions from
media, market participants, social media stars etc quite hypocritical.
Vijay Mallya (VM), also established a brilliant institution in
Kingfisher Airlines. I had really good time travelling in Kingfisher. I am sure
almost everyone did. Like VSG, he also had unpaid loans worth 8000-9000crs.
Both claimed to have sufficient assets to pay their loans, but faced inadequate
liquidity to regularly service their loans. Both had political connections.
Income Tax and Enforcement agencies alleged evasion of tax and diversion of
funds in both cases. Both chose to escape the situation instead of facing it.
The only difference is that VSG could escape to land beyond
reach of anyone, whereas VM is within reach.
For VSG plight, system is being blamed, whereas VM is made out
to be a villain.
I feel sorry for VSG, and I have no sympathy for VM. But I would
not blame the system for the plight of both. It's the greed, vanity, managerial
inefficiency, inability to manage the change, and disregard for the process of
law that took both of them down. And they are not alone. Many more are finding
themselves in the similar situation. I hope none takes the VSG or VM route to
salvation.
Chart of the day
What's bothering Indian equities - 2
I noted yesterday
(see
here), there is not sufficient evidence to establish beyond doubt that the
regulatory changes like LTCG tax, reclassification of mutual fund schemes,
higher effective rate of tax for rich and certain class of FPIs, etc may be
responsible for the severe correction in the broader markets in past 18months,
or the fall in benchmark indices in past 8weeks.
I may add that
outcome of an election fuelling a sustainable market rally is also mostly
anecdotal and not conclusive by any measure. For example, look at the following
chart of Nifty. The uptrend that started with RBI's strong measures to control
CAD and improve liquidity, was broken in August 2015, despite a strong
government perceived to be development focused at the helm. Nifty has never
been able to break out of that trend line since then. Nifty has given up the
entire post 2019 election rally within one month, despite the same government
returning even with a stronger mandate.
It is therefore
fair to assume that the market up move that started in February 2016 is in fact
a shallow bear market rally that has held up well for more than 3yrs.
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In this period about one fourth of the frequently traded 1300odd stocks on NSE have lost more than 50% of their value. Another 15% of these stocks have lost anywhere between 25% and 50% of their value. About 25% of stocks have moved between (-)25% and 25%. Only less than one third of the stocks have yielded a return better than bank deposit (~7% CAGR) since February 2016.
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.
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.
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
Analyzing the present Indian market context, I find that most of
the market gains in past 6years occurred due to PE expansion. The earnings
growth had been anemic, and dividend yield has in fact contracted since 2013.
It highlights that 75% to 80% of the equity return in past 6
years is consequent of PE ratio expansion and only 20% to 25% is due to
earnings growth. In this period Earnings have in fact grown at measly 3.7%
CAGR.
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As I wrote a couple of months ago also, once the market
participants are through with their affair with the politics, budget, global
trade war, rate cuts, need for fiscal stimulus etc, they would need to sit, put
their heads together and contemplate the following:
(1) How much is the
scope for further PE expansion of Indian equities?
(2) How much earnings
will have to grow in next 3years to normalize the rapid PE expansion of past
6years?
(3) Is there enough visibility
of earnings growth for next couple of years at least?
(4) Though the
premium of midcap to the benchmark indices has moderated considerably in past
one year or so, but does absolute valuations are attractive enough to provide
decent returns over next 3-4years?
(5) Is it reasonable
to assume that due to higher domestic inflows into equities, we might not see
any dramatic price correction, nonetheless a prolonged time correction cannot
be ruled out?
Answer to these inquisitions would guide how much return one
should be expecting from Indian equities in next couple of years.
Given the turmoil in corporate debt market and moderate gilt
yields, on risk weighted basis the overweight equities strategy will still make
more sense than a balanced asset allocation in my view. However, the return
expectations may need material moderation.
Besides the fundamental issue of earnings and overvaluations,
there are some market related issues that are of major immediate concern to the
market participants. I would like to highlight these issues also, in my next
post.
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