November 20, 2009

What’s on my mind – Nov 09

I am planning to start a new monthly post with the topic – what's on my mind. It's more likely to be a brain dump of my thoughts – more for myself – to check back in future as to what I was thinking (or smoking J ) at a particular point of time. This should help me cross-reference some of the investing decision I took at the time.

It's a natural tendency to look at decision after they play out with a fair amount of hindsight bias. Like others, I too have a tendency to forget the key factors which played into my decision and color the history based on present information. Anyway, more on this bias in a later post.

Dollar depreciation

The US is now running a deficit of almost 1.4 trillion (that's 1000 billion and 1 billion = 100 crores). That's a lot of zeroes. The deficit is almost 10% of GDP and projected to continue for some time. A deficit of this proportion would land (and it did in 91) a country like India in serious trouble very quickly. If we had to borrow as much to fund our deficit, we would have a crisis (as we did in 1991).

Now the US dollar is a reserve currency and they get to print it and hence can monetize their debt. In addition, it's a rich country, so other countries are ready to lend to the US. However there is finally a limit to everything and something which cannot go on forever will stop some way or other. In the usual case, a country incurring such a deficit could see its currency depreciate, cost of debt and inflation shoot up and contraction of its economy if it went too far. The US has been able to avoid all this as it is still the largest economy and other countries do not really have too much of an alternative.

That said, it is appear likely (atleast in the long run), that the currency will keep depreciating. That does not mean, that we will not have episodes (as in 2008), where the currency strengthened. However in the long run a country with a large deficit and growing debt can fix it in 3 ways – inflate, raise taxes and cut expenses. Inflation (via currency depreciation) is easier politically and hence looks more likely to happen.

All of the above is a conjecture, but still a probable scenario. Now, you may ask, how does it impact us? A few points come to my mind

  • Our currency is still a managed currency and everytime the dollar has depreciated, RBI attempts to control the appreciation of the rupee. This has in general resulted in high liquidity in the domestic markets which results in asset bubbles – spike in real estate and Stock markets etc.
  • Higher inflation due to higher commodity prices as most of commodities are priced in dollar
  • Reduction in margins for IT and export oriented companies due to stronger rupee and weaker growth in export market such as US

The problem with macroeconomics is that you may be right in the long run, but in the short run be completely off the mark. In addition, it is easy to guess, but difficult to arrive at specific investment decisions based on these macro-economic mumbo jumbo.

All said and done, I am worried about the implied (based on current valuations) bottom line growth for IT companies and the head winds faced by them.

Automotive sector

The growth for the current quarter is likely to be high due to the base effect (dec 2008 was bad) and hence the market may still react positively. However in view of the valuations, I have already started reducing my position in maruti. Need to make up my mind on Ashok Leyland, which has appreciated quite a bit

Overall market levels

I am not sure if the market are overvalued at 22 times earnings, but at the same time I have started reducing my Index ETF positions. I do not look at chart and any other technical indicators. As I have said in the past, when the market has fallen below 12 times earnings, it has generally been a good time to buy the index and a market level of 23 and above a decent time to sell. Its not a precise approach, but makes decent sense from a valuation perspective.

Fixed income investing

I would prefer to buy short dated debt (short term deposits) or floating rate funds. I think that inflation is likely to go up and hence it would better to buy floating rate funds than fixed rate ones. Again, no specific analysis as to why I think that inflation will go up – only reason is that the government has a stimulus package and low rates. Once the inflation starts creeping up, RBI may have to raise rates again.

New ideas

Not many attractive ones. So I am currently just studying some companies such as Tata sponge and others from a learning perspective. This should help me pull the trigger when the valuations are right. I need to avoid trying to be too clever for my own good.

19 comments:

jbr said...

For IT companies, there's also the threat of protectionism (atleast in the short run):

Example:

http://economictimes.indiatimes.com/infotech/ites/Tech-companies-find-it-difficult-to-crack-deals-in-US-Europe/articleshow/5248950.cms

On P/E, do you look at trailing or forward?

I find the macro arguments to be the consensus and maybe too obviously stated by many. It will be very interesting to see what US deficits are in 2010/2011. If the deficit disappears and there is a low probability of it happening soon and a high probability of it happening in the intermediate to long term, it changes things significantly. I think 2010 could bring up issues of trade tensions/protectionism (as the example link above).

Sachin Purohit said...

Aha ! Finally I see this article from you. You seemed to have maintained a Yogic silence on the dollar-mess the entire world has got into. I had been checking your site to see how long you can resist writing on it!

As regards India's managed peg - It seems like the next-door Giant (China) has forced India's hands more than anything else. So even if India knows that depreciating along with the weakening dollar is akin to go down along with the titanic, it can not allow the Rupee to float without hurting the exporters while China is having a fixed Yuan. In turn, this mad race to weaken one's own currency the most, the governments are causing the longest lasting asset bubbles across asia. I don't even see the light at the end of the tunnel, especially after today's statement by the Chinese Central Bank's governor demolishing the hope of an appreciating Yuan.

I continue to hold my free uninvested cash in Gold rather than Rupees or Fixed Deposits (either short-term or long-term)!

VISHNU said...

Hi,

Seth Klarman recently talked about buying options on Gold for a question related to investing cash.(Other answer is shorting $)

Do you have any idea ..how to implement these in Indian Markets ?

Thanks
Vishnu

ravi said...

Hi Rohit,

A nice post as always. Last night I was reading something similar by Wanger. He says you need to see long term and not short term. Long term is like predicting climate, you can say what would be the avg temp. short term is like predicting the weather next day or next week. I agree that US dollar has only one way in the long term and that is to go down unless they again go back to their earlier ways of innovation and consumption which looks like a low probability right now. My question to you is if our IT companies that has around 60% revenues from US know this, can't they take long term hedge for say 10 years or so? Wont the CFOs who are supposed to be smart reading this the same way we do? If yes, then it is more likely that the profit will remain stable as the hedging will cushion the dollar slide. What are your thoughts on that?

Rohit Chauhan said...

Hi jbr
there are several risks for IT companies such as dollar depreciation, topline issues etc. however the valuations dont seem to discount that..hence my discomfort.

on US reducing their deficit in the short run ..really doubt it ..a very low probability event. however in the long run if they dont, then it is likely to create a lot of problems

rgds
rohit

Rohit Chauhan said...

Hi sachin
i have concerns of the dollar and it will impact me in various ways. however my silence is less yogic and more the silence of a person who does not have much to say ..there are as many arguments on the direction of the dollar as people and each one has a plausible argument. so finally its anyone's guess

as far as gold is concerned ...it beyond my competence and hence i dont plan to invest in it

rgds
rohit

Rohit Chauhan said...

Hi ravi
long term hedges are very costly. for example if you were to buy a 1.5 yr hedge on a stock priced at 100 ..you may pay a hedge of around 20 ...this pricing will depend further on the strike price, the duration and volatility.

so a 10 yr hedge could easily cost almost 40% or even more of the amount hedged ..most companies dont even have margins of 20%.

i think even if CFO realised that the dollar would drop..a currency hedge would be very costly for the long term. in addition there are other MTM loss risks.

frankly companies with a pure labor and currency arbitrage model could have a tough time if the rupee appreciates too much

rgds
rohit

Rohit Chauhan said...

Hi vishnu
i am not sure ..but maybe there are gold ETFs available ?
other way is to buy gold from a bank ..

in the US ofcourse its very easy ..buy gold ETF or inverse dollar ETFs
rgds
rohit

ravi said...

Hi Vishnu,

In India too you can invest in gold ETF if you wish. If you are using Icici direct then type in goldex as the stock code and that is the benchmark ETF that is available.

Hi Rohit,

Thanks for your reply. As you rightly said, there is a cost to hedge for which I was not aware of the actual cost. I have some followup questions. Obviously, I assume that you know the answers which may not be true. Doesn't the MTM losses nullify the fluctuation of dollar. I mean lets say we take a hedge of US dollar at Rs. 45. Let us assume the current mkt price is Rs.40. So, when the company reports the topline, it would be the USD amount times 40 which means the topline and bottomline would go down. However MTM will show profit as we took the hedge. Yes, it will show losses when the USD moves up but in that case our topline and bottom line has grown that same %. As I see it its only the cost of hedge that is the issue. Now coming to the cost, I think that NIIT Tech had taken a ridiculous hedge that too a long term one. How do they manage to take such hedges when they are a midcap company given the huge cost that you mentioned. I am just trying get a better understanding of this hedging funda.
Regards
Ravi

Rohit Chauhan said...

Hi ravi
hedging is quite complicated and the example you give works if you have prefect hedge. also MTM losses are passed through P&L when the forecasted transaction occurs in case of an effective hedge
in case it is not an effective hedge , it has to be passed through P&L effectively

One correction to my statement - hedges can be built via futures too and those dont cost similar to options. the downside is that in case of options you can lose only the premium

In case of IT companies, they usually hedge through futures ..so the cost is almost nil, but the risk is high if the hedge moves against you ..hedge dont work linearly as forecasted and a lot of companies have found that belatedly

in case of 10 yrs hedge ..the challenge is to find some one to take the other side of this non standard transaction ..i doubt you will get bank to assume this kind of risk

The case of NIIT demonstrates perfectly the risk of long term hedges - in this case only 2 yrs and how you could be right in the long term and still lose in the short term

just imagine what would have happened if NIIT took a 10 yr hedge and the exchange went against the hedge..they would have a huge infective hedge loss

rgds
rohit

Prashanth BLR said...

Rohit,
Great post!
Just a hunch: if you do have a positive feeling about $ going down, can there not be an arbitrage opportunity of some form? Like buying the stocks of a US-exporter?

Madhav said...

Rohit,

I believe in the long term story of Indian consumerism and hence try to invest in many companies which cater to the Indian market. One example is Educomp, which albeit being a small cap stock, is a big education provider and so a company to watch for in a decade or so.

What do you feel about such India-focussed companies and their valuations? Interested to know if you have a certain view you have on them?

Anwar said...

Hi Rohit,

You said, looking at Tata Sponge. I would suggest you to have a look at Bajaj Holdings. It's market cap is 5K crores. It has fixed income instruments of nearly 3k crore and 30% investment in Bajaj Auto,Bajaj Finserve and Maharashtra scooters and has another subsidiary which is the promoter of Bajaj Allainze. The market gives value of Rs2K crore to this investments while actual value could be anywhere around 8K crore. Value buy? I know holding companies trade at a discount but not at 70% discount

Rohit Chauhan said...

Hi prashanth BLR
exporters will get hurt if the dollar drops.
the most direct way of play this would be to bus
futures ..though not sure if we can trade currencies as a retail investor

for me it is more an academic exercise ..i dont plan to play the hunch

rgds
rohit

Rohit Chauhan said...

Hi anwar
holding company stock are a much better buy when the market is down as the stock held by the company are also at a discount.
as of the now the companies held themself are fairly or sometimes overvalued and hence the discount appears more that it should
also the value does not get realised often if the management has no plans of unlocking the value
that said, i have not seen bajaj and would have a look.
rgds
rohit

Rohit Chauhan said...

Hi madhav
i am not a top down investor ..discussing and thinking on macro topics such as dollar, india consumerism is one thing ..but i generally dont use that to make investment decisions. it diffcult for me to translate such broad ideas to specific ideas. i prefer a bottom up approach ..if the stock appears cheap based on historical and conservatively expected performance ..i will buy it.

i have not looked at the company closely in the past the valuations have generally been too high for my comfort

rgds
rohit

Madhav said...

Hi Rohit,

I guess top-down or bottom-up is a matter of personal choice, though as a value investor we aim to buy the stock with a margin of safety.

Thanks for sharing your thoughts on that.

Regards.
Madav.

Rohit Chauhan said...

Hi madhav
thats true . that does not mean it is not an effective way of investing..some people are able to do a top down form of investing and it works for them. in my case i have not been able to figure how to translate those ideas into a specific stock pick and as a result i stay away from that approach

rgds
rohit

Vic said...

Hi Rohit,

I really like this post of "What's on my mind"..pls keep them coming in future as well.

Thanks,

Vikas