Thursday, June 26, 2008

The RandomChalice Price

A few days back on CNBC Europe I saw some UBS analyst talking about who is going to win the Euro 2008, no it was not a fun banter; this man had actually constructed a mathematical model!!! to predict this………no wonder UBS is doing so terribly, I really don’t know what value this analyst community actually add……..

Let’s talk about the value of a stock. Frankly there is nothing called a ‘right value’ or a ‘fair value’ of the stock and all these valuation methods of DCF/FCFE etc though may sound very logical but are nothing more than B School lab rats, think about it…………If I ask you about the fair value of the apple in the market, ofcourse you can theoretically calculate it by constructing some exotic utility function and projecting some inflation figures but your answer would be as good or as bad as mine if I wake up early morning and in my half asleep stage just take a guess. So what really matters is ‘Relative Value’

Keeping this thing in mind how should I take a call of investing in a stock, Let’s take the example of ICICI bank, currently ICICI Bank is trading around 800 rupees however at the time of writing this article it was trading around 950 rupees. Now for argument sake let’s assume its earnings growth remains linear at 25% (though I have my reservations over the fact that this bank would be able to keep up with this earnings growth). The reasons:

A banks growth is dependent primarily on its financial capital and human capital. The return on financial capital is going to be very mediocre due to the state of capital markets and the bank itself is scaling down on its employee intake. So with both aspects of growth faltering the earnings momentum of this bank is surely going to take a hit.

The price (P) of any stock is composed of two components:

- Linear price (Lp)
- RandomChalice price (RCp)

═> RCp = P - Lp

When I invest my money in the stock I expect it to grow faster than the money in fixed deposit. Now the PE of ICICI bank in case of the market price of 950 is around 26. Now if I put my money in FD, I can get my principal back in about 8 years. At 20% growth rate any stock

═> P/E = ((1+g)n – 1)/g

So in case of ICICI bank n ≈ 10 yrs

So much longer, at n = 8 years my P/E = 16.5, this implies that this bank warrants a reduction of 36.5% in price, which implies its linear price if approximately equal to around 600 rupees. Any excess price above this is what I call the ‘RandomChalice price’. This is the price we pay for positive surprises in the stock or in other words it’s the price of unknown (this can be due to anything: structural change in business, new invention/discovery, oil find, acquisition, increase in earnings or any other unimaginable thing on the planet or in the universe). At 36.5% this price is too high for this relatively mature stock when many other stocks are available in the market with a very low randomchalice price.

I have taken the benchmark as the return from FD, however the returns from stock should certainly be greater than that of an FD due to the higher risk associated with them (ofcourse a number given to this risk can always be subjected to argument). This is just an example to show how exorbitantly high the price of ICICI bank is.

So essentially after adjusting for the risk any price over and above the linear price is the randomchalice price, if this price is negative then either the stock is too undervalued or the associated risk associated with the stock is too high and you need to adjust your risk adjusted return. This is how one should really judge a stock by its randomchalice price because this what ultimately leads to real wealth creation and through some predictable mathematical model……..

And O! yes by the way that UBS analyst had predict Germany to be beaten by Switzerland in the quarter final, unfortunately Switzerland is out in the very first round so much for the mathematical model……………

Tuesday, June 17, 2008

Oil touches an Intraday high of $139/bbl

Oil shot an intraday high of 139 yesterday. I was watching an interesting debate yesterday on CNBC Europe wherein one of the guests termed this phenomenon as a transfer of wealth. I am afraid this is a very myopic view towards international trade. Wealth is not just measured in monetary terms. In realty oil is an asset for the oil producing country. So we are essentially purchasing this asset and giving out cash in return. Here is how the transfer takes place:

Now the key here is that what really country I and E does after this transfer. For the importer nation oil purchased at $139/bbl should yield more value than the price paid for it and if that is the case it is not really a transfer of wealth, wealth is still created in country I though some may argue that the pace of wealth creation can certainly slowdown, but again my answer to this argument would again be – ‘it depends’.

Since the oil price spike has been fairly quick and sharp the economies of the oil exporting nations are still not mature enough to absorb such sudden inflows (remember the funds flow problem in India during October – December 2007) so they are then forced to invest abroad and hence ultimately a large part of money ends up coming back into the Importer country (provided its assets are attractive enough for investment), so if the oil utilization is prudent enough any slowdown in growth due to the oil price hike should be compensated with the capital inflows, ofcourse if import oil and just burn it without any productive outcome then it will always yield you into a problem. Let me also add that subsidies also contribute to the inefficiencies in the oil utilization, however the Indian subsidy bill especially on petrol is just a farce as thanks to the taxes on petrol we end up paying much more than warranted.

So here is summary of the article:

- The rise in oil prices does not really lead to a transfer of wealth.
- Any possible slowdown in the importer country is avoided due to the capital inflows from the oil exporting nations.
- However for this to happen the attractiveness of its assets has to be proportional to the possible slowdown as a result of oil price hike.
- This is only possible if the utilization of oil is prudent, subsidies hamper this process in a big way.

Saturday, June 14, 2008

The Economic Growth of Nations

Sorry for delaying my articles all this time.....I have been consistently writing articles on my notebook during my flights, just never got the time to post them on the blog....I will try to be more organised now going forward....So going forward I will post 3 articles that I have written, I which I would post today relates to the another small step in decoding the economic growth mystery, next would be talking about a critical concept on investment fundamentals and in the third article I would continue with options trading.....I would delay the China topic for sometime ( I hope I don't have to write that article prospectivelly...), so here goes the article for today.........

Sitting on my flight to New York, I can't help but think how far has India grown (well atleast some part of the population). People essentially become rich because of wealth effect. However it does not mean that the 'income effect' is insignificant. Infact it is the rise in the income level that ends up driving the wealth effect.

15 years back a plane ticket to US was twice more expensive than what it is today around Rs 120000, however back then a good salary for an Indian used to be around 5000 pm, 15 years down the road this has multiplied 12 folds while the expenses on such items in relative terms have come down significantly. This phenomena is visible in every field. Let's take the e.g. of a Maruti 800, I remember we buying this car some 20 years back for around 52000 rupees, today this car costs around 2,00,000. A rise of just about 4 folds and compare this to the rise in paychecks.........So things are becoming cheaper relatively....Therefore the fundamental key to invest in such growth economies is to invest in areas werein in the pattern is as follows:

(1-∆price(relative))*∆growth(product) > ∆ income growth of the topmost percentile of people. The funda for such an investment decision is as follows….

Due to a high base the change in price (which is going to be negative as discussed above) is going to be lower, the change in growth is going to be higher due to a lower base ( as still a very low number of people are consuming the goods), stock/sector following this pattern would certainly outperform.

Just saying that a product or service would grow in the country is not enough because its price would inevitably depriciate vis-a-vis the income levels. So keeping this equation in mind I would say that the best investment in any gowth economy is real estate (ofcourse the flip side to this is the fact that in a slowing economy the worst sector is also real estate)

The 'price' is always a barrier to ownership. The price has to be higher preferrably much higher compared to than the current than the current income levels of the topmost percentile population. This leaves a wide scope for the prices to come down and also gives a lot of time for the prices to come down, also the service has to be prefferably more of a necessity (if not now then atleast in few years from now) this would ensure a very high growth rate.

So whenever a company says that it is moving to the villages because it sees growth there, consider that the growth story of the company is over ---- ' Get out of that stock'..........

As I discussed above that to me price is nothing but a barrier to ownership which can be really due to some tigh regulations, so any sector where such regulations are released also provide enticing opportunities for investment.....

My plane is about to land at the JFK airport but before I end this article consider this, the real estate prices in this country (atleast in the NCR area) have grown 100 times in the last 20 years!!! ofcourse there has been a currency depreciation, even if we take this account an Indian has gained over a New Yorker and now even this currency trend is changing so the gap between an Indian and an American is narrowing faster than ever before. Ofcourse keeping this thing in mind we should not forget that almost 60% of our population lives on agriculture and we desist when wheat, rice gain in prices so think about this that while some part of India is ceratinly becoming richer it is these people who are becoming poorer everyday, so keep up the economic growth momentum of this country it is imperative that we reduce the gap between these two halves of India by moving people away from agriculture or improving prodcutivity or else it is a disaster waiting to happen, time to see New York, catch you soon................