Market Liquidity (Retail Category)

December 3, 2010 1 comment

The recent 1800pt sell-off on the Sensex has made some investors jittery. The IPO market which was very buoyant in Sep-Oct has moderated. Several recent IPO’s are in the red post the recent correction. Market sell-offs usually impact the retail end of the IPO market the most. The Reliance Power IPO debacle hurt a lot of retail investors (several of whom had opened fresh Demat account for the IPO). Also IPO subscription figures available with NSE seem to suggest that the retail part of the IPO gets fully subscribed at the very end. The QIB end of the market is usually the first to get fully subscribed. So I though I will look at the retail end of the market for this article.

The MOIL IPO subscription has been excellent at 56x which was more due to the quality of the issue as well as the attractive price.

When markets are selling off, as a buyer you are bound to wonder when the selling will stop. And is there enough liquidity available with buyers to halt the fall. Measuring market liquidity is both difficult and complicated. Money can enter or leave the system via FII flows, DII flows, Retail money, Insurance fund flows etc.

Also during IPO’s a large part of funds committed to the IPO may be borrowed for short term. It is common for brokers to lend funds to investors for IPO subscription. Similarly, investors could exit from some stocks and commit those funds to the IPO. So there is no simple way to calculate net inflow of fresh funds.

Since the beginning of the year FII’s have bought close to $28 Bn. MF’s on the other hand have been facing shrinking asset base and have been net sellers. A lot of Retail money (some of it would be fresh) has entered the market due to the COAL India IPO, Power Grid FPO and the MOIL IPO. LIC has been indicating that they will be investing more year after year on back of record Premium collections.

I was looking at a way of gauging the approximate funds available with Retail investors (the smallest lot) to begin with. To do so let’s look at 3 IPO’s (Coal India, Power Grid – FPO and MOIL) all of which received good response and were well priced.

If we look at all 3 issues, we can see that there is money to the order of 10000-14000 Cr. available with retail investors. However these are the funds available for good quality companies with a fair bit of operational history.  Given the recent scams related to insider trading and the housing loans the retail end of IPO’s could become subdued.

Most big issues in India have been in the range of 8-15K crores. Coal India was around 15,000 Cr while Reliance Power in 2008 was 11,700 Cr. ONGC in 2004 had raised around 9,500 Cr. Since retail category is 35% of issue size, the retail end of all these biggest IPO’s have been in the range of 4000 – 5000 Cr. Current subscription figures suggest there is ample liquidity to absorb the retail end of these Mega IPO’s. However, quality remains a key criterion to attract retail funds.

This data should be good news for the Govt. given that many more FPO’s are planned over the coming months including the likes of SCI, SAIL, IOC, Hindustan Copper and ONGC. If other private companies planning to list soon want a piece of the Retail Pie, they will have to focus on the pricing and issue quality.


Back to Mt. 21K

November 13, 2010 Leave a comment

The markets momentarily reached back at 21000 on the Mahurat Trading Day. It has been almost 3 years since the markets breached the 21000 mark.

Last weekend I met a couple of friends who felt they had missed out on the whole 8000 – 21000 rally and felt that they should wait for a correction to invest. Waiting for a correction makes sense given the rich valuations. Even after the recent 800pt sell-off, the Sensex is trading at 23 times TTM earnings. The earnings are expected to pick up going ahead yet, margin of safety remains low.

However, even though the Sensex is back to 21000, there are literally hundreds of Mid & Small Cap companies which are still anywhere from 50-70% discount from their all time highs in nominal terms. Accounting for the Time Value of Money for 3 years, we can further discount the fall by 1.2x (TVM @ 7% p.a.) . This makes many stocks attractive even though the indices may be back to their all time highs.

Now, there are several reasons why stock prices of several companies are languishing. There are cases like Suzlon Energy and Punj Lloyd who faced problems in their core business. There are cases like Pyramid Saimira, Satyam & SEL Manufacturing where promoters were barred by SEBI for insider trading or there were accounting anomalies. Then there are cases like Indage Vintners, Koutons Retail and Vishal Retail where these companies are suffering from lower Sales and increased Debt burden pushing them on the brink of insolvency.

Another reason for the steep discount is the P/E de-rating that has happened in several sectors. PE re-rating and de-rating is the easiest way a stock price can move up or down.

In the heydays of 2008, the market was willing to value Power companies with almost no real capacity (plans were on paper), at par with listed Power Companies. Power companies being Utilities tend to trade 2-3 times of B/V but in 2008, they reached multiples of 7-8 times of B/V. In similar sense, companies having land banks were valued on the possible “development potential” of the land banks even though getting clearances, execution and financial feasibility was difficult for several land parcels. Infrastructure companies were again valued based on the pipeline of projects lined up. Once the sector fancy disappeared, so did the P/E premium that the market was willing to pay.

Today, leading Real Estate & Infrastructure companies are trading at multiples of 10-20 times which is a straight 50% cut from peak P/E ratios. This P/E de-rating has made several good companies across sectors cheap compared to broader markets.

Since, I prefer to look at specific stocks I shall list some good companies which at current stage appear to be attractively priced and also have a margin of safety given that they are significantly away from their all time highs. These are not necessarily recommendations as I am only trying to show that several companies are still cheap compared to their all time highs.

Note that most of these picks are attractively priced from a P/E & P/B perspective and are at 50-70% discount to their all time highs. Most of these companies are posting decent results and some like ABG Shipyard or Jyoti Structures have strong order book positions. In case you choose to invest please do your own Due Diligence.

If we dig deeper many such companies will emerge which merit attention and could give good returns going ahead.

Apart from this, there are several companies that have done exceedingly well and are now way past their old highs of 07-08. There are some turn-around cases and some totally new stories which the markets have discovered. The dynamism of markets is really unbelievable. During the last year, we had a slow sideways phase in the markets where the Sensex stayed in the 16000 – 18000 range for many months. Even during this consolidation phase many companies hit new all time highs and have multiplied many fold in a short span of time. Will save the details for the next article though.

Categories: Capital Markets, Sensex

Some Thoughts on Market Valuations…

September 18, 2010 5 comments

The Sensex closed at 19,594 yesterday which is still around 7.5% away from its all time high of 21,200+ in Jan’08. This raises a question about the valuation of the markets. We are almost within kissing distance of the all time highs and there is a need to evaluate the market conditions.

The current rally which began way back in March’09 as a bounce from highly over sold territory has seen the Sensex rise almost 140%. A large part of the rise from 8000 to 16000 was almost vertical and took place in just 3 months (Mar’09-Jun’09). Time and again the markets have refused to correct and several investors have missed the rally completely. September is traditionally supposed to be a “down” month but here we are making new highs every week. So let us retrospect and see how the world has changed and what could be the possible road ahead.

The world has changed a lot from Jan’08 till date. Baer Sterns, Lehman Brothers, Merrill Lynch no longer exist. GM has filed for bankruptcy while AIG, Citibank and several other behemoths are propped up on Government support.  Governments around the world undertook several stimulus packages to boost growth and stem the collapse in trade and private consumption.

Crude oil is still 50% away from its peak of $ 147. Gold has moved up from $840/ounce to $ 1280/ounce outperforming most other asset classes. Dubai, Greece, Portugal, Spain, Ireland have all given the markets a scare with the possibility of debt default. All these countries have unsustainable levels of Debt/GDP and their bonds are continuously being downgraded. Their fiscal deficits show no signs of shrinking and going ahead the markets may get spooked if one of them default.

In the developed world, US (93% Debt/GDP), UK (78% Debt/GDP) and Japan (227% Debt/GDP) continue to pile up debt. Given the huge Debt pile up across the globe (chart below) it is difficult to imagine that we would be getting back to the 4% Global GDP growth any time soon. However Indian equities don’t seem to care for any of these danger signs and continue to march ahead.

Since I am not an expert on Global Macro-Economics this article will now focus on market valuations. For those who are technically competent (in Economics) and would like to read about the scary details of Government Finances please visit this excellent site by John Mauldin. The ones who are not very competent can visit a much simpler series of article here (By Vivek Kaul of DNA, he puts the same concepts in much simpler words). The articles in both places are equally scary so be warned.

Coming back to market valuations where do we stand? Let us look at some possible alternatives.

1. Sensex P/E – The Sensex P/E stands at a rich 23.4 times as of date. This means we are around 44% higher than the long term average P/E of 16 times (data from brokerage reports). This P/E is a composite P/E of the 30 underlying companies. So it means that some of the companies would be trading at over 23 times while some will be trading below 23 times. The distribution of P/E is given below.

Here we can see that 20 out of 30 stocks are below the Sensex P/E while 10 have P/E ratios higher than the average. L&T  and Jindal Steel & Power are the most richly valued companies with P/E’s of over 40.

The P/E ratio is an indication of the expected growth rate of EPS. In my last article I have written about the lack of growth in Sensex EPS over the last two years. Looking at the historical EPS data it looks highly improbable that we can have a consistent 23% earnings growth going ahead.So based on P/E alone, the markets don’t leave much scope on the upside.

But if markets were still to go up then how high can they possibly go? Let us look at the historical peak P/E values during the last few Bull Runs.

During the Harshad Mehta led Bull Run in 1992, the market traded at an astronomical P/E of 56 times (which means we could potentially double from here on!!!). During the Dot-Com bubble we were at a less astronomical 33 times and during the Great American Subprime Bubble we were at a much conservative 27 times multiple. So given historical Bull Run P/E multiples, the markets could still go up. All that is needed is irrational exuberance of investors and ample liquidity.

As many experts have pointed out, a lot of funds and retail investors have missed the rally in Indian equities. MF assets have been shrinking over the last year. Pension money (Indian) is yet to come into the markets. FII inflows have been very good this year ($ 10 Bn plus). Interest rates are still very low across the globe. India is probably the only convincing balanced growth story. If the growth in the developed world continues to flag or worse we have a double dip in US and EU, a lot of funds would look to increase exposure to emerging markets and India would definitely get greater exposure. If everyone were to rush in, there is every chance we may head much higher.

2. P/BV and Div Yield – The P/BV stands at 3.7 times while the Div. Yield stands at a measly 1.07. These ratios indicate that the markets are highly over valued. But since we are looking at composite values for 30 companies there are some things to watch out for.

The P/BV is high for companies with very few tangible assets (Software, Telecom) while low for companies with large hard assets (Cement, Metals). Given that we are predominantly a service economy we should be able to have a higher P/BV than say a country like China or Russia which have large number of Manufacturing or Metals & Mining related companies as part of their stock index. I shall need to dig deeper on the P/BV data on individual companies to come up with any logical conclusion but anything over 3-4 times P/BV can be termed expensive.

In terms of Div. Yield we have to look at 2 aspects. Firstly in a fast growing economy, companies will want to retain earnings (i.e. pay less Dividend) as they need to fund capital expansion (As per the Pecking Order Theory of Finance, internal accruals/retained earnings from PAT remains the cheapest source of funds).Indian companies have also been acquiring companies globally since 2005. So several companies may want to retain funds for pursuing possible acquisitions.

My theory holds up pretty well given the fact that Bharti Airtel gave its first dividend last year as it believed prior to that it was better off ploughing profits back into their business. Similarly Infosys maintains Cash balances of almost $ 3Bn+  as it may want to acquire companies in the West. If companies retain or reinvest profits, Dividend payouts are bound to remain low and thereby keeping Div. Yield low.

Secondly, Indian companies are not the best when it comes to sharing wealth. If an American company skips or reduces dividends, it is taken very seriously. Investors over there would demand an explanation for such an action. But in India, most investors are invested for capital appreciation. Div. Yield rarely matters to aggressive investors who dream of making multibagger returns.

So based on P/BV and Div. Yields we seem to be in over valued territory but unlike the P/E ratio, dissecting these ratios is very difficult and hence making predictions based on them is inconclusive.

3. M-Cap/GDP ratio – I have written a detailed article on this ratio here. The current M-Cap for all BSE companies stands at $ 1.53 Tr while the Indian GDP stands at $ 1.23 Tr. Thus, the M-Cap/GDP ratio stands at 124% putting us in “Significantly Overvalued” territory.

4. Technical Analysis – For the readers who are unfamiliar with technical analysis, there is no need to worry. I shall try to look at current market valuations without use of too much technical jargon. I have focussed on a simple method based on the 200 Day Moving Average (200 DMA) to gauge the probability of a market correction. Markets are supposed to “Revert to Mean” meaning that stock markets cannot move vertically either upwards or downwards and excesses will get eventually get normalized. In simple terms we are playing with the law of averages.

Consider the chart below at the time of significant corrections since 2003. The whole idea of using the 200 DMA here is that it is considered as a long term support. Time and again during the last Bull Run, the Sensex has bounced off the 200 DMA proving its significance as a long term support. We have a few such instances shown below in “Red” where the market moved significantly ahead of the 200 DMA and an instance in “Green” where the market was much below the 200 DMA.

The data for the periods when the market was over-bought and then under went a correction is as below. I have approximated the values to the nearest hundred for ease. I have considered the lowest value within first 3 months of an intermediate peak to calculate the extent of the correction (as the period 2004-2008) was a constant uptrend.

The results here are interesting. In May’04, the market was a good 48% higher than its 200 DMA. It soon went a 32% correction when the NDA lost the elections in 2004. This was the day when the market hit the 10% lower circuit and later the 15% lower circuit.

Later on in May’06, the market was around 36% higher than the 200 DMA and soon experienced a correction of 30%. After that there were 2 minor corrections of around 10% each during Feb and July’07 when the market was above the 200DMA by around 15-20%.

Then during Jan’08, the market experienced a sharp 30% correction (which marked the beginning of the down-trend) and the difference between the market and the 200DMA was around 30%.

All in all data seems to suggest that the 3 major corrections (when the fall was around 30%) have all coincided with the market running ahead of its 200 DMA by at least 30%.  So, anytime the market moves ahead of its 200DMA by 30%, history suggests that it may be a good idea to look at booking partial profits.

Note:- It is necessary to understand the underlying dynamics of the 200DMA to make meaningful inferences. For example, when the market moved up sharply from 8000 to 16000 last year, the difference between the market value and the 200 DMA was massive. But the rally was V-Shaped and hence the difference was bound to be significant.

Once a significant gap is built up 2 things can happen. Either the market can correct and this reduces the gap between the market and the 200DMA. Or, the markets could move sideways (in a trading zone) and the 200 DMA can play catchup (like 2nd half of last year).

The chart below shows a snapshot of what happened last year. In June’09, the market was at 15600 while the 200DMA was a 11085 creating a massive gap of around 40%.

Ideally, the market should have corrected however the markets remained range bound and the 200 DMA played catch-up and once again the up-trend of higher tops and higher bottoms is in place.

Now, where do we stand on basis of this theory? The market is currently just 12% away from the 200 DMA indicating that it could still move up before undergoing a significant correction.

Conclusion:- I have looked at several parameters, some conventional and others not so conventional to look at market valuations. The markets appear expensive on several counts like P/E, P/BV or M-Cap/GDP. But history shows that markets can defy logic and move even higher. As the saying goes “Markets can stay irrational longer than you can stay solvent”.

I remember 2008 and the IPO market was crazy. The Reliance Power IPO was oversubscribed by 72 times attracting bids worth $ 186 Bn (almost 1/6th of the M-Cap of the whole of BSE at that point). Future Capital Holdings was oversubscribed by over 133 times!!! These 2 issues alone managed to get bids worth almost $200 Bn. The mood was super bullish and sectors like Power, Infra, Capital Goods and Real Estate were literally on fire. There was a deal making frenzy and we had a PE deal in India almost every day. It was a mood as if nothing could go wrong.

Today, there is still a lot of skepticism about the current market rally. Some IPO’s have struggled and retail investor participation has remained poor. The market volumes are also lower than that in 2008. This skepticism is in fact a very good thing as the crazy exuberance of 2008 is missing. This leaves room for some more upside.

I believe we could still see another 10-15% upside before we finally pause for breath. Slowly brokerages are suggesting that this rally may take us to the highs of Jan’08. This is a bad sign as the extrapolation game has just begun. No one would have thought in Sep’08 that the market would be back to their highs so soon. It appears as if something is wrong given that the Macro-Economic situation has changed dramatically.

But as they say Mr. Market is always right. It doesn’t care for economics. It doesn’t care what I think. The only factor that matters is global liquidity and investor risk appetite. Global liquidity should remain abundant as no debt ridden government wants to increase rates and hurt the fragile recovery. The RBI has taken baby steps in terms of rate hikes in spite of the fact that consumer inflation in India is in double digits.

Now what could be the key risks to the uptrend? Anything from terrorism to interest rate hikes to a slowdown in China or a default scare in Europe or elsewhere could spook the markets. A slowdown in China would definitely hurt commodities and earnings. Apart from that there is a huge pipeline of IPO’s waiting in the wings. A flurry of IPO’s could soak up the excess liquidity. If RBI decided to tackle inflation head on expect a 2-3% rise in Home and Auto loans and these sectors could be badly hit. No one knows how the markets may pan out.

But one thing is certain. And that is markets will remain exciting. Maybe they should have a tag line “Mr. Market – Expected the Unexpected”

The mystery of Sensex EPS growth

September 10, 2010 7 comments

Just last week I had pointed about the stock weightage issues with the Sensex over here. This week Deepak Shenoy (who has a wonderful blog at has discussed the fact that the Financial Services & Oil & Gas sectors have 20% weightage each for the Nifty. I had calculated the sectoral weightages for the Sensex but turns out the equation holds true for the Nifty as well. This creates a bias as the index value computation becomes heavily correlated with the performance of these 2 sectors. Also, these weightages do not necessarily imply the contribution of the sector to the underlying economy (It is largely believed that the Nifty or Sensex values are indicators of the underlying economy).

Apart from the similarity on sectoral weightages, he has written about the lack of growth in the EPS of the Nifty. I was planning to explore the same for the Sensex but with a different angle. So here goes.

Equitymaster has the following data on Sensex EPS from 1998 till 2010.

The Sensex EPS has grown from Rs. 163 in 1998 to Rs. 838 in 2010. This means the CAGR of earnings has been a decent 14.62%. The chart of EPS growth y-o-y is given below.

On basis of the given data we can make a couple of simple observations. The EPS CAGR of 14.62% is very much in line with the usual expected returns from equities. Over the long term most financial planners will project equity returns in the range of 12-14%. Data over the last 13 years does seem to be in line with these claims.

What is striking however is the fact that even though the Indian economy has grown every single year since 1998 (average GDP growth has been around 6.5+%), we have still had years when EPS growth has been either negative or in low single digits (1999, 2009 & 2010). What bothers me is that whenever I go through any research reports by prominent brokerages or I-Banks, they tend to assume earnings CAGR of 20-25%. It is common to find research reports projecting FY10 Sensex EPS at 1000+. Today we stand at Rs. 840 odd on the EPS front which is a good 16% below most estimates.

Also most brokerages use a common logic for projecting EPS.

First assume GDP growth at 8-9% (real growth). Based on historical WPI averages, project the WPI inflation in the range of 6-7%. Hence, Nominal GDP growth should be 15-16%.

Since the Sensex or Nifty companies are the usually the largest companies in their respective sectors, it is assumed that their topline growth will be in line with growth in Nominal GDP (i.e. 15-16%). Also, it is assumed that since these companies are the blue-chips of India they can improve operational efficiency each year and hence the profits will grow at a pace higher than the topline growth (1.2-1.3x multiplier). Thus we get a projected EPS growth outlook of 19-20%.

But practically this does not happen and may not happen in the future. The large part of EPS growth has happened between 2002-2008 (EPS CAGR @ 24%) when the economy was booming in sync with a global boom.So GDP growth does not necessarily translate into constant EPS growth every year. There has to be a better explanation for this lumpiness in earnings growth. The answer lies in 2 basic concepts of Corporate Finance – Operating Leverage and Financial Leverage).

Indian GDP growth was slow in 2000-2003. Capacity utilization for many companies was low (Autos, Metals, Cap goods etc). Once the GDP started accelerating and capacity utilization went up, the concept of Operating leverage kicked in (basically Fixed costs of running a business get distributed over a larger volume increasing Profits much faster than Sales). This coupled with rising commodity prices (which helped Hindalco, SAIL, Tata Steel, ONGC, RIL etc) led to an acceleration in profits unlike any other time in history.

In terms of Manufacturing, companies like Maruti, M&M, Tata Motors, BHEL, ACC, Ultratech etc benefited from greater capacity utilization while the same period saw the comeback of the IT biggies (Infosys, TCS and Wipro) and the emergence of Telecom (Airtel). The cement & steel sector gained from a boom in housing and infrastructure.

Now, let me focus on the role of Financial Leverage in EPS growth. As a company takes debt, its RoE improves. Most DCF models, make use of terminal growth rate “g” which is “Retention Ratio * RoE”. Mint has a chart of the RoE from 2003 onwards.

Using the DuPont Identity, RoE = NPM * Asset Turnover Ratio * Financial Leverage.  As the capacity utilization expanded, the NPM increased and the Asset Turnover Ratio also increased. The chart below clearly shows that RoE for the Nifty shot up from 16% to 28% in 3 years. This in turn allows the market to trade at a higher P/E multiples as a higher RoE gives a higher DCF based value.

Thus, the period of 2002-2008 was truly golden in terms of earnings as both Operating Leverage and Financial Leverage kicked in causing earnings to accelerate.

It was in 2007-08, that a lot of companies started doing acquisitions and also undertook a fresh round of capex to increase capacities. Cement,Steel and Auto companies are in an overdrive to increase capacities across the board. Acquisitions like Novelis (by Hindalco), Corus (by Tata Steel) & JLR (by Tata Motors) have added debt onto the balance sheets of companies. This coupled with Capex expansion, will cause the double impact of rising depreciation (from Capex) and higher interest cost (from Debt) which could keep earnings growth subdued.

Similarly, commodity prices are much softer today than in 2008 (Crude oil is still 50% below its peak of $ 147). Cement prices are expected to remain soft given the huge capacity addition taking place. So going ahead it may be a while before we can see 20-25% profit growth for all the companies.

One more aspect needs to be considered while looking at Sensex or Nifty earnings. Given that the Index comprises of 30-50 stocks, there is a natural EPS cancellation that occurs. Variables like interest rates, forex rates and commodity prices affect some companies positively and others negatively. A rise in commodity prices will be good for Cement & Metal companies but will hurt the earnings of Auto, Infrastructure and Construction companies. Similarly a rupee appreciation against the $ will hurt IT companies but will benefit companies importing Iron Ore, Coal or Crude. Hardening of Interest rates will help the earnings of Banks but hurt the Real Estate, Auto companies  & others in general. Thus, there is no single sweet spot where all companies can earn optimum profits and the Index EPS is maximized.

Conclusion:- The idea here is to give a probable explanation for the lumpiness in earnings growth irrespective of GDP growth. Also above data suggests that it may be a bad idea to extrapolate earnings in a linear fashion on the basis of historical performance.

India Inc. will take a while to digest all the acquisitions, debt funding and fresh capacity addition and once that is done we may again see an acceleration in earnings. The last couple of years have seen almost flat EPS growth (2008-2010 EPS CAGR @ 0.8%). If we continue to grow at 8.5%, and given that earnings have been flat for almost 2 years now, expect the next round of EPS acceleration to begin in year or two.

Some Sensex Facts

September 4, 2010 2 comments

The BSE website has a lot of detailed data here. I was browsing through it and came across some interesting facts.

The first is that the BSE has over 7,800 companies that are listed as of Dec’09. This is a really huge number as in my 7 years of following Indian equities I may have read about at the most 1,000 companies (in terms of area of business they operate it). It means I should be reading a lot more and there can be tons of opportunities still “hidden” from the public eye.

The second fact is that the BSE benchmark index, the “Sensex” is extremely top heavy. Just look at the data below and you will know what I am talking about.

Out of the 7,800 odd companies, the 30 companies comprising the Sensex account for a whopping 41% of the overall M-Cap of the BSE. It means that 0.38% of companies listed on the BSE account for over 41% of its Market Capitalization.

Now Equitymaster has a detailed break up of the Sensex companies over here. Even within the top 30 companies, only 6 companies account for 53.3% of the Index weightage. This means that these 6 companies can influence the Sensex almost equally (~ 50%) as the rest of the 24 companies. I have put the Cumulative Weightage data for the Sensex below.

These 6 companies which account for 53% of the Sensex weightage are Reliance Industries, Infosys, ICICI Bank, L&T, HDFC Bank and SBI. If we add ONGC and Bharti Airtel to the list, then these 8 companies will add up to 60% of the Sensex weightage. This is whyI feel the Sensex is very top heavy and there is tremendous bias towards the Banking & Oil & Gas sectors (~ 20% weightage).

It is worth wondering if as an investor, instead of going for a plain Index fund should he invest in these 8 companies alone and be well invested in the “India story”? How would an investor have fared had he invested in these 8 companies alone since the year 2003 onwards (the length of the bull run)? Would his concentrated 8 stock portfolio have performed better or worse than the Index?

These are tough questions and beyond a point of reasoning we get to a “Chicken & Egg” kind of problem.

When a company does well (in terms of Sales & Profits) over a period of time its M-Cap goes up. Beyond a certain point when its M-Cap is large enough it is included in the Index (either Sensex or Nifty). In 2003, Telecom was relatively new and Airtel was relatively unknown. It is only over the years that Airtel has become a Telecom giant. The same applies to L&T which rose many fold due to the Capex cycle of Corporate India and the Infrastructure Boom.

In hindsight, these 8 companies have given returns that easily beat the Sensex by a long margin. I shall give a rough approximation below. An equal weighted portfolio of these 8 companies would have given 12.56x returns compared to the Sensex gain of 4.35x (3400 to 18,220).

However, past out performance cannot indicate future out performance. Over time as a certain sector of the economy will grow, its companies will do well. The higher profits will create a demand for their shares pushing P/E ratios higher. Since M-Cap = PAT * P/E, the M-Cap of the sector in vogue will go up. Eventually some companies from the sector will be added to the Index to represent the growing contribution of the sector to the Economy. Other sectors which are in decline or degrowth will be moved out of the Index (read Textile firms in 90’s). The list of Sensex replacements over time can be found here. The last decade has seen companies like Castrol, Nestle, Colgate Palmolive, MTNL, Zee Tele & GSK Pharma being replaced by companies like NTPC, TCS, M&M, DLF, Hero Honda and Sun Pharma.

So the Index shall remain ever changing.  As our economy grows and changes, the changes in the Sensex composition will reflect the same. Telecom, Infrastructure and Real Estate are sectors which rose into prominence during the last Bull Run. Going ahead some new sector may steal the spot light and the heavy weights of today could see themselves pushed out of the Sensex if they fail to keep up.

There is a certain ease in passive investing or pure Index investing however, as seen from the data above, modifying weightages toward the Index heavy weights and adjusting sectoral exposure can help one beat the Index quite easily.

India 2020 or India 2040?

August 25, 2010 7 comments

Today’s ET has a chart on how India’s GDP has evolved post Independence. As you can see we have moved from a primarily Agrarian economy to a mainly Service oriented economy.

It is no wonder then that some of the biggest successes over the last decade have been companies in the IT/ITeS sector and other service sectors like BFSI, Retail and Telecom. The graph below shows how the share of services sector has expanded compared to the contraction in the Agriculture sector. It is a disturbing trend that the share of Agriculture as a % of GDP is dwindling given that it employs 60% of India’s population (directly or indirectly).

I was browsing through the GDP composition of some of the developed nations like US, Japan, UK, Taiwan and Germany. I noticed something very interesting in the composition of the economies.

All the developed countries have Agriculture as % of GDP at less than 2%.

Also the share of Industry varies between 22% – 28% and share of Services varies between 71-77% uniformly for these 5 economies irrespective of the path of growth chosen. Let us see how some of them have evolved till date.

1. US Economy – If we look at the US economy, it rose to prominence post World War II as an engineering goods, defense goods and automobile exporter. Later on the growth in hi-tech sectors like pharmaceuticals, semiconductors, telecom and IT made it the largest economy in the world. With increase in consumer consumption, sectors like retail and financial services increases many fold from 1970’s to 2008. This period saw New York emerge as the financial capital of the world. Also the US moved from a net exporter to a big net importer as of date. Simultaneously the savings rate in US has moved into negative territory over the last few decades. Capitalism and free enterprise is the most common reason quoted for the phenomenal rise of the US economy.

2. Japanese Economy – Japan on the other hand started with low cost exports in the post World War II period. The nation built its fortunes by exporting everything from cars, bikes to electronic goods to high-end engineering goods. The late 80’s in Japan saw a huge bubble in real estate and the stock market. The economy is characterized by high levels of domestic savings and over the last 2 decades, government spending has remained very high and bond markets dominate the financial landscape in Japan. The country still remains a net exporter in spite of the continuous appreciation of the Yen against most currencies including the USD.

3. UK Economy – The Industrial Revolution originated in UK in the late 1800’s. The economy of UK was characterized by Steel Mills, Textile Mills & Auto manufacturing in the middle of the 19th century. However, over the years UK has also changed into a Service driven economy and most of the manufacturing has moved to either Eastern Europe or East Asia. London emerged as the financial center of Europe competing with New York at a global stage. UK also witnessed a housing bubble and elevated levels of both public and private debt in the last decade. The UK is known for protectionism of smaller industries and various sops are given to these industries to enable them to compete against low cost nations.

4. German Economy – There is some similarity between the economies of Japan and Germany. Germany is the export power house of Europe exporting everything from high tech engineering goods, luxury vehicles to speciality chemicals. It has the highest per capita exports in the world. Rather than creating huge enterprises, the heart of the German economy is the Mittelstand (or German SME companies). They employ up to 70% of employees in private businesses and export up to 80% of their produce. Given their size they rely more on local banks than on Capital markets for funding their growth. The German government gives them sops and subsidies to allow these SME’s to compete against low wage countries of Eastern Europe and Asia.

5. Taiwanese Economy – Taiwan has a dynamic capitalist economy with guidance of investment and foreign trade by the Republic of China (ROC) government which governs Taiwan.  Taiwan is also highly export oriented and has the largest semiconductor facility in the world. Export composition has changed from predominantly agricultural commodities to industrial goods (now 98%). The electronics sector is Taiwan’s most important industrial export sector and around 70% of all semiconductor chips pass through Taiwan.

The point I am trying to make here is that all these economies are structured differently yet their GDP structure looks strangely similar.The chart shows how there is an uncanny similarity in the sectoral composition of these economies irrespective of the level of liberalization, time since liberalization, government regulation, domestic savings rate, exports growth, gross capital formation, demographics, development of capital markets etc. This is really strange as all these countries have vastly different underlying economies.

Also GDP = Consumption + Investment + Government Expenditure + Net Exports

The US and UK depend on Consumption and Government Expenditure for growth while Taiwan, Japan & Germany depend on Exports and Investment for growth.  Yet their sectoral composition remains puzzlingly same.

This raises a question that will India eventually have Agriculture as a % of GDP at less than 2%? Is this the defacto structure once an economy is fully developed?

If we assume that this would be the sectoral composition for any developed country then what would the GDP of India look like once it is fully developed?

For convenience sake let us assume that Agriculture will remain almost the same size going forward. Various reasons like lack of irrigation network, dwindling ground water levels, reduced area under cultivation and excessive use of pesticides and fertilizers can justify this argument.

The Indian economy is currently  $ 1.25 Trillion so the size of Agriculture sector is $ 212.5 Bn. If Agriculture were to stay the same size and be 2 % of the GDP, then the size of the Indian Economy would have to be $ 10.62 Trillion!!!

That means that Indian GDP would have to grow at 8.5 times its current size for this to be achieved. Let us assume that Industry as a % of GDP is at 27% and Services at 71% (average size based on sample of 6 developed economies). Then the overall picture would look something like this.

Now let us try to estimate when this may happen. Assuming a realistic GDP growth of 7% (given that the growth will decelerate going forward due to higher base effect), it would still take around 32 years for our economy to cross the $ 10 Trillion mark. So, India in 2042 could be a fully developed economy.

We are mostly going to miss the vision of being a developed country as per India: 2020 but maybe India: 2040 can be a more realistic target.

Note:- Maybe India will never have Agriculture as a share of GDP at 1 or 2% as the crop yields in India are low and average land size is small (so mechanization is not cost effective). Most of the developed countries use high degree of mechanization & technology in farming and hence it is possible for a small section of population to feed the entire country. In India however, 60% of the population is linked either directly or indirectly to Agriculture. The idea of the article was just to imagine a “What If” scenario and its possible implications.

The growth or decline of Agriculture over the coming decades can be debated but one thing is certain.  “Services” will continue to be a bigger and bigger portion of the GDP.

A 1.2 Bn+ population will need more and more of services like Telecom, Financial Services, Retail, Hospitality, Healthcare and Education. That space should grow well due to favourable demographics in the years to come.

Nominal Returns vs. Real Returns

August 16, 2010 3 comments

As an investor in equities, it is very important to understand the difference between real returns earned by an investor and nominal returns. If an investor wants to earn wealth over the long term he should focus on earning real returns of the magnitude of 3-4% over the risk free rate of the country (The risk free rate is the yield on the 10 year Gov Secs of the country – 7.75% for India)

Let me illustrate the concept better with an example.

DLF (India’s largest real estate company) went public in June 2007 with an issue price of Rs. 525/share. The stock listed decently and then went beserk and within six months reached Rs. 1200/share. After that the markets crashed and today the stock trades at Rs 320. In nominal terms the stock is down 39.05%. That may not seem very bad as several IPO’s in 2007 & 2008 are still in the red.

However, most investors do not focus on the “real returns”. It has been exactly 3 years since DLF was listed publicly. If an investor were to buy 100 shares of DLF during the IPO his investment would have been Rs. 52,500. As of date his holding value would be Rs. 32,000 i.e. a loss of Rs. 20,500 (ignoring dividends).

Imagine if the investor would have invested the same Rs. 52,500 in a FD @ 7.5%. Today, the value of the same would have been worth Rs. 65,220. Compared to the current value of the stock, the loss would have been much higher at Rs. 33,220 or 50.9%.

Here lies the difference between real returns and nominal returns. In nominal terms the investor has suffered a loss of 39.05% while in real terms his loss is much greater at 50.9%. In this scenario, there is a good 11% difference between his nominal and real returns.

This difference arises because nominal returns do not consider the time value of money. Over a period of time, there can be significant divergence in your returns depending upon how you choose to compute the same.