Archive for February 2006

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EM Bubble May Burst in 2006: Morgan Stanley

28th February 2006, 03:49 pm
by Andy Xie/ Morgan Stanley

Summary & Conclusions

Declining risk premium has been driving the emerging market (EM) boom. The EM sovereign risk premium has declined from an average of 352 bps in 1H04 to 52 bps. MXEF has risen by 82% since mid-2004. In 2006, the EM sovereign spread has declined from 76 bps to 52 bps and the MXEF index has risen by 11%. As the EM risk premium gets close to zero, the base effect suggests that the EM ‘re-rating’ story is also coming to an end.

Recent social, security, and economic risk events suggest that the decline in EM risk premium cannot be justified by fundamentals. Liquidity and momentum explain most of the decline in EM risk premium, I believe, with much of the gain in EMXF due to overshooting.

As the EM boom stalls due to a high base, events have greater potential to trigger the risk reduction trade than before. The reverse momentum could have the same power as the forward momentum. I believe the EM boom overshooting could reverse and then some in 2006.

The Incredible Shrinking Risk Premium …

The rapidly declining risk premium of EM debt rivals the flattening yield curve as a conundrum for financial markets today. The EM sovereign risk premium averaged 352 bps in 1H04, when the perceived risk was not high. It has since declined to 52 bps.

Substantial improvements in EM fundamentals have accompanied the risk premium decline. Brazil and Russian have been taking advantage of their good fortune from high commodity prices to pay down foreign debts. Korea has become a developed economy by most measurements. The three economies that were embroiled in financial crises in 1998 have fundamentally changed their balance sheets.

Further, most emerging economies have been running trade surpluses during the current boom, unlike in previous booms. The surging US trade deficit is the main factor enabling emerging economies to enjoy trade surpluses. The liquidity boom that may have caused the flat yield curve and strong consumption in the US has allowed EM economies to improve their fundamentals. Hence, the improving EM fundamentals would appear part of the bubble, rather than suggestive of a change in secular trend.

However, the fundamentals do not explain all the decline in the risk premium. The trend of improving fundamentals in Brazil, Russia, and Korea was well established in 1H04. Many small EM economies without similar improvements in fundamentals have enjoyed a similar decline in risk premium. The ‘liquidity effect’ may be a bigger factor in explaining the declining risk premium than improving fundamentals. Momentum-investors piling into a winning trend without improved liquidity may explain the entire decline in risk premium in recent months, I believe.

… and the Meteoric Rise of EM Equity …

EM equity has enjoyed a meteoric rise as the sovereign risk premium has declined, with the MSCI Emerging Market Index (EXMF) rising by over 80% since mid-2004. The same force – the global liquidity boom – drives both. There is no fundamental causality between the two. As equity investors tend to use bond risk premiums in calculating equity values, the declining sovereign bond risk premium technically causes a rising EM equity market. MXFM has appreciated by 11% so far in 2006, while the EM sovereign risk premium has declined to 52 bps from 76 bps.

I estimate the declining risk premium may explain 90% of the appreciation in EM equity since mid-2004. However, momentum has now emerged as a more important factor. The change in the risk premium may explain less than half of the EM equity rise in 2006, I believe. As the EM sovereign risk premium becomes too low to fall, momentum becomes the main factor explaining EM equity movement.

… but There Are Risk Events Aplenty …

Events in recent days suggest that the low EM risk premium may not be justified. The terrorist attack on an oil facility at Abqaiq, the imposition of a state of emergency in the Philippines, Mr. Thaksin’s dissolution of the Thai parliament and call for an early election, and the abolition of the Unification Council in Taiwan are events that can change the economic trajectory for a regional or global economy.

EM risk premium exists not just because of the external balance situation. The lack of institutions that enhance future visibility is far more important. It seems to me absurd to believe that such economies can enjoy just 50 bps of risk premium.

Economic risks are rising also. India, Thailand, and the US may be behind the curve in tackling their inflation problem. This could lead to worsening trade balances for these economies.

The policy of the Bank of Japan is perhaps the biggest area of uncertainty as regards the EM boom. The BoJ is probably the lender of last resort in the global financial system. The massive carry trade – borrowing yen to borrow US treasuries for interest spread income – may be the explanation for the flat yield curve. Indirectly, I believe the BoJ liquidity may have caused the collapse in the EM risk premium.

… and the Risk Premium Cannot Drop Below Zero

While momentum is still strong in favor of high beta assets, the near zero risk premium on EM sovereign debt suggests that the boom is nearing its end. The base effect is about to boomerang on EM assets, I believe. Simply put, the risk premium cannot drop below zero. If the EM sovereign risk premium drops to zero, the implied increase in EM equity value is another 12% at most, on my estimates.

The high base effect suggests to me that the momentum in the EM market could hit a wall this year. We could see repeated surges and retreats in the coming weeks. However, maths is against forward momentum. When markets fail to reach new highs a few times, momentum tends to shift the other way. Then, it may take just one event to trigger reverse momentum – that is, the risk reduction trade.

India’s Sensex, China’s H-share index, and Japan’s TOPIX are where risk-takers have been congregating. I believe comparing them against the NASDAQ in 2000 yields potentially useful indications of when these markets might run out of steam and reverse.

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Random Readings

28th February 2006, 03:48 pm
Click on the link to read the full story
On the budget day, it has been historically observed that there is volatility in the markets. Stockmarkets, as usual, may take a knee jerk reaction without understanding the appropriate implications of the budget proposals. Before you, the retail investor, take any investment decision, it is pertinent to take a step back and understand budget implications clearly, even if it means taking an investment decision after a day or two. “Reality leaves a lot to the imagination”.
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Random Readings

27th February 2006, 03:42 pm
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“This Time It’s Different” are among the most costly four words in market history - John Templeton
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Price to Book Value: Numbers Say It All

27th February 2006, 03:39 pm
The price to book value ratio is a basic valuation ratio to evaluate the fortunes of a company.
Price to book value ratio is one of the basic valuation ratios, one which you may hear most often after the P/E ratio. However, this ratio is not very useful in many cases, particularly at this time in the bull market.

In terms of definition, it is share price divided by book value per share. The book value per share is net worth divided by number of shares. Often, analysts adjust net worth by removing revaluation reserves. However, not many companies have revaluation reserves, so if you don’t bother about revaluation reserves, that’s fine in most cases.

The problem about book value is – it is not of much help when it is greater than one. Currently, in the BSE500 list, only 50 companies have price to book value ratio less than one. So 90% of the companies are quoting above book. When companies are quoting above book value, it is difficult to say whether they are cheap or expensive on the basis of only this ratio. For example, Hindustan Lever has a book value of 15 at current prices. Even at its low of Rs 100 a year ago, its book value was around seven or so. Clearly, a book value of seven didn’t deter the scrip from more than doubling. This is because, in HLL’s case and in many other businesses, book value will always be significantly greater than one.

Many FMCG companies like HLL have been working with negative working capital. They also don’t have much of fixed assets. Therefore, these companies can build sizeable businesses without having to keep too much capital in the business. In other words, they don’t need to retain too much of the profits to grow. Same is the case with IT companies. Infosys has a price to book value of 11 times. IT companies also aren’t too capital-intensive. Other than investing in office buildings, they don’t need much capital. Here again, price to book value has little meaning.

This ratio has some meaning only when it is less than or close to one. When it is less than one, then it means either of two things – either the company is undervalued or the company is in a declining business. Take the case of MTNL. It has a price to book of 66%. This company has been losing customers for the last few years to private telecom players. Its sales and net profits are declining. Or take companies like ITI and IFCI. These companies have eroded their net worth and have a negative book value. Escorts is another company with its price less than the book value. This company has not done well for years in any of its businesses. So most companies quoting below book value are now companies with declining businesses and with no great future. These are companies no one wants to own. There can be exceptions. If for example, MTNL gets its act together, there may be a great upside in the stock.

Price to book value has meaning for the banking sector. This is because here, the book value (or net worth) is a key factor which determines growth. A bank needs to maintain a minimum capital adequacy ratio, which acts as a cap to growth. That is one reason why banks should not quote significantly above the book value. HDFC Bank has a book value of 3.7, which is quite high for a bank. SBI has a book value of 1.4. Quite a few banks have book value less than one; examples being Dena Bank, Bank of Maharashtra and South Indian Bank. Some of these could be worth looking at.

Sometimes, companies quote below book value if their accounts are not genuine. Some companies show bogus profits, which means that the net worth shown is not correct. Sometimes, companies have high levels of debtors and loans and advances, some of which are not likely to be repaid. If such companies don’t take a write off, then again net worth won’t be genuine. In the current list of companies quoting below book, there are some companies which may fall in this category.
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Random Readings

25th February 2006, 09:04 am

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The only investors who shouldn’t diversify are those who are right 100% of the time - John Templeton

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Even the best can make the wrong moves

25th February 2006, 08:54 am
by Vivek Kaul/DNA Money
“Kyun dare zindagi mein kya hoga, Kuch na hoga to tajurba hoga” - Javed Akhtar
Dheeraj Sharma was going back to his office from a site visit. The company he worked for wanted to set up a new plant to expand capacities. Sharma was deputed to take a look at various locations and file a report, so that the management could finalise a site for the new factory.
Sharma was skeptical about his company’s decision to expand capacity but really could not do anything about it. He thought the expanded capacities would do no good to the company and just bring down prices, without really expanding the market.
When Sharma had started working around two decades back, he was of the opinion that it’s difficult for investors to figure out the future of the company. But people who ran the company (both managers and owners) would find it a lot easier being in the position they were.
Now, after two decades of work, he felt how wrong he had been. His experience had taught him that managements of businesses at times turn out to be as wrong about the future of a business as investors are at other times.
Sharma thought about the town of Modinagar he had to cross on his way to his hometown, Meerut, from New Delhi. Over the years, this town had turned into an industrial graveyard. One could see rows of dilapidated factories of cement, steel, textiles, etc. The family of Gujarmal Modi had tried to enter almost every business, unsuccessfully.
All this made Sharma wonder, “Why can’t the management of a company, being in the position where it is, see the future coming?”
Debashis Basu in his book, Face Value, Creation and Destruction of Shareholder Value in India, points out, “Managers are usually too full of their own strengths and cannot see the pitfalls ahead in their business when the market does.”
Further, it also does not help when the top management collect ‘yes men’ around them who go with what they are told instead of trying to question decisions.
Basu further points out, “Management assumptions always overestimate the future sales and underestimate the costs needed to get the projected level of sales. Actual performance rarely lives up to these rosy projections - as most project reports and analysts’ research reports testify.”
At times, the management is so focussed on the demand side of the business that they forget the supply side. In a climate where everyone is optimistic, managements tend to look at the growth opportunity that has presented itself without realising that there are many other companies in the market getting ready to tap the same market. This leads to a supply-side glut. Two excellent examples are the American and European consumer durable companies, which have come into India, but over the years really haven’t been able to make a dent into the market.
As Basu points out, “On the supply side, there are hundreds of drug companies in India fulfilling the basic needs of people. Like foreign consumer products companies, foreign pharma companies have to face doughty Indian competitors who happen to be more enterprising in changing their business model to discover new revenue sources.”
But the stock market usually figures out which way the company is headed in the days to come. This information gets reflected in the price of the stock. The stock market, at times, even ignores good financial results of a company. A good result is past data. What the stock market is interested in is the future. And if it feels that the future of the company is not clear, excellent financial results have no impact on the price of the stock.
The example is hypothetical

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Sensex @ 10,000+: Any party poopers?

23rd February 2006, 12:48 pm
Source: Equitymaster.com

The BSE Sensex has finally hit the ‘10,000-mark’. As a matter of fact, it has comfortably managed to remain above this level, falling below it just twice - on the day it hit 10,000 and last Friday. The liquidity flow into India continues unabated, investors from countries like Japan, the UK, Denmark, Sweden and the US alike continue to warm up to the ‘India story’. Corporate fundamentals remain on firm footing, GDP growth continues at an impressive pace - could anything be better?

Well, we, at the risk of being labeled as ‘bearish’, would just like to mention a few factors that could ‘potentially’ upset the apple cart. Please note, we remain positive on the ‘India story’ from a longer-term perspective, as we believe that major fundamental drivers, such as an expected increase in domestic consumption, a focus by the government on infrastructure development and the outsourcing story, all remain intact.

Interest rates and fund flows
With the new Fed Chairman, Mr. Ben Bernanke, taking office, it is widely expected that he will continue with an upward interest rate bias. The US Fed rate, at 4.5%, has seen the fourteenth consecutive hike since June 2004, when it hit multi-decade lows of 1%. Continued hikes will result in US assets becoming better yielding, with no currency risk to boot. Thus, it is possible that some money/funds will flow back to the US if this rate goes to a level that is ‘perceived’ to be safer by foreign investors. What this ‘threshold level’ is and what quantum of funds might flow out, is anyone’s guess. What we are saying is that it could be a ‘potential party spoiler’.

Oil prices
Global markets, including India, have been surprisingly resilient to crude oil price increases. Generally, any such increase is perceived as a ‘tax on growth’, which the economy has to bear, given the fact that ‘black gold’ is an essential commodity to keep the engines of the economy running. However, this time around, there has been no impact whatsoever. This can be explained by the fact that globally, stocks, real estate and commodities have all hit multi-year highs, causing a ‘wealth-effect’. This has been possible due to an increase in global liquidity, caused by accommodative monetary policies of central banks worldwide. Commodity guru, Jim Rogers, has said that over a period of time, he expects crude prices to hit US$ 150 a barrel. If this happens, it could seriously restrict global economy growth, including India.

Valuations-expectations-earnings growth
This is a linked chain that determines in a big way as to where the markets will go in the long term. Valuations, at present, may not be that attractive to a ‘value investor’. With the BSE Sensex trading at 18.7 times trailing 12-month earnings, it certainly does not appear too cheap at current levels. This is also a reflection of the market’s expectations from India Inc. Good earnings growth has already been factored in at the current levels and any hiccups on this front could result in some correction and a re-alignment of expectations from the markets.

Conclusion
India Inc will now need to deliver on the earnings front in order to justify current valuations. This is the main fundamental factor that is expected to determine the movement of the indices over the longer-term. At these levels, high earnings expectations have already been built into stocks on a macro basis and if they do not deliver, some amount of profit booking would be in order.

However, we would like to additionally stress here that ‘10,000′ is just a level and nothing else. For longer-term investors, it really does not mean a great deal, apart from the ‘psychological impact’. These days, often, it is difficult to say whether one is watching the Sensex or the Dow Jones! But for such longer-term investors, it is more a stock-specific approach that is important and whether or not the individual stocks have breached their target price or not. It is such an investing strategy that one should follow in times like this.

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Random Readings

23rd February 2006, 12:47 pm
Click on the link to read the full story
“An ounce of patience is worth a pound of brains“
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The best way to sell a stock: Tell a tale

23rd February 2006, 12:14 pm
by Vivek Kaul/ DNA Money

Nostalgia is like a grammar lesson: you find the present tense, but the past perfect! — Owens Lee Pomeroy

Sharad Mavlankar is retiring today. He has worked for a stock market broker for the last four decades. He has seen the market change and evolve over the years. When he started working in the mid-60s people had the time to listen to him. Every stock had a story behind it. And it was a part of his job to narrate those stories to investors. The best sales pitch for a stock was to tell the investor a compelling story, backed with some anecdotal evidence.

Over the years, things have changed. People still need a story to invest, but now they can get it from other sources like business media, websites etc. His role had diminished, and towards the end of his career, Mavlankar had very little work to do.

Aswath Damodaran in his book, Investment Fables, Exposing the Myths of “Can’t Miss” Investment Strategies, points out, “Investment stories have been around for as long we have had financial markets and they show remarkable longevity. The same stories are recycled with each generation of investors and presented as new and different by their proponents.” The present-day experts have simply been recycling stories that Mavlankar had always told his clients.

In his initial days, Mavlankar realised that it was easier to sell a stock if he could back it up with a story. As these stories appealed to the basic human nature of fear, greed and hope. And they came in various forms, each trying to target a particular kind of investor.

For an investor who is risk-averse, experts recommend stocks with a low price-to-earnings (PE) ratio, stocks which pay high dividends, which trade less than their book value, companies which have stable earnings etc. For the risk-seeking investor, there are growth stocks and loser stocks (stocks which have fallen to an extent that they can fall no more). For those who have taken poor investment decisions in the past, there were stories like stocks always win in the long-term, just follow the experts, etc.

There’s some amount of truth in these stories and that’s why they work. As Damodaran points out, “Part of the reason is that each story has kernel of truth in it. For example, the rationale for buying stocks that trade at low multiples of earnings. They are more likely to be cheap, you will be told. This makes sense to investors not only because it is intuitive, but also because it is often backed up by evidence.”

Damodaran, in the context of the American stock market, further says, “Over the last seven decades, for instance, a portfolio of stocks with low PE ratios would have outperformed a portfolio of stocks with high PE ratios by almost 7% a year.” But most of these rules do not work all the time. Now let’s take another oft-repeated story, “Stocks always give greater returns in the long-term.”

The BSE Sensex touched a high of 4546.58 in 1992. In 2000, it touched a high of 6150.69, giving returns of around 4% per annum in the intermittent period. In between, once it touched a high of 4643.31 in 1994. At the same time, other form of investments would have given better returns than the stock market.

The Sensex kept falling from 2001 till 2003 when the present bullrun started. So this story did not work for a period of 12 years — from 1992 to 2003.

As Debashis Basu points out in his book Face Value, “By the end of 2002, BSE Sensitive Index, was actually down over eight years of economic growth. Post office savings did better than the 30-elite Indian companies carefully chosen and changed to be part of the Sensex”. He further says, “Instead of investing in blue-chip companies like Reliance Industries, Hindalco, ACC, TISCO, Grasim, Telco, L&T, SBI, Glaxo, Gillette (earlier Indian Shaving), P&G, Thomas Cook, Nirma and others you would have been better off putting money in fixed deposits.”

The example is hypothetical

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The Limits of a Purely Technical Approach

22nd February 2006, 04:17 pm
By Rev Shark, RealMoney.com Contributor

One trap that many technical traders fall into is trying to find the one or two indicators that will produce a regular and steady flow of profits. They believe that if they just find the right combination of moving averages, stochastics, relative strengths or whatever, they can hit the buy or sell buttons when things align the way they should and take the profits to the bank. The market goes through cycles, and human behavior and emotions tend to be pretty repetitive, so quantifying things in mathematical terms shouldn’t be that difficult — right?

The search for the technical holy grail has gone on as long as the market has existed, and there have been systems that work for periods of time. Backtesting is a major industry, and there are all sorts of programs available that claim to have developed algorithms that will make you rich if you just follow the red and green signals.

There even have been some big hedge funds that have developed complex “black box” systems to trade the market. One of the most famous, and most secretive, was run by Ed Thorp, who wrote one of the first books about card-counting and blackjack basic strategy.

Mechanical trading systems can work, but few of them are adaptable to the ever-changing market environment. A system that uses a momentum scheme will break down in a trading-range market, and a system that focuses on overbought conditions will underperform in a strong trending market.

If you are tempted to believe that a couple of technical indicators can deliver consistent profits, ask yourself why the technicians employed at major Wall Street firms who spend millions of dollars on research aren’t simply programming their computers to do such things. Why aren’t the folks who spend their lives developing mechanical trading systems simply using the indicator that you like to make millions?

Despite all our efforts to quantify and understand the market, it will always be random and unpredictable to some extent. It simply is not possible to predict the news or how people will react to it. There are some things that remain constant, but not to the degree that we can ever be confident that we can capture the swings in the market through the use of a couple of simple indicators.

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