No silver lining yet

No silver lining yet

Wealth is best created through rational investing in great businesses when they are undervalued. But doing so with no reference to economic fundamentals is not rational.

Dipen Sheth

By all counts, it looks like equities will not be a winning trade in 2009. This sounds like an investing blasphemy from a stock market addict—and a practicing portfolio manager at that. After all, is it not true that equities are the ‘ultimate’ asset class and that they should outperform all other assets over time? If so, why should you avoid (or reduce) equity exposure in the next year? Here are some reasons:

Firstly, we are scratching the surface of what threatens to be a never-before economic slowdown occurring in tandem across countries. Earlier, if Malaysia had a currency crisis, Russia was growing. If the UK was slowing down, Germany’s manufacturing would look up. But this time, big daddy US is in a confirmed recession and there is no counter-trend in any large economy. Germany, the UK, France, Japan and, not surprisingly, China, are all in various stages of a slowdown. This contagion is truly global.

Second, in spite of the ‘decoupling’ that some diehard fans of this country have been talking about, the crisis will affect India. Delve deeper, and you will see the ‘connectedness’ of India’s economy and some of its stalwarts with the global contagion.

Consider the four giants of the Nifty. India’s largest private company, Reliance, is a refiner and petrochemicals manufacturer whose refining margins and petrochem spreads (admittedly superior) are completely linked to its global and regional peers. So, along with others, they have been falling daily as oil cracks. Their gas/oil reserves are still to be rid of pricing disputes and delayed production fears. Did someone say ‘retail business future value’?


• IPO validity increased from three months to a year.

• Future Venture and Adani Power IPO to raise Rs 8,300 crore.

• UTI and MCX are two big financial services IPOs that are likely next year.

• FIIs investment to remain volatile.

• FDIs in certain sectors to see foreign money for longer duration.

NTPC, India’s third largest business by market cap, is a power utility whose ‘mandated return business’ is overvalued at more than two times the book value, now that the bar for higher power generation (to earn higher than mandated return) has been raised. This, at a time when coal linkages threaten to disrupt generation at some of its most stable plants.

Infosys, run by the country’s most respected management, leads the IT pack and has a disproportionately large client exposure to, you guessed it, the US banks. This is not really a risk, it’s an opportunity, says the Infosys fan club. But is this just bravado in the face of a real business contraction imminent in the next few quarters? Why else is a company of this calibre trading for a little more than 11 times its 2008-9 estimated earnings?

Switch to Bharti Airtel, still reporting net customer additions that dazzle its followers month after month. But ask yourself whether it’s only time before this last man standing also cracks. Hero Honda’s October 2008 sales figures (up by 0.5% YoY) also stood out among the ruins just as we went to the Press. For the record, Maruti’s YoY volumes were down 27%, Mahindra’s fell by 40% and Bajaj two-wheelers posted a 37% drop. The Indian consumer is surely tuning in to the bad news from across the world. Now what do you think are the ‘coupled’ India’s chances of escaping the global contagion?

Thirdly, no matter which company or business you like, remember that stocks move up only when money chases them. Where are the investors who can provide this buying momentum? Hedge funds are stuck in thorny hedges, many of the ‘long-term’-oriented players among the FIIs are winding up their sub-accounts, and foreign banks with managed fund exposures are pulling out money from India in the face of the domestic crisis and redemption pressures. The net sales by FIIs have crossed Rs 1,00,000 lakh crore in 2008 (over $20 billion at Rs 50 a dollar). This figure will rise when you consider that many of those dollars were pulled out when the value of dollar was lower than today. Yes, Indian institutions have pumped in Rs 70,000 crore, but that’s surely not enough. Consider what will happen if the pullout sustains for the over $60 billion that the FIIs still have invested in India?

Fourthly, I’m getting sick of all these theories of domestic consumption and the investment-backed-bydemography argument. The demographic dividend will soon turn into a demographic curse if the job creation unleashed by telecom, software, banking and BPOs slows down. There is no denying the excellent products, super management capability and enduring brands of HUL, ITC and Nestle. But look at the PEs they are trading at. What do you feel like doing when ITC is at over 20 times, HUL kisses 26 times and Nestle wants to pole-vault over 30 times its earnings? Especially when you see how L&T is battered to 10 times, SBI to around book value and Tata Steel is at under its asset replacement value. And there seems no hope for these stalwarts in 2009.

So, at the cusp of 2009, I have told you all that I want to, as you bravely chart your way through the new year. I have no intention of being a party pooper. I still believe that wealth is best created through rational investing in the equity of great businesses when they are undervalued. But blindly advocating exposure to equities, with no reference to the underlying economic fundamentals or appreciation of the ground realities that affect valuation and sentiment, is not rational.

Surely, the tide will turn. Maybe a big event or a sequence of initiatives will take us into the next big equity boom. Maybe a new leader or political party will emerge in India and usher in the change that we long for. But right now, the ground realities of India call for capital preservation rather than any misguided conviction that equities are always better than any other investment avenue. Have a safe 2009.

— Dipen Sheth, Head of Research, Wealth Management Advisory Services