Time to Buy or Wait?

The investors at large are a perplexed lot today. The market after hitting the bottom of 7697.39 had bounced back to 10,000-plus and has now once again gone below the 9,000 level. The mood of the investors is quite confusing as uncertainty rules the roost. Some would suggest you to buy in this market as valuations have taken a great beating, while others would scare you with facts that indicate there is nothing going right for the market to move up and hence you should wait for the market to correct further. But in all this bedlam of the marketplace, you should remember one golden rule: one knows the top and bottom only after it is formed. Today, no one knows with certainty whether or not the market has bottomed out yet. And if the market has to go down further from here, how much more it can go down and how fast it can go? Does this market offer exciting opportunities to buy? Or is every rally an opportunity to take the cash home?

Dalal Street Investment Journal proposes to take a fresh view on the market to understand  and ascertain where the market is headed and would also try to find answers to some of the most nagging questions retail investors are facing at this point of time.

Fair Valuation – A Mirage!
Remember one golden rule - no stock market in the world trades at fair valuation. The market trades either above fair valuation or at a discount to fair valuation. In between, we see phases of the market when it trades excessively above the fair valuation or at a great discount to fair valuation. When it trades excessively above fair valuation, it is called the bull run and when it trades at great discount to fair valuation it is called the bear run. With stock indices down by more than 58.63 per cent from the all-time peak level, the question that arises is: Are we trading at a great discount to fair valuation, meaning it is time to buy? Or are the indices still above fair valuation, meaning the market may take a further beating?

Now, the point is: what is fair valuation? Is it the P/E of the stock index or any other indicator that suggest fair valuation of the market? We are of the opinion that fair valuation is summation of various macro and micro indicators of not only India but also of the world. Due to the dynamic global situation, fair valuation of any market is not an easy thing to work out. It is a relative term and hence cannot be looked at in isolation.

Let’s take a few examples to see how fair valuation undergoes change as time passes so that investors understand the same in the broader manner. Let us start with Tata Steel which was a screaming ‘buy’ not so long ago at a P/E of 15x but today, despite the scrip being available at a P/E of mere 3x, is not finding takers. Unfortunately, Tata Steel, which spent $12 bn to acquire Corus, is now available at a total market cap of $2.58 bn! Take another example of Hindalco, which saw its rights issue devolving, paid $6.4 billion to buy Novelis, but ironically its own market cap presently is a mere $1.96 billion. Yet another example of fair valuation changing with a change in the market sentiment is that of Ranbaxy. When Malvinder Singh sold promoters stake in Ranbaxy, Daichi Sankyo found the valuation of Ranbaxy shares right at Rs 737 per share, but the same scrip is now available at Rs 216, a hefty discount of 71 per cent to the offer price in just six months! Remember, other pharma companies have not taken this kind of beating on the bourses.[PAGE BREAK]

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Or, take another example of India’s largest private sector company Reliance Industries, which has highest weightage of 13.58 per cent in Sensex, was a good buy at 17x P/E sometime back, is not finding enough support at P/E of 11x. The company’s valuation was justified then by its embedded value due to its stake in Reliance Retail and Reliance Petroleum. Now, the news floating in the market is that it would be available in the region of Rs 800 per share to justify not adding it to the portfolio.

So, the fact is that fair valuation is subjective and differs from person to person, which is precisely the reason that we have buyers and sellers for companies or indices at any point of time. No wonder, it is very difficult to come up with ‘right’ valuation of any company or, for that matter, any stock index. We come across many research reports on companies wherein one report comes out with a yelling ‘buy’ on a company while another report at the same time puts out a strong sell on the same company.

With this information as a backdrop, let us now try to find out whether it makes sense to get into the market at the moment or to wait for some more time. Remember, when the market was surging past 20,000 level many told you that Sensex would surge further and may touch 30,000 soon! But the fact is that, at that level you missed a good opportunity to book profits. So, is it the right time to buy so that you can make a killing if the market sentiment improves in the near future?

Now, let us look at the factors that would be affecting the market in the near future as well as in the medium term and then try to reply to some of the nagging questions.

Sentiment is the King
In any market, sentiment is the king. As common psychology suggests, we want to buy when assets are on the upward curve, thinking that we would buy now and sell later to make a profit at the higher level. Today, the sentiments are down as we are being flooded everyday with all the negative news of huge magnitude from all across the world. The problem is that the news is coming at regular intervals from unexpected quarters not allowing the market to settle down at one level.

In India, it was first believed that the US financial crises would not impact the Indian market as Indian economy was domestic consumption-driven and hence quite immune to the global financial meltdown. Based on that feeling Sensex remained at 14,000 levels for quite some time after the US sub-prime crisis emerged sometime in May-June. Even the Prime Minister and Finance Minister made us believe that India would be least impacted. But as situation started unfolding, India realized that it is no longer immune to the global problem. With GDP being revised on the downside at regular intervals, it is unlikely that the market sentiment would change in a hurry. This means that we may remain at the lower level for some more time to come (which does not mean that we may go down further from here on) before we can see the Sensex going back into the bull orbit. In other words, sentiment in the market is unlikely to change any soon.[PAGE BREAK]

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Rupee fall steals the charm of Indian market
Indian rupee has fallen substantially since March 2008 and is down by 23.77 per cent. The falling rupee does not help FIIs who have been the prime investors in the Indian market. In fact, the credit for taking the Sensex to all-time high level goes to them. In the last three years up to 2007, FIIs pumped in $44.84 billion launching the Sensex on an unprecedented surge. And their YTD sales of $10.83 billion saw the market plummeting. The falling rupee has taken away the charm of the Indian market as their returns in dollar terms take a huge beating. Hence, it is very critical to know when FIIs would return to India.

One of the key signs that will bring FIIs back into the Indian equity market would be when rupee becomes less volatile. The second sign would be strong rebound of rupee against the dollar. This rebound should not be temporary and should be with strong sustainability at higher levels. So do not expect a sustained bull run till FIIs come back into the market. We’ll touch upon why FIIs cannot afford to ignore India in later part of the story.

Liquidity
Today, most of the global institutional players are facing liquidity crisis. One of the reasons why market surged globally is due to excess liquidity in the system and recent market fall is due to the situation of tight liquidity. Most of the financial institutions have either incurred huge losses due to the sub-prime crisis or are facing redemption pressures from their clients forcing them to remain either net sellers or maintaining enough cash to meet any unexpected redemptions. This is impacting their risk-taking capacities. We have seen in the past that rate of interest and P/E ratio has inverse ratio. As long as rate of interest remains at the higher level, do not expect P/E ratio to improve much. The good sign for the Indian market to revive is when the rate of interest starts falling, making equity an attractive proposition again. Right now, due to tough liquidity situation, risk averseness has gone up, which will not allow equities to surge on a sustained basis. The first sign of infusion of ample liquidity into the system would emerge when there would be drastic reduction in the rate of interest. We feel that 300 basis points reduction from the peak PLR rate would be a good indication that liquidity in the system has improved. So watch out for interest rate cuts to make next move.

Leaders of last rally are laggards in the next rally
It has been observed that leaders of the last rally are laggards in the next rally. Just take the case of year 2000 rally when IT companies surged on the bourses. In the last eight years, despite the huge surge in the Sensex, IT companies (or last time’s rally favourites) have not given any returns to the investors. Three examples will prove this point. Since March 2000, IT giant Infosys has given returns of mere 33 per cent in the last eight years, which is lesser than what risk free bank deposits would have offered, while HFCL is down by 99 per cent and so is the case with Sterlite Optical which is down by 94 per cent. It should be noted that these counters were not lapped up by the investors during the Sensex’s journey from 6,000 to 21,000 in the last eight years. They had their [PAGE BREAK]

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mini bull runs in between, but overall, they have proved to be underperformers on the bourses. We feel that this will also happen in the case of favourites of the just concluded bull run. Real estate and infra companies would have a tough time remaining market performers in the months to come even though they may see some rally in between. Please note that quite a few real estate companies have taken a huge beating in the present down-turn and have crashed by more than 90 per cent. We feel similar fate awaits even for the commodities stocks, irrespective of what happens to the commodities prices. Please keep this fact in mind as it would help you to decide which stocks should not form part of your portfolio.

So should you buy now or wait?
We have given enough pointers that could see revival of the market. Now the basic question is: Should you buy now or not? We feel that the market has taken a huge beating in the last eleven months. We do not expect market to go down substantially from the current level. Even if it goes down, we feel it will not remain at that level for a long time. Any fall from here in the Sensex would result in sharp bounce back, such as the one we saw recently in the market.

We have also relied on the past data. If one goes back to history since 1990 there have been many bull and bear cycles. The average cycle lasted for 247 days, with highest fall in percentage terms being 58 per cent (not during the same period). Today, our bear run is more than 10 months old and we are down by more than 60 per cent.

But even if we consider the worst case scenario, market pessimism suggests that it can go to 6,500 level, that is near about 25 per cent down from the current level. But, on the other hand, we should also consider what kind of returns this market can offer to investors. One of the bear proponent of the market Shankar Sharma feels that Indian market can go to previous high levels in the next three years. In other words, even if one goes by one of the pessimists view, we can expect the market at 20,000 level in the next three years. This means that if you have a time horizon of three years, one can expect over 100 per cent returns from the market with a 25 per cent downside risk. This is quite a good risk versus return ratio.

But the question that arises is: what should one buy in this market to remain market outperformer since each and every company will not rally as and when the market surges. We are of the opinion that equity market is nicely poised to give returns, provided one applies basic rules well and have patience to ride this bear run. Here are some basic investment guidelines for the investors:

Look out for companies that have made buybacks from open market
This is a very strong sign from the company as this shows two things. First is that the company is cash rich and second is that it shows that the company is confident of its future earnings. The buyback of shares would mean that the company’s EPS would also increase as shares bought back would get cancelled. Just one line of caution. Do not go merely by the intent of the promoters, but see that the company has enough cash to meet its buyback intent. Please avoid those companies who try to play to gallery.[PAGE BREAK]

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Promoters acquiring stake through creeping acquisition route
In the last few months, quite a few companies have taken a beating, taking their share price much below their intrinsic worth. This is giving cash-rich promoters a good opportunity to increase their stake in the company. This would have two positives. First, any supply on sell side would get absorbed in a much better manner due to promoters’ buying, and second, it is a strong signal to investing community that the scrip is going cheap as promoters themselves are buying, indicating strong future. We all know how Reliance Industries last year surged on the bourses when promoters increased their stake in the company. One should apply reverse logic when promoters are selling and you should also exit along with promoters.

Cheap is not cheap
Do not judge companies merely by the P/E ratios. Presently, there are many companies that are available at a very low P/E ratio. In fact, many of the real estate companies are available at mere one or two P/Es. But low P/E does not capture future earnings deceleration.  This is especially true for the commodity stocks like steel and cement and also for the real estate stocks. These companies’ future earnings are a big question mark and hence, as we move along, with drop in the earnings these companies’ P/E ratios would surge, making them unattractive and costly. So what is looking cheap today may be costly tomorrow.

Dividend's don’t lie
We have not done any empirical study on whether, over a longer period, dividend-paying companies from the same sector do well over the non-dividend paying companies. But we have a gut feeling that dividend-paying companies must be outperforming non-dividend paying companies from the same sector. With this assumption, it makes sense to invest in dividend-paying companies. Just look for companies which have paid interim dividend this year as this would mean that these companies are also liquid even in these bad times. Also, closely look out for companies that would be announcing interim dividend. Remember, dividend is cash outflow from the company, and in this tight liquidity situation, a company shelling out cash is quite a positive indicator.

Prefer companies having topline growth over bottomline growth
Those who understand accounts would agree with us that it is easy to manipulate the bottomline while it is difficult to manipulate the topline. From fund managers and analysts point of view, it is always better to look for companies that are growing in topline as these companies are able to sell their products in difficult times and increasing their market share. As and when the sentiment improves, economies of scale would bring in good profits for the companies. So, we would suggest giving preference to companies that are growing in topline faster over the bottomline. That does not mean that one should go for loss-making companies. But, as long as topline is growing at a smart pace and the bottomline is growing at a decent pace, it makes sense to go for the same.[PAGE BREAK]

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Higher tax outgo is a good sign
During bullish times, analysts always used to grill management on tax planning of the company. They are of the opinion that tax outgo can be planned to reduce the tax outflow, thereby increasing earnings per share. One common thing that we can recollect which India Inc. did in the last few years was to go for setting up factories in tax free zones and to go for the wind power mills to reduce their tax outgo.

But times have changed and we feel that companies which have paid higher tax in the first six months vis-a-vis previous six months should be better beta as they have better earnings visibility and have hence paid higher tax. This indicator can be used effectively with topline growth to find the winners from the stock market.

Look for domestic-driven companies whose product cannot be easily imported
The slowdown in the world economy would mean that there would be lesser number of import-export transactions in the global market. First, the recession would slow down demand from the importing countries, and second, countries would start putting import barriers to protect local industries (as recently done by India). On the other hand, domestic consumption story would remain relatively strong. This would ensure that companies keep growing albeit with low pace. In these times, FMCG and pharma companies which cater to the domestic population make sense to take exposure as they would remain relatively better performers in the market.

Prefer companies that are not leveraged or less leveraged
Many of the companies have taken huge debt to fund their expansions. They are in a very odd position as their expansion plans have got stuck mid-way as they are not able to fund the balance part of the project for want of funds. On the other hand, those projects that just went on stream would not be able to operate at the optimum level due to demand contractions. These companies would see their interest outgo surging, thereby impacting their bottomlines. On the other hand, less leveraged or debt-free companies would be able to weather the storm in a much better manner. We have a feeling that zero debt companies would outperform higher leveraged companies in the near to medium term on the stock market.

Why FIIs would come back to India
One would be surprised to note that despite heavy selling by FIIs, the number of registration of FIIs in the country is on the rise. At present, we have 1,554 FIIs registered as against 1,219 in 2007 and 993 in 2006. This shows that FIIs are very much interested in the Indian equity market. Also, remember that India would be still growing at 6 per cent GDP while many of the other economies would be in recession. Sooner or later, funds would flow to the growing economies. Even if we look at India, amongst the BRIC economies India stands at better place.[PAGE BREAK]

Brazil is a commodity play and with commodity prices taking a beating, it may not be exciting in the near to medium term. Russia is an oil play and we all know that crude has taken a huge beating in the last couple of months. China’s economy is driven by exports to western countries and western countries are in recession. This would make Chinese growth story less attractive. But on the other hand, China has an advantage as it is less leveraged than the other BRIC economies. On the other hand, India has a strong domestic consumption story as its trade accounts for a mere 32.5 per cent of the GDP. We have a highly educated young population with high savings rate. This would ensure that India would continue to grow at a faster pace as compared to the other global economies. This fact will always bring back FIIs into the Indian market.

Summary
To summarize what we have said above, we feel that the Indian market has little scope to go down from this level. Any fall from this level would mean that there would be sharp upturn. Invest in future leaders rather than investing in past heroes and finally, yet importantly, watch the rate of interest very closely to gain from the equity market. Since this market will not rise in a hurry, invest in small lot.