CategoryMarket analysis

Found this post on mark cuban’s Blog

The Stock Market is for suckers….

I agree with mark’s basic premise which is that one should invest in the stock market only if one has an edge. However I do not agree completely with mark’s extreme view that the stockmarket is a place for suckers and there is always sucker on one side of a trade (although a lot of times there is one). The stockmarket is not a zero sum game and if one can avoid the extremes emotions of greed and fear, then one can get a resonable rate of return. Even on a trade, the buyer and the seller need not be a sucker. The seller may not be comfortable with the risk associated with the stock, may have achieved his targeted return or could be selling for some personal reason. The buyer on the other hand may have a similar view point, but could more comfortable with the risk on the stock, or could be hedging his position on some other stock.

I would say as an individual, I can have the following edge over the market

• long term view : If I have long term view and can think beyond the immediate short term view point of the market, then I can find some good long term investment opportunities. For ex: FMCG in 2004 and early 2005 were good investment opportunities when the market was bearish about the short term outlook of this industry.
• Investing in one’s circle of competence: As charlie munger’s says, it is not in human nature to be an expert in everthing. But if one works hard at it, then one can become an expert in a few areas. For me my circle of competence is limited to FMCG, industrial and a few other industries. So as long as I limit myself to these industries I should do fine. Ofcourse it means that the number opportunties are sometimes limited if these sectors are overvalued. But then as an individual one has the luxury of investing only when the opportunity is right.
• As an individual investor, I have the luxury of being out of the market when I don’t find any values. A proffessional investor cannot do that

But at the same time, if one strays from his circle of competence and gets swept by greed or fear, then I think it is closer to gambling than investing (where the odds are against you )

Mark talks about technology investing in his post. Substitute ‘technology’ with any industry which is outside your circle of competence and I think the result would be the same. I think if one does not invest the required time to develop a deep understanding of atleast a few industries, then it is difficult to get a return higher than the market.

I have followed a thought process (and here) in terms of looking at market valuation in terms of PE bands. So if the market is below a PE of 12 or below, it likely to be undervalued (odds are favorable for an investor – to the tune of 7:1 or better). At the same time if the PE is more than 20, the market is moving towards overvaluation (unless there is a recession in the economy and earnings are really depressed) and the odds are against an investor (1:3 or worse). However, I found it difficult to form a firm opinion between the above PE levels. The market is typically between these two levels 60-70 % of times and as result I am inactive and not buying an ETF or Index funds. However if the market drops below a PE of 12 or below, I usually start buying actively and if the market goes above a PE of 20, I start a slow liquidation.

I don’t use the above approach to individual stocks, where it is possible for me to have a better idea on whether the stock is over or undervalued (provided the stock is in my circle of competence).

I was pleasently surprised to find the following reply from Warren buffett in his Q&A at Wharton.

I would suggest downloading the Q&A (pdf) and going through the complete transcript for other nuggets of wisdom from buffett.



Q: You made an argument for 7% returns over the next decade in Fortune. Given that (1) profit margins are at least 30% above historical averages, (2) the ratio of prices/GDP is at least 25% above historical averages, and (3) interest rates are ~25% below historical averages, assuming mean reversion, wouldn’t one conclude that while economic earnings growth plus dividends may be 7%, that we are at an unsustainable valuation plateau?


A: We are near the high-end of the valuation band, but not really at an extreme. I have commented on the market 4 or 5 times in Forbes interviews previously (1969, 1974, 1981, and 1977 in Fortune). Most of you can say if something is overvalued or undervalued, you can spot the occasional extreme cases.
There is a big band of valuation and the idea is to calibrate extremes. When I look at a business, I look for people with passion. I can recognize a 98 or a 6, not a 63 (emphasis mine). This rule is good enough in life and investment. You refer to my 2001 article, but returns have not exceeded 7%, so I guess that this is not that precise of a band.

The above comment is from warren buffet. He has also written in the annual letters that he prices the market, rather than time the market. The difference is substantial between the two approaches. The first one, is based on valuation and understanding when the market price is way above the intrinsic value and then going ahead and selling the overvalued security.

The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.

The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example

Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)

Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)

The effective cost (rate an HFC should charge me) should be around 7.5 % – 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.

As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.

I could be wrong in my decision if

• Inflation for next 20 years remains below 5 %
• NPA for most of the HFC are below 0.5 %

But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.

I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.

Please share any such experiences you would have had

I have been asking this question time and again to myself . Am I being too pessimistic ? I have some statistic below which I calculate to see how the over all market is looking like in terms of valuation and fundamentals ( extending back to 1991)


Return on capital, earnings growth seems to be at an all time high. The earnings have more or less doubled in the last 2 years. As a result the valuation do not seem to be stretched. The market is definitely not as richly valued as 2000 or 1992-93. At the same time the earnings growth , return on capital and interest rates are much lower than what we had at that point of time.

At the same time, will it get any better going forward. Can the Return on capital improve further, interest rates fall further and earnings growth improve further ? My thought is that the odds are low ….

But does it mean that one needs to sell or the market is ready for a crash ?? again I don’t think that is likely. I have not been able to come to a definitive conclusion and hence have chosen to do nothing ( not buying and not selling ).

Maybe another 10% increase in the market in the next couple of months could change my mind

Cannot find much to invest !! I typically run screens provided by icicidirect. Most of the companies being thrown up below a PE of 10-11 (I keep a cutoff at 10-11 as I think that would be the approximate value of a company with no growth and returns at cost of capital. So any company having growth and a ROC of greater than Cost of capital would be worth more).

Sample of some companies which came up

– EID parry: In commodity industry (sugar etc) and selling at 16 times peak earning (the screen was wrong and did not consider the 1:5 split.
– Banks: Several banks like Karnataka bank etc came up. Need to check if any banks would have value
– Tata steel, Essar steel, Gujarat ambuja cements – Commodity companies selling in low teens of Peak earnings. Would not be looking at investing at peak / uptrend of business cycle. Also PE is generally a poor indicator for cyclical companies. Generally during downtrends these companies would sport a high PE on depressed earnings and that could be a good time to invest.
– UB holding – A Loss making holding company selling at a CAP of 1100 crores. Tangible assets appear in the range of 300-400 crores. They could have some undervalued assets on balance sheet such as land holdings at cost, Investments in subsidiary companies. Looks unlikely to be worth more than 800-900 crores. I will need to look closely.

Any good ideas ??

I have been reading a lot of analysis on the market valuation levels. A few articles are citing that at a PE of 14 – 15 the market is not too overvalued and should give good returns.
On the other hand , some statistics show that market is fairly or overvalued as the ROE for the indian industry is at its peak, Interest rates low, inflation low and the demand robust. As a result we are seeing these PE levels which are at the peak of a cycle and the normalised PE should be close to 17-18.

I find both arguments plausible, but my money is on the overvaluation side. I have become fairly cautious for some time and would be looking at initiating selling if the markets keep rising.

Also the overall market valuations are important if one is invested in index funds or ETF’s. Otherwise rather than concentrating on the market, i am looking at my individual holdings and would start reducing them if they start getting more overvalued (i think some are fairly close to their overvaluation levels)

Although i am not invested in commodity companies, i would look at their valuation levels more closely and would even look at selling them as my thought process is that commodity cycle is at a peak and industry profits are at a cyclical peak (for steel, cement etc ) due to robust demand, high capacity utilisation, low debt and interest level. PE for these companies is very low and i would not base my evaluation on those PE as the earnings are at a cyclical peak. In addition a lot of capacity addition is starting now, for ex: Tata steel seems to have announced a huge capex plan. So i would be wary of putting any money or holding onto commodity companies

Any thoughts ? please share with me

for the same reason, when the price of a computer, telecom charges, or any other stuff which i need to buy falls !!

It allows me to buy more of it ….

The above way of thinking is ofcourse not original …kind of learnt it from warren buffett. But having internalised it, it makes a lot of sense

so every day when the market falls , i smile and hope that the stocks which i am wanting to buy and have not been able to, would be available soon at a good price

Read this interview of chetan parikh (he runs the excellent website capitalideasonline ). He is an exceptional investor from the graham – buffett school of investing and among the few investors whose views i respect.

The complete interview is available in moneycontrol website

http://news.moneycontrol.com/backends/News/frontend/news_detail.php?autono=174200

some snippets below

He says, “I would be comfortable with the levels being below 6000, because if the market goes below the 5500-6000 levels, there would be a lot more trading opportunities. But at this point of time in the market, it is difficult to find stocks with a large margin of safety.”
He adds that, a good band of trading for the market would be between 12-18 times earnings, and on that basis the Sensex should be anywhere between 5000-8400 levels.
Parikh says, “At the 7300 levels, the risk reward is not in favour of investors. This does not mean that the markets cannot go up, because on liquidity the markets can go even upto 8000 levels and past that. But from the risk management point of view, the odds are not in favour of the investors, from a one year perspective.”

He says, “My sense is that the operating margins have peaked, and going forward, operating margins could come under pressure. A whole lot of companies have gone in for capital expenditure, and therefore the return on capital employed will come down. We are also seeing the bottom of the interest rate cycle, so there will be a pressure on margins, on return on net worth and capital employed, in the future.

i would completely with his analysis on the return on capital and other fundamentals. The BSE sensex stocks at an aggregate are returning 20 % + ROE (with the past no.s around 16-18 % at best ). So although the pe are not high , i would kind of wary of putting any more money. on the contrary i have started looking at reducing some of my holdings which seems to be get in the over valued territory.

Look at any financial website / papers and there is euphoria all around …

Cant figure out a rational reason other than that it is good to excite people, get more hits or sell copies.

what’s the big deal about 7200 !! or any other number .

The market is selling at 14.3 times backward pe . If the economy does fairly ok , and the corporate profits continue to grow at 10-15 % , then some time in the future we could have the sensex touching 8000 and then maybe 8900 …provided there is no major shock to the world economy / indian economy … anyway how does it matter

well if the market was selling at say 20 times pe , then it would matter as i would start selling ..or if it was selling at say 10-11 times pe (like 2003 ) then it would matter …as one can buy some very good companies at good prices …but now we have pockets of overvaluation and to be fair pockets of undervaluation …so it means more work ..

so i guess if the markets shoots to 8000 + soon or drops to 6000 types , then it is action time …otherwise it is back to reading annual reports and better off watching the discovery channel

seems like a lot of noise ..but then what can once expect from the most of the financial media !!

Initial analysis shows good performance from major companies. Major companies continue to do well. The profit growth is good. Return on capital is good. This is inspite of supply side inflation due to rising oil and commodity prices, high competition.

The market at 6500 does not look too expensive , provided corporate india is able maintain its return on capital (read efficiency), inflation remains moderate and the goverment doesnt do something stupid.

Most of the news channel / website are talking of record highs in the stock market. This is clearly rear mirror view. The absolute level of the stock market does not matter. The current levels should be analysed keeping in mind the following factors

1) return on capital for corporate india – currently 20% plus

2) inflation – moderate inspite of oil prices

3) robust demand

All in all the overall corporate performance gives me confidence to hold on to my positions , maybe add to a few too