kfa: flying on the fly

What happens to a business that requires tons of money on a regular basis, and does not earn enough on that capital? It loses that money!

Moreover, if that business continues for long it eventually fails. Isn't this simple enough to understand? The more capital it receives the longer it operates, and the longer it operates the more it loses that capital.

If that is the case why should that business continue? Kingfisher Airlines owes truck loads of money to various stakeholders, viz. employees, suppliers and lenders. There is one problem though: it does not have cash to pay them. It also owes big time to its shareholders is another matter.

Those stakeholders have only two choices: Ask for the full amount owed which is not possible or accept a big write-off and restructure the amount. That's like something is better than nothing for them. That hope that they will get something someday will keep them. But will they?

The company has never earned before; market share has gone way down; costs will build up. More capital will be required, and more often. Who will supply the capital now - promoters and related parties? The shareholders of the airline have already lost their money. Now if the shareholders of the related parties start funding a deteriorating business..well, it will be a bold move.

Then there are some others who can supply: the FDI. Will they? Why?

More than anything it is a bad business to be in. Leaking boats can be replaced with another boat. But what if it is not a good idea to be in any boat?

Airline is that boat; it is one such business.

reporting flaws..blame it on regulation

All listed companies have an obligation towards an effective corporate governance framework. One of its key tenets is that these companies should provide all important information related to the company, including aspects directly or indirectly affecting the business, in a timely manner.

The key words are all important and timely. An information is considered important if non-disclosure of that affects, directly or indirectly, stakeholders' decision-making. Stakeholders include employees, suppliers, lenders and shareholders; and all those who have a business-relationship with the company; they include potential investors as well for this is what a listed company has asked for to begin with. Needless to say that any disclosure is meaningless if not made on a timely manner.

Does it really matter if some of such information disclosure is not mandated by the regulation? It is the moral obligation of the board and management to provide information which otherwise they would have expected if the positions were switched.

Yet, it is not surprising to see companies world-over hiding and/or delaying/manipulating information to the stakeholders. They either breach the regulation or blame it on the regulation. This is true not only in India but everywhere - it is the same human breed.

To test this aspect of corporate governance, pick any annual report, quarterly report or corporate announcement and see if the information is sufficient for you as an investor for your analysis; see if this information is timely or should have been provided to you much earlier.

The regulation (the companies act, the SEBI, the stock exchanges, the accounting rules and the like) provides some minimum rules regarding information disclosure. It is not sure, however, whether it is both sufficient and timely.

Take for example, quarterly reporting from companies. All they throw is some information regarding revenue, costs and profit or loss. Is that sufficient? Don't you think as investors we need a full set of financial information including the balance sheet, income statement, cash flows, changes in equity and key events during the quarter? To get to know of information related to cash, new loan, acquisition or equity, we have to wait until the year-end annual report. Isn't this ridiculous?

Whatever happened to the shareholders' rights?

What sort of governance is this - both from the board and the regulation? If the regulation does not provide for this, a responsible board should voluntarily supply; if the board does not supply, the regulation should wake up and mandate it.

Is this asking for too much?
 

extreme publicity

Greed is good said Gekko. Debt generates economic growth and amplifies returns says this. Well, Modigliani–Miller also said something and got the Nobel.

Debt can only be good when there is capacity (earning power: cash profits) to repay it with coupons. This happens when one is certain that return on debt capital is much higher than cost of debt.

It is easy to say this than see it, which is why we are witnessing the global financial crisis and the European sovereign-debt crisis; weaker US; slowing down China, and slowed down India; and the obvious consequence - the recession in the global economy.

And when someone says debt is good, it is just an extreme publicity!

deccan chronicle: debt is what it does.....to lenders

The story goes: when a borrower owes his bank 100,000, he loses some sleep; when he owes 1,000,000, the banker loses sleep.

When does it make sense to lend money? Simple answer would be when it is certain that the borrower is able to repay the money and interest payments.

When and how will that certainty be there? That is when the borrower is worth several times over the money borrowed.

That sounds prophetic. But then why would the lenders do what they are not supposed to do?

Year ended 31 March 2011:

Quarter ended 31 March 2012:

As per this article the company's debt stands at whopping Rs.4,000 crores in 2012. How did the company manage to borrow so much?

Correction: how did the lenders lend so much to that business? How did the lenders view of their loans?

Repayments do not come out of air; no assurances no promises; you need to see cash profits for the business to be able to repay.

And ouch! the analysts:

With a market valuation of about Rs.180 crores for equity, and debt running many times over, the lenders deserve that treatment. The only problem is: it is not their money; it is the lenders' lenders' and lenders' owners' money.

While we can get away with saying that the lenders' owners deserve that treatment too, it cannot be said for the lenders' lenders. For the lenders' lenders are the common people who have put their hard-earned money into the savings account with those lenders.

Too bad!
 

innovation for existence...Apple

The firm value
What drives a business? The only rational reason for a business to continue as a going concern is to continue to earn a fair rate of return on its capital in order that the capital providers are not let down. If this were not to happen, the business is meant to fail and will be better dead than alive.

What drives return on capital? It is the combination of nature of business itself and invested capital. If a fundamentally economical business is provided with adequate capital it will be a good deal. This is true at least for the foreseeable future as opposed to infinite time.

Capital, growth and return on capital will influence the firm's value.

Growth can come either through efficiency in current operations, although with a limited power, or it can, and more likely, come from reinvestment. Without reinvestment, no business can continue to grow for long. However, growth requires reinvestments to continue to earn return on capital similar (good) to, if not better than, the business currently earning. If not, this additional capital will not add value, or worse, might destroy value. That is why just physical growth does not matter.

The technology business
What about technology companies? What about a technology company earning very high return on capital?

Growth for this business should come in just the same manner as to any other business. However, the key difference is that technology business is never a sustainable business. This means (even) for a truly wonderful technology, there will be periods of high growth followed by lower yet decent growth, and then followed by sudden or slow death depending on the extent and impact of the competition and change in technology.

The key driver for the technology business is innovation. As long as this business, with its wonderful technology, continues to innovate, it will experience growth. Nevertheless, the high return will attract competition and this will bring down the return initially (that is, slower growth) and then ultimately will evaporate all excess returns or even bring about its fall. Research In Motion and Nokia should be able to vouch on this based on their bitter direct experience.

For a technology business which has experienced, say, a decade of growth, it is absolutely crucial to innovate even for its sheer existence. There is one problem though: for any business it will be very difficult to innovate until eternity; innovations cannot come every year.

Apple
Apple is a case in point. With ridiculously high return on capital (don't even try to calculate), crazy amount of excess cash (it's really crazy), and a history of extensive growth and innovation, now it is at crossroads. It must innovate or perish by its own standards.

Given its past records and investor expectations, it will be extremely difficult for Apple to replicate. Too many smart phones and tabs have been floating around and many more to come from competition.

The Samsungs are dominating; the Sonys, the Microsofts and the Googles are giving more for less to consumers; there are many other players in the market; and the RIMs and the Nokias are not giving up (don't ask why). 

Sooner or later this will deepen the price and volume war, and lead to an eventual loss of market share. It will be foolish for investors to think that that pile of cash is going to produce miraculous returns. From now on, Apple needs to innovate simply to exist, i.e. to maintain its market (scope for growth has become limited).

Extraordinaire
In this situation, what better way than to do something that has never been done in such doses in the past? It is time for Apple to return that cash to where it belongs; to its shareholders.

But then
While an extra-large cash dividend or stock-buyback is unlikely from the management, it will be interesting to see how the story unfolds into the future.

Since a high ego usually hurts, management will be well advised and shareholders will be well off if a rational decision is taken.

But then you never know...there could be an i-computer, i-tv, i-kitchenware, i-anything..

The contrast
Check out some samples: Apple witll hit 1650 and Law of limits - what do you think?

The insight
You see, since I am extremely good with hindsight, I should very well be able to tell you in a few years time.

ril: conflicting analysts

Have a look at the valuations from analysts:

The highest valuation is Rs.301,550 crores and the lowest is Rs.230,540 crores. That is a difference of Rs.71,010 crores, and a change of about 23-31% of total value.

Analysts and brokers will have to come up with something which they do all the time. It is for the investors to be wary of these reports before their action. The maximum we can take from the analyst reports, if at all we have to, is the data compiled by them rather than their recommendation itself. The data can be useful for our own independent analysis or at least for some cross checks since these analysts are able to extract information from managements.

Most of the time, however, their reports have no added value. It is best to ignore their reports in full; use company generated (annual) reports instead. In fact, this should be the standard practice.

The first step in analyzing a business is to do it independent of any influence and bias. Beware of analysts' bias and selfish motives.

rcom: debt and lows com

The company made debut on the stock exchange in March 2006 with an opening market capitalization of Rs.35,000 crores. Market cap touched Rs.100,000 crores in Februrary 2007.

It made about Rs.4,800 profits in 2008-09. Then things changed.

With about Rs.45,000 crores cumulative put in by the equity owners in the company to date, the market value has come down to about Rs.13,000 crores.

Those who bought the stock at the peak in 2007 would have seen their worth eroded by a compounded rate of nearly 40% pa.

What next? 

oil is well only when it is there

How to value an energy business, especially the upstream? The two key components to be considered are oil reserves and oil prices.

While we do not have control over oil prices, it is possible for the companies to manipulate their oil reserves, thus misleading the investors.

Oil reserves are the total volume of oil in the oil reservoir. However, it is not possible to extract all oil that is there in the reservoir. Much of it depends on the reservoir characteristics and technology used. The simpler the reservoir characteristics and the more advanced the technology used to extract, the higher the possibility of more oil to be extracted.

Thus the reserves can be classified as:

1) Proven (1P or P90) reserves - have very high (at least 90%) possibility of recovery.

2) Unproven reserves - have lower possibility of recovery:

a) Probable (P50) reserves - have reasonable (about 50%) chance of recovery.

2P reserves represent proven plus probable reserves.

b) Possible (P10) reserves - have very low (at least 10%) chance of recovery.

3P reserves represent proven plus probable plus possible reserves.

Under these circumstances, the company is best advised to disclose only proven reserves to the investors.

It is not certain that the company will be able to recover its proven reserves in full in the first place since these are all estimates.

If unproven (probable or possible) reserves are disclosed, it will only complicate matters and mislead the investors. Market participants are ready to sniff anything that is given to them. Lest they go astray, it is well advised that the company does not go any farther than its proven reserves.

Estimates of unproven reserves should be an internal matter for the management for its decision-making regarding capital allocation.

If you attempt to value the business considering its reserves that are not yet proven, do it at your own peril.

implied market rates

There are various ways of valuing a security. The most acceptable one calculates value as the present value of all cash flows over the life of the security discounted at a rate appropriate with their riskiness.

If we consider equity, the value of equity then represents the present value of all cash flows from equity (including cash outflows) over the life of equity, that is, life of the business itself. Cash flows depend on the nature of business, its reinvestment needs, growth periods and growth rate.

Since values are only estimates, these are highly subjective and depend on the perceptions of the valuer. Hence, these will invariably differ when estimated by different analysts. Also, the value will differ at various points of time when calculated by the same analyst due to changes in perceptions.

We can also extend this equation to the entire market such as an equity index. The value of the index then becomes present value of all cash flows from owning that index over its life which is a very long period of time.

Since we know the present value of the index (which is its current value), we can calculate growth rates and expected returns (discount rate) implied in the index value.

We can calculate implied rate of growth by keeping the index value and discount rate constant or calculate implied discount rate by keeping the index value and growth rate constant.

Based on this equation, the implied rates of nifty as of 4 October 2012 (index value: 5787.60 with a dividend yield of about 1.5%) are as follows:

Note: We have to view the following in the context of high inflation and government bond rates.

A 5-year growth period is assumed.

1) Keeping discount rate of 10.50% and terminal (stable period) growth rate of 8%, the implied growth rate (growth period) is about 18%.

2) Keeping discount rate of 13% and terminal growth rate of 8%, the implied growth rate is about 37%.

3) Keeping discount rate of 13% and growth rate of 18%, the implied terminal growth rate is about 10.75%. This means the market is implying that the companies will be able to sustain a growth rate of 10.75% until almost infinity.

These implied values are indicative of what the investors, speculators, analysts and others are expecting from the underlying businesses.

We can change any variable and see how it affects other variables. It is an interesting exercise just for fun to see the ingredients in the market.

This is just a nice little game when you are in that mood; not to be taken too seriously.  Play it at your own risk.

quality of voting rights

It is not unusual to find companies issuing dual class of shares, one having voting rights and the other having limited or no voting rights.

Issue of non-voting rights shares breaches the fundamental right of the shareholders.  Equity investors are effectively the owners of the business having certain advantages over providers of debt capital. These include entitlement to: receive dividends, attend meetings, participate in new issue of shares to protect dilution, receive reports, residual claims (including undistributed profits) on the assets, and vote on the important matters.

If any of these advantages are taken away from the shareholders it will not be considered fair.  Imagine where a company issues new shares to some private institutions thereby creating dilution for the existing shareholders, or where (more serious) a company does not pay dividends to certain group of shareholders. When such things happen it is natural to question the integrity of the management. Despite this, plenty of instances, albeit of less serious kind, are available in the corporate world.

Let us concentrate on issue of non-voting shares. Just why the management would want to do this? The main reason as it appears is that the majority shareholders want to retain or increase their control in the business. Furthermore, they may also want to protect themselves from a (hostile) takeover by an outsider. It seems like a noble thought, but only if taken in the right spirit. It is one thing when there is a well run company which is under a threat of takeover and another thing altogether when there is a show of only the majority power.

Under the circumstances what should the minority shareholders do? Well, it depends on what they are looking for. Usually a company develops its own clientele when it comes to the type of shareholders. For instance, a high dividend paying company will have shareholders looking for stable income such as pension funds and retirees. A high growth company not paying dividends will have shareholders looking for long-term growth and capital appreciation.

Similarly, when a company issues non-voting shares it is conveying a message, and therefore it is appropriate for only those investors who are happy with the present management having control on a long term basis. 

Let us look at this way: Generally when you buy a stock, you are not going to look for having control and running the business. Instead, you will look at the business and management, and its past record and future prospects before the purchase. The right to attend meetings and vote on the important matters is only secondary as usually management will have a majority voting due to its higher shareholding. Therefore, the investor’s participation in voting does not matter much and the investor knows it. If the purchase of a stock is for the right purposes, that is, to participate in the business and its profits, the correct way to look at is to see whether you are comfortable with the present management and the way they have run the business. If not, there is no question of buying that stock. Why would you buy a share in the business if you are not happy with the way it is operated?

If this argument is true, why would you be bothered whether you have voting rights or not? Good management brings forth good results and eventually, good market value anyway.

In another situation, let us say, you are already a shareholder in a business and now note that the quality of management has deteriorated and you are worried about it. You have a few choices to make: 1) sell the shares – this depends on the prevailing market price versus the price you paid for the stock; 2) do nothing – but pray for the better sense to prevail upon the management; 3) do something to change the management so that the business is run more efficiently.

Now, if you have full voting rights, how can you ensure change in management? You have to hope that some hostile takeover takes place to overthrow the majority shareholders. However, for that to happen some shareholders will have to sell to these activists – majority shareholders (present management) will not do that. The only way is a large group of minority shareholders to sell their shares and exit. If that takes place you as the remaining shareholder will benefit after takeover and change in management. The question is – will you want that? What if all minority shareholders are like you and wait for others to sell? That is why those voting shares will trade at a premium over non-voting shares. The activists will be more willing to pay a higher price to acquire control. The higher the premium, the more likely that voting shares will be sold.

If we consider these arguments, the value of non-voting rights becomes a bit clear. In most situations there will be no difference between the (intrinsic) value of voting and non-voting rights shares; none. This is true whether the business is good or bad, or whether the management is efficient or not.

Only in those rare situations where there is a high probability that a change in management will take place and business is likely to be run more efficiently, the value of voting rights shares will be higher.

But the catch is, the shareholder having voting shares will be able to sell to the activists at a premium but will not be able to participate in the prospects of a now more efficiently run business. It is then the remaining shareholders – both voting and non-voting rights – who will benefit from the new management. From that point again there will be no difference between the value of both classes of shares.

Voting rights never matter to an ordinary shareholder except when those can be sold at a premium.

Assume this: There is a business with current market value of 10000 m. This value will change to 15000 m if it is run more efficiently. It has 250 m voting rights shares and 400 m non-voting rights shares. There is about 25% probability of change in management for better.

In this situation, corporate finance will give a control premium value for voting rights shares as follows:
Value of non-voting shares = 10000 / 650 = 15.38 per share;
Value of voting shares = 0.25 * 5000 / 250 + 15.38 = 20.38 per share

While voting rights share will have a premium, it will be difficult to calculate unless there is a high probability of change in management. A mere 25% probability will look good in theory; in practice, it will still mean a low probability of change. Only when there is a very high probability the voting rights shares should trade higher. If not, both classes should trade more or less at similar price.

When there is a very high probability of change the (maximum) value of voting rights can be in the region of (assuming business values are accurate): 5000 / 250 + 15.38 = 35.38. This appears very high compared to the non-voting shares because this example assumes far lower number of voting shares and about 50% higher new value of business.

To conclude, the investors should consider (of course among other things) only the quality of management before deciding to purchase any stock, irrespective of voting rights.

1) If voting shares of a good business (good management) are trading much higher than non-voting shares, it is far better to buy non-voting shares. 

2) It does not make sense to buy any shares of a bad business (bad management) whether voting or non-voting rights. 

3) A shareholder of a business with deteriorating management should estimate chances of change in management for better and if such chances are high, both voting and non-voting shareholders should do nothing.

Note that the change will happen only if some voting shareholders sell. They will need to sell (of course at a premium) to facilitate the change in management and increase the prospects of the business and its shareholders (both voting and non-voting) who did not sell.  

google's googly

From the first founders' letter -
“We are creating a corporate structure that is designed for stability over long time horizons. By investing in Google, you are placing an unusual long term bet on the team, especially Sergey and me, and on our innovative approach...

.....In the transition to public ownership, we have set up a corporate structure that will make it harder for outside parties to take over or influence Google.…

...The main effect of this structure is likely to leave our team, especially Sergey and me, with increasingly significant control over the company’s decisions and fate, as Google shares change hands…

Our colleagues will be able to trust that they themselves and their labors of hard work, love and creativity will be well cared for by a company focused on stability and the long term…

As an investor, you are placing a potentially risky long term bet on the team, especially Sergey and me. …. Sergey and I are committed to Google for the long term.”

From the 2012 founders' letter -
"...In our experience, success is more likely if you concentrate on the long term....We have protected Google from outside pressures and the temptation to sacrifice future opportunities to meet short-term demands...

...Today we announced plans to create a new class of non-voting capital stock, which will be listed on NASDAQ. These shares will be distributed via a stock dividend to all existing stockholders: the owner of each existing share will receive one new share of the non-voting stock, giving investors twice the number of shares they had before....It’s effectively a two-for-one stock split—something many of our investors have long asked us for.....

...In November 2009, Sergey and I published plans to sell a modest percentage of our overall stock, ending in 2015. We are currently halfway through those plans and we don’t expect any changes to that, certainly not as the result of this new potential class. We both remain very much committed to Google for the long term."

From the 24 July 2012 - 10Q
".... The amendments authorize 3 billion shares of class C capital stock and also increase the authorized shares of class A common stock from 6 billion to 9 billion. The amendments are reflected in our New Charter, the adoption of which was approved by stockholders at our 2012 annual meeting of stockholders held on 21 June 2012. We have announced the intention of our board of directors to consider a distribution of shares of the class C capital stock as a dividend to our holders of class A and class B common stock."

End of quotes

Corporate governance - control...more of it!
Presently, Google has class A shares which are traded and class B shares (having much higher voting power and mainly owned by founders) which are not traded.

Now the company has announced a dicey corporate governance structure which provides for issue of 1 class C share (new class) which will be traded separately against 1 existing class A (same for class B) share. Is it a stock split...or..a stock dividend? I don't know. Google calls it both, sounds weird? That does not matter in the larger scheme of things.

The fact is that the market value of the company should not change post this structure as nothing fundamental has taken place with respect to its cash flows, reinvestments, growth and risks, or so we hope.

But here is the catch: class C shares will have no voting rights, effectively cutting the existing voting rights by 50%! Not that it matters to an ordinary shareholder, for someone said, that is the most docile and apathetic animal in captivity. Shareholders' rights and powers look good on paper not in practice.

A shareholder who currently owns, for instance, 1000 class A shares of Google will get 2000 shares (1000 class A shares with voting rights and 1000 class C shares without voting rights). The market value is supposed to remain the same on a combined basis.

The board has not set a record date for the issuance of the class C shares.

The bully: management has announced clearly as before their intention to hold control and call shots whether a shareholder will like it or not. That is exactly what they want. Considering this it is doubtful if they will issue class A shares again.

Would it really matter to a shareholder?
Considering the ordinary shareholders' position, intent, time and power, it would hardly matter. The market value of the shares do not change and the shareholder does not care for vote anyway especially when the management already has majority control.

The change in voting power should look like this: Class A has 1 vote per share; class B has 10 votes per per share; class C has no voting power.


It's bonkers!


This is as per the present understanding. The real damage however depends on the total number of voting and non-voting shares in the business.

Because of lack of voting power the class C shares should be selling at a discount and class A shares at a premium. Whether they will, and if so, by how much, I will tell you once I know.

Clearly, Google stock is meant for those animals in captivity - take the piece of the meal thrown at, eat and enjoy, but dont' complain. In management's own words....you are placing an unusual long term bet on the team.....As an investor, you are placing a potentially risky long term bet on the team...

With all this, there is no denying that Google has in fact changed our lives significantly. It has become a free educational institute. To see why, just google it!

As long as management is doing a good job, that is, operating the business and allocating capital well, there is no reason to complain.

Here's what they have given to the shareholders, the meal...(source: yahoo finance):

Can googlies be good? Your call.

airline business: castles in the air

Where are the earnings?

 

 

Jet Airways - all debt

Kingfisher - piled up losses

Air India - ? Any other airline......? The story may not be very different.

Physical growth does not always mean maximization of shareholder wealth. The capital that goes into a business has to translate into cash profits at a decent rate on a long-term basis. If not, the business is destined to destroy wealth.

When you are in a business that is fundamentally uneconomical, it is not a good idea to continue to be in it.

what moves market

Nifty closed at 5,787.60 yesterday. Some rally was seen in the past few days due to positive news regarding the reforms by the government.

Historical values for nifty are shown below:

 

The nifty

What do you make of these? Nifty has had a steady rise since 1994; peaked at 6274 in January 2008; bottomed out at 2553 in November 2008; and peaked again at 6312 in November 2010.

 

In the interim many things happened - good news, bad news, good results, bad results - however, the march was on as we can see.

 

The biggest fall came in 2008 from the January peak to the October low (a fall of more than 3500 points). Compare this to the fall after IT bubble in 2000 where nifty fell from the peak of 1756 (February 2000) to the low of 1045 (September 2001).

 

As we stand now, nifty is not very far from 6000 levels; whether it will breach that, time will tell. While it is inching higher, the key question is how high it is now. Is it expensive or is it cheap? We cannot tell this by just looking at the absolute nifty values. We will have to relate these values to some other values, more prominently earnings.

 

The earnings 

If increase in nifty values are generally in proportion to that of the total earnings of the index companies, it should be fine. After all, businesses are meant to grow. If not, it tells you that there is a gap between the price and value. It could either be a buyer's market or a seller's market depending on the type of the anomaly.

 

The high points of price-to-earnings were at 28 in February 2000; at 22 in March 2004; back to about 28 in January 2008; and at 26 in October 2010. 

The low points were in May 2003 at about 11; in June 2004 at 11.62 and then again in October 2008 at 10.68.

This should remind us of the bubbles of 2000, global crisis of 2008 and the aftermath.
 

With the current multiple of 19, it is about 33% lower than its peak value. How cheap the value is depends on whether and how soon we will get to see the peak multiple again.

 

The dividends

Dividends after all are paid out of earnings. It is logical to relate dividends to earnings and hence, dividends to market values.

 

Dividend yields from nifty have never been great. In May 2003 a high dividend yield of about 3% was recorded; since that time it reached to about 2.6% in 2004.

 

Lowest yield of about 0.6% was in May 2001 although p/e multiple was only at 15; this suggests that probably the companies backed out from paying dividends during the period. The low point of the yield at 0.8% in January 2008 corresponds to the high valuation.

 

The current yield of about 1.4% is not very attractive either. If you are looking for good dividend yields, better look for specific companies having more stable earnings.  

 

Price-to-dividend multiple is the reverse of the dividend yield. Accordingly, the graph should be the mirror image. Just like p/e multiple shows how high or low valuations are compared to earnings, p/d multiple shows in relation to dividends.

The book
Price-to-book multiple compares the market prices to the book values. A high multiple suggests high valuations and vice versa. The differences between the market and book values are due to goodwill component of the business itself. This is reflected by the earning power of the business. However, if earning power is lower compared to the price attached by the market, it reflects something else - both p/e and p/b can be outrageous!

This multiple only reconfirms our analysis drawn from the earnings and dividends. Usually you see high p/e, high p/d, low dividend yield and high p/b going together.
 

With the power of hindsight the best time to pick stock was in late 2008, second-half of 2001 and of course just before the beginning of the bull market in 2003. If only we had the foresight!

All we can say now is that the market does not look very expensive as per the past records; it is not very cheap either.

If earnings and cash flows are likely to grow, and inflation and interest rates can be contained, the current valuations look good; if not, you know what I mean.
 

 

expected return, an incorrect precision

Corporate finance talks about it; investors and speculators talk about it.

When we invest our money, there is a natural expectation that we earn a fair rate of return on it. It is true whether we buy bonds or stocks.

Since debt has a fixed coupon on it, there is no confusion regarding expected return. A 10% bond due whenever, has expected return of 10%, not more not less, unless of course we are keen on investment at discounted prices.

It gets a bit complicated when it comes to equity investment. The world is just confused about what to expect from it. There is consensus that returns from equity investments require extra profits when compared to any other investments. That ends here however. How much extra returns, it's a hot debate out there.

Equity investment expects returns higher than that of cash, money market, government bond or corporate bond; while this expectation is given, there is no guarantee that it will actually provide that. Lop-sided equity investment can yield far lower return compared to the other so-called low-return investments.

Assuming investments are made in a more sensible manner, it will be interesting to analyze how we should expect returns.

We have some alternatives after we ignore the famous risk-return models of corporate finance.

We could find out historical equity returns over a fairly long period of time and expect that rate to prevail in future as well. This is a reasonable assumption even when one can argue that, times have changed. We can consider 10-15% annual compounded rate as a reasonable rate to expect from equity markets.

We could take long-term government bond rate, add a few points to it and consider that as expected rate for equity investment. Corporate bonds are not considered here as they have much higher default risk.

We could estimate long-term inflation rate, add a few points to it and consider that as expected rate for equity investment.

It is important to note certain fundamental and implied assumptions in every equity investment: compensation for postponing present consumption and uncertainty associated with long time period, and expectation to at least (perhaps more) maintain current purchasing power.

If these arguments are accepted, we come to a logical conclusion that equity investors need to be rewarded with a rate that is not less than inflation rate to start with. Once this expectation is met, there should be some additional points for forgoing present consumption and for assuming some uncertainty. Now, there is no exact science to compute these additional points to precision (if there is one, you go for it). Why not add as you deem fit albeit within reasonable boundaries? It does not bother us if investors add 5 to 10 points above inflation rate.

Equity investment fails to be an investment if it does not guarantee a rate at least equal to the inflation rate.

Consider this:

1) Expect market rate of return (hopefully this exceeds inflation rate; we have no particular reason to reject this), if you do not want to work hard either because you have no time or do not enjoy the process or because you think there are better things in life than spending time on equity analysis. Here your best bet is investment in the equity index itself. One thing is guaranteed: no one will question your judgment or rate of return achieved in the long run. For, many so-called sophisticated and well-equipped investors and investment-managers know how difficult it is to beat the market.

2) Expect inflation-plus-some-points depending on whether and how much efforts you are willing to put in. If you are not to be bothered, you need to join those passive investors and expect market rates. If you are more willing to put in time and enjoy the process, you should expect some higher points for your efforts. How much higher is directly proportional to how much time you have spent on analyzing the business and gap between its value and price. However remember this: on a long-term basis, it is not possible to exceed the inflation rate or market return by say, 5-10 points. For an ordinary investor, an additional 5% will have made more than adequate return compounded in the long run. Pick a rate and try its power of compounding over say, 20-30 years, and you will know why.

Now, it amazes me as to why one should think too much about return expectations. As someone once said, it is better to be roughly right than be precisely wrong. So add those points and move on.