GOING DIGITAL – A suggestion to the PMO

Going Digital is the way forward. I think all are in agreement on this. There are some obvious places where the government CAN and SHOULD go digital IMMEDIATELY. Let me list out a few obvious places, which would help prevent lot of frauds and be in the public good.

 

  1. DOCTORS

On a public website, list out every doctor, name, year of passing and photograph. This will help weed out fakes and rogues. The details could also include names of doctors who are suspended / degrees cancelled etc.  Verification of qualifications becomes so much easier. Every recognized university should list the full details. Not very difficult.

  1. DEGREE HOLDERS, PROFESSIONAL QUALIFICATIONS ETC

Every institution that is recognized, whether it be IITs or CBSE or colleges, SHOULD put on their website, names and photos of every one who passed out of their academies, year wise. This will weed out those who submit fake papers for getting jobst etc. And will obviate the need for ‘certified’ true copies etc.

This is especially relevant for professional institutions like IIMs, IITs etc. Jobs are given before the results are out. Publicly available database of results will help weed out frauds.

These are two basic categories, which affect the public. This can be extended to various spheres of public impact areas. Whether it be IAS officers or Gazetted Officers or Public officials.

PUBLIC ACCESS OR RESTRICTED ACCESS?

Does this violate privacy? My answer is, NO. If necessary, the grades, the marks etc need not be made public. However, the fact of someone being a pass or a fail should not be hidden.

I am sure, if the government implements this, it would be of huge public benefit.

R Balakrishnan

 

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ARE YOU BUYING MIDCAPS?

(This appears in Deccan Chronicle – http://epaper.deccanchronicle.com/articledetailpage.aspx?id=9339913)

As you try to exit the mid caps and you find that the scrip which was so easy to buy, is not shifted to “T to T” or “Cash” segment, selling becomes a full time operation. Enjoy the ride, take some money off also. )

THE BULL MARKET INVESTOR

I read a nice quote, which said that today’s stock prices are roaring so fast that the prices have landed in to the future. It carries a very subtle message. Markets celebrate every buy order with an uptick in prices. Bad news is greeted with ‘oh, it means the worst is over, let us buy NOW’. Every stock is a buy.

This is a market which gives you no time for thinking. The temptation to avoid process is very high. You sit down with the financials of a company and if you stupidly look at the price movements before you finish your analysis, you would despair.  Welcome to 1991. Welcome to 2000. Welcome to 2008. Welcome to 2017.

However, in this noise, I am trying to figure out some themes that will play out over the next few years.  Some of the factors at play, include:

  1. GST implementation could take two years to stabilize, but it does not seem to have dented corporate profits. Life goes on. And things shift from unorganized to organized. Things get better, bar the shouting;
  2. Consumption is the principal driver of the economy. Consumption that is aided and assisted by easy finance;
  3. Infrastructure spend is just beginning. On a scale that is unprecedented. There is a lot of action lined up;
  4. Company profitability can only go up from here;
  5. Liquidity is set to rise still higher as the FIIs will come back and domestic participation is rising day by day;
  6. PSU Banking sector looks set to bounce back to business as recapitalization plans announced, thereby increasing availability of funds for growth;
  7. Debt laden companies are getting a second life as banks are in a hurry to ‘resolve’ things and carry on with life;
  8. Valuations are not being discussed. As stock prices keep hitting new highs, the target multiples and prices also move up correspondingly;

The market mood is extremely buoyant. Mid cap stocks are the flavor. A small chat on a WhatsApp group and there is a ‘gap-up’ opening. Some speculators drop out. The seasoned punters get in and out, using a combination of inconsistent strategies (fashion for the times) to keep enlarging their portfolios. All that is needed for a price jump stretches from something earthshaking as announcement of quarterly results or a big brokerage house research report or the news of some contract coming the way of a company (does not matter that it is the routine business of the company) or the appointment or sacking of a key person or a celebrity mentioning the stock on social media.

In this bull market, there is no need for news to be earnings boosting. Mention gets a few percentage up on the stock any way.

And the ‘rumorists’ are having a field day. One speculative item in the social media and the stock price does high jumps. And then after a few days, a quiet ‘denial’ to the exchanges. The sheer magnitude is such that law enforcement will not just be able to catch up.

As a desperado in the stock markets, one has to now ‘anticipate’ which stock or group of stocks will be the prime & price movers on any given day. And the winner of the daily lottery is the one who has the best ‘hunch’ or the best ‘source’. And all the action is in the mid-cap and small cap space.

So what does one do? Either we are brave and ride the surf. Keep our eyes on the screen without blinking and press the ‘buy’ and/or ‘sell’ buttons without bothering to think about any ratios or business. I can see that this has become an occupation for many. Whether one makes profits or losses will depend on the character. In this day trading, you have to be brutal about not keeping a stock with you for long and be in love with prices rather than the company. This way, you also get to test your temperament.

For the more sober persons, who do not have a heart that is strong enough to bear the pressure, or for those who cannot spend the time needed, life becomes simpler. It is a good time to shift some money to large caps from mid caps. Not all sections of a market are equally valued. The large cap stocks will be less volatile. Will fall less than the mid caps, should the tide change. Correction can take two forms.  One is by prices going down to make valuations reasonable. The other one is by prices stuck in a range and earnings catching up over time. In effect, both mean that the ‘prospective’ returns for the asset class is lower than what one would like, at this point in time.

 

IPOs Ahead….

(This is a piece I had written for Moneylife in 2008- Before it became readable- the rough draft)

IPO’s and the merchant bankers- Takeaway for investors

Quotes from a newspaper:

“regulator’s inspection showed that the details of the promoters as mentioned in the IPO document were different from the one filed with the Reserve Bank of India.

, the merchant banker had not even verified the plant and machinery of the companies, the issues of which they had managed

one IPO, the regulator found out that the post-issue capital of the company was higher than its authorised capital —“

Above are some “omissions & commissions” by merchant bankers whilst managing IPO’s, according to a press report. The report also says that the regulator is likely to impose penalties on the merchant bankers concerned.

IPO business is funny business. Every issuer wants to sell shares at the highest possible price. Obviously, once an issuer short lists a few merchant bankers, then the actual choice would be made on who would offer the highest price. In any IPO, the fee is large. It could be a lowly 1% to as high as 5%. For an issuer, the total expenses can be in the range of 7 to 11% of the issue. Naturally, a 10% higher pricing means that the issue expenses are covered.

IPO’s, under the book building route can only proliferate in a bull market. In general, most IPO’s tend to be overpriced. All IPO pricing is based on some rosy picture of the future, so it is but natural that at least half of them will fail to live up to promises.

Once an IPO goes under water, the IPO investor feels cheated. Once many go, the noise levels increase. Investor forums start shouting and ask for action against lead managers etc.,

Firstly, no investor is forced by anyone to invest. He makes a conscious choice. He is being misled by the noise surrounding an IPO. He has no access to the prospectus or has no expertise to understand the same. So, he goes by his broker/friend/media views and plonks his money. Most investors I know want to keep flipping each IPO on allotment and move on to the next. One group just keeps piling up the IPO allotments. Over time, they sell where they see gains and hold on to the ones under water. In many cases, the reasons for holding on are psychological. Further, in each issue, the amounts involved are small (though it all adds up to a tidy sum) so there is a tendency to hang on. Over time, some of them become worthless and move on to the “vanishing companies” list.

What about the lead manager? To my mind, the lead manager/s should be punished only if there are compliance issues. If there are mis-statements, suppression of facts (which any due diligence should have thrown up) or any other act/omission which could have materially altered the story, then they should be punished. Here, the punishment should be severe and not nominal. I would say that suspending all the business of the entity for six months to a year plus a financial penalty which is at least four to five times the total fees involved in the issue should be levied. The penalty should hurt. A few lakhs does not make a difference to most merchant banks. Suspension of activities (all business done by the entity/group) in capital markets is a must. Only then would it hurt.

There would be instances where the lead manager is taken for a ride by the company. Such cases would be complex in nature. For instance, one of the cases cited above relates to the company filing some return with the RBI. It is very unlikely that the merchant banker would be able to verify this and to my knowledge, would not fall in the check list for due diligence. However, non-existence of plant and machinery is something that is amazing. So is the case of the authorised capital not being adequate. These are elementary errors and the punishment should be very severe. In fact, taking away the capital markets business licence would be a fit action in these cases. When a merchant banker takes on an IPO mandate, his responsibilities are huge. He may not have all the expertise himself, so he has to hire the right people to help him in this. On pricing, it is what the traffic can bear, so no issues with them. I would not blame a merchant banker on this. If he does this frequently, the market place would judge him over time.

Pricing is something we all like to hold the merchant banker responsible for. If an issue lists at a huge premium, then the issuer has lost. Similarly, if the issue lists at a discount, the investors get hurt. There is no answer to this. The merchant banker gets paid by the issuer. Naturally, his first loyalty lies there. As far as the investor is concerned, he has to take his call. There is no point in saying that if institutional investors put in money, they would have done their homework. World-over, there is an unholy nexus between institutional investors and merchant bankers (who also are brokers). The institutional investor can move more quickly, he has access to much more information than the retail investor would have.

The retail investor is all alone in this. The IPO grading system has been discussed in our magazine. Whilst it is a useful tool, it gives no help on pricing. This brings home the lesson that equity investments are fraught with risk. IPO investing is perhaps more risky than a secondary market investment. In the secondary market, you would have access to more information, research and price history. Further, in most IPO’s one has no idea about the management quality and capabilities. You may end up with a multi-bagger or end up with tissue paper. It is best to be cautious. In IPO’s, the advantage is typically with the issuer. He comes in at a time and price convenient to him. It need not coincide with what is good for an investor.

One issue relates to pricing disclosure. Whilst giving the mandate to a merchant banker, all issuers insist on a “price range” at which the merchant banker can place the shares. Without this, no issuer will give a mandate. However, the public get to know of a price only when the issue is about to open. All offer documents have a blank in the price disclosure. I understand that pricing can change, in tune with market conditions. However, why not give the indicative price band whilst filing the red herring or the draft prospectus with SEBI? This would give time to analysts to give their views on the issue. Today, most analysts do not get time to do this efficiently, because the price band fixation and the issue opening happens with a gap of a few days. This is something for the regulator to consider. Let the issuer be free to fix a totally different price when actually opening the issue. By giving the indicative price range up front, it would help the investor to take a better view and lead to more analysis and information to the potential investor.

The funny thing is that we all get introspective and rational when the markets are down. When a bull market resumes, all of us forget our lessons and plunge headlong in to putting our money back in to the markets, hoping to make a quick killing. By and large, IPO’s do give an opportunity to make money, depending on whose greed is greater at a point in time. In a bull market, the issuer takes advantage of the investor greed. In a bear market, unless the issuer is desperate, he waits it out.

 

 

August 23, 2008.

AXIS BANK- THE MIS-SELLER

One of the Axis Bank account holders got a ‘free’  Group Insurance policy from Apollo Munich insurance co. The account holders do not have a say in this.  Axis Bank gets noted as the insurance broker and in exchange has sold the data base of account holders. The account holder will now be a victim of calls and emails from the insurance company.

The account holder contacts AXIS Bank to get out of this mess and is directed to the Insurance company. It is a nice merry go round created by the crooked banksters in search of a few rupees of commission.

With bankers like AXIS BANK selling your information in an illegal manner, your privacy is shot to hell. And RBI may impose some idiotic fine of a few rupees and let the dishonesty continue

Wonder if RBI or IRDA or anyone has anything to say on this.

Of course, it is useless to expect any degree of honesty or ethics from this shady bank which has its roots in the erstwhile scam tainted Unit Trust of India.

Come in to the parlour… The markets beckon

(This appears in yesterday/ today varied editions of the Deccan Chronicle. Essentially a view about bull market and how the push happens to get us in to the market. And the world of ‘top picks’ based on festivals .. A ritual that the ‘sell’ side excels at .. Luring you to part with your money)

Diwali Sale is yet to come to the markets

 

Another Diwali. Another list of ‘best buys’ from all the brokers in town. You have new money. Last year Diwali picks? Confine them to the dustbin. Keep buying more. After all, the brokerage industry has to feed on your trades.

Diwali, English New Year, Financial New year and all seem like major events which change the direction and/or quantum of earnings of companies, going by the stock market recommendations. My inbox and WhatsApp groups have a total of around thirty recommendations urging me to put money in their “top ten” or “top five”.  One interesting thing is that these brokers do not seem to have anything in common. So now I have a list of around one hundred stocks that are compelling ‘diwali’ buys. Some brokers have put price targets, some have not.  Alas, none of them have also published their last ‘diwali’ recommendations to see how good their festive forecasts are. SEBI should do something about this.

Armed with a hundred ideas, I have just one thing stopping me. I do not have too much money and the brokers have not given me what to sell from my portfolio, so that I could buy in to their new festive ideas. I think it is very unfair on these brokers.

I prefer the Amazon and Flipkart mails that hit my inbox, with Diwali discounts on stuff that I do not need, but with large discounts. No one gives me Diwali discounts on Sugar or Cashew Nuts or Edible Oil or even the humble daily vegetables. It is available only on ‘smart phones’, wireless speakers and their like. Stock brokers must learn from these sellers. Tempt me to buy shares by offering me a discount.

Now, these brokers will have Diwali recommendation, then the English new year will come round, then Pongal, etc. How much money should I allocate to each of these festivals to buying stocks? The brokers should think of all these things. What if I blow up my entire cash on the Diwali ideas and have no money to buy their ‘new year’ ideas?

I do not know why an advisor or broker cannot tell us about ‘good’ or ‘high quality’ companies that one should consider owning, instead of telling me to buy and sell. Just give me  a pool of good companies (surely not too many that are worth investing for keeps) and tell me if it is a good ‘price’ to buy. Why does not any broker or advisor give us that service? Why have a view on every stock, most of which are of dubious quality, with no mention of promoters, business etc?

As an investor, I have to be on my own, if I have to build a portfolio for the long term. I have to either put the money in to a ‘diversified’ equity fund or in to an ETF (which will mirror the market).  SEBI has so many requirements to become an adviser/broker etc but I wish there was a way that they are also measured and their quality is up in the public domain. Today, the brokers are not accountable to anyone. Everyone in the game is a part of this circus to make sure that the investor is kept in the dark and keeps giving business. Even the ‘business’ media does not track the ‘sell’ side broker recommendations. For mutual funds, there is evaluation from brokers, from independent agencies and so much micro regulation from SEBI etc.

If you are a ‘qualified’ investor in equities, it would be a good idea to make a ‘short list’ of good companies (high quality of earnings, likelihood of surviving ‘long’, good promoter reputation, predictability in their business etc) and build your portfolio out of that. You may like to build your long term portfolio from that ‘short’ list. You could build your strategies to time your buys. This can be discussed in a separate article.

Outside of this ‘investment’ list, the rest would fall in to the ‘trading’ bucket, if you are so inclined. You buy them with a view to sell them in a short term. Many of them will be stocks from the commodities sector. Essentially, it is taking advantage of the behavior of other investors. When commodities cycles turn weak, these companies’ earnings suffer and there is sell off. We buy them on the assumption that the cycle will turn up. And when it does so, people once again start to buy them and push prices high. We could discuss this also in another piece.

I know that this makes investment in to stocks a very boring thing. The excitement created by the ‘sell’ side is not something that helps you in your investment returns.

 

 

Please sign this to help abolish personal income tax

I have initiated an online petition through change.org to make a radical change to the personal income tax imposition. I am seeking total abolishment and I am sure you will all support me in this.
I also request you to circulate this as widely as possible to your friends, colleagues and groups and help me reach a respectable number that will make the powers that be sit up and discuss this.

Here is the link

https://www.change.org/p/the-prime-minister-of-india-abolish-personal-income-tax?recruiter=1668472&utm_source=share_petition&utm_medium=copylink&utm_campaign=share_petition

 

Portfolio Management Services- Fees etc

Recently, some one wanted to check with me the ‘terms’  of a portfolio management scheme being offered by a broker.

As per the offer, the portfolio manager would be paid management fees whenever he beats the ‘hurdle’ rate. And this was an ‘annual’ measurement rather than a full period one.  What it means is that let us say that in year one, the portfolio dives 20%, the manager gets no money. In year two, if the hurdle is ten percent and the fund value moves from 80 to 91, he will get management fee!! The portfolio is still under water.

SEBI should look in to this.  Fees which are based on performance, should be calculated at the end of the term or exit. Hurdle rates, should be compounded. For instance, if the hurdle rate is ten, then it should be taken to understand that the goal post is a ten percent CAGR.

 

Addendum” A gentleman pointed out that as per law, there is something called ‘high watermark’ which actually covers this. I am not very sure, but if that is so, I stand corrected.  I however strongly believe that the fee should be taken when the investor exits rather than annual basis.

 

 

Lure of the Trading Ring

(This appears in Deccan Chronicle. Today. Maybe now the number of stocks to read up and track will increase as the exit door gets crowded. Another lesson. Forget. Next time will be different. Like this time is different)

Bull markets are a great thing. Apart from happiness to those who trade in the market, it also makes us feel very intelligent and confident. Without being an analyst or a professional investor, we start to build portfolios. There are so many recommendations and tips that come, we tend to buy as many different shares as possible. Every share comes with ‘hot’ news and they all tend to move rapidly when we hear about them the first time.

 

In the initial phase, we want to be sure. We take the recommendation. Then we check out the highs and lows and the recent moves. We see that the sharpest moves have happened just before the recommendations came to us. So we say, let me wait till it goes down a bit. It has gone up too fast. This way, we see that in a week or so, some shares do not come down. At the same time, we have received a few more ‘sure’ winners’ tips.

 

Now, we decide to buy small quantities (instead of twenty-five thousand rupees per share, we will limit our first buy to fifteen thousand rupees) and then add up. So as soon as we get the tip, we buy first. Afterwards we find out the spelling of the name, the business and maybe some headline numbers. Our comfort is the fact that the ‘source’ of recommendation is good and probably he makes so much money and is intelligent that we cannot question or doubt. If we ask questions, we think that we will sound silly.

 

Thus begins our journey of growing up.  Soon we have more number of shares than we can remember. And we follow a simple rule of selling off those that make us some money. We may all have some rules or we may just get negligent and keep watching them every hour without doing anything except searching for our next hot number. Slowly we see some stocks slipping in to the red. But then we rationalize. At some stage we use our second instalment to buy more. On those that rise, we are hesitant to spend our second instalment. We think that once it ‘corrects’ to our original buying price, we will buy the lot.

 

In all our decisions, we have let our common sense go to sleep. We had a fear of ‘being left out’ in conversations and WhatsApp groups. What we have done is to bet on price behavior of unknown bunch of stocks. We look at the insides of the buys we did and decide not to discuss it at any forum. We never had a strategy in mind about how much gains or when to get out. We remain in this suspended confusion for a long time. We now start tracking buys by big names of the market and try to tailgate them. The problem here is that by the time we get the news the price runs up and we will never know when they get out. Many ‘big’ names use this crowd following to make quick bucks. Large lots are bought. News is made public AFTER their buying is over and prices already show some jumps. Now the fans get in. No one asks the ‘big’ name about why he bought it or when will he sell it or how long he will hold it. Some of the ‘big’ names even mislead with public talks or selective leaks. Then the ‘big’ names will sell in small quantities at higher prices and totally exit their positions. They make their quick money. And now we see the prices slowly crashing. We do not have the heart to cut our losses and become wiser till the next tip comes round.

 

Some of the trades will NEVER make money. Some will make money in a bull market. The important thing to see is that the overall returns are not going to be something that you will boast about. The average returns will be just around the index. The more likely possibility is that after some time, we will realise that we cannot make money continuously, even if we spend more and more time.

Sometimes, it is good to have a break from routine. Keep your regular investments as they are. Do not listen. Do not track things that will never qualify for long term investments. Remember that only success stories get told. Even a Warren Buffett admits that some calls go wrong. We are not him. And the other thing is that the ‘big’ names probably devote a small part of their portfolio to this kind of aggressive or momentum trades.

 

Always have a plan for exit before you buy enter. And lay down rules and follow them. That way, your trading experience may not become sour and drive you out of investing. Fundamentals and prices can be at disconnect for a long time. Like there is no reason for a rise in the market, when it falls, you will still keep searching for reasons.

 

 

R Balakrishnan

 

 

 

Making a quick buck in the market ..??

(Some thoughts on the trades in the marketplace.  This appeared in Deccan Chronicle on 11th Sept 2017 )

(The long term trend is always valid till change. So far, the mood is good and everyone is searching for ‘buy’ ideas. Money is pouring in.. Some observations ..)

Stocks in our markets seem to move by rotation. Sharp traders who spot the trends early, make money.  When a wave of money moves in to or out of any sector, there can be a whiplash on the ‘investors’ who board the train late.

Till a year ago, pharmaceutical companies were prized investments and were quoting at crazy levels. Then the skeletons started to tumble out and the prices crashed. So someone might think that there is an overreaction and buy the fall. However, this may not work out well. For one, the industry woes do not seem to be over. And secondly, how are these companies going to regain the markets and pricing power that has been lost? It is going to be a long haul. And one could wait for a very long time before the sector finds favour again. One important thing that people could overlook is valuations. Even after the fall in prices, the valuation has merely come down from exorbitant to expensive. There is still no margin of safety. Thus, by buying now, you may be able to make some smart trading gains if your timing is right, but it is unlikely that you will make supernormal returns in quick time.

Similarly, look at stocks in metals. Many of the fallen stocks are now finding favour and there is a run up in prices. Whether it is Tata Steel or Vedanta, the prices have rallied sharply. Maybe there is some more steam left in the sector as the benefit of rising metal prices start reflecting on the bottom lines. However, we always run the risk that the juice in these stocks have already been extracted by the first movers and after the sharp moves on think volumes, prices can get sluggish. Unless there is concentrated buying, prices will not go up. And at every rise, some early entrant will be offering fresh supply as he pockets his gains. I am not an expert on commodity prices, but have seen this cycle play itself often. The stock prices peak much before the underlying commodity price. When everyone starts to notice and talk about the sector, the time to look at other things is around.

Microfinance, Housing finance are two other sectors that are in favour. Valuations are very aggressive and prices are now hyper sensitive to bad news or ‘disappointments’ in results or magnitude of problem loans. Yes, there is a big shift that has happened when growth moved from PSU Banks to private banks and private players. However, this will taper off and growth will slow down to reasonable levels. This will mean that stock prices will either slide or stagnate for a long time, before earnings catch up with stock prices.

With so much money flowing in to the markets, it is difficult to spot undervalued stocks. Thus, there is a rush towards the ‘out of favour’ sectors. If you are lucky enough to catch the trend early, you make some quick money. The later you get in, the worse your chances. Smart money moves in to these sectors long before research reports get published. They make the big money on these cyclical moves and the investors who follow the noise can end up even losing money.

Most of these stocks that are ‘out of favour’ will have one common characteristic. Poor ROCE, lumpy and jerky profit numbers and high leverage. They are unlikely to fit in to a long term investment list and should be seen as trading opportunities, if one is so inclined. Discipline in trading will certainly help. Do not get carried away and place disproportionate bets.

This market does not offer much comfort in terms of valuation. However, given the strong funds flow and the fair economic conditions, the poor earnings are not impacting investment sentiment. While we see the broad indices of the stock market stuck in a zone, the mid cap space is seeing a lot of churn. Mid cap indices which had fallen sharply have pulled back as sharply. The valuation matrices are still not tempting, but there are many investors who probably have the ‘left out’ feeling.

Know the risks at this level. If you are in diversified mutual funds, there is less to fear. And if you are in SIP mode, do not bother. These are interesting times. Globally, the world is on an edge, politically and economically. Growth numbers are getting smaller. However, there is surfeit of money.  Personally, I am happy to keep away from the stocks. I do not have a ‘compulsion’ to invest.

 

 

Stocks- Confidence in earnings & valuation

(Some thoughts on valuation with specific reference to predictability of earnings.. Faith in what we are sure about.. Appears in the Deccan Chronicle of yesterday/today)

VALUATION AND EARNINGS PREDICTABILITY

Valuing stocks is often a subjective exercise. We all have our ‘objective’ yardsticks, which could be related to PE, EPS, Book Value, ROCE, ROE or any other matrix or a combination thereof.  Even there, there is always a final element of ‘subjectivity’.  We often fail to find a good reason and then simply say that a similar company trades at so many times earnings, and therefore this company deserves better. Very often I have seen research reports give precise price targets as if they are a holy grail.

 

Common sense says that if we use a multiple, say Price to Earnings (PE) as one indicator, there should be some rationale. A company can have a high PE or low PE. It does not necessarily mean that the company with a low PE is undervalued or vice versa. All quantitative measures have an element of subjectivity when it comes to valuation.

 

One thing I like to look at is the ‘predictability’ of earnings of a company. I do not refer to the precise numbers, but to whether I can predict that under normal conditions, the company will keep making money. For instance, if I take a company like HUL or Marico, I know that their products will continue to sell with reasonable margins and there is a high level of predictability about their earnings.  This, to me, is important. On the other hand, if I take a company like L&T, a lot depends on the stage of completion, the revenue recognition methods etc. Similarly, a construction company will always have work in progress. A completed contract is when the earnings can truly be recognized. However, some of their contracts will cross the financial year end and some work is still left before revenue can be recognized. However, they use something called ‘stage of completion’ and recognize some revenue and profits. To me, this is not high quality. Nor is it ‘predictable’. For instance, we know that in the year 2016-17, Bajaj Auto sold “X” no of two and three wheelers and made “Y” rupees. In 2017-18, I am sure that they will do the same or better both on the volume and on the profits.  This company has highly predictable earnings stream.

 

I am willing to pay a higher multiple for a more predictable stream of revenue as compared to ‘probable’ or not so certain streams of revenue. A rupee earned by Bajaj Auto is valued higher than a rupee earned by L&T. In Bajaj Auto, the future is less volatile. So, one is willing to pay a higher ‘valuation’ – whether it is in terms of P/E multiple or P/B etc. It may be also incidental that Bajaj Auto earns a Return on Equity that is immensely superior to L&T.

 

Industries that have poor predictability of income include commodities, engineering, construction etc.  They also could have ‘lumpiness’ in earnings.

 

One of the most ‘predictable’ industries should be banking and finance. However, while one can forecast numerical growth in lending, interest rates etc, the element of risk in lending vitiates the industry valuation. So we look for comfort in history. By now the market believes that HDFC Bank or Kotak Mahindra are great at managing loan recoveries and also have good lending practices. So, these banks command a premium in terms of measures like Price to Book or Price Earnings. On the other end of the spectrum, we have the PSU Banks, where the only predictability seems to be the recurrence of NPAs.

 

Commodity sector also has very low predictability of earnings. They go through business cycles with price movements of commodities swinging to extremes. Thus, this sector valuation is the most tricky. If we take a ten year average earnings cycle, we probably get a better fix on the ‘average’ profitability. Price swings are huge.

 

However, our markets are young and tiny. We have too much money chasing stocks and there is not enough depth or breadth in the market. So, we probably have no valuation rules except those decided by flow of funds rather than any yardstick. We tend to swing between extremes of optimism and pessimism. And our optimism is often based on who is buying, the recent price moves etc rather than any genuine exercise at studying the P&L, Balance Sheet and the management.

 

However, the earnings predictability is certainly anchored in to a lot of valuation, if we look at stocks in the FMCG or consumer spend sectors or in growing B 2 B spaces. If we want to look for big winners, we should try and evaluate:

  1. Will the products or service sell profitably?
  2. Can the company pass on cost increases?
  • Will the demand grow in line with the economy?
  1. Is the cash flow and profits in line with each other?
  2. Is the ROE / ROCE attractive?

 

If the answer is yes to all the above and the stock commands a low PE or low Price to Book, it is worth digging deeper. Sooner or later, the market will recognize this and give it a greater valuation.