Buy Gold anyone?

(Warning: This post is unlike some of my others as this one contains an overdose of Tabular information)

Bloomberg: Feb 17th, 2012

“LONDON: Gold traders are getting more bullish after billionaire hedge-fund manager John Paulson told investors it's time to buy the metal as protection against inflation caused by government spending.

Speculators in US gold futures are now their most bullish since September after the Bank of England and Bank of Japan said they will buy more assets and the Federal Reserve said it was considering purchasing more bonds.”


I agree. While the world’s macro-economic fundamentals have improved, the markets too seem to have run up a lot over the past few weeks. And though not all companies are over-valued, one can see quite a few where the price rise seems without any fundamentals. In such a situation exercising caution wouldn’t be out of order. Hence, one could consider Gold as an investment.

Except that my definition of Gold is teeny-weeny different.



I like STOCKS that are equivalent of gold. Something that serves as a flight to safety when all else is disintegrating.

I had bought and had recommended Colgate in 2008. I had also commented about its stock performance during the crisis period in one of my blog articles (dated April 11, 2010).

Now allow me ‘lay’ down the reasons as to why I believe that it may still be a stock worth buying and retaining.

1. Play on the long term potential of India

In any company’s valuation, one of the toughest things to do is to forecast the future growth. In other words, we need to look for predictability of the earnings.

The FMCG sector is one where, especially in a country like India, given its demographic and GDP growth potential (no need to elaborate), the sales growth is almost a given. Hence, that is a logical place to start the research.

The BSE’s FMCG index has 11 companies listed and the table below shows the sales and profit growth for each of them over the last 3, 2 and 1 year periods. What we are looking for is consistency.



In case you thought 3 year figures are not long enough, pl. see below the EPS figures for the key companies (the ones not mentioned in the table do not have figures worth mentioning, hence deleted. In the case of Jubilant, the figures are only since 2007, hence ignored for the purpose of the analysis).



Just in case the print is not too legible, Colgate, Godrej and Nestle have provided long term (7-9 years) EPS CAGR of 22%, 27% and 21% respectively.

2. Good Dividend payout

Confession: I like companies that pay regular dividend and I have regularly used dividend yield as one of the themes for my investments. (I agree that this is at variance with Buffett’s teachings but maybe it’s a hangover from having worked on a regular income for so long in my life). The table below shows the dividend payout ratio for each of these companies.



In this respect, Colgate and Nestle are the noticeable standout leaders, distributing over 70% of their PAT as dividend. Colgate has the highest dividend yield (2.4%) amongst these companies.

Regular high payout % + increasing profits = increasing dividend

3. Leadership in the line of business

A commoditized business is typified by low profit margins, low return on equity, absence of brand name loyalty etc. In such a case, only the low cost producer wins. Even there, the business is faced with cyclicality, often debilitating the performance in the event of a glut or shortage.

It doesn’t have to be that way with a consumer monopoly (a ‘franchise’ in Buffett’s words). Colgate was awarded the # 1 brand position in India and was reported to have ~ 60% market share in the oral care market.

To state the obvious, oral care has low weightage in a monthly budget and hence has less price sensitivity. And with more money flowing to the rural sector, more villagers are likely to substitute their local concoction with a Colgate toothpaste and brush. And this is actually happening. Whenever I happen to travel through far-flung villages (especially in the hills, which I love to visit every once in a while), I see the evidence of Colgate’s distribution. (As an aside, toothpaste consumption in the country is at 0.07 kg per capita as compared to 0.40 in Thailand and 0.61 in Brazil).

I also like the fact that Colgate’s is a mono-line business unlike, say, an ITC, which sells tobacco as well as runs hotels and has a paper related business AND also sells Bingo potato chips.

4. Superior economics of business: High return on capital employed

Last year, there were only about 40 listed companies in India above the market cap of USD 100m (and with debt to equity of less than 0.1X), which reported a return on capital employed in excess of 30%. (There is no logic for my benchmark of 30%, it is just a high enough figure for a country like India which has had inflation levels of 10% in the not so distant past).

Obviously then, a company that can make returns in excess of 30% consistently is bound to be unique. (Why is having a high return on capital important? Well, for starters a consistent high return on capital is an indication that the management is not only making money, but is also employing the retained earnings to make more money for the shareholders. It’s just about the power of compounding! Higher returns will mean more profits – it’s as simple as that).

Amongst the FMCG companies, the table below shows the returns on capital over the last 7 years. Amongst these, Colgate, HUL and Nestle tower above the rest.




5. Consistent performance in the stock price

Carrying on from the previous points, if a business does well shouldn’t the stock follow? The following is what these stocks have provided their owners in excess of Sensex returns (without including dividend).



There are a couple of things I’d like to bring out of the above table:

a) At the risk of repetition, these are the returns above whatever the sensex has returned
b) Companies like Colgate (and Godrej, Marico, Nestle etc) have performed well (business and stock performance wise) even during the uncertain period of 2008/ 2009, earning themselves the status of safe haven or ‘Gold’ stocks
c) Performance of most of these stocks have faltered in the stock market over the last month or so, as the liquidity has chased the most undervalued (and in some cases speculative) stocks. In this respect I remind the readers of Ben Graham’s adage that in the short term the market is a voting machine, but in the long term it is a weighing machine. Performance will eventually win, which means that this may be an opportunity at the current moment.

6. Low beta

The safe haven status on some of these stocks implies low beta, as shown below. This is something I wouldn’t mind in case there was to be crash tomorrow (and I am not saying there will be).



7. Valuation

I haven’t forgotten that price is everything in a purchase! Below is a table that compares the companies by the ratio of their Enterprise value to PBDITA (essentially EV to cash generated).



Before the conclusion, let me recap.

I have tried to demonstrate that in terms of the earning power, dividend payout, consumer franchise, return on capital employed and stock returns, Colgate (and Nestle if I were to add another name) truly make a mark. At the same time, they have also proven to be all-weather friends even when Mr Market decided to go into a manic mood.

So for all the benefits listed above, is paying 24X cash for Colgate expensive?

Well, let me put it this way – it is not cheap… Yet, simplistically, if Colgate grows it’s EPS at 22% p.a., with all the other attendant benefits as explained earlier, then 24X on EV to cash doesn’t sound so bad. The 1994 purchase of Coca Cola by Buffett was at 22.5X.

But having said that, if the growth doesn’t happen the way it has had – for whatever reason – then the market could be unforgiving. Remember that the HUL stock languished between Rs 200 and 250 from early 2006 to mid 2010 because of performance issues.

But… all said and done, we are talking about Gold here! And Mr Paulson says ‘Buy’! So I plan to add a bit in my portfolio, if only as an experiment.

Readers will obviously need to decide for themselves.'

Noise

NOISE



Nowadays whether the markets fall or rise, the experts tend to be equally surprised.

I have no hesitation in admitting that I have been as surprised by the stock market upswing as any other bloke.

And I am not even an expert.

Problem is, whenever there is a major movement in the markets, vividity takes me right back to the dark days of 2008 and a rise or fall seems equally fraught with danger. Dusk and Dawn are similar to look at after all.

The feeling of ‘Deja moo’ takes over. What if the rise is a dead cat bounce? What if the fall is the first step towards the 55% fall in 2008?


Meanwhile the experts all over the world are laying down their arms. As per a report on Bloomberg, strategists at the biggest banks are capitulating on their bearish forecasts after the best start to a year for global stocks since 1994.

Two weeks after saying that investors should “remain cautious,” Larry Hatheway, the chief economist at UBS AG, raised his recommendations on global shares and high-yield bonds in a Jan. 23 note to customers entitled, “Wrong, but not too late.”


As per a book called ‘The Zulu Principle’, both bull and bear markets have several different stages. In a bear market for example, stage 1 is usually a sharp fall during which economic conditions remain positive.

In stage 2 economic conditions deteriorate but the market becomes over-sold.

There is then a sucker rally, powerful enough to persuade most investors into believing that the market has bottomed.

During stage 3, the economic news becomes awful. Investors panic and sell at any price. The market declines very sharply as the downward spiral becomes self-feeding. Stage 3 is only over and ready as a springboard for the next bull market when investors abandon all hope for the future. The first positive sign will be that shares no longer fall on bad news.

That’s fine and dandy. But how does one figure out if this is a sucker rally or the end of Stage 3?


And what’s caused the recent rise anyway?

It’s almost as if people were just waiting for 2011 to be over before they wipe off the cobwebs on their cash piles and jump into the markets like this is all they were forever waiting for.

Meanwhile:

Did the European crisis get solved? Well, not really, no.

Did Greece, Spain, Portugal and the others manage to pay off their debtors? No..

Did the Israeli PM just tell Iran ‘let bygones be bygones’; Iran is Israel’s long lost brother? Er.. No.. There are enough indications that there could be a unilateral strike by Israel sometime in March.

Did US and UK’s debt levels come down? Of course not!! ‘Austerity drive’ everywhere is just polite noise from politicians. Everyone has one eye on the elections (the statement could be true from Greece to US to India).

Did China’s GDP just go up by 10%? No.. Recent reports suggest that China’s GDP could fall by HALF if Europe goes into a turmoil.

Did India’s Government just decide to be investor friendly and were the ‘policy inactions’ fixed by the Government? NO! (I don’t even want to elaborate on this.. you trying to embarrass me??)


OK, so what the heck is going on?

Niels C. Jensen of the Absolute Return LLP is someone whose writings I follow carefully.

In a recent note he writes: “The ECB’s balance sheet has expanded almost 50% in the last six months to €2.7 trillion and it doesn’t stop there. The balance sheets of the 17 eurozone central banks have grown even faster and now add up to €1.7 trillion, creating a consolidated balance sheet in the European central bank system of €4.4 trillion, almost twice the size of the Fed’s balance sheet.

“There is no question that the liquidity made available by the ECB has eased the liquidity squeeze in the European banking system and thus provided some much needed energy to the equity markets.”

He further makes an interesting differentiation between Economists’ Hypothetical Time (EHT) versus Real Market Time (RMT): basically suggesting that market practitioners (those who manage money and thus have an effect on markets) are forced to operate in RMT if they have any desire to make money for their clients.

Thus, as per him market practitioners no longer care about Greece or about Portugal. Instead they are now entirely focused on whether Italy and Spain can ride out the storm. And as per him, on the evidence of the recent performance of European markets, the verdict is that they can.


There you go.. The last of the dominoes just fell. The above, in my view, very eloquently explains the reason for the increase: The heady mix of liquidity and money managers’ frustration at being made to look like fools by holding on to cash while the markets went up.


As for me, purely by instincts since everyone is now positive, I tend to be the reverse. It helps that I am not answerable to too much ‘external pressure’ as of now.

I recently did a review of the portfolio under my management; tactically exiting some stocks that I felt had reached their optimal value. These included some mistakes, eventuating into losses. This freed me up with some cash in case some good opportunities come knocking.

Yet, I am holding on to the ‘long-term positions’. These are stocks that in my opinion will accrue positive returns to me over the longer period of time, notwithstanding the short-term blips. A list of such stocks is the topic for another note. More important for now is to explain my rationale.

Forget the Noise. Think longer term.

Firstly, like I said, after the 2008 knockdown in the markets, I am able to sleep more peacefully by being more conservative. Hence keeping cash on the side helps in case 2012 becomes 2008.

On the other hand, longer term, there is nothing better than equity in my view. This is one of the only asset class where the underlying value can be assessed closely. One can decide whether to pay 3x or 5x or 10x the earnings/ cash for a stock. But the underlying the valuation is visible: earnings (or cash on books or whatever). How does one decide the optimum value for Gold, for example?

For a company that is likely to have a growing trend on earnings or one which has some other hidden value, one has to stick on, no matter how the market behaves.


Prof. Shlomo Benartzi, an authority on behavioral finance, in an interview differentiated between Loss aversion and the myopic component of investing. We all suffer from one or another every once in a while.

Loss aversion refers to the fact that people think illogically about losses, so the pain of suffering a loss is about twice that of the enjoyment and pleasure of having an equivalent gain.

The myopic component occurs because people tend to count their money very often they tend to be myopic, i.e. they focus on short-term gains and losses, rather than taking a long-term perspective.

As per him, the “typical” investor has a horizon of about one year (BTW, one amazing stat quoted in Niels Jensen’s note was that the average holding time of a stock in US is now 22 seconds! Blink an eye and the stock got sold. Go to the loo and the entire portfolio got bought and resold!).

Prof. Benartzi goes on to say that if people count their money less often they would put more money into equities and the equity premium would probably be lower. Accordingly, he tried to focus on how to stop people from focusing on short-term losses.

To do this he conducted a few experiments. In one of them people were presented with an annual return on a stock fund and a bond fund and asked to decide how much to put in each fund. In this case they put about 40% in stocks.

In another version he showed people what the returns would look like over a 30-year horizon. Now they put 90% in stocks.

That’s because they stopped thinking about short-term losses.


Returns Since %

1992 (20 years) 778%
2002 (10 years) 420%
2006 (5 years) 95%

And these are just the sensex returns. Any individual stock picking strategy should yield much more.

Need I say anything mooore?