In Through the Out Door

The wise men that matter are now more or less agreed that economic growth in the developed markets will approximate a “U” going forward. Indian investors pride themselves on always being a step ahead and so it is with growth — hence, a “V” shaped recovery is now emerging as the consensus among smart money managers. Despite being seriously battered in the last quarter of 2008 as a consequence of the havoc wreaked by a bunch of wobbly banks in the USA and Western Europe, the Indian market has been intent on emulating the hare since the global market rebound of March.
Seen in this context, the massive gush of liquidity is easier to understand.

International investors, worried about missing the right side of the “V”, have flocked back in hordes. Stock market behaviour is often (mistakenly!) interpreted as a leading indicator of economic recovery. By that token, bulls around the world and even more so in India have a lot to cheer about. Intel, Goldman Sachs and JP Morgan Chase are just candles in the dark compared to the sparkle in the current crop of second quarter earnings reports for Indian companies.

Given that a number of announcements (Bajaj Auto, HDFC Bank and TCS) just shot the lights out, the market now seems well set for a robust rally. The festive cheer of investors is reinforced by low inflation and the continuing desire of central bankers around the world to intervene in order to keep interest rates as close to zero as possible!

The news from China is even better. Iron ore imports from China set a new all-time high in August. And despite all the growling, the Chinese have willfully opted to increase their holdings of US Government bonds! Even though the greenback is plumbing new depths, it does not seem to have raised the risk of importing inflation just as yet. Put all this together and the odds must be stacked in favour of the market going higher in the next couple of weeks.

Yet a number of risks loom large. First, the process of de-leveraging in the developed economies still remains a work in progress. While it is true that the global banking system may be back on its feet, it is still seriously debilitated by credit losses and a crisis of confidence in lending. Second, the sheer pace of China’s expansion makes the prospect of overheating a genuine risk. Third, the helping hand of intervention by robotic central bankers cannot persist forever. The thought of the liquidity tap being turned off should be enough to have punters running helter skelter. Fourth, Mr Mukherjee still seems to be short of a coherent plan to tackle the fiscal deficit apart from paying lip service to “austerity”. Finally, current valuations offer absolutely no margin of safety — a single misstep and you will sink rapidly in the quick-sands of exalted expectations being shattered.

Clearly, the best rewards will come from identifying “resilient” businesses with sustainable earning power, metronomic cash flow and upright management with a demonstrable track record of rational capital allocation.

But herein lies the rub — if the vast majority of investors can figure these attributes out as well future returns are unlikely to set your pulse racing. It is vital to narrow the search further — seek companies where either the growth or earning power is misunderstood and greeted with scepticism! Honeywell Automation (Rs. 1,921) meets this test in spades — return on equity averages almost 30 percent in the last five years, sales growth has been handily north of 15 percent barring 2008 and the company has a truly robust, self-financing business with a pristine balance sheet. Critics are quick to point out that the company skipped paying a dividend last year despite earning Rs. 92 per share!

Equally, there is a fair bit of discomfort with the notion that all its major customers are “cyclical” and unlikely to boost capital spending at this juncture. But there is little doubt that earnings growth will exceed 35 percent in calendar 2009 and the stock trades at a reasonable multiple of 14 times earnings on that basis.

Comedian Groucho Marx may have had an inkling of what it takes to make winning investments considering that he said: “Anyone can get old (substitute rich). All you have to do is live long enough.”