Bulls, Bears & The Sheep

The Bulls make money, the Bears make money & the Sheep get slaughtered!!!

Investors are not unknown to above proverbial charm, yet we all consider ourselves as the Bulls & the Bears of the street. We don't usually think of us as the slaughtered sheep and let a bad bet go unnoticed. This blog is dedicated to all those ostentatious sheep  who live under the pretension of being Big Bs. I am neither a Bull nor a Bear, I dream of being one and yet I haven't accomplished that. I don't know my kind but am sure of being anything but a sheep. I am curious & cautious investor who is willing to let go opportunities rather booking losses. I know that is not a wise thing but hey, I am still improving. 

Let us talk about NIFTY and where it is headed. I did a post almost 1.5 years back on the likely outcome of Nifty under various scenarios. With the new government at helms, it broke all barriers and marched right up to 9000. What next? Are we going to see another upside move or we have exhausted all the optimistic drive? Well, I don't know, infact nobody knows. The traditional street often driven by fundamentals are being guided by easy monetary policy. Past week, the Nikkei touched an all time high and so was with Nasdaq. Our own Nifty is hovering around 8600 levels. If you hear "experts", Nifty may well be headed towards 10000, but that reminds me of 2007 when some of the reputed brokerage house gave the SENSEX target as 29000! You can't blame them - they didn't know the crisis was coming :-)

The Bulls drive the markets higher, we need them in the uptrend. Similarly, the Bears drive the market lower and we need them for a downtrend. The Bulls and Bears are the smart lot who know what they are doing. They are big players who have the capacity to drive the market in their direction. They know how to make money and their moves are often guided by rationals. Unlike them, the sheep are followers. They have a herd mentality of simply following the trend. Trend is the Friend works for them provided they know when to get off the euphoria wagon. Often they mis-time it and eventually get slaughtered.

Coming back to the NIFTY: 

It has been in uptrend since last may. It tried to cross 9000 levels on two occasions and trying again for a third time. However, looking from the Open Interest levels, the bulls seem to have left the market already. The OI is at a much lower level, suggesting that the uptrend is not supported by fresh buying. If that is the case, we will most likely see the Bears taking over the market at 9000 levels forming a triple top pattern which is a reversal sign. This can take the Nifty back to 8200 range. We may also see a higher level of volatility in coming weeks (Q4 results) and hence all the sheep needs to be more careful. Well, I would reiterate again that nobody can predict markets with certainty, but for all the sheep, the following may help:

1. Do not go Long unless there is a break out above 9000. In that case, one should wait for the correction at let NIFTY come back at 8800 level. That would be the new support zone and a good point to enter the market with Bulls.

2. The India VIX is around 14.5% and volatility is expected to be higher. A 25 Delta Strangle should be a good bet in Options

3. If the OI level increases and the market turns south, it is time to feast along side Bears!

The ITC

I have mostly analysed a stock from valuation perspective and I rarely use technical indicators to predict price movements. Here is an attempt to do so with one of the heavy weights at NSE, ITC Corp. I tried to model the with a linear trend and sinusoidal wave (owing to cyclical nature).

The stock behavior has typically two characteristics, the linear trend and the cyclical nature. Further to that, we have noise behavior. The below graph shows how a base model differs when the noise term is added. Basically, noise is nothing but the randomness.

Coming back to the ITC share price, the model behavior is as follows: 

The price can sway around the model prediction (blue line) due to the noise. The model predicts that there is a 2 in 3 chance that the price will go down to 320 and bounce back to 350 in the remaining 2 months.

The NIFTY: Where is it headed?

It has been quite sometime since my last post, and the world seems so different. The Syrian conflict, gold bouncing back, Rupee touching new lows and stocks crashing, all in just 3 months! A friend asked me if it is the right to time to invest money in stock markets, as he heard someone on CNBC that most of the stocks are at 52 weeks low. As usual, I believe no one can predict what would be the levels, but yes, one can ascertain the fundamental valuation. I validate the pricing models for derivatives where I see numerous complex mathematical models and formula, and all of them useless if they fail to calibrate to the market price. We depend on mathematical tools to predict the future, while in reality, the tools are meant to expect the future. And that is a stand-off! Not that I claim to be the primus inter pares on Dalal Street, but I look at things from a different perspective, and it is this perspective which woos me to be a Blogger.

I mentioned in my Infosys blog in the month of May when Infy was trading at 2200s, that I would like to go long when the street was shouting to go short. Well, I got richer by 40%, although it doesn't mean I am always right. As I said, I cannot predict but expect, and there is a very fine line between the two. 

Let me come back to the main topic that you read on the header - Where is Nifty headed!!

Let's see how the Nifty P/E ratio and earnings look like.

You can find out the P/E levels from my blog P/E conundrum, for different combination of growth and cost of capital. From the graph, you can see the blue line which is the P/E ratio, it is above 20 for a brief period of time. For a country like India, where the 10yr Govt Bond yield is around 9%, this will make the minimum cost of capital as 12.50% for the Nifty listed companies. For for this level of CoC, we need a growth of at least 15% year-on-year. The earnings growth for period 2003-2008 is 22% y-o-y. I am not surprised that the blue line in the above graph crosses the 20 mark quite often during that period. This is also the period when India's GDP was growing at a healthy rate of 8 to 9% per annum.

 Now, let's talk about the last 5 yrs, when the earnings growth have been just 7% and GDP growth has been touching lows of 4%. Clearly, with such indicators, we cannot have a P/E of more than 15. However, it would be foolish to believe that the earnings growth would remain below 10% for Nifty. I mean, yes there are challenges but the growth in earnings would at least be 10% to be on conservative side. With a positive outlook, we can expect it to be 14% per annum. Now that we have the data, lets do the maths!

So If we expect that nothing will happen i.e. no rate cuts and the growth is subdued then in that scenario the worst level for Nifty would be a P/E ratio of 15. With a positive outlook and softening of rates, I will expect it to be above 20. 

Based on the above analysis, you can have your own views of how the Indian market would shape up. I believe we are very much in the neutral zone right now, but with a population of more than 1.2 billion people, I don't see that the growth story of India will ever go down the hill. I think that any positive news would certainly lift the Nifty from here and take it above 6000 level. There has been enough discussions around key global events such as Fed tapering, Euro crisis, asset bubble in china, slow down of emerging markets etc. I think none of them will have any direct impact on Nifty valuations in longer term. Yes, you may see a sudden crash, but I believe that they will bounce back . As per the sectoral plot of Nifty, you can have your own assumptions on how they will perform.

To summarize, I think that we are very much in a neutral zone right now. A negative outlook can bring Nifty down, but the downside is floored at 4900 level. Even if the market crashes, we will expect a bounce back as the Indian growth story is not yet over. I expect it to be in 6000 range if the market sentiments are neutral to positive.

The P/E Conundrum - How to take advantage from it!

"....the forward earnings multiple is attractive and we suggest a buy rating on the stock." 

How often have you heard the above lines in the morning talk shows at CNBC, ET Now etc? You will find almost every analyst talking about the "P/E multiple" as a base for stock picking. And poor investors like us often get trapped in what I call The P/E Conundrum! And believe me, the conundrum is good and if you learn how to solve it, you will always have an edge over others in picking the right stocks!

P/E represents the ratio of price of stock over its earnings per share. For e.g, a stock trading at 150 per share with EPS(earnings per share) as 10 will have a PE ratio of 15. A PE multiple or ratio suggests how much price you are willing to pay for a stock in terms of its earnings. If you believe that the company has a great growth & earning potential, you will tend to pay a higher multiple of its earnings. In 2012, when Facebook went for the IPO, the market was ready to pay more than 100 times its earnings for the stock. We all know that how facebook crashed to almost half of its listed price with a subdued PE. 

There is no denying the fact that P/E ratio helps in decision making for most of the hedge funds, money managers and individual investors. The father of value investing, Benjamin Graham often used P/E as a guide for finding right stocks. A company with sound business operations trading at P/E multiple around 14 used to be his value pick. However, P/E has its own pitfalls and gaps, and all we need to do is to understand those limitations. The three golden rules which you should never forget are:

• The P/E ratio works only for profit making firms who have not reported significant deviations from their past earnings. Don't use it for growth stocks or firms which you think have reported huge changes in their earnings without any significant move in their top line or bottom line growth.
• P/E alone cannot be used to estimate the intrinsic value or for relative analysis of the stocks. You should consider the net debt, cash balances too
• P/E depends not only on the future expected growth but also on the cost of capital for the firm. Two companies with the same P/E doesn't necessarily mean that they are expected to grow at the same pace!

Now, let's resolve the conundrum and see how we should use P/E to value a firm, and also what P/E should be considered as the "right" P/E. The chart below shows the P/E ratio of CNX Nifty stocks for the last two years.

The PE ratio has been  mostly in the range of 17 to 20, but we do observe them touching as high as 26. So what do we make out of these numbers?  Also, Larsen & Toubro is trading at a PE multiple of 18, while ITC is trading at a PE ratio of 35. If that was not enough, BHEL is trading at a PE of 7. Three large caps, all profitable and yet such a different PE! The conundrum, isn't it?

So the first challenge is  to ensure that we estimate a right PE, and then to estimate the margin of safety in using it for stock picking. We neither need to be too conservative and miss the opportunities nor be aggressive enough to buy at a high valuation. I will now give a simple tool which shall help you in finding the fair value of any stock. This definitely can't solve the conundrum in whole but will certainly help you to avoid expensive stocks and help select cheap ones.

As I have stated earlier, the PE depends on the the cost of capital for the firm as well as the expectation for future growth. Theoretically speaking, the inverse of PE is analogous to the yield of a fixed income security. Hence, it depends on range of different factors. The table below can give a fair estimate of how the PE should be:

So If you see the matrix above, you can estimate the fair PE value for any firm for which you know the growth rate and its balance sheet.  Now growth rate is something which you can find from the earnings report and then qualitatively estimate the future trend. Similarly, a firm which has high capital value, less debt and financially more sound will have a lower cost of capital compared to the firm with a high debt and more volatile earnings. Let's use the table to estimate the intrinsic values for few well known stocks.

ITC:  ITC is a very stable firm that has shown a growth of about 25% YoY. It has a wide range of business from tobacco to agriculture products, FMCG, hotels etc. It is fair to estimate that it will grow by 20% for the next 5 years. Also, if you see the balance sheet, ITC has negligible debt making the cost of capital small i.e. around 10% to 12%. So let's find the PE from the table above. Using our estimates, the PE for ITC should be in the range of 28-32. It has 3000 cr in cash and bank deposits. So it is fair the estimate that the PE should be about 32. With EPS of 9.4, the fair value of stock comes as 300. ITC is presently trading at 330. So any price below 300 should be a value pick. Please note that the 3 month low of ITC is 281 which was a value pick point.


L&T: Let's try this for Larsen & Toubro. Now this is an infrastructure company which has huge debt and also has a lot of project risk. It is fair to estimate the cost of capital to be around 16%.  The top line has grown by about 20% over the last few years and is expected to maintain so. Now, if we pick the PE number from the table above, i.e. for 5th column (20% growth) and 3rd and 4th row, it comes in between 22 and 25. It is fair to estimate the PE as 22 to be on safer side. Please also note that L&T has about 12,000 Cr of debt which translates as 196 per share. So, using the EPS of 79, we get the fair value of L&T as (79 X 22 - 196) which is around 1541 per share. L&T is presently trading at 1456 with a 1 month high and low as 1652 and 1407. This means that anything below 1500 is a value pick for L&T.

So what we have seen here? Regardless of where the market is trading presently, you will always find days when the traded price touches the intrinsic value and that is the time when we should use the value picking strategy. I hope the PE table above shall not only help you come out of the conundrum, but use it for your advantage.

If you want more clarifications on how I have created that table or how should you use it, please feel free to connect with me at LinkedIn. Happy Investing!

TCS and Infosys - The Value Stock?

In the last 20 yrs, India has emerged as the new face of IT outsourcing hub. The IT sector has created the saga of a more empowered middle class which in turn has resulted in a booming GDP growth of world’s second most populous country.  It is still early to say what would be the future growth of this sector. Mostly dependent on US and European markets, IT sector has faced challenges over the last few years but the investor's penchant for IT stocks have been up-beat.  Let’s take some of the key IT stocks in Indian market and where they stand

 

The two top Blue chips from IT sectors are TCS and Infosys. Both the companies employ in access of 150,000 people and has been the success stories for India’s IT boom. The two sister companies were moving parallel until TCS took the lead. As an investor, this always confuses me which of the two has more promise for future growth. Infosys which is trading at a PE multiple of 15, has a huge cash balance of USD 4 Billion, while TCS is trading at a higher PE and also retaining the number one spot in IT outsourcing space globally. Let’s compare their highs and lows over last 1 year.

 

As we can see, both the companies have shown similar gaps in the highs and lows over the last year and any investor could have found the opportunity to be 50% richer, had they bought them at right levels.  So the million dollar question is “what is the right level and how the valuation can be affected with the changing economic landscape?”

The average growth in sales and operating margin for the two companies over last 5 years are:

 

Recently, Cognizant has replaced Infosys from no. 2 position. While Investors have always been critical of Infosys operating model, the company has managed to maintain a healthy operating margin at the cost of a slow growth in its top line compared to its peers. So let’s see what should be the ideal valuation of these two stocks and the probable scenarios which may affect future valuations.  I have taken four scenarios here:

Case1:  The next 10 year growth remains similar and the operating margin is maintained

Case2:  The next 10 year growth slows down moderately

Case3:  There is a gradual decline in top line due to competition and bleak economy outlook

Case4:  There is a change in operating model and the company sees a sharp growth

The valuations of the stocks in the above 4 cases are:

 

Based on the analysis, I feel that Infosys is a better choice compared to TCS. Firstly, its present valuation is more attractive as the true valuation can be around 2400 INR.  While TCS has shown a surge in valuation, I don’t think that the present level of INR 1400+ is sustainable even with the best possible growth prospects.  Also, compared to Infosys, TCS has a smaller Beta and hence the implied risk premiums associated with it comes to be lower. In case the beta moves up, we can see a drop in prices. The reason why TCS is trading above par is mainly due to the uncertainty with its other peers in this sector.

To summarize, I would still go long Infosys as I see value in the stock. My fair estimate for the stock is INR 2400. Hence any drop from the present level should definitely provide a buying opportunity .