Three things you look in a company before investing – Growth, Growth & Growth

At Pi Square, the stocks we select show a major percentage increase in the current quarterly earnings per share (the most recently reported quarter) when compared to prior year’s same quarter. Historically, we have always seen that prices are slaves to earnings.  From 1990 to 2012 most of the very best performers in Indian Equity markets showed earnings gaining from 30% to 100% before their big price moves. So, if the best stocks had profit increases of this magnitude before they advanced rapidly in price, why should you settle for anything less? You may find that only 5% of listed stocks will show earnings gains on this size. But remember, you are looking for stocks that are exceptional, not lackluster. Don’t worry they are out there.

The EPS is the single most important element in the stock selection today. The greater the percentage increase, the better.   

We are amazed at how some professional money managers, let alone individual investors, buy equity when the current reported earnings are flat or even negative. There is absolutely no good reason for a stock to go anywhere in a big, sustainable way if its current earnings are poor. It’s not only quarterly EPS growth but consistent earnings growth and improving margins which shows efficiency of top management.  Look for top players in each segment, showing consistent growth and still priced at reasonable valuations. 

In February 2011, we analyzed FAG Bearings, second largest bearings manufacturer in India. It was valued at INR 795.00 on February 3, 2011. This is how last 4 quarters EPS numbers looked like.

Quarter	EPS	Growth (Y-O-Y)	Net Profit Margins (%)
Mar 10	13.52	61%	9.47%
Jun 10	20.36	82%	12.41%
Sep 10	18.92	90%	11.54%
Dec-10	20.31	105%	12.68%

At these levels in March 2011, FAG Bearings was priced at P/E of 10.00 and ROCE (Return on Capital Employed) of 31.60. Consistent growth, improving net margins and cheap valuations – FAG Bearings became a core holding for Pi Square Portfolio.  Below is the chart of FAG Bearings from February 2011 to February 2012.

In 12 months ending February 2012 FAG Bearings produced 76% returns compared to -8% by NIFTY (Index Returns).  FAG Bearings is a 100% debt free company with second largest market share in Bearings Industry.  FAG Germany owns 56% of total issued share capital of Indian subsidiary. In March 2009, FAG Bearings was priced at INR 277.00 (produced more than 500% return in just 3 years). 

As a retail Investor, keep your research simple and look for good valuations around you. Equity Investing will always reward a magical combination of growth and valuations. Don’t fall in trap of low book value or low P/E numbers – these are just numerical numbers without mix of business cycle or growth story attached.

-          Pi Square Research Team

Indian Equities 30% in 33 days.Seen it before? ....YES

Indian markets have started outperforming not only developed markets but also emerging markets in the correction phase. Indian Equities in local currencies has provided 20% in first 5 weeks and 30% in currency adjusted terms. Next question on every investors mind is “30% in 33 days! Seen it before?” Actually Yes. This rally – 33 trading days so far, and currency adjusted - only makes the middle of the 5 big rallies in the last decade. Lot of fund managers explained 2011 as a minor correction in the long term bull phase.

Change in valuation (1-Yr Fwd Consensus P/E) 100 Days into rallies

 So how is this rally different than rallies of the last decade?

a) More broad-based (relative mid-cap/small cap performance is second best)

 b) Starting from a relatively higher valuation (1yr fwd PE: 12.6x – second highest; range: 9x-16.5x)

c) Outperformance is led by the usual sector suspects (Materials: 16%, Industrials: 10%, Financials: 8% and as always

d) has been led by strong foreign Inflows, though this time there has been aggressive domestic selling (almost 50% of foreign buying). Not enough to say its ‘different this time’, but there are differences.

Liquidity driven rally has pushed emerging markets to next level outperforming Developed Markets once again in the recovery phase. India has led the global equity market rally: up 30% in 33 days in USD terms, 20% in local currency terms, and tracked closely only by Brazil amongst the relatively large EM’s. It’s in part a bounce-back from a very poor 2011 (-38% in USD), but it is nonetheless a very strong bounce-back.

India’s performance relative to EM’s (in local currency) has tended to be more middle of the road in the early part of the rally (local currency): with India Underperforming EM’s in the 2003 rally, and outperforming in the 2009 rallies (the two big EM rallies – the other two were a little more India-centric. Its USD based performance this time though is stronger than any of the other rallies in the early part; and that India went on to out-perform at the 100 day mark of these rallies suggests a very strong start.

Will this outperformance continue? We believe the jury is still out. In 2003, India was sitting on very low valuations and high operating leverage at the start of rally. And in 2009, valuations were a lot lower and while India did face a financing crisis economic momentum was only mildly interrupted by the slow down. This time, while the market’s start has been strong in absolute and relative terms; starting valuations are less compelling, and its economic outlook more tepid.

MSCI India relative to MSCI GEM in rallies (USD)

Leaders and laggards are pretty traditional:

Are the leaders and laggards very different this time? Not really: it’s the rate sensitives – Materials / Industrials/ Financials that drove the market. And it’s the traditional defensives – Consumers, IT and healthcare that make up the rear. We believe if the rally is to continue, then it will largely be these sectors that will lead, although materials will potentially be a little less predictable given the increasingly varied global driver. We also expect Consumer discretionary to potentially outperform going forward given their relative rate sensitivity and make more of a mark compared to the material sector.

Sector Leaders and Laggards in rallies (returns relative to MSCI India)

Conclusion:

We do however choose to run some risk and at the market level, stick with what we believe is fair value for the Indian market. Which remains 19,400 for Dec2012, based on a March 13 PE multiple of 14.5X, a slight discount to the markets long term multiple of 16X. We recognize the market mood has changed, there is more capital that is available (and that is critical for a market / economy like India), and there is probably a little less caution with the corporate sector than two months ago. But not enough has changed on the ground in the broader economy, or the corporate sector. We argue that while the macro and the market have moved favorably – the economy/corporate sector have to play catch up, and deliver in earnings, investment, expansion and risk appetite. From liquidity rally, we will see a minor fundamental correction which will allow long terms investors to enter again with high risk – high reward ratio. India is still a long term growth story and as at heart majority of India is still living in villages, actual growth will be seen in small and mid-size corporate in next 4-5 years.