Forecasting Market Direction - A Macro Perspective

A two part column which I had written for Wealth Insight for March and April. Can't locate this in their website, so I am posting from my own copy.

Investors constantly seek an answer to the question – “which way is the market headed”? Answers usually take the form of unsupported opinion –“ I think it will go up/Down”. Sometimes, it involves some arcane justification – “India is a growth market and will therefore go up”. The quantum of solace the first response provides is dependent on the profile and reputation of the speaker. It is totally unhelpful to the questioner in making decisions in the future. The second response is even more useless in terms of its information content. India was always a growth market (in terms of GDP) , but equity markets have remained in a range over 16 years of the past 20.

A systematic investment plan helps to remove the requirement of market timing. However, it requires investors to take a really long term view of investing and have the patience to sit through long periods of no gain.

A macro approach to market timing

Markets respond to many factors simultaneously. Often, investors are not able to identify the primary driver of market movement, and when to use what indicator. I present a simplified formulation to help decide the market direction over the near term (say the next 6 months) on a broad brush basis. A word of caution - when we use macro numbers that change slowly – sometimes once in a quarter or so, the indicators are not in a position to forecast daily or even weekly moves. At best, they provide a framework within which near term movements can be viewed or interpreted.

My simple framework has four components – growth and the price of growth, money and the price of money. Let us look at these in some detail.

Growth

This indicator is among the most common indicators in vogue. A growing company will, over time, generate more wealth as compared to one which is not growing or growing slowly. The underlying assumption is that there is some “equivalence” in the capital employed, and the risk of the operating business. A company may generate a higher profit or cash flow if it has more capital than its peer. That does not count. Similarly, a business that is more risky will need to generate a higher return to attract investors. In all this, we speak of growth in profits. There are several subtleties here – a growing company which is rapidly adding customers will, perhaps in the near term, lose money (for example the early stage development of telecom companies), but may be an attractive investment. This is because investors assume that when the rate of client addition slows, profits will shine through. There are other issues, but I want to skip these and keep it simple.

How do we estimate growth? and especially for the market as a whole? The way we get this is by taking the consensus of the estimates made by analysts tracking the companies in an index, say, the sensex, and then combining it in the same proportion as the company’s weight in the sensex.

For example, current estimates for sensex earnings are :

Table 1	FY12E	FY13E
EPS (sensex)	1163	1303
Growth	5.4%	12%
P/E (@ sensex of 17360)	14.9	13.3

The “price” of growth

The price of growth is commonly called “valuation”. Since investors prefer a company that is growing faster to one that is not, there will be a tendency to pay more for growth companies. In other words, the growth is often “in the price”. We therefore need to compare the “valuation” ie, how much are we paying to own a share of the company for each rupee of profit that the company earns. The ideal way to compute this would be a “discounted cash flow model”. However, a rule of thumb that works reasonably is P/E. A company with a high E/P (earnings yield) is generating profits that are priced more reasonably, as compared to one with a lower earning yield.   As always, there are several issues here. P/E does not take into account the capital employed to generate the returns. Take the case of two companies below:

Table 2	Company A	Company B
Sales	1000	1000
Profit from Business	100	100
Shareholders fund used	100	200
Equity Capital	100	100
Reserves	0	100
Earning per share (EPS)	Rs 1	Rs 1
Price per share	Rs25	Rs 25
P/E	25	25

On the basis of EPS and P/E, it appears that the two companies are identical. Clearly they are not – “B” uses twice the amount of shareholders capital as compared to “A”. Of course, this will be reflected in the share prices of the two companies (they won’t be equal as assumed above). The point to be remembered is that Return on Equity (RoE) is far more important that P/E in looking at investments. But, we use P/E as a proxy since it is easier to compute and understand.

 

How do we use P/E? First we must have a benchmark. The graph shows the rolling P/E of the sensex over the past 25 years. When smoothed over 5 and 10 year periods, it is clear that the valuation of the market rarely stays at or below 12x, generally trades at 14x-16x and except when in a raging bull market (1992, and 2000) rarely goes beyond the range indicated.

It appears that with the current estimates for consensus earnings (Table 1), we are trading at 14.9x march ending 2012 earning, and 13.3x next year earnings. In the context of the earlier graph, the market is “cheap”

I will discuss the other two factors in my next column, and then propose a simple method to use them as a general guide on when the allocation to equity assets can be increased. On the data discussed so far, it appears that while earnings growth will increase (the previous year EPS was 1103 – which implies a 5.4% growth from FY11 to FY12e), valuations are relatively cheap – should you be increasing your equity asset allocation? Perhaps, but we will find out.

My Column in DNA Money on Budget Day

This article was written on the budget day in 2012. Two issues I had warned about - the risk of foreign exchange exposure and the dangers of GAAR have since haunted the markets.

Budget 2012: Bus missed, administrative nightmare ahead

Anand Tandon | Saturday, March 17, 2012 

The finance minister’s latest fare offers little to cheer - either for industry, individuals or the market. However, the markets tend to be optimistic.

The introduction of tax relief for equity investments up to Rs50,000 for small investors is being viewed favourably. Whether it will induce investors to invest or not is another matter.

This seems to be a modified equity-linked investment scheme. Along with the exemption of interest on bank deposits up to a limit, it signals a return to ad hoc tax exemptions—something the government was moving away from.
 Individuals will face the prospect of higher and sustained inflation—as service tax and excise increase across most products. There is absolutely no attempt to reduce government spend.

On the contrary, the minister has promised to make available resources for the Food Security Bill—guaranteed to increase expenditure out of proportion and cause sustained inflation. Anyone hoping for a sustained interest rate cut needs to take a deep breath.

Corporate income tax contribution to the government revenue is budgeted to grow 14%— not a challenging assumption. However, higher excise and service tax will potentially reduce growth as companies struggle to pass on cost pressures to the consumer.Incentives for investment remain elusive—growth, if any, is still likely to come from consumption rather than investment.

The opening up of the ECB route for funding domestic infrastructure is likely to create longer-term problems. Bankability of infrastructure projects is a key issue and not so much the source of funds.

With domestic earnings and foreign exchange exposure, the need for careful hedging by borrowing companies cannot be overstated. Given the penchant of the Indian industry to look short term, we are likely to see unhedged exposures leading to demands for increase in user charges when volatile foreign exchange markets are increasing overall cost of borrowers.

Two issues related to taxation have the potential to create long-term growth problems.

One relates to taxation of transactions by overseas companies holding Indian assets. With the Budget allowing a reopening of old cases, the potential for litigation and for an adverse effect on foreign investment is real.

The “GAR” —general anti-avoidance rule—is draconian. Income-tax officers have been handed discretionary powers that are far-reaching. This will seriously complicate tax administration and has the potential to increase corruption manifold.

Other measures such as requirement of tax deduction by purchasers of immovable property can pose administrative nightmares - the devil will lie in the detail.

The decision to increase the cess on up-stream oil companies, potentially reducing post-tax profits by 10%, just a few days after having sold a large chunk of shares in ONGC - and that, too, to LIC should rank as a case of insider-trading of the worst kind.

If this were to be done by shareholders of a private company, it would surely attract a class-action suit. Luckily for the government India is less litigious, and has no precedence of class action of this kind. 
However, this would indeed be a fit case to start.

The best that can be said of this Budget is that the government is unwilling to give a direction on where the economy should head. We will therefore continue to be dependent on foreign flows - which are themselves subject to their own central bank policies.

Currently, the positive for the market even after the performance of the first quarter of this calendar year is that at 14.5x FY13; the market remains relatively “cheap”. This is on current expectations of growth.

A slowdown in China, a serious possibility, can lead to lower commodity prices and help Indian companies.
On the flip side, we may see earnings expectations get muted as taxes bite into consumers.

If global flows were to reduce for any reason, the going can get tough. Keep Draghi and Bernanke’s pictures on the wall of your trading floor and seek their blessings. We seem to have run out of ideas.

Anand Tandon, CEO, JRG Securities

A Faustian Debate - Inflation vs Growth

This article appeared in Feb 2012 edition of Wealth Insight - Surprisingly still relevant :)

 The author tells us why the real reform in India would be reducing the size of government expenditure & not raising user prices

By Anand Tandon | Apr 14, 2012

Economic growth requires savings (investment) and savings need positive real interest rates. Industry and markets have been quick to lay the blame of a recent fall in economic growth at the door of the RBI. RBI had, since February 2010, increased the repo rate from 4.75 per cent to the current 8.5 per cent in the face of persistent high inflation levels. This has fuelled fears of an economic slowdown, something that the policy makers want to avoid in an election heavy year.

Has the RBI really been "hawkish"?
The graph below tells a different story.


Post the economic meltdown in 2008, RBI moved quickly to drop interest rates. The same alacrity was missing on the way up. Inflation started to rise by November 2009. RBI took corrective steps only in March 2010, that too in very small steps allowing inflationary expectations to build. Real interest rates (=interest rate - inflation) which measures the payment a saver receives for postponing consumption has been negative since November 2009 - and continued to be so till now.

How does negative real interest penalize the saver? Let's assume movie tickets last year cost Rs 100. With interest rates of 10 per cent, a bank fixed deposit (FD) of Rs 1000 yielded Rs 100 in interest - you could use it to watch a movie. This year, price of movie tickets increased to Rs 112. If interest rates remained unchanged, you would now have to dip into your FD to watch a movie. In other words, you would have been penalized for saving (postponing consumption).

The Indian economy witnessed a sharp recovery in 2009-10. The justification of negative real interest rate did not exist - but did either industry or market participants complain? Monetary policy is supposed to be counter-cyclical. It has to provide stimulus when the economy slows, and "take away the punch bowl" when the economy is over-heating. The latter is always difficult if the stimulus stays for too long. Borrowers get addicted!

But isn't it obvious that higher interest rates will slow the economy?
The relationship between growth and inflation has been the subject of much research. Evidence is mixed - but in general, it appears that low rates of inflation may help growth, while sustained high levels inflation harm long term growth rates.

In the Indian context, "threshold inflation" below which inflation is assumed benign has been variously estimated at between 4 per cent and 7 per cent. A RBI working paper published in September 2011 suggests the relationship as in the graph below. Inflation as measured by WPI becomes damaging as is rises beyond 7 per cent.

Other studies, e.g. Prasanna and Gopakumar, (IGIDR) conclude unequivocally "that any increase in inflation from the previous period negatively affects growth". In any case, not curbing inflationary expectations when the inflation rate is near double digits would mean that the RBI is not performing its key task - that of maintaining price stability.

In short, while the near-term growth prospects may seem subdued, failure to curb inflation would hamper longer term growth in the economy. Don't shoot the messenger!

Domestic saving and growth
Why is it necessary that savers receive positive "real returns"? Growth requires investment. In India, it requires Rs 4.5 of investment to generate Rs 1 of income per year going forward. This rate is referred to as ICOR (Incremental capital output ratio). ICOR is a measure of the efficacy of use of capital. ICOR has averaged between 4 and 4.5 for the past two decades.


Over the past few years, domestic savings have averaged around 33 per cent of GDP. Current account funds another 1-3 per cent. Overall, assuming that the ICOR remains at 4.5, India should be able to sustain a growth rate of 8 per cent (= {33%+3%}/4.5) on an average. To increase this to 9%-10% however, one of two factors must change - either savings rate has to move to 40 per cent, or ICOR has to drop to nearer 4. Offering negative real interest rates to savers (as has been the case for the past 3 years) is not likely to move savings rate to 40 per cent.

Efficient use of capital too requires that poor capital allocation decisions be avoided. When interest rates are low, borrowers are encouraged to take risks - often leading to mis-allocation of capital - and increasing ICOR. The real estate asset bubble of the US is a case in point. In capital deficient India, this would be unacceptable.

Reducing ICOR requires policy initiatives
Post liberalization (1991), the Indian economy used capital judiciously as witnessed by an ICOR of 4. India is now entering a period of infrastructure building. This is more capital intensive, with returns that are often back-ended. ICOR will rise.

Another factor is the increasing dependence on government decision making. While the early 90's marked the removal of the need for government approvals, many industries now are again dependent on licensing and allocation of public resources (e.g. telecom, mining, power). Once again, industry looks to government policy to grow. Lack of policy initiatives will drop growth not RBI.

All policies are not equal
Post the polls in UP, markets expect several policy changes - indicating government's willingness to address the concerns of investors. It's likely that there will be a slew of announcements.

When examining announcements, keep a "framework" in mind. Ask if a policy announced allows industry to make better capital allocation decisions over the long term. Ad hoc exemptions and tax rate changes may provide temporary relief, but not sustainable growth. Investment requires a stable policy environment. Fickle decision making does not work - not even favourable decisions.

Foreign investment may receive favours. Policy makers would do well to remember that foreign savings make up less than 10 per cent of the total saving in the country. Undue focus on international capital flows while neglecting domestic markets does not make sense. Money has the same color - irrespective of its origin.

Real reform for India would be reducing the size of government expenditure and not by raising user prices. The government has created a list of entitlements and threatens to create more without debating. How these will be paid for.? Last year, the finance minister promised not to have costs off the "balance sheet". He failed. Let's wish for a better year ahead. Else, the Indian growth story will remain the best potential play - only the potential will take another decade to realize.

From Debate to Spin

My article published in "Wealth Insight" in Jan 2012 . Reproduced below as well:

Will consumers benefit from 100 per cent FDI in multi-brand retail? The author finds the benefits are not easily visualized

By Anand Tandon | Mar 10, 2012

If you don’t share the government’s enthusiasm for allowing dominant foreign ownership in Indian multi-brand retail, you must be a luddite – that’s what the media would have you believe. The spin doctors of the policy have simplified the issues to the level of “with me or against me” – and opposition to foreign ownership is being defined in terms of resistance to “reform”. But are the issues really as clear?

Waste reduction through improved supply chain
India’s supply chain is regarded as inefficient. This is particularly true for perishables. Improving this is one of the key benefits of foreign investment, we are told. However, a broad-brush assertion of this nature is only partially accurate. The supply chain of milk and milk products does not seem to suffer from this infirmity. Cereals, pulses, sugar, edible oil, spices too – which make up more than 24 per cent of monthly expenditure per person (NSSO study 2004) — are well handled. Fruits and vegetables seem to suffer the most, but make up less than 10 per cent of the consumption basket.

This graphic shows that per capita food loss in Europe and North America is between 280-300 kg/year. In South and Southeast Asia, this figure is 120-170 kg/year – about half! While it is true that a larger part of the waste in South Asia is in the “production to retailing” chain, it’s important to note that it is lower in absolute terms compared to the “more efficient” supply chains of Europe and North America. The loss in the “retail to consumer” segment is not even worth comparing. The assumption that foreigners do better at preventing wastage is not supported by facts.

Back-end investment is already allowed
Importantly 100 per cent FDI is already allowed in supply chain infrastructure. Actual investment has been insignificant. The DIPP (Department of Industrial Policy and Promotion) attributes this to absence of FDI in retailing. In other words, it is not worthwhile to invest in back-end infrastructure, even to service the “organised retail” outlets owned by Indian entrepreneurs – unless one owns the final retail outlet. How is this to be explained?

If the need for cold chain infrastructure is so compelling, returns on these investments should be attractive. Additionally, government incentives are available. There should be investors lining up to set up these. Discussions with large supply-chain managers – the likes of NBHC (National Bulk Handling Corporation) and NCMSL (National Collateral Management Services Ltd.) reveal that investment returns on supply chain infrastructure does not exceed single digits – unless one also factors in the appreciation in land value. Business returns are lower than domestic cost of capital, and returns are derived from speculative asset price changes. Perhaps, the issue is less to do with the availability of capital as with high land prices, and uneconomic land sizes which increase the cost of procurement and handling.

Better farmer prices – price discovery is more important
Another “benefit” that is ascribed to foreign ownership is better price realisation for farmers – at the expense of the intermediary. However, this is more a case of price discovery and its transmission.
Lately, price of processed pepper (garbled) has been lower than that of unprocessed pepper. First, this is unusual. But it does demonstrate that for commodities where there is an organised “price discovery” mechanism – through a functional exchange — the farmer is not being fleeced. In fact, today the farmer is well informed about prices across markets, and sells at a price that just leaves the intermediary with margins that equal cost of capital and transportation costs, leaving the aggregation risk to be managed by the intermediary.

Procurement issue is also about size
More losses occur due to farm holdings that are fragmented, leading to multiple handling and storage issues, than due to any “inefficiency” in the supply chain. To think that managers from ITC, Reliance and Tata’s, or for that matter, those from Olam, Cargill, or LD would not have sorted out supply chain issues if there was a way to do so, is to assume that Indian companies are poorly managed!
Yes, procurement is already 100 per cent FDI compliant – so if large efficiencies were to be gained by foreign capital, they already would have been. If despite being free to buy from India, large global retailers buy 20 times more from China, that tells you what is going to happen once they are allowed to sell in India – we will build a supply chain for Chinese products to be sold in India.

Lower consumer prices – but how?
With no likely improvement in procurement methodology, and with higher costs associated with supply chain (assuming that it is actually set up), how will the prices at the retail level fall? Perhaps by diverting more supplies to towns (cold storages will allow perishables to last longer) at the expense of rural India. But will higher cold chain storage and transport costs allow final prices for urban consumers to fall? And, importantly, what happens to the food supply to semi-urban and rural areas – they are left with less food diversity and poorer health perhaps.

Who gains?
Industry, in particular owners of retail chains, will benefit with expectations of large investments from foreigners at a premium to current prices. Real-estate mall developers will be direct beneficiaries in a sticky market. For the rest, the benefits are less easy to visualise. For retail investors, in the event that FDI in multi-brand retail is allowed, the run-up to the decision is likely to be more profitable than the post-event entity that is formed. Transfer pricing issues will take a long time to sort out, and domestic minority shareholders will find it difficult to make money. As with all investments, hype often does not mirror reality.

A year later (well almost)

After my last post in Aug 2011, I fell silent. Besides the excuse of not finding time (only partially true), the more important one was a complete state of disgust with the affairs of the nation. I thought that rather than venting, I should take some time off and let things settle.

Well, things have settled. It is now settled that the momentum of the economy has run aground. Its settled that the incumbent policy makers suffer from serious nostalgia - they are trying their atmost to return us to the "mai baap" sarkar of the decades of the seventies - when most of them must have been in their "youth". The "inspector" raj is back in full force.The difference is that a activist judiciary has decided it needs to decide where you can dig up mud from (almost - there is a court imposed bar on mining sand in the state of AP!)

The only writing I have done in the past few months has been to contribute a monthly column to "Wealth Insight" - a magazine targetting the equity investor, and being published by Dhiraj Kumar of Value Research. I started writing in Jan 2012 and have contributed 5 columns to date. The next few posts will carry these columns. From now on, I hope to start writing again, and I look forward to seeing you readers back !

Anna - The end of a beginning

Democracy is defined as “rule of the people” – and the Indian democracy showed that it is just that. Last evening was a red-letter day in Indian democracy - as Parliament passed a resolution to take on board the three demands that Anna Hazare had raised before it.

Anti-protest commentators which included a pro-government channel, and members of the NAC (an extra-constitutional body that "advises" the government on law-making - a clear case of constitutional impropriety) kept up the charade that these protests in some way detracted from India's democracy. My take on three key issues that were raised :

1.       Supremacy of Parliament – huh? What’s that?

A key claim was that Parliament is supreme in law making and that the agitation somehow diminished the “prestige” of parliament. Absolute Balderdash!  Nowhere in the constitution is there either a direct or implied “supremacy” given to the Parliament. Quite the opposite - The constitution is clear that the PEOPLE are supreme, when it states “We the People of India..... do Hereby Adopt, Enact and give to Ourselves this constitution”. MP’s are but representatives of the wishes of the people. The "confused" are mistaking procedural matters for “fundamental” issues.

2.       This is “mobocracy” and somehow sets a bad precedent. First, we have to agree that self regulating bodies rarely work. Allegations of corruption and nepotism in higher judiciary, a medical council that refuses to book errant doctors, and failed self-regulation in the case of life insurance companies are cases in point. If we agree, then when it comes to making laws that effect the law-makers and the bureaucracy, self-regulation will not work, and we HAVE to take into account the wishes of the people directly.

Can this be repeated? We have only to look at the case of Swami Nigamananda, who died earlier this year fasting against the government's inability (or worse) to implement a supreme court decision against illegal mining in the Ganga river bed, or that of Irom Sharmila from Manipur who is protesting against Armed Forces Special powers Act for the past decade. In both cases, the public imagination could not be captured, and while both causes are legitimate, they have failed to attract anywhere near the kind of public participation to force the government to act. To see Anna's protest as something that can be easily replicated displays a misunderstanding on what led to the massive public support that the movement generated. If our politicians do not get this, they are really not in touch with their constituents and should anyways be voted out.

3.       The Lokpal bill will not stop corruption. This must rank as among the silliest complaints. Courts and police do not stop crime, they just create enough of a disincentive to stop most people from committing them. Likewise, Lokpal may not stop corruption – where ever there are people, there will be greed and some will succumb. However, it will hopefully create some disincentive. Additionally, as I have argued in the past – what prevents us from modifying and improving the law once it is enacted. Should we start with an imperfect law or wait another 50 years in the hope we will get a “perfect” one.

The debate in parliament showed up the real leaders. Sushma Swaraj sparkled, Sharad Yadav argued like a has-been, and Anand Sharma rambled. Our PM was ofcourse silent - but could you expect anything else?