Friday, 28 August 2015

Right Stock Selection in a Turbulent Market Environment

Right Stock Selection in a Turbulent Market Environment

7 Lakh crores vanishes from the market on a Manic Monday in India with over 500 Billion Euros wiped out in the European market, wonder what has happened to your investments in the stock market which you have made with your hard earned money. With Large cap and Mid cap stocks falling all around there is a blood bath in the world markets with blue chips falling in almost double digits, what stocks does an investor look at investing in and how does one select an appropriate strategy. The classic age old saying is buy low sell high but in practice is this really the low or would it go down further or this is the right time to buy. Even professional investors are unable determine the exact time when to enter a stock at its lowest levels or sell at the heights point hence in order to create wealth in the long term an appropriate long term strategy must be in place  in order to withstand the short term shocks and stress that the markets would pose.

As discussed in the earlier post one of the most important things that one should look at in any stock is the corporate governance standards in the company along with the fundamental strength in the company. In order to make an appropriate choice out of the universe of stocks a few thumb rule techniques could be applied in order to arrive at the appropriate stocks. One of the time tested methods that can be applied and has worked over a period of time not only in the Indian markets but also internationally is the two pillar approach of selection of stocks: Dividend Yield and Return on Equity (ROE)

In order to build long term wealth and have a regular stream of income the strategy to pick high quality companies with a dividend yield of 2% or more and having a ROE of 20% or more could be one of the best possible strategies. Anecdotal evidence shows that Rs 1 crore invested in such a portfolio of stocks which are selected with a dividend yield of 2% or more would end up in a corpus of Rs 4 crores with an initial income stream of Rs 2 Lacs per year growing up to Rs 8 Lacs  at the end of 10 years.

Starting from a universe of all the listed companies listed on Bombay Stock Exchange (BSE) and short listing companies that are selected would be relatively large businesses having market capitalization between Rs 700 crores and above. Post which the criteria of ROE of 20% would be applied and finally the last criteria of dividend yield of 2% or more. The analysis period was January 2003 to June 2015 of such selected stocks shows that a return of 34% compounded annual growth rate (CAGR) over the period when the NIFTY returned 19% CAGR over the same period. This means that the investment of Rs 1 crore would have become Rs 26 Crores in 2015.

The dividend yield at the time of investment in a portfolio having selection using the above criteria was 4.8% and by 2015 the dividend yield was 3.8%. The rupee payouts would have been much higher at Rs. 480,000 in 2003 compared with the conservative estimate of Rs. 2 Lacs and would have been almost Rs. 1 crore in 2015 compared to the conservative estimate of Rs. 8 Lacs that we have taken above.

The portfolio value would fluctuate depending on the time period like in 2008-09 it would have fallen substantially as the markets overall did and the value would have risen in 2014 as the overall market did. The NIFTY has dropped around 55% in one year that being its worst drop, in the same year a portfolio of stocks selected with above criteria would have dropped around 34% much lesser than the overall market.

Applying this portfolio of stocks  to a different time period say beginning of 2005 and you had held these passively till 2015 Rs. 1 crore would result in Rs. 6.3 crores with a 19% CAGR compared to a 14% CAGR of the NIFTY. The dividend received in the period would be over and above this.

If such a portfolio was selected in January 2008 at the peak of the markets the last life time high, the selection would result in picking 15 companies which pass thru these two criteria Rs. 1 crore invested would result in Rs. 3.4 crores over the period of 2008 to 2015 resulting in a CAGR of 18% compared to a NIFT return of CAGR of 5%.

This clearly illustrates that long term wealth generation in the market can be attained by selecting large cap stocks having established track record and a substantial size. The above section criteria would help you select companies in sectors like FMCG, IT, manufacturing, Oil and Gas and Public sector enterprises there by restricting your choice to very large companies and proving the myth wrong that long term investment would give you a multi bagger return only choosing small and mid-cap companies.

In order to survive a very challenging macro-economic world environment it is essential to choose the right companies to make long term investments in so that the returns over a period of 5 to 10 year period would be far superior than the overall market and such a section would result it wealth creation and help in capital protection in very challenging times.  It is of prime importance to evaluate other fundamental factors in selecting a stock but this could be used as one of the techniques used that has stood the test of time and may resulting in similar performance in the future as well.

_ Farzan Ghadially



Saturday, 22 August 2015

Mid Cap Mania

Mid Cap Mania

With the market inching towards the 20,000 mark after the uncertainty  faced by most industries in early November, there has been a run up in blue chip as well as mid cap companies. With the initial set of results coming in on the positive side, a lot of market participants are looking at investing in mid cap companies in order to find the next multi bagger. As the saying goes buyer beware, it is extremely important to study the mid cap and small cap companies specially on the corporate governance angle.

Retail investors listen to the term corporate governance lot of times but are not able to understand corporate governance in depth. One of the most important documents that an investor must study and analyses is the annual report of the company. When you read the annual report of any company there is a report on corporate governance which in most cases mentions that highest level of corporate governance is followed by the company and gives no adverse remarks. However as an investor corporate governance, must be checked first and then one must evaluate the investment decision based on the valuation parameters.

As the saying goes that there is no good company or bad company the investment decision must be based valuation and an average stock bought at a throw away valuation is better than a very good stock bought at a very high valuation. However in order to apply this logic the corporate governance standards must be good so that a fair investment decision can be made.

In the Indian market we have seen small caps and mid cap company stocks make over 100% returns within a very short period of time and then fall like nine pins and most retail investors who enter the stock at the wrong time are stuck with almost all of their invest wiped out.

How does this really happen when at the surface the company looks good in terms of valuations and fundamentals then how do companies and promoters really cheat the investors. In order to analyses this, some common symptoms are present in one form or another in these companies and it is very essential to evaluate these before making an investment in any of the mid-size companies.

A.     Camouflaging of Profits:

When you analyses the financial numbers the company is showing a good track record of profit and growth in profit year on year (YOY) when you deep dive you realize that the profit after tax (PAT) is generated without actual cash generated by the company.
We can identify this by analysing the cash flow statement with Profit and Loss (P&L) statement. . If a company shows a good PAT number but the same is not translated in cash flow from operations this is an alarming sign. Negative cash flow from operations is not always bad but in most cases especially with companies listed on the Indian stock markets it would be an alarm bell.
There is a cash flow statement in every annual report where cash flow from operating activities is arrived from adjustment in PAT figure e.g. Depreciation, Inventories, Receivables etc... One should try and identify the source of cash leakage then come to conclusions.



B.    Camouflaging of Profits: Second way:

In this case the company is showing a good PAT and YOY growth in PAT with positive cash flow.
Since there is a good growth in PAT and a positive cash flow is positive it would skip the first test mentioned above. However in this category you will see low Debtors’ Turnover Ratio. If the debtors’ turnover ratio is low you can smell that something is wrong. Sundry Debtors is the field in the balance sheet which indicates how much amount is due from the customer and other parties (Receivables) most fraud companies show growth in PAT, because of the increased Sundry Debtors. It is not difficult to manipulate PAT by Sundry Debtors. These companies increase Sundry Debtor amounts each and every year and after a few years write them off. One should not conclude that Sundry Debtors is bad for every company or industry as every sector would have its own payment patter as the company you are analysing should be compared to the other companies in that sector before drawing any conclusion. Hence if the company has a very low debtor turnover ratio compared to its peers in the sector it does indicate low quality of profits.

C. Share Holding Patter:


Every listed company provides the share holding pattern every quarter, a lot of investors just looking at the shareholding under the category of Promoter & Promoter group, in case the shareholding under this category goes up it is considered as a positive as the promoters have faith in the company and have increased their holding at the current prices where they find value at the price at which it is trading, in case the promoter reduces the stake in the company it is taken otherwise.
However one needs to deep dive and also look at shareholding under the category of Public shareholding both under institutional as well as non- institutional. Under the institutional category the quality of institutional holding the shares is very important and gives a lot of confidence to the new investors and under the non-institutional category if there are known good value investors that are known in the market for their long term investment ideas it should be taken as a big positive.  In case there is a lot of movement in terms of shareholding quarter after quarter, with unknown names as such, it should be taken as a sign that large quantities of shares are sold from one investor to other there by parking of the shares in proxy names and this should raise the red flag immediately.




D.   Turn over Generated by showing sales booked by Subsidiaries abroad:

This is very difficult for a retail investor to really identify and many a time’s even professional investors are unable to really spot this kind of pattern. This normally happens in mid and small size IT companies who are not even having proper infrastructure or the requisite personnel requirements run a software company forget executing high tech export orders. What is really done is the Indian company that is listed on the stock exchange executes the order that is received by its subsidiary abroad. The Subsidiary abroad is setup a small company incorporated having no real staff or setup; this subsidiary abroad claims to have won a contract or order from overseas clients that are relatively unknown as such and gives the work to the India Company. Most of the subsidiaries are setup in free ports like Hong Kong, Dubai or Singapore or certain tax heavens in the world where money can be remitted back and forth with ease.
The Indian promoter sends money abroad to these subsidiaries setup in relatively friendly tax jurisdictions via unofficial means and then these subsidiaries pay the Indian company as per the contract executed in dollars here in India there by increasing the turnover of the company. With decent growth in the sales the company increases its fundamentals and there by showing decent profits where the tax rate would be relatively less as all the income is shown as export income and in case it operates out of an IT park or Special Economic Zone (SEZ) where in lower tax rates are applicable the relative tax outgo that the company needs to pay is lower than normal.

After this exercise the stock price is managed by a stock market operator/manipulator that artificially increases the trading volume and price of the share and is being supported by the company with increase in sales and profitability.  When there is a substantial rise in value of the share the operator and company sell large amounts of shares at that price and retail investor start believing in the companies story as the stock price kept rising and then post the exit of the operator the share price falls like nine pins and investors are stuck with the ill liquid shares almost having no value. This is popularly known as Pump and Dump in the stock market context.

In order to create long term wealth in these stock market never depend on buy on the rumour and sell on the news as it may work once in a while as a part of trading strategy but as a long term investment in most times the genuine investors would lose their money.

Needless to mention that there are many Mid-Size companies in India that have the potential to make it very big and investing in those companies would result in multi baggers but when making the investment decision a check on Corporate Governance along with fundamentals must be carried out by the investor.

_Farzan Ghadially




Thursday, 13 August 2015

Chinese Currency Devaluation.



 


 
 China carried out the biggest devaluation of the Renminbi in two decades to boost its slowing economy, marking an escalation of international currency wars, surprising markets and risking a clash with Washington.

The central bank’s 1.9 per cent downward move was its biggest one-day change since 1994  and since China abandoned its tight currency peg for a managed float in 2005. It pushed the daily fix to Rmb 6.2298 against the dollar, compared with Rmb 6.1162 the day before. The biggest shift this year had been a 0.16 per cent adjustment.

The move, coming as growth has flagged and the currency has been under upward pressure from its informal peg to the rising dollar, is in sharp contrast to policy during previous times of stress when Beijing resisted pressure to devalue. It should help combat a big fall in China’s exports fueled by the Renminbi’s relative strength.
It comes as China pushes for the Renminbi to be accepted as a global reserve currency alongside the dollar, yen, euro and sterling by the International Monetary Fund, which has cited greater exchange rate flexibility as a key factor.

The adjustment opened China up to criticism of adopting a competitive devaluation and is likely to complicate President Xi Jinping’s September visit to the US, where politicians have long argued the Renminbi is undervalued.
  
Government bonds attracted demand from investors worried about weaker global growth. Copper, a barometer for global activity fell 4 per cent to a six-year low. Brent crude, the benchmark oil price, fell almost 3 percent; back below $50 a barrel the day China devalued its currency.
The People’s Bank of China said the move was a one-off to reflect changes in the way it calculates the daily fix — the rate at which the central bank sets the currency every morning and from which it is allowed to move as much as 2 percentage points in either direction.

In order to understand the current situation and effect on the world economy a few points that need to be analyzed:

What is the daily fix?

Each day at 9.15am in Beijing, the People’s Bank of China (PBOC) sets a midpoint for its tightly controlled currency. When the market opens 15 minutes later, investors are   allowed to trade the currency 2 per cent either way from this midpoint.


 Why did the Chinese government devalue the currency now?

  An obvious catalyst is the slowing economy. In the first and second quarters, China’s economy grew at an annual rate of 7 per cent, the slowest pace in six years. Data realised just before the devaluation  showed exports fell 8.3 per cent year on year in July, far worse than expectations for a 1.5 per cent decline. A weaker currency should help make Chinese exports competitive.
  
Is the devaluation as a result of any external pressure that China is facing?

Before the end of the year, the International Monetary Fund (IMF) will decide whether to include the Renminbi in its special drawing rights (SDR), a global reserve asset comprising the dollar, euro, pound and yen. Inclusion would mean endorsing the Renminbi as a formal reserve currency.
The IMF conducts a review of the SDR only once every five years, so the PBOC could be stepping up its efforts to liberalize the currency as part of its quest to internationalization use of the Renminbi.

Is this the right step towards reform for the Chinese market?

It is extremely hard to judge if this is the move towards market reform, the Renminbi had been under pressure to weaken for months because of capital outflows, but the PBOC restrained any depreciation by setting the fix higher and selling foreign exchange reserves. Today’s one-off depreciation eases some of that pressure.
Economists were optimistic and some of them called it a revolutionary move but we will not know if China is truly letting the market have a say in the currency’s value until we have seen it move in a direction that would not be supportive to its own goals.
The Chinese currency has a soft peg to the US dollar, which has surged this year and contributed to the decline in Chinese exports. A weaker Renminbi could support the economy, so Beijing could simply be allowing the currency to slide and use the talk of market reform as political cover; otherwise it would be controversial for the currency to be devalued.

Would the Currency Devaluation matter outside China and have any impact on rest of the world?

 Yes. China is a large consumer of commodities and if the move is interpreted as a sign of economic weakness, there will be ripple effects. Every currency in the region weakened against the US dollar; those of New Zealand, Taiwan, South Korea, Singapore and Australia fell 1 per cent or more the day the Renminbi was devalued.
Dollar strength could make the Federal Reserve reluctant to lift interest rates, as that would cause further upward pressure on the US currency.
  
What are the risks with this devaluation?

Investors have been pushing for the Renminbi to weaken, and if they are allowed to determine where the fix is, it is possible the currency could depreciate quickly. Investors could see the Renminbi as a one-way bet and start to position against the currency, raising the prospect of more substantial Renminbi weakness and more economic uncertainty.



 What next does hold in store as far as the Chinese currency is concerned?

The question that needs to be looked at is whether Beijing really does allow the currency to trade more freely. Last year the PBOC moved to stamp out one-way speculation, when the Renminbi was continually appreciating, resulting in the currency’s first annual loss in two decades.
If investors begin to push the Renminbi lower, Beijing may feel the need to act again. If it does not, neighboring countries that compete for exports may complain.
The US could be in a tough position. It has asked for reform for years, but if China allows the daily fix to be determined by market forces and the currency depreciates, hurting US manufacturers, the US would be in a real spot of bother.

According to conventional wisdom, wars are easy to start and difficult to end. Similarly Beijing’s devaluation, the biggest one-day currency move since 1994, represents the latest skirmish in an emerging battle which, analysts warn, may be hard to reverse.

The move marks a shift in China’s policy during times of economic stress. In the late 1990s, the country was widely credited with containing the destruction from the Asian financial crisis because it held fast to the Renminbi exchange rate in the midst of competitive devaluations across the region.
In the global financial crisis of 2008, Beijing also refused to devalue even as its exports, a driver of the economy, evaporated overnight.
But now, in the midst of a pronounced and persistent Chinese economic slowdown and continued appreciation pressure resulting from the Renminbi’s dirty peg to the soaring US dollar, China’s leaders have decided to take the plunge.
  
 The unexpected move by The People’s Bank of China to weaken the Renminbi by its most in two decades fueled talk of currency wars, although others interpreted the intervention as a welcome gesture towards market reform and financial liberalization. The Renminbi fell to its lowest level in nearly three years after the central bank set the daily fix for the currency 1.9 per cent lower, the sharpest shift on record.

China devaluation raises spectre of currency wars. Beijing’s attempt to deal with a slowdown may have a spill over effect.
All currency wars are self-defeating for their combatants. When a country slashes the value of its currency to boost exports, it inevitably triggers competitive devaluations by its trading partners, thereby robbing the first mover of its initial advantage. Thus it is unlikely that China, which in effect devalued the Renminbi by 2 per cent, was intending to whip up currency skirmishes among its trade partners into a full-scale war.
China’s position as the world’s largest trading power ensures that its action will distribute deflationary pressures throughout its global supply chain, while intensifying pressure on competitors to seek their own currency depreciations. Such pressures will only grow if such action signals a sustained trend of weakening.

In its most crucial sense, the impetus for China’s devaluation, which represented the Renminbi’s biggest drop since 1993, was self-defense. It is not just that exports have been dismal so far this year and tumbled again in July by 8.3 per cent. It is also that China is suffering from a chain reaction of structural economic ills that threatens to run out of control. As ever, China’s true predicament is obscured by official statistics. The official gross domestic product growth rate was 7 per cent in the second quarter, but several independent analysts estimate that in reality it may be closer to 4 per cent.
A similar situation exists with investment, an important growth driver. Official numbers put fixed asset investment growth in the first half at 11.4 per cent, but a cleaner measure of how much companies are investing to boost their productive capacities gross fixed capital formation is running at an estimated 4 to 5 per cent, from 6.6 per cent in 2014..Allowing for the depreciation of existing plant and machinery, it is possible that China has already ceased adding to its productive capacity.


Beijing called it a step towards financial liberalization but that did little to mask the true nature of a decision that, at a stroke, reduced the value of the Renminbi by 1.9 per cent. This was a devaluation a modest one, but still the biggest one-day change in the value of the currency since China began daily adjustments a decade ago. The consequences may be profound.
The timing of the announcement was surprising. Later this year, the International Monetary Fund board will review the composition of the special drawing right, the IMF’s accounting unit.
China is keen for the Renminbi to be admitted, and had tried to maintain a stable currency and pursue financial reforms that the IMF would expect of an SDR member. The decision to let the Renminbi slide, however, shows that Beijing remains committed to intervention.

 A fall in the yuan was undoubtedly what the authorities intended. They wanted it for two reasons. First, its trade-weighted value had risen significantly in recent months.
Second, it amounts to a further easing of monetary policy in the face of sluggish exports, a hiatus in economic growth, and the sharp depreciation of the currencies of many of China’s emerging-market competitors.
This intervention follows a series of policy failures. Beijing’s attempt to bolster the stock market partly designed to nudge state enterprises away from debt and towards equity financing, has not worked. There is still serious overcapacity in the construction sector, and in heavy industries. The weight of debt in local governments and in non-financial companies is undiminished.
Beijing has been pulling other levers to try to stimulate the economy. Government controlled institutions such as the China Development Bank have been allowed to issue Rmb1tn in new bonds to finance infrastructure projects.
Local government financing conditions have been relaxed, and the PBC had lowered interest rates and cut banks’ reserve requirement ratios, allowing them to lend more. In the first seven months of 2015, new loans were 36 per cent higher than in the same period a year ago. In short, officials had tried more or less everything they could short of devaluation.
  
As the Renminbi hit a fresh four-year dollar low, its neighboring currencies came under heavy pressure. Malaysia’s Ringgit fell 2 per cent to its lowest level since 1998, while Indonesia’s Rupiah fell a further 1.4 per cent, also a 17-year low. Singapore’s dollar weakened as much as 0.6 per cent, while Taiwan’s fell 1.1 per cent.
Vietnam was the first country to take policy action. Authorities widened the Dong’s trading band from 1 per cent to 2 per cent. The dong weakened 1 per cent, with 22,040 dong required to buy a US dollar.

It is also important to acknowledge that Beijing’s new policy possess a risk for China on the whole.
The weaker currency increases the odds of a surge in default of foreign currency debt, which makes the country highly vulnerable to capital flight. The PBOC is aware that a lower currency would push others to the brink, which is why that there is a high probability that they won’t allow the currency to fall much further.

As far as India is concerned the winners would be mobiles, laptops, toys as they are mainly imported from China and they will become cheaper further.
The losers would be metal and steel sector as imports from China would flood the market, new capacities in steel and other metals that have been commissioned recently may struggle to compete with the cheaper imports.
Tyres is another sector that would be hit as Chinese companies are selling tyres  almost 20-25% cheaper than the Indian companies and Chinese imports make up 34% market share in replacement market for trucks and radial tyres and 45% of passenger car radial segment. With margins very slim in the textiles currency volatility plays a very important role and China imported 39% of the total cotton yarn of India worth $ 1.7bn in FY 15, Indian textile industry faces stiff competition from India.


-Farzan Ghadially