Profits on the high seas

SMARTSHARE

In 1972, near the peak of a massive bull-run, Warren Buffett offered to dissolve his asset-management partnership and return money to his investors. He claimed he couldn't find good businesses at decent values. His investors refused the offer. The oil-shock following the Yom Kippur War of 1973 triggered a bear market, solving Buffett's stock-picking problems!

Most asset managers wouldn't dream of emulating Buffett. If there are investors offering cash, the funds will take it. If the fund managers think valuations are inflated, they'll simply keep more of the corpus in cash. Mutual funds sell more units during bull-runs. So, they would be foolish to refuse fresh funds simply because prices are rising.

But a couple of Indian funds have recently frozen unit sales. The reasons are similar to that cited by Buffett "" it's difficult to find stocks at decent valuations and they are trying to protect their long-term unit-holders by not buying at these levels.

This is odd, given a current Sensex PE of 16.9. This is moderate by historical standards. The Sensex hit 29 PE in the 2000 bull-market and 55-plus during the Harshad Mehta run. The Sensex PE has remained almost stable through the last 10 months though the Sensex itself has risen 30 per cent. Big stock earnings' growth has kept pace with prices. The value-equation is much worse in smaller stocks. The CNX Midcaps is over 19 PE and that ratio has risen along with the index; earnings growth has been outpaced by price-rises in midcaps. Smallcap valuations are even more stretched; the BSE 500 is above 22 PE "" that's after adjusting for 40-odd lossmakers.

Higher PE ratios can only be justified by higher growth rates after adjusting for risks. There are no loss-makers in the Sensex-Nifty universe at present (that will change by end 2005-06, given petro-pricing policy). Almost 10 per cent of the BSE 500 group is in red-ink territory.

The risks in small stocks are obviously higher. The growth rates in small stocks would have to be much, much better than in big stocks to justify a 35 per cent valuation premium and the higher risks of a 9 per cent 'loss-rate' (versus zero). I doubt the relative growth rates are that much better.

Chasing growth may be a mug's game now. If growth stays high in a crashing market, a growth-investor will still lose capital. If we look for value instead of growth, very few companies fit the bill.

Most value-plays are cyclicals with an embedded potential for collapse. Shipping shares for instance, are trading in low single-digit PEs and so are some good metal stocks. If global trade eases off, or crude prices rise 10-15 per cent, the shipping business will be hard-hit. If China's metal demand-supply equation changes, global metal prices may collapse. Chinese steel production has risen 28 per cent in the past six months, which leaves metals very exposed.

In the shipping industry, Indian companies have finally, successfully lobbied for a switch to tonnage tax. This protects post-tax earnings "" provided earnings are positive and fleet expansion continues.

The latter is a given because vessel orders are booked many years in advance and every Indian company has ships on order. There is no apparent reason for global trade to suddenly collapse even if crude prices keep rising.

If I was a fund manager right now, shipping would definitely be an area of focus.