Markets at new high, fundamentals at new low-Should we buy or sell?

We have again reached a point where attempting to explain an utterly irrational market, in which sentiments turn quickly overriding any fundamental news flow. With stocks reacting like petulant, schizophrenic children, fundamentals are totally meaningless: rally of over 800 points on Sensex in last 3 days has become perfect example- as unchanged credit rating by Moody’s and bullish note by leading broker, both said absolutely nothing of improving business/economic environment - have been enough to override last 1.5 years of actual deteriorating fundamental data.

Despite GDP growth slumping by over 250bps in last 1 year reaching the lowest point since 2003 in Q2FY13 at 5.3%, inflation remaining stubbornly high, current a/c deficit at levels difficult to imagine and fiscal deficit showing no sign of improvement; equities have clearly given all a miss rising by over 20% in YTD12 hitting 19400 on Sensex. 

In the meantime all the sell side firms are turning overtly bullish on outlook for 2013, for reasons they themselves fail to explain and have contradicted in the past. I wish I can repost all my collection of Outlook for 2012 published last year by leading brokers; needless to say they were all cautious or bearish when Sensex was at 15500. I don’t mean to demean these institutions bcoz they have been very successful for spotting new trends, stock ideas and market movements in the past. Could it be that they were just lucky–in an up market? I think in estimating future, there are only good ideas, bad ideas, and luck. And really, it’s mostly luck.

Nasim Taleb in his books Black Swan and Fooled by Randomness has addressed this issue brilliantly.  His basic premise is that financial experts underestimate risk. As such they are caught by surprise when some significant unforeseen event occurs. Taleb’s conclusion is that the success of most traders in hedge funds and investment banks are mostly the result of luck. Their investment philosophy just happened to coincide with the market at a given time.

Honestly, the rally has taken me by surprise and I have a strong left-out feeling for not investing in market after crossing 18400 in September. Therefore, I have decided to consciously review the current scenario and have unbiased expectation for future to decide next course of investments. Many experts believe that current downtick in GDP/ fundamental data is similar to Tech bubble of 2000-02 and is a therefore good entry point for investors who missed out on 2003-07 super rallies as we could see a similar rally in coming years as data improves. An extension to this thought to which I also readily agree is that while GDP has fallen to 9 yr low, the rate of fall (second derivative of GDP growth) is decreasing and we have likely seen the bottom of GDP / investments and will see improving data points from next qtr.

Yes, current economic situation is very similar to FY01-03 period when GDP had dropped sharply along with strong rupee depreciation. The corporate sector going into 2000 was not too dissimilar from what it has been going into 2012. Balance-sheets were extended – leverage was high, margins had fallen and ROEs were modest. Sales growth was beginning to slacken, high interest costs were hurting, and asset risks for the broader banking system were high.

As the table above highlights, over the three year period, when growth was low and below its previous averages, there was a positive reversal in most macro parameters. Inflation moderated materially, interest rates stepped down structurally as banks hoarded capital and moderated risk, banking sector liquidity rose substantially, and the current account turned into surplus.  

Now to have a rally similar to 2003-07 post crisis periods, we need to see these data improving like it did in 2003. Therefore, the next big question is- are we at a similar starting point for reversal of economy?

Inflation unfortunately shows no sign of improvement- thanks to easy money policy by Fed which has kept crude prices at high despite falling demand; interest rate though likely to come down in next 6 months has failed to meet expectations of sharp climb down. Current a/c deficit cannot improve in short run as we fail to exploit the advantages of weak rupee (at Rs56 now) when countries like China, US and Japan are striving hard to keep their currencies artificially low and promote exports. In fact the big difference that I see between 2003 and now is emergence of Indian IT industry on a global scale which contributed substantially to GDP growth as well as building foreign reserves. My imagination fails to see the next big league of industry/service that will bring dollars back at home.

On valuations, despite macro data disappointments and downgrades, Sensex is now trading at 14.2x forward earnings which is slight discount to its long term average (LTA) but at significant premium to its previous down cycle years. I think we should not rest our case on LTA as we are unlikely to see 9% GDP growth in near future and tail risk for global economy also exist.

Therefore in my opinion, street is pricing in too many optimistic outcomes and downside risks remain high on slight disappointments. Importantly, we do not have global economy support which was omnipresent during FY03-07 period (it was not just India that did well during this period but all major economies including US,BRICS, PIIGS have seen strong equity rallies during this period and we were not very different from world as perceived by many). Fiscal cliff in US and Greece/Spain bailout outcomes can see sharp downside cuts in coming weeks and will therefore invest only at declines. I know by waiting on sideline, I could miss out on a big rally but then I am a "Thinking Analyst" and not a gambler who wants to double the money quickly. I dont mind buying at higher levels when data shows some sign of improvement rather than buying in the hope that things will change for reasons unknown to us now.

Down and out- Is ARSS Infra Speculative or Contrarian bet? (CMP Rs46)

A company with market cap of only Rs680mn, having lost more than 60% in last 3 months, perceived to be driven by operators  and in a sector which nobody wants to own, ARSS Infra has all the elements for being a perfect short candidate for many and certainly  in “Not Interested” list for fund managers. I know it could be tremendous risk for my blog to start writing on a company which is down and out with no possible investors.  I might be classified by some of you as a speculator or by some other as inexperienced, untalented and high risk seeker analyst who is interested in making quick money like Rakhi Sawant or India TV.

But then investments is not always about buying the best companies but it is also about buying not so bad companies at a value which is dead cheap. Ofcourse some will argue, bad companies have zero value and will be delisted but then how to classify them is a difficult task. Therefore, let me take you into this company some 2 years back.

Company had raised Rs1030mn through IPO in Feb 2010 with a price band of Rs410-450 per share. At time of listing, nine month financial details for FY10 were all upbeat –Revenue of Rs6100mn ,EPS of Rs 40, book value of Rs 158, RoE at 29% and order book of over Rs25000mn (4x FY09 sales), resulted in huge investor appetite and the issue got oversubscribed by whopping 48 times. With listing gains of Rs300 and then trading firmly to make a high of Rs1250 over next 4 months, ARSS looked poised to be next big infra bet for many with market cap of Rs18000mn.  But that is history now, as financials have deteriorated and so has stock price.

Reported FY12 nos showed contraction in topline, ballooning interest cost, colossal jump in receivables and loss at PAT level. As if it was not enough, inability to meet margin calls by promoters has led to massive selling by financial institutions. As on March 2012, promoters owned 54.5% of equity (80.7 lakh shares) about two-thirds of which was in the pledged form. In June alone, IFCI sold nearly 43 lakh shares, which account for a 29% of ARSS Infra’s equity capital and the stock slipped 26% to Rs 40, which is over 90% lower than the price at which the company had made public issue in early 2010. What surprises me is if IFCI sold 43lac shares even at avg price of Rs 60, it would not have recovered  more than Rs250mn, that is too less for a client who has more than Rs2800mn of long term debt & another 7000mn of ST borrowings. I wonder how institutions operate when they sell shares. But that’s not the agenda in this post, maybe another blog someday on such cases.

Unlike a regular analyst, I don’t want to start believing outright that things will improve immediately & then with an estimated EPS of blah blah and multiple of x, stock should easily trade at Rs100. For companies which are outright in distress with zero visibility in business should in my opinion be valued at liquidation value- (a value that can be recovered by selling physical assets and paying off its debts). Markets are unlikely to give them any premium or multiple as they are enclosed by uncertainty.

Benjamin Graham, a legendary value investor in early 1930’s suggested an easy formula for liquidation. Value of Company > (Total Cash & Equivalents + 0.75 *Receivables+ 0.5*Inventory – Liabilities)  I tried running this criteria over Indian companies but couldn’t find reasonable sized company trading at deep discount to liquidation value. The next simple and logical step is Book value (Value of Assets- Value of Liabilities). Stock trading at discount to book value indicates that market is expecting company to erode value through increased losses which will wear down previous years retained earnings i.e in accounting terms- RoE will be less than required rate of return. For my friends from non-finance background, I know it is difficult to comprehend and is similar to how I see Alpha, Gamma and sin teta, but you can chose to ignore if you want to.

The next obvious question in my mind is what discount to book value is great entry point for value investors? I picked up few construction companies, where sustainability of businesses were in doubt either due to regulatory, political, balance sheet or governance issues to check out what lowest price to book multiple they traded during last 1 year. Since estimation is poor indicator for distressed companies, I relied on reported book value at that point of time. 

Exhibit 1: Large construction companies under stress

Exhibit 2: Pure road construction players at their lowest valuation

Exhibit 3: Similar size peers at their lowest Price to book valuation

The exhibit says it all.. Stress is never permanent as you see how swiftly prices have moved for larger companies whose survival was in question just few months back. I find it difficult to believe, that company with Rs12000mn revenue and B/S size of Rs20000mn to trade at lowest multiple  which was not seen for any company in last 1 year.

Even valuing ARSS at lowest multiple of 0.2x, will take stock price higher by 20% and going by avg of its immediate peers it should double the stock price.  Therefore, I would like to take a small exposure of 3-4% in a portfolio. I believe stocks like ARSS Infra have potential to turn multi-bagger but are surely for high risk seeker investors. If sentiments improve, then we could see going concern value in addition to liquidation value & that could re-rate the stock from current levels. No doubt, we could also see sharp downside cut in the stock as events unfold but I guess it’s worth a risk.

Key Risk

My underlying assumption behind this thesis is ofcourse, reported numbers are genuine and not manipulated as we see in increasing infrastructure and real estate companies and that remains key risk to investment. Next 2 quarters results will determine the destiny of this company and shall be subject to high risk events. 

Idea behind "Thinking Analyst"

What’s in a name, said a Shakespeare and I believe it is “Everything”. A good name is a strategic asset that can be leveraged to gain competitive advantage; it is a safety buffer that can be called upon to protect you against negative news, it is a brand which commands premium at market place and hence dedicating my 1^st first article on etymology of “Thinking Analyst” and idea behind setting up this blog.

Being a bachelor and no editorial writing experience before, this is my only chance to give a name to somebody- my new born blog desires to have a name that reflects my persona and symbolizes the contents on this blog. Like Ekta Kapoor, I could have chosen long, entertaining and exciting name that would have compelled the readers to open the blog atleast once but I chose other way round- an unexciting, sector specific and undemanding name. Underlying motive for keeping it simple is that this blog intends to discuss ideas with people who want to and not like Insurance companies who are into force selling these days.

When I first discussed this name with my friend, his obvious question was- Who in this world doesn’t think? And how different are you from other analyst in this world? His questions swayed my doubts and helped me finalize the name. While “Thinking” and “Analysing” is a human nature, regardless of one’s qualification, experience and religion, what is imperative in any field is thinking in right direction and analyzing the accurate material. Therefore, while the name is universal, the intention would be to create a niche analyzing all possible scenarios and thinking beyond consensus. I know it is difficult and most people out there have same intentions but I will make an attempt. I can accept failure, everyone fails at something, but I can't accept not trying.

Just last week I completed professional 3 years in equity market, when I realized that markets have given me a steep learning curve. No no don’t get me wrong, markets haven’t moved a tad from where I started but there are some things you learn best in calm, and some in storm. While I was lucky to see euphoria of Oct 2010 when we kissed new high on Sensex but I was also there battling tough times in Aug 2011 when Greece exit from Europe looked inevitable with sentiments of despair, anguish and stress all around. From initial days of my career, where everything seems baffling and irresistible with desire to jump on to stocks to make quick gains without adequate research was high, things have changed for the better. Not that I am an expert now but last 6 months have turned fruitful with some of my ideas going right. Invested in markets at 4900 in May (when everyone was bearish), made fabulous return of over 50% in 1 month on Mannappuram Finance, missed out on Ajanta Pharma- a stock I long wanted to buy only to realize it has doubled in last 3 months. No, I don’t want to sound like a self- proclaimed successful analyst but these events made me think whether huge gains come only out of sheer luck or is it a result of good analysis & judgement?

Like a true marketmen, I might be undergoing a regret aversion bias (a term I learned during CFA preps) i.e I might be analyzing too many stocks and some of them turns to be a multibagger- giving me a feeling of regret of not buying it. Is it that I recollect only winning stock ideas and easily overlook the losing one’s which have resulted in huge trading loss in my portfolio? Is it an improvement or overconfidence bias? Do my thoughts swing with the flow of market or am I too adamant to not accept changes in market and business environment?

Thinking deeper and reading on the web I found out the best way to overcome it all is to track your ideas, build rationale before investing and follow up buying, observe result of your estimates and then evaluate the outcomes.  I think many people keep diaries, or journals, to write thoughts down and reflect. But for me (a young Indian who spends atleast half an hour on Facebook everyday & who can live without TV but not internet) a personal blog is just a way to get things out, and if people choose to comment, then great, if not – it’s still out there.

This blog will take you through a many facets of Indian equity markets and beliefs & opinions that come with them. It’s an attempt to discuss markets without any biases or favoritism, pen down thoughts and stock ideas to track their outcomes, learn through interaction and more importantly search for a person that I aspire to be.

While this blog is dedicated to equities, it would not be wise to think of markets operating in isolation to society. Therefore, the contents shall range from but not restricted to Indian equity market, global markets (though my understanding of complex world is limited), macro economics, technical trends, political issues, current affairs, movies, cricket and perhaps everything that inspires me to think.