Why do stocks go up?

Why do stocks go up? Benjamin Graham, the father of value investing was asked that question. And his answer was: I don’t know.

Many others are less frank. Some say it has to do with earnings, others say it has to do with the market fancy or hype. For most others, it is akin to asking a question like, is there life anywhere else in space – some will say an emphatic “yes”, others will say “no” and many others will shrug their shoulders and say, “who knows?”

On Jan 31st of this year, I looked at a stock called ‘Standard Industries’, which looked cheap. It was then priced at Rs 24 with a market cap of Rs 154cr. Its main line of business used to be chemicals and textiles at one point in time (it is a 104 year old company). However it lost its way on the main business. But here is the twist: fortunately it had 93 acres of land in navi mumbai. They asked a Singapore company to develop 30 acres and recieved around 230 cr. for the same last year.

Why it looked cheap was as follows: While the company was valued at Rs 154cr., it had Rs 139cr. of hard cash sitting on its balance sheet. And it had 63 acres of land left from the original 93 acres.

So if one was to extrapolate the value of the 63 acres of land on the basis of what they had received for the 30 acres, it meant that it had land worth at least Rs 460 cr. With the hard cash of Rs 139 cr., the company should have been valued at almost Rs 600 cr. Against this, the current market cap was of Rs 154cr. More or less at a quarter of its value.

Being on a day job and working out of Singapore, I requested a friend, a professional and a past master in this field, to find out why the market was treating the company so shabbily. He found out through a colleague that there was indeed no reason for the market to not recognize the value. But there was a problem. The volume was very low and so buying a meaningful quantity was difficult.

Meanwhile, within a month and a half of this dialogue, here is what happened to the stock price:



And ofcourse the volumes went up too.

Hence, to ask the earlier question in a more pointed way, what has changed between February of this year and now, when the price is pushing Rs 52 a share (117% increase)?

Well nothing as far as the company is concerned. There are no announcements from the company, no news announcement far as I can tell. Note that it has still not reached anywhere close to its true value, but once the market decided that it is undervalued, it was being bought like it had just been launched.

And the answer is??

Well I am in the category of the ‘shrug-your-shoulders-and-say-who-knows?’ But I can quote something else from Ben Graham, which has remained with me ever since I read it:

If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

Day-to-day price changes can be inexplicable. And that's a really good reason for not watching one’s portfolio too closely. Concentrating on the company's intrinsic value and acting on it is far healthier than worrying about why stocks go up.

Shinier Teeth or brighter clothes?

Looking at my personal portfolio, one of the stocks that has returned me ~ 100% on the original investment (made around 2.5 years back) is Colgate Palmolive India.

Browsing through my research notes of the time (Q4 2007) when I had done the research on the company, I had written the following:

Result: Financially a strong company, debt free, cash rich and generative, knows how to keep shareholders happy either by giving higher dividends or as happening now, by returning capital (deemed dividend). Has deep franchise value in the market and consequent high ROE (50%+).

Now, just as a perspective, this was a time when the stock market was reaching dangerous levels and the markets were about to crash at the start of 2008. The chart below shows the price movement of the company as it charted through choppy waters of the economic meltdown and beyond.



As is evident, the stock has returned around 64% or so in the last one year, which is really around the same as that of Sensex so I wouldn’t call it an extra-ordinary performance in a relative sense. The real extra-ordinary performance was in the fact that it provided the rest of its increase in value (40%) during the time the markets were discarded like old fashioned trousers by the investors. So in that sense, it served its purpose for me as a great hedge against the uncertainties. Perhaps like Gold would have.

On the other hand, I looked at the performance of another wonderful company of our times: Hindustan Unilever Limited (HUL) (which I don’t own).

This company, like Colgate, also has super ROE of over 50% - last year the ROE was over 100%. And it is MUCH bigger in size than Colgate. It is also a company’s whose financial management is the matter of folklore amongst finance professionals (I did a project on its working capital management when I worked for Modi Xerox and then again looked at its insurance management – they had a unique system of self insurance – when I was at PepsiCo India. In both instances we implemented the learnings from my projects and saved a lot of money for the respective companies).

This is a company that generates to the order of around Rs 2000-2500 cr of free cashflow every year, has around Rs 2000 cr in liquid or near liquid assets, has a negative working capital and has some of the best brands and minds in business.

When Professor Greenwald (Columbia University) had come visiting India in January of 2008, he had singled out this company as the one to invest in, given the times that we were headed into (I remember it was only a few days after his warning at the conference that the world stocks went into a tailspin).

And HUL’s subsequent price performance (shown below) right through the crisis has proved Professor Greenwald’s words entirely true:



However, unlike Colgate, the price performance of HUL has languished in the past year. In the last one year, it has returned 2.5%. Comparatively, the Sensex returned over 65%.

So unlike Colgate, which has continued to perform in good times and bad, HUL has served the investor well only during the bad times.

The difference in the 2 companies lies inter-alia in the growth rates – and we know the market is obsessed with growth. Colgate has done supremely well on this front– growing its topline by around 15% and more (quarter over previous year quarter). And its PAT has grown by even a higher percentage.

HUL on the other hand, has had an anaemic growth in topline and its PAT has in fact shrunk. This is the result of its ongoing ‘Detergent wars’ with P&G (which I might add that it has been on the losing end of) and earlier due to a severe cost inflation.

This ofcourse may be a simplistic explanation and there could be many other factors – like management quality etc, which I do not have enough knowledge about.

The comparative story of these 2 stocks provides me with many important lessons, 3 of which are:

Firstly, this debunks the theory that a ‘good company’ (which HUL surely is, looking at its brand value and financial solidity) equates to a good investment. In fact compared to both HUL and Colgate, there are many stocks that have returned over 200% in the last one year alone. Even now, HUL is valued at over Rs 48,000 cr (USD 10bn) in the market, which to me, still looks rich. But then so is Colgate looking at its present price, though the latter has growth in its favour.

Secondly, what may be a good investment during a certain period may NOT be a good investment during another period. HUL was a ‘safe’ stock during the crisis due to its financial solidity. At that time, most investors were more worried about the return OF investment than return ON investment (incidentally something which we should always remember).

And surely in that respect, HUL had all the hallmarks of safety. An FMCG company in a huge market, great brand names, no debt and steady cash flows. Growth was not important. But when the economies became steadier, every investor headed for the greener pastures. Suddenly the same company LOST in market value despite having more cash on its books and having had a more profitable year than earlier.

Lastly it reminds me that the price of purchase is all important. I wouldn’t buy Colgate at today’s prices because the growth is factored in it. But there must have been a time when HUL was much more expensive than it is today. Its price in 2006 was higher than now by 33%. So in a sense, the stockholder who purchased the stock at that time has really paid the price (pun intended) of buying the stock expensive.

Neither did they have the benefit of the bull market of 2007, nor the recovery of 2009/ 2010. They only had the pleasure of knowing that they did not lose as much as others did over 2008.

As a parting shot, I would say that what may seem uninteresting today may not remain so forever. Managements and companies change every now and then, and so should opinions. If HUL were to come back on a sustainable growth trail with a brilliant marketing strategy that blows P&G away, then who knows – it may yet again become the stock market’s darling.

That’s the beauty of the stock market. It has time for everyone – the shining teeth as well as the brighter clothes.

Here we go again

Yippee!!

It is not yet like the ‘old times’ but I sure hope it is a start. Late last week’s global sell-off was almost as good as anything we have seen since the worst fears of the crisis began to abate last spring. The fear is back and for some, the rebound is just a memory.

We all know why it happened (though I have to admit that for me, the reason is not that important – if we were to believe in Taleb, there could have been ANY reason for the markets to fall. After all there was so much belief in the ‘green shoots’).

But still a quick run through on the reasons being quoted:

Firstly, there is this lack of confidence in the European governments' ability to repay their debts. So fears over Greece added to a troubled auction of Portugal's debt. Which then were added to the concerns that actually Spain's bigger economy could be in even deeper trouble than Greece or Portugal's. And ofcourse there are the issues with Ireland and Italy.

(Altogether, there is an acronym for this combination of countries – PIIGS. Not a very adorable term if you happen to be from any one of those countries). See chart below which depicts 10 years government bond spreads for each of these countries (specially note Greece’s trend line – not yet a Greek tragedy but maybe a Greek drama).



And to these concerns over sovereign debt came the news of rising unemployment in the US. For all one knows, there could be a glitch in the data compilation – if it can happen to reports on melting glaciers, why can’t it happen to jobless claims data?

Notwithstanding how the data came about, there were 6 per cent more new jobless claims last month than in December. This was certainly not in the script that the ‘markets’ were waiting to read.

“If you're not confused, you're not paying attention”

Ofcourse we know what effect it had on financial markets. On the equity front, the Emerging market equity funds lost $1.6 billion in weekly withdrawals, the biggest outflows in 24 weeks. Even Gold and crude were no exceptions. See the chart below.



“Expert: Someone who brings confusion to simplicity”

The interesting thing however, is the change in tone of the commentators and the role played by the media in hyping such events. I am not sure whether in such times all commentators change their messages from positive to negative or the media only reports the negative side. I suspect it could be a combination of both.

So amongst others we have reports of JPMorgan Chase saying that it was turning “less bullish” on developing-nation equities in the first half of 2010 and the term ‘double dip’ beginning to mean a bit more than dipping your favourite tea bag a second time. Naseem Taleb has also reportedly said that if there is one trade that every human should have, it should be shorting US Treasuries.

“One man’s meat is another man’s poison”

On the other hand, there are others like Kraft Foods, the maker of Oreo cookies, who have just issued bonds for its takeover of Cadbury Plc. Pepsico did the same for its acquisition of 2 of its bottlers. In fact companies in the U.S have spent the highest portion of bond-sale proceeds in more than a decade for acquisitions and expansions. This was ofcourse led by Warren Buffett’s “all- in wager” on a US recovery (purchase of Burlington rail by Buffett) and taking advantage of the lowest borrowing costs since 2004.

So everyone obviously doesn’t think alike. And these mixed signals are exactly what creates the confusion. And by the way, this also tells us why someone buys stocks when exactly at the same time someone else is selling (buy has to equal sell at all times – if everyone was a seller at a particular time, who would buy?). And so it is in times like these that value investors start to find bargains.

A couple of mispriced stocks came on my radar over the last little while. Two of them are Aditya Birla Chemicals (earlier called Bihar Caustics) and Visaka Industries.

Aditya Birla Chemicals (ABCIL) – CMP 77/- ; PB of 0.6; market cap of Rs 170cr

The company’s main products are caustic soda and chlorine. The industry has been plagued by over-capacity (more than 80% new capacity has been added in the industry both within and outside India) and countries like US and China have reportedly resorted to dumping in the Indian markets. In consequence, companies like ABCIL and Gujarat Alkalies have been forced to cut prices. This has led to a recent fall in their realizations and hence profits.

However, the interesting thing is that over the last 6 years, ABCIL has had a free cashflow (pre capex) of Rs 50-60cr a year. Also, their known capital expenditures seem to be over and they have repaid quite a bit of debt. Hence, at this point in time, the market is valuing the company at ~ 3.5-4X its yearly free cash generation.

This company therefore could become a rerating candidate – that could happen in case there are ‘surprisingly’ good results over the next couple of quarters (that in turn could happen if the prices of caustic soda trend upwards). Or they may decide to do something with their extra cash (as mentioned their capital expenditure now should be limited). For example, they may decide that the market is not rating their company fairly and may do a buy back. Either way, this is a cheap company (which could well become cheaper, but that should not matter).

Visaka Industries – CMP 123/-; PB of 0.87; market cap of Rs 200cr (USD 45m).

This company manufactures asbestos cement products. The business has been showing a growth YOY and QOQ. It has paid a minimum Rs 3 as dividends since 2005 (around 2.5% yield at current prices) and over the last 6 years, the company has had a free cash flow of around Rs 25-30cr. This company is what we would call a ‘GARP’ (growth at reasonable price). Demand for the company’s products are likely to go up, as these are attractive to the rural market, being affordable as well as weather and fire proof. These are therefore natural upgrades from thatched and tiled roofing that exists in many parts of the rural housing.

“I have nothing to offer. Except my own confusion.”

As an aside, I was re-reading Malcolm Gladwell’s “Outliers’ recently. The concept behind the book is that when we hear the success stories of some of the biggest names like Bill Gates or The Beatles, we conjure up visions of brilliance and the extraordinary talent they have/ had. However, by diving deeper into the lives of a few of these successful people, the writer illustrates that there was much more to the success than just talent. It was about being born at the right time.

In a similar way I believe that by being born in an era where the balance of global economic power is shifting eastward, we too have a historic opportunity available to us. To be able to get good returns in the right priced opportunities available in places like India or China.

And the more the prices fall, the better the probability that we can realize the historic opportunity quicker. So let the confusion reign – its better for investors like us. There is no confusion in my mind on that.

Gold Ahoy!

I have to admit. It’s not my forte. And that’s why I decided to put some research into it. With the gold prices going sky high and some well known investors like Jim Rogers and David Einhorn recommending that some part of the portfolio be dedicated towards gold, it certainly deserved serious attention from an investor.

A bit of background

Gold has been valued from the early Bronze Age. The first known gold objects, dating possibly as far back as 5000 BC were Egyptian ornaments, ritual vessels, and personal jewellery. Gold’s high melting point and resistance to corrosion made it indestructible and very useful indeed.

Goldsmiths in the 17th century issued certificates representing gold on deposit, which were among the earliest forms of gold backed paper notes. When the Bank of England was created in 1694, it mainly financed government debt by issuing these notes.

Safe Haven

“Europe collapsed and North America collapsed!”, said the Indian finance minister, Pranab Mukherjee as he announced India’s purchase of 200 tonnes of gold from the IMF. This purchase was the single largest central bank purchase in 30 years over as short a period as a fortnight.

This must have been a BIG decision by the country’s think tank considering that this constitutes over a 50% addition in its gold reserves. After the purchase India now has close to 560 tonnes of gold (about 6% of the reserves in value), that’s the ninth largest gold holdings amongst central banks. China on the other hand has grown its gold reserves by 75% vs. last year (as of now China has around 1000 tonnes of gold, constituting around 2% of its reserves). Compared to some of the other nations like Germany (69%), Italy (66%), France (70%) – this is still a miniscule percentage.

And therein lies the logic of the gold purchase by India and China – diversification of risk to assets other than USD. At a governmental level, it pays more to safeguard the country's assets than to look for returns.

Gold and Dollar are considered the world’s primary safe haven investments. If the confidence in Dollar collapses, gold then takes over as the world’s sole safe haven investment. In that sense, gold has historically provided a low and even negative correlation with most other asset classes and has been used as a portfolio diversifier whenever there has been a perceived high level of risk.

As the following chart shows, gold rose from USD 100 per ounce in the period ‘75-’78 to a high of USD 750 per ounce around the early ‘80s. This was a period marked by high credit (average annual credit grew by 11%) and at times higher inflation (average inflation rate of 12% in 1974 and again in 1979-1980). Investors flocked to buy gold as confidence level in the world economies fell.



Just immediately after this, gold’s price fell massively (in 2000 it was back to around USD 250 per ounce) as monetary order was restored and the economy and stocks soared.

Moving back to the present times, with the US Congress spending billions of dollars in stimulus funds to jump-start the economy funded almost entirely with debt, the dollar has become weak since currency investors tend to shy away from high-debt countries - just like in equities where (all other things being equal) we would not prefer to invest in a company that is highly levered.

In the case of a country, a high level of debt also causes higher inflation, another reason for investors to stay away from USD and hence moving into the only other known safe haven – gold.

Resultantly, the yellow metal now rules over USD 1100 per ounce. This means a return of over 50% over last year.

Crystal Ball gazing

So with gold now at the USD 1,100 per ounce levels, bets are being placed on what could be the next probable price target. Wild guesswork is at work, as is usual. And some say that even US$ 1,500 by the end of 2010 does not look like a very tall order.

It was reported that Barrick Gold, the world's largest producer of gold is moving to completely close its hedging operations as it does not believe that gold prices could fall a great deal from here. The company feels that global output has been falling by roughly 1 m ounces a year (approx 33 tonnes) since the start of the decade and hence, there is a strong case to be made that we are already at 'peak' gold.

And with central banks around the world also turning into net buyers of gold in recent times, supply crunch is likely to worsen a great deal more, taking gold prices even higher.

Barrick is not the only one betting on higher gold prices in the future. Marc Faber, one of the world's pre-eminent investors has also jumped on to the bandwagon. "We will not see less than the US$ 1,000 level again", he is believed to have said at a conference today in London. "Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold", he is reported to have said.

Even the best can’t be right all the time

The average investor is blindly following these noteworthy men.

But as the earlier chart depicting the gold price showed, gold as an investment suffers from the same malaise as any other investment. Buy at a high and the probability increases that you will lose.

Notwithstanding what Barrick believes, the Fortune magazine has reported that gold miners invested more than $40 billion into new projects since 2001, and they "are now bearing fruit." Bullion dealer Kitco "predicts that these new mining projects will add 450 tons annually -- or 5% -- "to the gold supply through 2014, enough to move prices lower." The demand also brings out sellers of scrap gold, which adds even more to the supply.

All this while world demand for gold (as in the demand from the ordinary consumers) has dropped 20% in the past year. In fact according to the World Gold Council, India's gold demand dropped 38% in the second quarter, with jewellery purchases down 31% from a year earlier. For India! This is where everyone loves gold!

By the above logic, if the supply is going to move up and the consumer demand is down, the only reason that the gold will continue to rise in the future is if the investors continue to buy more gold.

Don’t know if it is the right comparison, but this sounds like a giant Ponzi scheme. As long as there is fresh demand from investors, the prices will rise. And we know these don’t last forever. Remember oil DID NOT reach USD 200 per barrel from the USD 130 levels or so, despite a lot of the so called experts preaching that it might.

What can turn the tide?

Very clearly the return of the US economy back on track.

As mentioned earlier, all things considered, gold is essentially a bet on the collapse of the current monetary arrangement based on paper currencies. And although the US dollar might look like it is overvalued and prone to collapse, what if the US economy does not collapse and actually recovers and the Fed starts raising interest rates?

Mr. Buffett is already betting on it.

“It’s an all-in wager on the economic future of the US. I love these bets... America’s best years lie ahead, no question about it” so said the sage of Omaha, Warren Buffett as he announced the acquisition of Burlington, a US railroad company at a total price of USD 44bn, his company's highest investment thus far. Ever.

As for gold, he had the following to say:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

(Fittingly one commentator used the above to say this about printed money: “It comes in abundance from trees with little to no efforts, we print as many as we want and assign whatever value to it, but we make certain it contains official looking faces and logos so that we can pay people with it to stand around guarding it!)

So there. After all the research, I have to admit that I still don’t know how to value gold like I would value a company. Which means that if I can’t invest in (Indian) equity, which at this point in time seems the case, then gold doesn’t look the right choice of investment either. Back to square one.

Umm, and Indian equities?

Well just because the US economy is looking to come out of the doldrums and Mr Buffett is betting big time on it, I am afraid it does NOT mean that the Indian equities will follow suit. This could well mean a flight of capital from emerging markets like India and back to US (I referred to this in my last blog entry too), with obvious effects on the market levels.

Meanwhile, the best strategy in my view is to keep smiling that golden smile and hold on to the cash. The time to invest will come.

Whither the markets?

Whither the markets?
November 1st 2009

In the Indian family context, until the first child is born, the question that a couple is most often badgered with is - when is the good news coming? Atleast that was the case over a decade back (thats when we had our babies, so obviously after that thankfully we stopped getting those questions).

And in the context of the stock markets, though the 'good news' had been discounted for a long time (remember the 'green shoots'?), yet when it actually came, there was much excitement around it. I am referring to the latest numbers reported for the US economy showed that the US GDP had grown by 3.5% YoY during the quarter ended September 2009 (3Q09). See the graph below.



For real?

Many though, are still doubtful whether this is sustainable. This is given that a large part of this growth in US GDP has been brought about by the government's stimulus program that has helped raise consumer spending, and housing and automobile demand.

For instance the cash for clunkers program. This is the program wherein the US government was offering a cash subsidy to consumers to exchange their old cars for new ones and was done with a view to bail out auto companies, which stood on the brink of bankruptcy. This has pushed up the automobile output during the September quarter by a massive 158% YoY, which in GDP terms, according to the US Bureau of Economic Analysis, added around 1.6% to the US GDP growth figure reported. Thus without it, GDP growth would have been only 1.9% (3.5% minus 1.6%) during the third quarter.

Sauce-Bearnaise Syndrome

I heard of this term only recently. Basically if you end up eating something that violently disagrees with your system and you end up vomiting, you'll likely find yourself suffering from Sauce-Bearnaise Syndrome. Otherwise known as taste aversion, it causes us to associate the taste of the food we've puked up with the illness that caused it to such an extent we're unable to face eating it again.

If from my notes you get the distinct feeling that I am being too pessimistic in my views of the stock market, then you know the equivalent of the Sause-Bearnaise syndrome is working on my mind where investing is concerned. I still haven’t quite forgotten the paper losses of just a few months back.

People who came out of the Great Depression in the US are known to have been highly risk averse when it came to investing. Including the great Ben Graham, the eventual teacher to some of the greatest minds on the investing landscape, including Warren Buffett and Walter J Schloss. So I am in August company where this feeling is concerned.

The sky is falling!

I read somewhere that losing in the stock market is an everyday reality: Stock prices go up and down daily. Inflation corrodes the purchasing power value of investments-day after day. The challenge-and the opportunity-is to lose less.

General George Patton said it this way: "Let the other poor, dumb son-of-a-bitch give up his life for his country." They are all talking about the same thing: Don't be heroic. It doesn't pay.

I am not the only one with the feeling that notwithstanding the streaming economic good news, all is not well in the stock markets.

Renowned economist Nouriel Roubini said on Oct 31st that we can possibly have a market crash all over the world. The reason? He is of the opinion that everybody is currently busy shorting the dollar, borrowing and investing in assets all over the world. That has helped push the dollar to a 14-month low.

People are essentially borrowing at zero percent interest rates in the US and investing in other countries, which is even more beneficial for them because we currently have a falling dollar. But according to him, the dollar will eventually rebound. And when that happens, everyone will have to close their short positions and dump their assets, and this is how we can have a market crash all over the world all over again!

A journalist on the FT, who I respect for his views also said that the next ‘correction’ in the stock markets will be caused by the foreign exchange markets, predominantly the US Dollar.

There is no doubting that the greenback has taken a beating. The rupee has gained ~5 per cent since this time last year, the euro has gained ~18 per cent, gold has risen in value by 17 per cent against the dollar since the start of the year etc.

The oil-exporting world is worried, since oil is priced in dollars. As is the Indian infotech industry since the bulk of its earnings are in dollars. The Chinese are practically paranoid, for they are the world's biggest lenders to the US. You would be too, if you had invested $2.27 trillion mostly in US government bonds. The governor of the People's Bank of China, wrote in a recent essay that the world needs a new global currency to replace the dollar.

Some of the dollar's recent losses are, of course, a manifestation of the perceived return to normalcy in the financial world, and a reversal of global capital's "flight to safety" in the dollar last year at the height of the financial crisis. As appetite for riskier investments returns, capital is moving out of the dollar comfort zone in search of better returns.

But more deep-seated concerns about the structural weaknesses in the US economy -- principally, a toxic mountain of debt and the absence of a strategy to overcome it -- are giving rise to a chorus of concerns that the dollar is at risk of collapsing and being dislodged from the pedestal of its global reserve currency status.

As if till now you weren't convinced of my negative views on the markets, I am going to quote another interesting article - this time something that I saw on the Wall Street Journal. This one said that the markets in the emerging economies could be headed for a downturn irrespective of how the developed countries fare in the future.

Basically as per this theory, if the US and Europe continue to grow sluggishly, countries relying on exports such as China and Brazil will be hit hard. So if the world economy slows further, commodity prices will plunge. On the other hand, if the US economy for instance starts growing at a strong pace, interest rates will head upwards and the dollar will appreciate thereby taking the sheen off emerging markets.

Damned if I do, damned if I don’t!



Despite the interesting insights that these theories provide, why should we concerned on this? Because foreign money flows into the Indian markets are the ones that move our markets. As seen from the chart above, there emerges a very close connection between how FIIs (foreign institutional investors) have behaved in the past and how the Sensex has danced to their tunes. And as compared to the FIIs, inflows from Indian mutual funds have been relatively steady and small.

When Warren Buffett was asked in 2006 whether there was a bubble in commodities, Buffett observed that, like most trends, it was driven by fundamentals at the beginning and then speculation takes over. 'As the old saying goes, what the wise man does in the beginning, fools do in the end.'

This was in the May 2006 period when the stock market was booming, just ahead of its correction. Every second fund manager was aware of the market's potential fragility and Buffet's analogy resonated with many investment people. 'It's like being Cinderella at the ball,' he said. 'You know that at midnight everything's going to turn back into pumpkins and mice. But you look around and say “one more dance" and so does everyone else. The party does get to be more fun-and besides, there are no clocks on the wall. And then suddenly the clock strikes twelve, and everything turns back to pumpkins and mice.'

For us, this means that till the time the FIIs decide to stick around, well and good, but when its time for the clock to strike midnight - for whatsoever different reasons - could be the dollar, could be their reporting periods or their percieved attraction to another market - they will go home.

And?

Well, while everyone has to have an their own independent line of thinking on investments. From my standpoint: Wait.

Mohnish Pabrai, said in an interview recently that one of Warren Buffett’s key trait that he has followed is that “you make few bets, you make big bets, infrequent bets and you only make bets when the odds are heavily in your favor.”

I so whole heartedly agree. I was having difficulty finding real values in the Indian stock markets. And notwithstanding the recent ‘correction’ in the Indian stock markets (probably caused by the exit of some fickle fund money), I am not waiting with bated breath on the big crash which may or may not happen. I would invest when the odds are heavily in my favour.

It is in times like these when interesting opportunities usually start to appear. I hope I can write soon about those.

Because that would be the real good news.

Armageddon Off The Table?

Armageddon Off the Table?

It was reported recently that 2 new luxury flats in Hong Kong had been put on the market for a record per square foot price of HK$75,000 (US$9,640) as the buoyant economy and stock markets on the Chinese mainland had lifted demand for exclusive properties even beyond pre-crisis levels. Sun Hung Kai Properties, the world’s biggest developer by market value, now aims to sell the three-storey apartments – on the 91st to 93rd floors of twin 270m towers – for HK$300m each, HK$50m more than previously priced.

Singapore Property Price Index had risen so much so fast that in fact the government had to recently take steps to cool down the housing market.

The Standard & Poor’s 500 Index has had the biggest rally since the 1930s as it has climbed over 50 percent in six months; the Shanghai Stock Exchange Composite Index nearly doubled from November to July before pulling back last month and the Indian stock exchange has almost doubled from its lowest point this year.



On the other hand, Nuriel Roubini, the NY University professor also known as “Dr Doom” who in 2006 foretold the worst financial unraveling since the Great Depression wrote in the FT that, “There is a big risk of a double-dip recession,” He had earlier written in March that the advance was a “dead-cat bounce,”.

Interviewed recently by CNBC Roubini said "It's going to be death by a thousand cuts. The financial system is severely damaged, and it's not just the banks. The gap between supply and demand is so huge we could stop producing new homes for a year to get rid of all the inventory," he said.

So are we there yet or not – remember that during the decade-long Great Depression there were many stock rallies, including a 67% gain in the Dow in 1933. So is this what it is – a dead cat bounce, as Professor Roubini calls it?

Don’t know, but please see below the movement in BSE Sensex since Jan 2007 and its PE multiple:



What seems clear is that the Indian market is now back to where it was in August/ September of 2007. And just like those times, it is very difficult to find value in the prices – at 20+ x on PE, I am not sure if things are cheap anymore. There are other factors such as dividend yield and Price to Book which are giving the same message.

Fact is that we have heard a lot about the “green shoots”, but the way the markets have moved up, it seems everyone is already discounting that the green shoots will soon become large forests. To me, it seems that though some of the imbalances underlying the credit crisis are ebbing, others are persisting and new ones are being created by policymakers’ attempts to stimulate economies and markets. Everything is not yet hunky dory and to my mind atleast 2 issues remain:

1. US fiscal issues and related issues
2. Bubbles in emerging markets

On the US fiscal issues, I came across a nice statistic recently – one year after the collapse of Lehman Brothers set off a series of federal interventions, the government is the nation’s biggest lender, insurer, automaker and guarantor against risk for investors large and small.

Hence, the US government is financing 9 out of 10 new mortgages; if you buy a car from General Motors, you are buying from a company that is 60 percent owned by the government; if you take out a car loan or run up your credit card, the chances are good that the government is financing both your debt and that of your bank. And if you buy life insurance from the American International Group, you will be buying from a company that is almost 80 percent federally owned.

For much of the period since the Second World War, the dominant force in global demand has been consumption in the developed nations, with US consumers being the largest single block. The mirror of this was in Asian countries, which had low consumption but managed to expand their exports and built large FX reserves in the process.

However, the recent crisis had a dramatic effect in reducing these imbalances rapidly. The US trade deficit shrank from around –5% percent of GDP in early 2008, to –2.4% in early 2009. The household savings ratio fell close to zero during the boom as a result of easy credit, but rose steeply as the crisis intensified, reaching almost 4.5% in the early months of 2009, taking it halfway back to the level of around 9% that prevailed for three decades before Mr. Greenspan’s expansionary Fed policies. Will this remain at the same levels or will the consumption go back to earlier levels soon?

Can the Asian countries, faced with export declines of between a quarter to 50%, regain growth without relying on the (earlier) booming consumer markets like the US and boost domestic demand on their own? Can the developed economies of today manage to keep their banking systems stable and can its consumers reduce debt relative to income gradually rather than suddenly?

In 2007, the US accounted for about 30% of world con¬sumption while China accounted for 5.3%. It is being projected in some quarters that China will overtake the USA as the largest consumer market by 2020. By then, China is expected to account for 21% of global consumption, and the USA for 20%. The assumption is that this will result from a combination of China’s income growth, currency appreciation, demographics, in addition to the deleveraging effect among US consumers.

This view is widespread. Recently, Sir John Major, former Prime Minister of UK was asked as to which countries he thought will likely lead us out of this recession. His answer: China. Perhaps followed by other parts of South East Asia as well.

Are we relying too much on China – whose transparency in facts and figures are much in suspect? Are we at the cusp of a historic shift in consumption pattern from the developed to the developing nations? Is the market recovery too soon too fast? Are there bubbles forming – property/ stock prices etc, fueled by easy money availability?

I don’t know the answers to this and the many questions that are being asked. What I do know is that with price and value in reasonable balance, the future course of the markets will largely be determined by future economic developments that defy prediction. There are very few names that are compelling buys at this point in time.

On balance, I do think that while Armageddon may be off the table, better buying opportunities may lie ahead. Unfortunately I am sure there are many others like me (not to mention institutional funds) waiting to invest their monies at the hint of a fall. So either the fall has to be huge and dramatic, or else we just need to go back to being tactical in investments again and not look for the easy kills anymore. Time will provide the answer to that one. Meanwhile, my money is lying safe in my bank account. I hope.

Active or Passive Voice?

Active or Passive Voice?



We had once recommended a stock called Merck Limited on our blog. It seemed to be a value investor stock by all counts.

The cash flow of the company is reproduced below:



Looking at the last 5 year results, the company has made a good (and stable) profit and the average cash flow from operations works out to around Rs 93cr. – the last years cash flow fell because of higher inventories and receivables – a sign that the company probably tried to push its products at the end of the year. Nevertheless, a company with high cashflows.

Its dividend has been rising over the years – from Rs 2 per share in 1988 to Rs 20 per share in the 2007. However, in 2008 they did drop the dividend to Rs 17.5 per share to conserve cash, keeping the tough economic conditions in mind. Even at this reduced dividend, the dividend yield works out to around 4.5% on the CMP of Rs 398. Certainly, a situation where we are being paid to wait for the stock price to appreciate.

The company’s current market cap is around Rs 670cr, of which are Rs 330cr (as at the Dec’08 closing) was held as cash/ bank/ investments (not adding another 36-40cr in cash that they made till June’09). Hence, the market is valuing the company with an average cash flow of say 80-90cr a year at Rs 340cr (market cap of Rs 670cr less cash held of Rs 330cr). Say around 4-5 X of cash. That should be considered cheap.

Surely in the near term the prospects look tough given that around 50% or more of the company’s products are covered under the Drugs Price Control Order (DPCO), which means that to that extent they do not have the freedom to price their products (mostly vitamins). With input costs having gone up, this has meant reduced margins – which is showing in their recent performances. But thinking the contrarian way, Merck, being an MNC would like to introduce more products to get out of the DPCO’s grasp. And the company has been on the ‘prowl’ (as reported in a newspaper article in 2003) for an acquisition in the Indian market and has been conserving cash (almost 50% of their market cap) for that purpose.

But 2 years into my personal investment, lets relook at these assumptions: Merck (the parent company) has a 100% subsidiary through which it is reportedly introducing new products (this way they don’t have to share their profits with the minority shareholders). And why has the company not been able to find any acquisition target in India despite being on the ‘prowl’ for the last 6 years?

The market usually tires of waiting for a catalyst and that is true for Merck as well. But despite this, the price chart below shows that even during the period 2008- early 2009 when the markets went for a long holiday, the stock has actually done well to hold its own and didn’t fall by much. It has therefore served its purpose as a defensive stock when it was recommended in June 2008 (its market price then was around Rs 330 and hence has provided a 20%+ return).



But whereto from here?

Either we give up – admitting that it is unlikely to reach its expected value – which to me is atleast around double of its current market cap. Or else we wait.

But besides this, is there another choice? Should we just act as a Buy and Hold investor or try to be THE catalyst? That is the subject matter of this article.

Ronald D. Orol has covered this in a book called Extreme Value Hedging, wherein he has written on value investing v/s shareholders activism to catalyse value and about the pros and cons of the 2 styles.

He writes that Mohnish Pabrai, managing partner at Pabrai Investment Funds of Irvine, California, is a true value investor. Unlike activist investors, at no point will Pabrai engage or even seek to talk to the executives at the companies he allocates funds.

Executives at one company called him one day to see if he had any advice or ideas. Pabrai, an 18 percent investor in the corporation, says the call was a big mistake. "I have never made a phone call to any management of any of the companies I am an investor in," Pabrai says. "The way I see it, if they need my help, there is a problem."

In fact Pabrai questions whether activists, in their drive to raise the value of corporate shares, are actually improving the long-term businesses interests of their target companies.

Opportunity Partners' Phillip Goldstein (now runs a hedge fund called Bulldog Investors) takes issue with the idea that activists aren't contributing to the long-term viability of corporations. On the other hand, sometimes value investors infuriate activists with their passive approach. Goldstein says he once approached a value investor who held a substantial position in a company to see if that manager would support a possible proxy fight he was considering. Goldstein was contemplating a proxy contest to oust directors and pressure executives there to sell the business. The support of this particular value investor would go a long way toward putting sufficient pressure on the company's management. But without them, Goldstein says, he didn't believe he had enough leverage to sway the executives.

"I said to them that I believed the company was on a course for declining value and that it needed something to change its direction," Goldstein says. The value investment fund managers responded in a way Goldstein didn't expect. No decision would be made one way or another on a proxy contest until it happened. The manager was unable to tell Goldstein whether he would support his possible endeavor. "Do they even know why they own the stock?" Goldstein asked. "They want to stay aloof, but what they are doing is harming their investors."

Which approach is better? Goldstein says it's unfair to compare the profitability of the two approaches. It depends on a case-by-case, fund-by-fund analysis. Either can be successful or a failure in different instances, and when one strategy is successful, it often may be because it took advantage of the other strategy.

There are some definitive differences and similarities. While value investors, for the most part, quietly sit and wait for their investment to appreciate, activists must be successful at wooing other investors to support their efforts.

But unlike traditional value investors, activists will use their knowledge of the company's legal structure, their ability to file lawsuits, engage and negotiate with management, and launch proxy fights to provoke change and improve value. Insurgents argue that value investors must be careful not to fall in the value trap, that is, invest in a company they expect to appreciate in value within five years and find out five years later that because of management or external factors that company still remains intractably undervalued. (I am close to 2 years in my investment in Merck India.)

Zeke Ashton, founder of $50 million Dallas-based value fund Centaur Capital Partners, says a key difference between activists and value investors is temperament. "To be a successful activist investor, in many cases, takes a confrontational personality;' Ashton says. "It requires someone that will fight with management to accomplish certain goals."

Goldstein agrees that temperament is important to the approach. A successful activist can't get aggravated or lose sleep when faced with lawsuits or screaming CEOs. He adds that an activist must enjoy being the catalyst. "How much abuse can you take before you say this is not right?" Goldstein asks. "You can't be a shrinking violet and run for cover anytime somebody sues you; otherwise, you're going to get bullied."

Many traditional value managers will become reluctant activists if they become sufficiently aggravated about a particular situation. Even value investor extraordinaire Warren Buffett, arguably the most successful stock picker, has on occasion taken an activist tack. In a 2001 confer¬ence call, Buffett expressed his displeasure with real estate company Aegis Realty Inc.'s decision to buy P.O'B. Montgomery & Company, a Dallas-based shopping center developer, for $203 million. He also was involved in several quarrels with management of Berkshire Hathaway before he bought enough shares to take over the company in 1962.

Value investor Christopher H. Browne, managing director of Tweedy, Browne Company LLC, another firm that we think are amongst the true value investors, also grudgingly engages in reluctant activist efforts in some situations, when provoked.

On the other hand, Walter Schloss, (called a ‘superinvestor' by Warren Buffett) and a value investor about whom we had written in May’08, is truly of the old order. He likes to buy and wait, his usual holding period being 4 years. “Something will happen”, he likes to say.

In comparing value investors to activists, it is unclear whether the approach favored by Schloss, Pabrai, or Goldstein makes the most sense.

To me, the best investors are those that can adeptly engage in both value and activist strategies based on changing circumstances. Goldstein was once asked whether as a hedge fund manager he was more interested in the activism or in making money. His response: “I am out there to make money. The activism is the means to the end. “

I have to agree with that.

At my own end, I am clear that companies like Merck do not deserve to be listed on the stock market unless they can efficiently allocate capital. They need to either acquire a company at the right price (which I am sure would have been available a few months back when EVERYTHING was cheap) or distribute the cash as dividend. Or acquire the public shareholding by doing a buy-back. But surely something needs to be done.

While it can’t be me (I have a day job), I am hoping that just as in the cartoon someone will come out of the woods and insist (with a growl, I might add) that the management stops thinking that the company is their own backyard. The investors need their living room space too.

Till that happens, I am willing to wait – its not as if there are a lot of other investing opportunities right now in the Indian market and hence the opportunity cost is not high. All said and done, Merck continues to be a defensive bet even in the present market. And being a rationalizing person, I would think that I am still only at half of Schloss’s normal holding period. Maybe something WILL happen.