Do it yourself

Tuesday, December 23, 2014

2015: Earnings picture still hazy, valuations not crazy

Thought for the day

"Apparently there is nothing that cannot happen today."

- Mark Twain (American, 1835-1910)

Word for the day

Beatific (adj)

Giving joy, blessing or making exceedingly happy

(Source: Dictionary.com)

Teaser for the day

Could VHP set the clock back insofar as economic deterioration of India since 19th century is concerned?

2015: Earnings picture still hazy, valuations not crazy

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could." Rudiger Dornbusch

The dictum of Rudi Dornbusch has proved itself time and again. It is true for the present state of Indian economy and therefore corporate earnings also.

The current consensus estimates for FY16 and FY17 corporate earnings are running at 17-18%. Most of these estimates appear to be discounting a sharper economic recovery in FY15-FY17 than what the actual trends so far are showing.

To the credit of analysts, we have seen some serious downgrades in past three months, the forecasts however still appear more optimistic. In my view, it is a clear case of hope rather than data driving the analysis.

As per Credit Suisse research, so far, industrials and materials have driven the downgrades. In fact, over the last two years, seven out of ten sectors have seen net downgrades to their FY16 earnings.

On disaggregate basis, of late there have been suggestions that while the commodity producers may see even sharper downgrade post 3QFY15 results, we may see upgrade returning to the commodity consumers, especially consumers and automobile. The data for November 2014 has shown some promise especially in core sectors. However, the recent commentaries of the managements of sector leaders like HUL, Hero Honda, and Maruti is not very encouraging suggesting a disconnect.

In my view, expecting any dramatic turnaround in at least 1H2015 may cause disappointment. Given the low level of capacity utilization and high operating leverage, the outlook for revival of capex and therefore industrial sector remains little hazy.

The financial sector has shown strong earnings growth in recent quarters. However, doubts over asset quality cloud the earnings' profile of most state owned banks and NBFCs.

In absence of a material growth in the demand, most of the earnings growth appear to be coming from cost rationalization, lower finance cost and expected better utilization.

The comforting part so far is that the aggregate valuations have not entered the helm of unfairness; though it could not be said about individual sectors.

In my view, we are not likely to see any major surprise on earnings front during 2015. It will mostly be the continuation of existing trend - marginal deterioration in 1H2015 and a gradual improvement in 2H2015.

I also do not see much probability of re-rating of PE multiples. Though, the de-rating is possible, should the global risk aversion accelerate.

Monday, December 22, 2014

2015: Global narrative is scary

Thought for the day

"You can't depend on your eyes when your imagination is out of focus."

- Mark Twain (American, 1835-1910)

Word for the day

Larrikin (adj)

Disorderly; Rowdy.

(Source: Dictionary.com)

Teaser for the day

Should the Representation of the People Act, be amended to add the following ground for automatic disqualification of elected representatives:

"If he/she stands or speaks in the house without explicit permission of the presiding officer."

2015: Global narrative is scary

In past three months the global narrative has turned really scary. I am sure, Santa this year will have a really tough time, for the number of prayers are going to be much larger, louder and desperate.

I find myself thoroughly incapable in expressing the fear in my own words, as I do not feel it with the same intensity, sitting at a distance. I am therefore reproducing some popular sentiments.

China will be the focus of many, many boardroom discussions around the world next year. Unlike most previous years, the topic won’t be whether to double down on China—it will be whether to hold or even reduce exposure to a particular sector or the country overall. With China experiencing lower growth, greater competition, and more volatility, it won’t only be multinational companies having these conversations. (McKinsey & Co.)

A look at the long-term charts of the DXY Index shows just how massive the potential reversal of this trend is; and based on Raoul’s roadmap, the sheer size of the reversal gives us a strong hint of the degree of carnage that will be wrought upon a world in which the dollar carry trade has reached somewhere between $5 trillion and $9 trillion. (Mauldin economic)

Greece is back, front and centre — just as it was at the beginning of the euro crisis in 2010 and at the depths of the euro crisis in 2011. The only difference is that now, after several more years of depressionary policies have been foisted upon the people of that proud nation, the likelihood of an establishment victory (and thereby a continuance of the status quo) is far less than at either of those previous junctures. (Mauldin economic)

Do you want to know if the stock market is going to crash next year? Just keep an eye on junk bonds. Prior to the horrific collapse of stocks in 2008, high yield debt collapsed first. And as you will see below, high yield debt is starting to crash again. The primary reason for this is the price of oil. The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market, and those energy bonds are taking a tremendous beating right now. This panic in energy bonds is infecting the broader high yield debt market, and investors have been pulling money out at a frightening pace. And as I have written about previously, almost every single time junk bonds decline substantially, stocks end up following suit. (The Economics Collapse)

In the last two Absolute Return Letters I have argued why one should expect global GDP growth to be below average over the next decade or so, why interest rates should, as a consequence, remain low and why equity returns should also disappoint. (Absolute Return Partners)

In Europe, so far, Germany has been repatriating gold since 2012 from the US and France, The Netherlands has repatriated 122.5 tonnes a few weeks ago from the US, soon after Marine Le Pen, leader of the Front National party of France, penned an open letter to Christian Noyer, governor of the Bank of France, requesting that the country’s gold holdings be repatriated back to France; and now Belgium is making a move. Who’s next? And why are all these countries seemingly so nervous to get their gold ASAP on own soil? (Grant Williams)

In short, between Europe and Japan, thanks to the BOJ and ECB, there will be literally no bonds that will make their way from the primary to the secondary market! Which means only one thing: those looking for the marginal, and only, source of high quality collateral in 2015, will find it coming right out of 1500 Pennsylvania Avenue, NW in Washington. And that assumes, very generously, that that other famous institution located on Constitution Avenue Northwest doesn't come out of hibernation and resume soaking up collateral on its own if and when the S&P500 finally corrects from its unprecedented, and manipulated, bubble levels. (Goldman Sach via Zero Hedge)

Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned.

The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars.

A chunk of China's borrowing is disguised as intra-firm financing. This replicates practices by German industrial companies in the 1920s, which hid their real level of exposure as the 1929 debt trauma was building up. (BIS via Telegraph)

Do you remember seeing old pictures of the Great Depression which depicted “lines?” There were two types, bread lines and also lines to the front doors of banks. While we don’t see any bread lines today, trust me, there are bread lines in every single state and long ones at that. Nearly 50 million people in the U.S. survive on SNAP, EBT cards or whatever they are called in your state. Can you imagine the “confidence” it would instill if each day on your way to work you saw massive lines of people waiting for breakfast? Or, when you came home from work you turn on your television only to see long lines again, this time for supper? I can see it now, some reporter out on the street giving us the “good” unemployment, inflation or GDP news with a line of people in the background waiting for food. My point? False economic news would be harder to “sell” and even harder to “stomach” (pun intended). (Bill Holter in Miles Franklin Blog)

It was during this period at the end of the 1960s and the beginning of the 1970s that the Bretton Woods system of fixed exchange rates was breaking down, with key developments in 1971 and 1973. There was much academic debate over fixed versus flexible exchange rates. More economists appeared to support fixed rates, but the other side had the advantage of being led by Milton Friedman. As it turned out, however, flexible rates were not “chosen” but were what was left when fixed rates collapsed. My take away from that period most relevant today is that it is foolish to try to save a fixed exchange rate after it has come under severe attack. I’ve heard talk all day on the large amount of reserves held by Russia and whether they would be used to defend the collapsing Ruble. In my opinion, that would be a total waste of resources. The only cure for a Ruble down 50 percent is to let it go down even more, until the market recognizes the undershoot. (Bob McTeer)

Friday, December 19, 2014

2015: Rural income - no material improvement seen

Thought for the day

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence."

- John Adams (American, 1735-1826)

Word for the day

Chutzpa (n)

Unmitigated effrontery or impudence; gall.

(Source: Dictionary.com)

Teaser for the day

By blocking business in Rajya Sabha, is Congress vindicating BJP's behavior during 2004-2014?

2015: Rural income - no material improvement seen

Almost two third of the Indian consumers derive their livelihood directly from the rural economy, including farming, horticulture, animal husbandry, cottage industry, forestry, etc. The rural economy directly supports a large number of industrial enterprise, like crop protection, farm equipment, transportation, food processing, etc.; besides providing material indirect support to industries like textile, consumer staples, durable, and services such as financial services, trade and communication etc.

Anecdotally, we know that the health of rural economy is important from political and fiscal perspectives also. Since independence, problems in rural economy have invariably led to fiscal deflections and political instability.

While the budget allocation to the rural sector has increased steadily, the investment in the sector has been on the decline in past two decades.

Source: Planning commission

Consequently, we have not witnessed any sustainable rise in productivity. The agriculture sector growth had remained anorexic and highly volatile in past two decades.

The rural income had however shown a tendency to rise in past one decade due to a variety of factor, especially rise in rural wages, higher support prices for farm produce, rise in demand and prices for animal produce, and higher farm subsidies.

Most of these drivers have shown distinct signs of fatigue in past couple of years. The recent commentary by most consumer product companies suggests that this fatigue is for real and there are no signs of rejuvenation as yet.

The government of the day has certainly won the battle at WTO by ensuring continuing subsidy support to Indian farmers. But it might just have weakened its position in the war against low productivity and structural reforms in the farm sector.

Record global food production and the early forecasts of 2015 El Nino conditions are also not helpful for Indian rural income in 2015. Lower diesel prices is the just one major positive I can contemplate at this point in time.

Thursday, December 18, 2014

2015: Household savings - lower inflation offers little respite

Thought for the day

"As much as I converse with sages and heroes, they have very little of my love and admiration. I long for rural and domestic scene, for the warbling of birds and the prattling of my children."

- John Adams (American, 1735-1826)

Word for the day

Bespoke (adj)

Made to individual order; custom-made.

(Source: Dictionary.com)

Teaser for the day

Will someone tell HRD Minister that "It is definitely not about your idea of "what is right for Indian kids".

2015: Household savings - lower inflation offers little respite

In my view change in domestic savings pattern in past one decade is cause of concern for Indian macroeconomic fundamentals.

Traditionally, domestic savings, especially household savings, have been a stable and sustainable source of funding for both private as well public investments. Though liberalization of capital controls has opened the doors for foreign capital. It still is not a major source of funding.

Source: Planning Commission

More particularly, the decline in financial savings of households that begun in early 2000's has accelerated in recent years. This has serious implications for the economy and therefore equity markets.

I believe household investors had began meaningful investment in listed equity in late 70’s at the time of FERA dilution of MNCs. Reliance in 80’s and PSU disinvestment and capital market reforms in early 90’s drew the 2^ndlot of household investors. IT boom of late 90’s drew the 3^rdset to listed equity. In these 3decades households invested 8-17% of their financial savings in capital market related products.

Though the household financial savings started declining from mid 1990’s, 2000 was the key inflection point. Since then household have invested more in physical asserts than financial instruments.

The key cause for this trend could be listed as follows:

(a) Fall in average age of house ownership. Higher income levels in urban areas, rise in nuclear families and rise in real estate prices has prompted people to buy houses earlier in their life cycle.

(b) Rise in personal automobile ownership.

(c) Low growth in white collar employment opportunities as compared to growth in workforce has led to phenomenal rise in self owned enterprises leading to diversion of savings to physical assets.

(d) Rise in gold prices in 2000’s has definitely contributed to the trend.

(e) Persistent negative real rates.

I do not see any reason why this trend will reverse in 2015. In fact there are reasons to believe that household savings may diminish further in next couple of reasons. For example consider the following:

(a) Consumer prices for households will remain high. Expenses on items like education, health, energy, transportation, communication, rental, protein, and fruit and vegetable shall continue to rise disproportionate to rise in income. Hence the savings may decline further.

(b) Implementation of GST will reverse the wealth transfer for at least couple of years. Lower revenue for the government, hence lower social welfare spending growth; higher incidence of service tax; disruption of thousands of household businesses to the advantage of large organized players; employment restructuring as redundancies rise on a massive scale and skill requirement change.

(c) Factors like lower investment growth, higher productivity gains through automation & elimination of redundancies, restructuring of PSUs shall continue to impact the employment growth, especially for skilled labor.

(d) Lower employment opportunity may force more and more people towards self-enterprise, leading to higher household debt.

(e) Given the sluggish credit growth outlook for at least 1H2015, the deposit rate may decline further, thus de-motivating higher savings.

(f) Last but not the least, the trend for changes in consumption pattern shall continue. Bicycle and Transistor Radio have definitely given way to motor cycle and smart phone as essential marriage gift (dowry) in hinterland. The running expenses are to be paid by someone after all - be it the bridegroom, his parents or the bride's parents.

The economic growth will have to find an alternative source of funding (no capital control) or a way to grow household savings (lower taxes, higher rates, cheaper houses/rent, good public health/education/transport, and farm employment).

I have not seen any proposal for either as yet.

Wednesday, December 17, 2014

2015: Investment cycle not seen reviving in 1H2015 at least

Thought for the day

"The happiness of society is the end of government."

- John Adams (American, 1735-1826)

Word for the day

Fait accompli (n)

An accomplished and presumably irreversible deed or fact.

(Source: Dictionary.com)

Teaser for the day

The wheel turns full cycle. "The Parrot" to make its master sing

2015: Investment cycle not seen reviving in 1H2015 at least

Reviving the stalled investment cycle is the key to the myriad of problems Indian economy is facing at this point in time, in my view. Simple, as it may sound; this is the toughest challenge before the government, RBI and the business community.

In my view, the investment cycle in India is stalled not just due to normal economic cyclicality. It is congregation of a number of socio-economic and political factors.

Mostly ignoring sustainability concerns, poor demand assessment, political impropriety and banker-entrepreneur connivance have led to serious misallocation of capital and piling up of unviable projects. Irrational and random political resistance to foreign capital has also impacted the investment environment in the country.

Y2K led global ITeS boom, easy credit led private investment surge, Cheap Chinese import led consumer spending and massive government spend on infrastructure funded by public sector and deficit financing created a mirage of India shining. The unsustainable higher income-higher consumption and savings-higher investment effect of all this reflected in data with a lag during early years of UPA I regime (2004-2007).

The real problem however is that all this liberalization, investment etc. was done (a) without creating any conceptual framework; (b) without instituting adequate and appropriate institutional and regulatory framework; (c) without addressing sustainability concerns; and (d) without making appropriate financial viability study. This all led to:

· Rampant corruption in public offices, as allocation of liberalized national resources to private parties was left mostly at the discretion of politicians;

· Widespread obstructions and delays in execution of mega projects as these projects conflicted with the sustainability objective and environmental concerns;

· Advancement of future investment demand impeding financial viability of projects and creating massive stress in financial system;

· Decimation of domestic SME and household sectors which could not compete with cheap Chinese imports leading to structural pressure on currency; current account and general employment level;

· Unmanageable rise in aspirations of youth population leading to substantial changes in consumption patterns and thus pressuring household savings and consumer prices;

· Sharp rise in rural land prices making food inflation a structural problem.

The consequences are:

(a) Most of the infra developers and operators are facing serious credit worthiness issues. They are not in a position to undertake further projects, while the existing projects are either stalled midway or have become unviable due to a variety of issues.

It is important to note that many of these projects have been unviable ab initio though few would like to admit.

(b) Banks are not willing to extend further credit to core sector. The stated reasons are poor balance sheet and financial unviability of projects. The unstated reason include the fear and extreme risk aversion amongst individual bankers, which is quintessentially an outcome of past excesses.

(c) Erosion of banks' capital base is also a major hindrance in kick starting the investment cycle. Fiscal constraints of the main promoter (the Government of India); persistent failure in labor management (unions resisting diluting government stake) hinder recapitalization of public sector banks.

On the other hand as I write this, a number of large corporate have already reneged or are on the verge of defaulting on their covenants. The amount of accommodation loans masqueraded as restructured loan to protract the default technically are staggering.

A few balance sheets which are strong have the option to choose between acquiring an operating or partially built asset at favorable terms or undertake a green field project. To me the choice is but obvious. So how the fresh investment cycle will get started?

Moreover, we are entering a phase when 2-3years down the line easy credit situation prevalent in western world may cease. The cost of capital will start rising for already troubled businesses.

The long term solution lies in opening the Indian markets to open global competition. The government may provide support to businesses which have demonstrated their capability to compete with global players. The inefficient and incompetent should be allowed to fail.

In the short term however, the government will have to undertake the onus of kick starting investment cycle on itself. The best way would be create social sector infrastructure, e.g., education, skill development, water, sanitation and healthcare. The government has rightly initiated some programs in this direction. The faster and efficient implementation is the key.

Do not expect any meaningful investment happening in 1H2015.

Tuesday, December 16, 2014

2015: 10 things to watch

Thought for the day

"While all other sciences have advanced, that of government is at a standstill - little better understood, little better practiced now than three or four thousand years ago."

- John Adams (American, 1735-1826)

Word for the day

Querulous (Adj)

Apt to find fault; habitually complaining.

(Source: Dictionary.com)

Teaser for the day

Why listenership of "Man Ki Baat" is dwindling with each episode?

Is PM not talking what we want to hear?

2015: 10 things to watch

In my view, regardless of the jitteriness of the markets during last week, it is worthwhile to discuss a strategy for next year or may be two. The exercise may look little less interesting at this point in time; still it is worth undertaking in order to suitably calibrate (a) asset allocation (b) return expectations and (c) sectoral preferences.

In my view, the following 10 key factors are critical for the Indian financial markets, in particular, in next 12-18 months. Investors therefore would want to keep a close watch on these. Prima facie, these factors are very generic and may offer no great insight. But, I would like to watch of these from my colored glasses and see through them the emerging trends.

(1) Revival of investment cycle

In my view, it will depend on a host of factors like credit worthiness of borrowers and project undertakers, extent of bank capitalization, viability of infra sector projects, policy support and investor's risk appetite to name a few.

(2) Household savings

Employment growth and household inflation would be key deciding factors.

(3) Rural Income

Rural wage growth and monsoon are key factors to watch.

(4) Corporate earnings

Pricing power led by demand growth and higher utilization needs to watched.

(5) INR movement

Restoring faith of Indian investors and NRIs in INR strength, USD relative strength and current account management are the key factors that need to be watched.

(6) Bond yields

Credit demand growth & fiscal prudence would be key factor to watch.

(7) Political will

The political will to pursue radical reforms and faster growth agenda would be a key determinate of the future growth trajectory

(8) Global economic growth

In particular price stability and consumer demand growth will be the key.

(9) Global flows

(10) Technical trends

In next few days I shall discuss each of these factors in some detail.

Monday, December 15, 2014

The longest hour

Thought for the day

"Our Constitution was made only for a moral and religious people. It is wholly inadequate to the government of any other. "

- John Adams (American, 1735-1826)

Word for the day

Efface (V, trn)

To cause to disappear by rubbing out, striking out, etc.; to erase; to render illegible or indiscernible.

(Source: Dictionary.com)

Teaser for the day

I dare all champions of Hindu cause to visit Vrindavan during rains!

The longest hour

This morning the financial market place seem more like a war front to me; where the next one hour seems much more critical than the next day and no one seems interested in talking or listening about next one month or next one year. Survival is the key here not the longevity.

Writing a strategy about next one year under the circumstance seems like a hazardous task to me. Nonetheless, moving with the heard, I would like to foresee the events in the womb of time and bet my money on some of the events which I feel are most likely to occur.

I am encouraged by the fact that despite all grave accusation and great provocations, I maintained my NIL weight to commodities, underweight to infrastructure & financial, and overweigh to consumers and exporters stance throughout the year.

I am also satisfied by not getting carried away by the change in government in India and insisting on first seeing the change on ground before betting on my money on broader economic growth trade.

I have always maintained that historically, a large majority of Indian businesses have grown on government patronage and/or resource arbitrage opportunities and have been low on innovation, productivity and scale. The politically advantageous socialistic façade of the government, especially during 1950-1990 led to misallocation of resources, trade and capital controls, demand suppression, and protectionism that promoted low productivity. The conditions have changed in past 10-15years but not sufficiently to make a majority of Indian businesses globally competitive.

The following trends, which are quite likely to strengthen in next few years, would suggest that a large number of small, over protected, less productive, uncompetitive, under-capitalized businesses should become extinct in next decade or so.

In past two decades we have seen this happening with small steel and cement plants, textile manufacturers, petrochemical plants, numerous public sector undertakings, NBFCs, etc.

There is no reason why it should not happen to (a) small and mid-sized engineering and construction companies which purely survive on administrative patronage: (b) ITeS providers who are pure commodity plays solely focused on wage arbitrage opportunities; (c) mid-sized commodity producers who cannot scale up to compete with global corporations in a more open, price & quality competitive and transparent market; (d) intermediaries who are not adequately capitalized and technologically prepared to serve or compete with large global businesses which are highly price sensitive, etc.

Over next few days, I will present my thoughts on various issues concerning investors.