SP500 Valuation Review – July 31, 2011

SP500 Quant report based on operating earnings as of 31 July 2011 can be viewed here; the SP500 Quant report based on as reported earnings can be viewed here. The commentary below is based on SP500 operating earnings.

Sensex Valuation Review – July 31, 1011

Sensex Quant report as of 31 July 2011 can be viewed here.

Earnings estimate used is Rs 1,175 for FY2012; a fairly modest growth expectation of 16% (7.5% real GDP growth plus 8.5% inflation) over FY2011 earnings of Rs 1,013. This is moderately below consensus estimates which are tending towards Rs 1,200 to Rs 1,215. This is good news since expectations have been revised downwards from overly optimistic levels which reached as high as Rs 1,275 to Rs 1,300 at one point in time.

With the Sensex at 18,197, the valuation based on current year and prior year earnings estimate multiples are in line with decade median levels; in fact 2.3% to 2.5% undervalued. The valuation based on forward year earnings suggests an undervaluation of 7.8% relative to decade median levels. Using current and forward year cyclically adjusted earnings, the multiples indicate an overvaluation of 5.2% to 6.4% relative to decade median levels. Using prior year cyclically adjusted earnings, the market is 8.7% undervalued relative to decade median levels. Relative to valuations on the SP500, the Sensex is 8.6% overvalued when using a single year earnings model and 8.3% undervalued when using cyclically adjusted earnings. 

Will Better Sense Prevail in Washington

Yesterday I said "People bet that Washington is not that stupid so as to allow a default or downgrade. But Washington is that stupid, the Great Recession as it is now known, was probably caused by bad policy decisions - Like GM, Lehman should have been rescued or sunk in a controlled environment, not the, melt down that was. I think the Tea Party bunch, are well meaning nitwits, who will hurt without the intention of harm. Well let us hope Washington learnt from recent experience and don't repeat bad policy; I'd say the odds are (1) No downgrade and no default 50% (2) Downgrade but no default 25% and (3) Default and downgrade 25% - perhaps I am too optimistic.".

Should we Fear the RBI’s 50 Basis Point Rate Hike?

Don't Fear the Rate Rise

The market reaction yesterday is simply disappointment in that expectation was not met. It will reverse once markets have assessed whether it is a bad policy move or not. I do not believe it is a bad policy move. With the reverse repo at 7% and CPI running at 8.7%, the real interest rate is still negative 1.58%. The median real reverse repo rate over the last decade has been positive 0.20%. During this period nominal interest rates ran at a median of 5.5% with median inflation at 5.3%. RBI policy has indicated that they expect inflation to stabilize at 7% by Q1 FY13, to keep real interest rates at 0.20% real a further 25 bps rise to 7.25% is possible. The question is whether there is good reason to expect long term inflation at 7% compared with decade medians of 5.3% - since 2003 we have lived in a world of rising commodity and food prices. In addition global money supply has expanded phenomenally. All this is inflationary. Going ahead, deleveraging in DM`s could be an offsetting factor to these inflationary pressures. Specific to India we have domestic problems such managing the deficit (both fiscal & trade) and a desperate need to invest in infrastructure (transportation and warehousing); without these productivity enhancing investments we will have an upward pressure on inflation. 

ONGC FPO – Possible Impact on Market

• ONGC and SAIL FPO to increase free float market capitalization by Rs 60,000 Crores or approximately $13 billion (ONGC Rs 53,000 Crores [approximately $11.8 billion] & SAIL Rs 6,000 Crores [approximately$1.2 billion]).
• Increase in free float market capitalization of Indian markets could lead to index investors and global equity allocators adding money to India equities.
• Today ONGC trades at 10.5X; well below broad market multiples. An increase in ONGC index weight-age could increase Sensex EPS thus bringing down PE multiples to a more attractive level.
• CIL IPO raised Rs 15,000 Crores of $3 billion; FII's applied for Rs 2.36L Crores ($52 billion) worth of CIL shares.
• If ONGC and SAIL attract same interest (unlikely), we could look at $200 billion application.
• Indian Rs could strengthen to Rs 42.75:$1 as money flows into meet demand for ONGC and SAIL FPO's.  We could see the Rs weakening subsequently as $ demand rises if equity flows reverse, together with significant $ demand to finance oil purchase, and yet more to re-finance FCCB's.  Of $15 billion FCCB's in issue, it is estimated that $7 billion will come up for redemption or conversion within 2 years.  Of this amount, $4.5 to $5 billion will probably need to be redeemed or refinanced since conversion prices are well over market prices.
• Equity markets have tended to peak with the Rs strong in relative terms. A weak Rs on the other hand has not always correlated with a bottom on the Sensex.
• Short term debt returns to remain strong as liquidity remains tight to meet FPO funding.

On Dividends & Buybacks

Companies create shareholder value through earnings growth. Companies return shareholder value through dividends. Buybacks are a hybrid method through which companies return shareholder value to exiting shareholders and create shareholder value through earnings growth for the remaining shareholders.

Dividends are nice because they create shareholder choice. The company pays cash; the shareholder pays tax and spends the rest of it. Dividends carry appeal to investors because they provide liquidity and income and the tax cost associated with a dividend is an acceptable cost. However, institutional investors and investors who typically elect the dividend re-investment option might not like a dividend because the tax cost makes it inefficient compared with earnings growth or share buybacks.

Buybacks are nice because they deliver exactly the same end result as a dividend paid with the reinvestment option, except that because no tax is paid on the number of shares acquired is higher. Thus this option carries appeal to a significant number of investors. The problem with buybacks is that most buybacks occur during periods when shares trade at a premium to fair or intrinsic value; if a buyback program was, like a dividend, designed to return shareholder value in a consistent and recurring fashion, it would work very well. The alternative would be to have a buyback program built on a market timing model where shares are only bought back when they are undervalued - very easy to say, but very difficult to implement since most companies really do not have in-house expertise to either time markets or determine fair or intrinsic value; investment is not their business, running the company is.

I Just Don't Get India Real Estate

Would you like to buy one of these lovely row houses for $1.44 million where the cost of debt for home buyers is well over 10%?

SP500 Valuation Review - Q2 2011

SP500 Quant report based on operating earnings as of 30 June 2011 can be viewed here; the SP500 Quant report based on as reported earnings can be viewed here. The commentary below is based on SP500 operating earnings.

Earnings estimate used is $89 for 2011, assuming no disruptions from private and national debt markets will manifest itself into a crisis this year. This is below consensus estimates, which are tending towards between $93.5 and $96.5. This is bad news since expectations have not been revised downwards from what I see as overly optimistic levels. However, earnings season is about to begin and the guidance downwards ahead of results has not been significant. This means companies expect to perform broadly in line with guidance; but it does not mean they expect to perform in line with consensus. There is a chance that markets could trade down as earnings growth expectations return to more sensible levels. For EM's this could mean new money flows because the earnings downgrade cycle is in an advanced stage in EM's.

Sensex Valuation Review – Q1 FY 2011

Sensex Quant report as of 30 June 2011 can be viewed here.

Earnings estimate used is Rs 1,175 for FY2011. This is moderately below consensus estimates which are tending towards Rs 1,200 to Rs 1,215. This is good news since expectations have been revised downwards from overly optimistic levels which reached as high as Rs 1,275 to Rs 1,300 at one point in time.

The valuation is in line with the median cyclically adjusted earnings multiples people have been willing to pay over the past economic cycle. Valuation based on current year multiples, prior year multiples and forward year multiples are all in line with what investors have been willing to pay at median levels over the last decade. Markets are about 5% below the decade median levels of prior year cyclically adjusted earnings. But markets are about 10% over the decade median levels of current and forward year cyclically adjusted earnings. All in all, valuations are very normal indicating a market which is neither cheap nor expensive. Portfolio allocation says hold. The buying opportunity to go overweight lies ahead and will arise as and when fiscal problems in developed economies crystallize into severe slow-downs if not recessions. In the meantime, stay with allocation, rebalancing each time risk aversion abates – I'd rebalance if the market hits 20,000 levels, especially if the 10 year G-sec is yielding at levels below decade average levels.