For value buying to come in, markets may have to slip by another 15%.
By all accounts, the current financial crisis is the worst since the Great Depression of 1929-37.
It is certainly altering global trade patterns, and the financial industry will never be the same again.
It’s quite likely the global economy will go into stagnation or even recession as the IMF’s latest advisory suggests. Other experts have revised estimates downwards through the last three quarters. Once the July-September numbers flow in, another global GDP projection downgrade is likely.
Even worse, there is a huge liquidity crisis. The buyers and lenders of the last resort, the US government and those of the other First World nations, are running out of funds. You have a paradox – so much forex has gone into US debt, the dollar has appreciated. When that trend reverses, it could get more painful.
The current crisis is a payback for a Faustian bargain. Previous Fed Chairman Alan Greenspan’s policies helped mitigate Asian Flu and the Russian crisis, contributing to several years of unprecedented global growth. But that growth turned into the largest bubble in history. Bubbles eventually deflate and the bigger the bubble, the more painful the process of deflation.
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Right now, sound balance sheets matter more than profits. Every company, which is leveraged up and cash-negative, will struggle. Companies with low debt and cash reserves can ride out the storm. They can even buy cheap assets and develop new business avenues. That is what the Indian IT industry, for example, will have to do.
There will be even greater consolidation in growth industries, like telecom, that need external capital.
Telecom needs enormous investments over the next three years to roll out more networks and induct new technologies. The growth and profit records of Indian telecom businesses are excellent. So the better-managed companies will find investments flowing in even if there are stringent conditions attached.
Cyclicals will take a long ride through a dark tunnel. The entire value chain is affected. There’s no demand for end-products. (Cars, high-end retail, white goods, housing). That has meant a drop in demand for commodities. Revival will come only once commodity prices have got really low; users have passed on input cost-cuts; and consumers have started buying again.
In these situations, valuations need to capture sustainability rather than growth prospects. Look for low PE ratios and high dividend yields. The third classic measure of sustainability is a low market cap to net worth ratio – that is, a low price-book value (PBV).
Unfortunately, India is an emerging market and emerging markets typically don’t have low PBVs. Taking these three standard metrics, we know that in recessions and bear markets, Indian markets have bottomed at Nifty price-book values of around 2.5, PEs of 10-11 and dividend yields of close to 2 per cent.
By those standards, the current numbers are edging closer to the green zone, but they are not there yet. The PBV is 2.9, the price earnings (PE) ratios are just above 15 and the dividend yield is about 1.6 per cent. Current estimates suggest the forward PE is about 11 – that implies analysts are still seeing over 25 per cent earnings growth.
That could well be revised downwards once Q2 results are in. Even otherwise, the light is amber for investors rather than green.
If you are getting selective, use the market bottom numbers as a primary filter before making specific picks. Quite a few companies trade at PEs lower than 10. Fewer have PBV ratios lower than 2.5. Very few also offer dividend yields of 2 per cent-plus.
Once you have that basic list, start looking at more criteria such as low debt, positive cash flow. Only after that you can move into the grey areas of specific business characteristics, management quality, etc.
The fact is very few Indian companies will pass the initial mechanical filters.
Far more of them would have made the investment-grade in 2005 or even 2006.
That reinforces the feeling that the market may fall further. Alternatively, it will take a long time to recover. If earnings estimates are met, and prices don’t change, the market would start looking attractive in the first six months of calendar 2009. It would have to fall another 15 per cent to be a genuine value buy.