Thursday, October 29, 2009

>Just Deserts and Markets Being Silly Again

Just Deserts
I can’t tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee’s sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn’t seem deserved. And then it occurred to me. Isn’t that the point these days: that rewards do not at all reflect our just deserts? Let’s review some of the more obvious examples.

1. For Missing the Unmissable
Bernanke, the most passionate cheerleader of Greenspan’s follies, is picked as his replacement,
partly, it seems, for his belief that U.S. house prices would never decline and that at their peak
in late 2005 they largely just reflected the unusual strength of the U.S. economy. As well as missing on his very own this 3-sigma (100-year) event in housing, he was completely clueless as to the potential disastrous interactions among lower house prices, new opaque fi nancial instruments, heroically increased mortgages, lower lending standards, and internationally networked distribution. For these accumulated benefits to society, he was reappointed! So, yes, after the fashion of his mentor, he was lavish with help as the bubble burst. And how can we so quickly forget the very painful consequences of the previous lavishing after the 2000 bubble? Rewarding Bernanke is like reappointing the Titanic’s captain for facilitating an orderly disembarkation of the sinking ship (let’s pretend that happened) while ignoring the fact that he had charged recklessly through dark and dangerous waters.

2. The Other Teflon Men
Larry Summers, with a Financial Times bully pulpit, had done little bullying and blown no warning whistles of impending doom back in 2006 and 2007. And, famously, in earlier years as Treasury Secretary he had encouraged (I hope inadvertently) wild and reckless financial behavior by helping to beat back attempts to regulate some of the new and most dangerous instruments. Timothy Geithner, in turn, sat in the very engine room of the USS Disaster and helped steer her onto the rocks. And there are several others (discussed in the 4Q 2008 Letter). You know who you are. All promoted!

3. Misguided, Sometimes Idiotic Mortgage Borrowers
The more misguided or reckless the borrowers, the more determined the efforts to help them out, it appears, although it must be admitted these efforts had limited effect. In comparison, those who showed restraint and either underhoused themselves or rented received not even a hint of help. Quite the reverse: the money the more prudent potential buyers held back from housing received an artifi cially low rate. In effect, the prudent are subsidizing the very same banks that insisted on dancing off the cliff into Uncle Sam’s arms or, rather, the arms of the taxpayers – many of whom rent.

4. Reckless Homebuilders
Having magnificently overbuilt for several years by any normal relationship to the population, we have decided to encourage even more homebuilding by giving new house buyers $8,000 each. This cash comes partly from the pockets of prudent renters once again. This gift is soon, perhaps, to be extended beyond first-time buyers (for whom everyone with a heart has a slight sympathy) to any buyers, which would be blatant vote-buying by Congress. So what else is new?

5. Over-spenders and Under-savers
To celebrate the overwhelming consensus among economists that U.S. individuals have been
dangerously overconsuming for the last 15 years, we have decided to encourage consumption and penalize savers by maintaining the aforementioned artifi cially low rates, which beg everyone and sundry to borrow even more. The total debt to GDP ratio, which under our heroes Greenspan and Bernanke rose from 1.25x GDP to 3.25x (without even counting our Social Security and Medicare commitments), has continued to climb as growing government debt more than offsets falling consumer debt. Where, one wonders, does this end, and with how much grief?

6. Banks Too Big to Fail
Here we have adopted a particularly simple and comprehensible policy: make them bigger! Indeed, force them to be bigger. And whatever you do, don’t have any serious Congressional conversation about breaking them up. (Leave that to a few journalists and commentators. Only pinkos read pink newspapers anyway!) This is not the fi rst time that a cliché has triumphed. This one is: “You can’t roll back the clock.” (See this quarter’s Special Topic: Lesson Not Learned: On Redesigning Our Current Financial System.)



Investor focus has shifted from earnings to valuation. We are now most often asked at what P/E should the market trade. We offer four approaches: (1) history of multiple expansions from bear market lows suggests 14.1x; (2) our top-down P/E model suggests 13.7x; (3) our DDM-derived 2009 price-target of 1060 implies 13.1x; and (4) the Fed Model implies 16.4x.

P/E multiples will likely remain below average in 2010
Our top-down regression and DDM models cannot precisely pinpoint a correct P/E multiple. However, the current weak macroeconomic backdrop as well as the historical trading pattern of bear market recoveries suggest P/E multiples will stay below average in 2010. Our forecast that multiples will remain below average represents an out-of-consensus view based on recent conversations with a wide range of portfolio managers. Many investors expect S&P 500 will reach 1200 by year-end. However, we believe it will take a higher E – not higher P/E – for the market to sustain levels above our current 1060 target.

The debate has shifted from EPS to valuation. During the past 18 months, we have focused our research primarily on the earnings power of the market and the trajectory of S&P 500 EPS. This emphasis was appropriate given forward bottom-up consensus EPS estimates for the S&P 500 plunged by 37% from $98 in September 2008 to $62 in May 2009. During the past five months, however, EPS estimates have edged up slightly, currently hovering around $68. Given the recent stability of earnings estimates, investor focus has shifted from earnings to valuation.

The Multiple Mystery: At what P/E should the market trade?

(1) History suggests 14.1x, or 34% expansion from the trough
Historical analysis reveals a consistent pattern of bear market recoveries: first multiple expansion, then earnings growth. The market multiple tends to expand by 34% during the first 10 months following a bear market trough but then remains flat during the subsequent 12 month period. Since the March low, multiples have risen by 30%, on track with historical precedent, to 13.6x currently. A further 4% rise would lead to a 14.1x P/E.

(2) Top-Down P/E Regression suggests 13.7x
Macro model of inflation and the output gap suggest multiples will remain near current levels into 2010. Both variables appear negatively correlated with P/E (output gap is positive when GDP is below potential). We acknowledge that these two variables may not have a completely linear relationship with P/E multiples. For example, a deflationary environment probably would not lead to higher P/E (despite the negative correlation between P/E and inflation). However, our 2010 headline CPI forecast equals 1.2%, a rate within our historical regression sample set. The standard error of our model is 3.4 points, indicating the regression results should not be interpreted with a false sense of accuracy.

(3) Comparison with DDM (13.1x) and Fed Model (16.4x)
Independent valuation models provide varying implications for year-end P/E multiples. Our 2009 year-end price target of 1060 stems from our Dividend Discount Model (DDM) and implies a year-end 2009 P/E multiple of 13.1x, based on our 2010 pre-provision and write-down EPS estimate of $81. This result represents the lowest implied P/E of our various approaches. The Fed Model suggests P/E multiples may expand significantly in the near term, rising to 16.4x by year-end 2009. This model suggests equities are undervalued relative to bonds. The usefulness of this methodology in the current environment is limited given the unprecedented government actions that have kept interest rates unusually low.

P/E is hard to target; using 15x long-term average is too simplistic
Most investors agree with a $75-$80 EPS estimate for 2010. Bullish investors argue for 15x P/E multiple based on long-term history, and a year-end 2009 target of 1200. Our year-end 2009 price target remains 1060. We recognize the possibility the S&P 500 could rally sharply in 4Q boosted by better than expected earnings results and increased risk appetite. However, we reject the argument of many investors that re-valuation alone will propel the market higher through multiple expansion back to the long-term average.

To see the full report: PORTFOLIO STRATEGY



India Infoline, Motilal Oswal & Geojit BNPPARIBAS, the three major brokerage under our coverage universe have come up with their Q2FY10 results

All three have delivered results which are better than the street expectations

The companies scored on top line front mainly on account of increased revenue realization from equity and commodity brokerage segments while segments such as Mutual Fund advisory and Wealth management also registered healthy increase.

The companies witnessed significant growth in margins mainly on account of an increased customer base, increased participation from the retail investor segment and an overall positive breadth on the market front also added to the cause

The recent credit policy aimed at tackling inflation will have an impact on the revenues of the companies because reduced participation on the retail front and with the markets heading back to positions which we would term as expensive considering the valuation parameters a wait and hold approach from investors could dampen revenues. However considering the fact that the companies are regularly innovating their product portfolio and with an ever increasing demand for professional money managers the industry sure has a bright future ·

Moreover we believe that with SEBI giving clearance for the extension of timings of equity market, would lead to higher revenues by the brokerage houses and thus we retain our earlier BUY call on each of the three stocks.

To see the full report: BROKING SECTOR


Numbers in line with estimates; Eduresource grew substantially: Everonn Education (Everonn) reported consolidated sales of INR 731 mn, up 70% Y-o-Y, in Q2FY10. A substantial portion of the incremental revenues was contributed by its hardware trading subsidiary Eduresource that grew 2.4 times Yo-Y. Revenues in its Vitels segment grew 67%, to INR 348 mn, while ICT segment grew by a marginal 6%, to INR 139 mn.

EBITDA up; drop in ICT margins cause for concern: EBITDA for the company was higher by 74% Y-o-Y; EBITDA margin was, however, lower by 510bps Q-o-Q, as a substantial portion of the incremental revenues originated from Eduresource – an extremely low-margin business. Also, the ICT segment, despite reporting 6% Y-o-Y growth in revenues, posted 18% drop in PBT. We believe margins in the ICT business could continue to remain under pressure as competition intensifies amongst the existing players.


Plans to move up the education value chain; execution key concern: Everonn has announced an ambitious plan of venturing into management of education institutions (schools & colleges) through its ‘Educating India’ project. Currently, the project is at the conceptual stage, with the exact timelines and business model still unclear. We believe execution will remain a key challenge in this venture, especially since Everonn has little experience in managing educational institutions.

Outlook and valuations: Risk-reward favourable; maintain ‘BUY’: We maintain our revenue and sales estimate for Everonn and expect a consolidated topline CAGR of 47% and net profit CAGR of 68%, over FY10-11E. Everonn is currently trading at P/E of 17x FY10E and 11x FY11E. Adjusting for aggressive revenue recognition (refer risk factors), the company is trading at a P/E of 13x FY11E. The Vitels segment remains key driver for the company’s valuation. We believe continued strong performance will drive a re-rating in the stock. We maintain ‘BUY’ on Everonn.

To see the full report: EVERONN EDUCATION


Disappointing performance; net profit down 11.6% Y-o-Y: Titan Industries’ (TIL) Q2FY10 revenues grew only 5.3% Y-o-Y, to INR 11.5 bn, below our expectation of INR 12.5 bn. In spite of festive season, revenues failed to show buoyancy, signaling a substantial decrease. In Q1FY10, the company changed its accounting policy (to FIFO instead of weighted average method) for valuing gold inventory.

Skyrocketing gold prices hit jewellery business yet again: As TIL’s jewellery business battled spiraling gold prices, its growth disappointed with a mere 9.4% Y-o-Y growth. Net revenues stood at INR 8.2 bn versus INR 7.5 bn in Q2FY09, driven by ~15% increase in gold prices, signaling a significant decline in volumes (~6%). This lead to 200bps erosion in EBIT margins that stood at 7% against 9% in Q2FY09.

Macro headwinds temper growth

Watches business failed to enthuse: Watches and clocks business also exhibited dismal performance with revenue decline of 2.6% Y-o-Y. Sales from the business stood at INR 2.9 bn against INR 3.0 bn in Q2FY09. EBIT margins were down 20bps Y-o-Y, at 19.7%. TIL expects the December quarter to witness a strong comeback for this business, but we stay cautious and would watch the space closely.

EBITDA margins down 218bps Y-o-Y: EBITDA margins were down 218bps Y-o-Y due to 245bps decline in gross margins. Employee costs were up 57bps, but other expenses were down 84bps; hence, the net impact on EBITDA was to the tune of 218bps. Most retailers have seen a Y-o- Y decrease in staff expenses, except for TIL.

Outlook and valuations: Cautious; maintain ‘REDUCE’: We expect the watch and eye wear divisions to see some uptick due to higher discretionary spending and improving consumer sentiment. However, lower volumes in the jewellery division, due to spiraling gold prices, will continue to be drag on the business. At CMP of INR 1,361, the stock looks expensive at P/E of 29.6x FY10E and 24.6x FY11E. We maintain our ‘REDUCE’ recommendation on the stock, and rate it ‘Sector Underperformer’ on relative return basis (refer rating page for details).

To see the full report: TITAN INDUSTRIES


We highly - very highly - recommended that you take the time to read the only article on the weekend worth reading, which was "The View Fron Inside a Depression". Have a read of the excerpts from Benjamin Roth's diary of the roller coaster ride that come to define the economy and the financial markets during the 1930s. How it was all over by 1930 - but it wasnt. How everyone was giddy from all the government stimulus in 1935 and 1936 - and the sudden and dramatic reversal in 1937 and 1938. It reasonates, especially at a time when all the mainstream economists focus so intently over the latest tick in the regional manufacturing indices or jobless claims or inventory-sales ratios.

To see the full report: THE GREAT FRAUDULATION