When Pigs Take Wing

Isaac Newton’s credibility has been seriously dented by the behaviour of the stock markets over the past two months. What has changed since March 9? With consumer confidence clearly on the rebound and investors spotting fresh “green shoots” in every compost pile, it is tough not to join the party. The bounce in US junk bond returns, rising oil prices, tightening credit spreads in the corporate bond market and a weakening enthusiasm for gold all point to improving sentiment and a new-found risk appetite. Company results across the globe are now being viewed through a positive prism. The story is no different in India. Government-owned banks led the charge in persuading investors that the light at the end of the tunnel is getting brighter by the day.

Hero Honda and Bharti Airtel became the cheerleaders for large cap stocks. Even the uninspiring numbers from Reliance Industries were given a positive spin by analysts. Corporate earnings for more than half the Indian companies announcing results are clearly under the hammer in absolute terms. However, that is an irrelevance since the “deterioration is less than expected”. Two further developments have decapitated the bears: The Fed’s upgrade of US economic forecasts and the impact of stimulus plans. The bulls certainly seem justified in suggesting that economic apocalypse stands deferred. Domestic investors are heartened by the fact that freight volumes are up (3 percent), wholesale price inflation is under 1 percent and the RBI is intent on talking interest rates own. Liquidity abounds driven by foreign portfolio inflows of more than $1.7 billion since March. Is this a case of acute colour blindness on my part — seeing red instead of green?

Housing prices are yet to stabilise in most parts of the developed world. The effects of de-leveraging worldwide remain a work in progress despite the good news from banks in the first quarter. Capital spending is at a virtual standstill and the trust that drives credit markets is nowhere on the horizon. But most importantly, stocks are not currently valued such that they off er the prudent investor focused on capital preservation a margin of safety. Based on 10-year “normalised” earnings, the BSE Sensex trades at a lofty multiple of 24! Most established companies are either priced to perfection (ITC, Nestle, Cipla, Hero Honda, Bharti Airtel, Reliance Industries, BHEL, HDFC, Maruti Suzuki) or require a leap of faith that economic recovery is round the corner. Hardly any stock with demonstrated earning power, rational capital allocation and compelling valuations stands out. A few exceptions that merit a closer look are IL&FS Investment Managers, Voltamp Transformers and Esab.

Esab (Rs. 315) is an outstanding play on industrial recovery. Fears about its ability to maintain margins (five-year average ROCE of 79 percent) have led this “debt free” company to trade at a price-to-earnings (PE) multiple of 8. Voltamp Transformers (Rs. 460) is a prime example of a remarkable growth stock with predictable cash flows. Post-tax profits have multiplied 25 times in the past seven years with no equity dilution post IPO, the ROCE is in excess of 60 percent yet the stock is on offer at just over 4 times current year earnings. The financial performance of IL&FS Investment Managers (Rs. 115) reflects the appeal of owning a money manager! Despite profits having compounded at 29 percent over the past decade and a dividend yield of 6 percent, the stock trades at a trailing PE of 12.

With a new government coming in, this is the time to recollect the wisdom of the Roman Stoic philosopher Seneca: We are hurt most by what we do not expect. Far better to prepare ourselves for what can happen rather than what should happen in a time when the world seems happy to accept that pigs take wing rather than cause swine flu!

The author is a partner at Fortuna Capital