Taking a little more risk

Our fund manager short-sells another stock in Wealth Zoom and explains why. Readers, however, are sceptical.

Dipen Sheth        Print Edition: May 28, 2009

After a 48% bounce-back from the lows of early March, the one question everybody wants answered is, are we at the cusp of (yet) another bull run or is this merely a technical pullback from oversold levels? Are the 'green shoots' that sprouted out of the ides of March for real? After all, 48% is no joke.

Even as we go to the press, the BSE Sensex is trading at over 14 times the 2009-10 estimated earnings (Street estimates are huddled around the Rs 850 a share mark for the Sensex), implying a relatively low 7% earnings yield (roughly similar to 10-year government paper). A fair level during these tumultuous times would obviously involve a premium over treasury paper, say, something like 3%. Which means the Sensex should trade for a yield of 7+3=10% or 10 times. Allow for a 30% swing both ways and you get an optimistic bound of 11,000, about 9% lower than the current levels. If only it were that easy.

The pendulum, as we have found to our chagrin over 2006-7 and 2007-8, bobs viciously both ways. Admittedly, the margin of safety is on the side of the seller today. But that does not rule out another run up to 13,000 or (hold your breath) even 14,000 as the green shoots are lovingly watered by coordinated monetary easing, 'creative accounting' norms and benign bank stress tests. Just forget the strife in Pakistan, Sri Lanka, Bangladesh and Nepal, and the post-election equations that threaten to throw up an unstable coalition. Patience in the face of short-term volatility is a virtue we can well afford today, especially since we have 92% and 80% cash in the Wealth Zoom and Safe Wealth portfolios, respectively.

With the margin of safety loaded against investing, but momentum building up in favour of the bulls, the right thing to do is to stay out rather than go aggressively long or short. Since we are at very low exposures in both portfolios, I don't mind being caught on the 'wrong' side of the trade either way. If you can't figure out what's happening with reasonable certainty, stay out.

In Wealth Zoom, we have initiated one more short: ABB. Now this one is really interesting because in the Great Bull Run of 2004-2007, it was ABB that was among the darlings of the stock market. Aided by the natural operating leverage inherent to the capital goods industry, ABB went from strength to strength in servicing the growing needs of the industry and the power sector during the best years of India's investment phase. A global leader for a parent, operating leverage-driven margin expansion and increasing free cash flows (the final word on value creation) ensured that ABB climbed to the top of the charts. Revenues grew at 38% compounded annual growth rate (CAGR) between 2004 and 2007, while profits galloped at 48%. Cash flow from operations topped Rs 310 crore in 2007 and ABB traded at a PE of over 63 times! But all that is behind us.

In 2008, ABB stumbled, in line with the deteriorating macros in the capital goods industry. Working capital sagged, revenue growth slowed down to under 20%. Return on equity (RoE) reversed from 34.5% to under 30% (our estimates, after a depressing first quarter showing indicate a crackdown to 20% in 2009 and 2010). Also, ABB's balance sheet is bloating more and more in response to a tougher working capital cycle; the total capital employed in the business is slated to rise by 130% to Rs 2,300 crore from 2007 to 2009, while adjusted profit after tax (APAT) is expected to remain flat at a shade under Rs 500 crore. So why should we continue to give a fancy multiple to this increasingly 'ordinary' business?

Meanwhile, it looks like we have mis-timed our earlier shorts in Crompton, Tata Motors and TCS, but since then nothing has happened to make us reconsider these short calls. In the same light, the slight fall in Zee Entertainment should also be seen as randomness rather than any sort of stupendous validation of our short position.

Safe Wealth's invested portion (however small and timid it might seem in hindsight) has delivered a 2.7% return on its original value. But this gain obviously makes a much smaller impact as we have chosen to remain 80% in cash. The Wealth Zoom portfolio, with its lately acquired long-short ambition, has not done as well and seems to be grappling with volatility. Thank god we are invested only 17.5% at the gross level (long+short) and around 8% at the net level. With the margin of safety clearly favouring the short side, another thousand points on the Sensex should see us exiting many long positions in both the portfolios. Not to mention fresh shorts!

Readers' Response

I am alarmed at the new instrument, shorts, that is being used by you. This is contrary to our investment mandate. Shorts are only for day traders and should not find a place in our portfolio. It will misguide readers as being a quick way to make money. Shorts are very difficult for the average investor to master, so I request you to discontinue the usage of this instrument. Also, we will never be able to monitor its use by you.

A good stock for Wealth Zoom is Dish TV. The DTH space should grow exponentially in 10 years' time. Telecom companies such as Airtel and Reliance Communication have also entered this business, but Dish TV has the early-mover advantage with a 48% market share. The company has a very high debt, but it is unavoidable at this nascent stage.
— Pramod T. Palathinkal

I believe you are confused about investing methods. You talk of long-term investing but do the opposite. While stock identification and justification are fine, there should be a defined guideline for a manager. If you calculate NAVs like mutual funds, then you should follow the rules of mutual funds in portfolio management also.
— ahajoy2003 (Via e-mail)

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