Enjoying the Whirls and Eddies

For the overwhelming majority of professional investors, vertigo is a more serious risk than swine flu! The Indian stock market has more than doubled in 11 months from the lows of October 2008. Few would have been bold enough to predict at the start of the year that the Indian bourses were destined for FII inflows of $9 billion before Diwali. The brute power of liquidity has destroyed the “heretics” who were claiming the end of the old financial order and mounting a grand campaign for reform. Instead, the current debate is how far this rally can continue and concerns relating to how markets will cope with the stimulus tap being turned off.

Almost a year on from the collapse of Lehman Brothers, one would have thought investors would begin thinking afresh about risk and the perils of crowd madness. But as the Belgian surrealist painter René Magritte put it, “the more things change, the more they remain the same.” As ever, analysts are obsessed with forecasting economic growth in 2010 and, consequently, corporate earnings assuming the two are linked and are the prime drivers of shareholder returns. This one assumption is possibly the best starting point for a fundamental rethink on how stock prices behave.

Long term data, collected across a truly diverse range of markets, suggest virtually no correlation between economic growth and inflation-adjusted equity market returns. The problem with the conventional worldly wisdom is that it ignores that growth needs to be financed. The important issue is how you do this and the imperative to “maintain or enhance profitability” as opposed to priming earnings per share (EPS)! In essence, the trick remains to stay focussed on cash flow and efficient capital allocation.

Relieved of the growth albatross, the emphasis should shift to seeking value. Put differently, the question to ask is can I identify companies today that have robust and sustainable revenues, margins and correspondingly cash flows with a balance sheet that can comfortably weather adversity at a price attractive to a long-term owner of the entire equity capital. With few exceptions, the answer is NO if one is seeking a “margin of safety”. So does that mean we are looking at another “bubble” fairly soon? Probably not, since the market still trades at 18 times the current year earnings and most strategists are convinced that earnings growth for the next year will be at least 20 percent.

What pointers does crowd psychology have to offer at this juncture? A fair number of investors have missed at least part of the rally to date, and they remain keen to pile in if the news flow remains upbeat in the short term. Many are seeking to recoup the losses of 2008 by betting on market momentum. Therefore, the motto of Olympic athletes “faster, higher, stronger” may well prevail in the next few weeks. Yet for those who respect the old-fashioned virtues of common sense and recognise that timing market peaks require Olympian skills, this is clearly a time to take money off the table and rein in risk taking.

In earlier columns, I had recommended owning Voltamp Transformers (at Rs. 460, now Rs. 825), IL&FS Investment Managers (at Rs. 115, now, Rs. 260), Procter & Gamble (at Rs. 910, now Rs. 1405) and Phoenix Mills (at Rs. 112, now Rs. 177).
Clearly, a rising tide has helped vastly!

In the interests of staying afloat, may I urge that you bid adieu to these feisty stalwarts. Just one company seems worth a look for the unabashed Ben Graham fans — Hyderabad Industries (Rs. 415). The company is the largest manufacturer of asbestos cement sheets used for roofing, has a strong consumer franchise (Charminar) and seems likely to achieve double digit sales growth for at least the next couple of years. The return on equity has been 25 percent plus since the business hit a sweet spot in 2008, dividend yield for the year is likely to be 3 percent. Yet, the stock trades at a multiple of less than five times the current year earnings.

The last few weeks in the market have felt like the period that just precedes high tide. There have been whirls and eddies, a strong underlying current but no clear direction. Pause for breath to praise the Lord and rejoice in the fact that his blessings have left you considerably better off.