Monday, 28 May 2018

Analyst earnings estimates: Do they reflect reality?

“We don’t own it for the next quarter. It’s incredible to me how you read the investor conference calls… you read all the analyst reports… they talk about what it’s going to do next year. No one buys a farm based on whether they think it’s going to rain next year or not.”  Warren Buffet
Biased by career risk
In the analyst and fund management community (institutional side) there is a sharp focus on near-term performance. It is abundantly evident to these individuals that short-term underperformance could get them fired or at least reduce their take-home package.  

As a result, almost all earnings calls, television interviews etc. focus on the short-term triggers in the next one or two years. Therefore, their widely shared conclusions on growth, earnings etc. fails to focus adequately on the business ecosystem and competitive edges that generate superior performance in companies.

There is nothing inherently wrong with trying to focus on short-term catalysts in hopes of increasing the turnover of your capital. It’s just that I think this is an extremely competitive and crowded approach, which makes it very tough to use profitably. We at Zara prefer focusing on a business cycle of 5 to 7 years where there are a minimal number of players to trade/bring efficiency into the markets and where an understanding of a business and its valuations lead to superior performance.

Consensus earnings forecast versus actuals

Given below are consensus earnings estimates in the first quarter for various fiscals based on media reports in those years versus actual earnings in those years.



Earnings
Growth

No of yrs
Financial Year
Estimate in Q1
Actuals
Estimates
Actual
Difference
11
FY19
2000

25.2%


10
FY18
1980
1598 E
37.8%
11.2%
26.6%
9
FY17
2140
1437
48.0%
-0.6%
48.6%
8
FY16
1780
1445
10.7%
-10.1%
20.8%
7
FY15
1665
1608
24.1%
19.8%
4.2%
6
FY14
1470
1342
20.2%
9.7%
10.5%
5
FY13
1475
1223
37.2%
13.8%
23.4%
4
FY12
1265
1075
25.3%
6.5%
18.8%
3
FY11
1000
1009
10.8%
11.8%
-1.1%
2
FY10
850
903
8.8%
15.6%
-6.7%
1
FY09
1011
781
18.4%
-8.6%
26.9%
0
FY08
839
854
18.8%



Average



6.9%
17.2%


You will observe the following from the above data

·       On an average, the consensus estimate of earnings growth tends to be 2x or double plus of actual growth. Estimates of the increase in earnings were lower than actuals only in two years in a  decade, indicating that the errors in growth estimates are intentionally biased upwards. Otherwise, you would have to conclude that these highly intelligent workers have no clue of what they are doing.
·      You would note that post fiscal year ending March 2008; the estimates couldn’t predict the recovery timing nor its strength.
·    The extreme upwards bias in estimates in recent fiscals FY17 and FY18 reflects in addition to the usual forecast errors inability of the analyst to get their head around NPA write-offs in the banking sector.


Conclusions

In most cases, if you examine the incentive of the person you are dealing with, you can predict the extent to which you can depend on them if at all. When buying equities from a person incentivised to sell them to you like brokers, mutual fund distributors or mutual funds themselves, should n’t you expect them to hard sell eps estimates and talk only of forward pe, especially when actuals arent good enough.

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Warren Buffet

In marketing, some of these intermediaries will use forward earnings multiple of the market and compare it with the several years average trailing price to earnings,   when they should use the same period average of forward price to earnings multiples versus the current forward earnings multiple to have a meaningful comparison.

With the support of the upward bias of consensus estimates (not a prime mover though), markets in recent years have grown faster price wise than fundamentals like earnings and book value. Hence, it’s not fundamentals that have been the primary driver of the current market rally, but overseas developments namely the continuation of an easy money policy by the American federal reserve. After all, we in India measure our currency value with a loose peg to the dollar (the default reserve currency of the world). It’s a widely known fact that if you peg your currency value loosely or otherwise to another currency, you inadvertently import its monetary policy. No wonder we have seen loose financial conditions in India exactly when the US has had such conditions too. It also explains the correlated train wreck in the world markets in the years 1996, 2001 and 2009, and the peaks in 1994,2000 and 2007.

“Apply logic to help avoid fooling yourself. Charlie [Munger] will not accept anything I say just because I say it, although most of the world will.” Warren Buffett

As a panacea for these issues, I recommend cultivating independent thinking,  patience and maintaining a long investment time horizon. If then you find the rare opportunities from market mispricing’s, you may allocate capital aggressively. Otherwise, you should sit patiently on the sidelines, which is generally most of the time.

                                       
In your service

Dinesh da Costa, CFA                                                                          28th May 2018
Principal Officer & Investment adviser
Zara Investment Advisory
Email:dineshd@zarainvestmentadvisory.in
Phone:(0832)2268252,Mobile: 9822280576
Delivering on an "Investment edge through risk management."


Please leave your comments below or email at dineshd@zarainvestmentadvisory.in 

This blog expresses the views of the author as on date and such views are subject to change without notice. Zara Investment Advisory/Dinesh da Costa (used interchangeably) has no duty or obligation to update the information contained herein. There is no representation made. Moreover, wherever there is a possibility of gain there is also a possibility of loss.

The blog is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services. Certain information contained herein concerning economic trends and performance is based on third party sources, believed by Zara Investment Advisory to be reliable. However, we cannot guarantee the accuracy of such information and have not independently verified the accuracy or completeness of such information or assumptions on which such information is based.


This blog and the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Zara Investment Advisory/Dinesh da Costa.

Monday, 2 October 2017

An important question, two articles and statistical evidence

This short note was circulated to our clients on 18th September 2017.

Zara Investment Advisory has expressed its cautiousness with regard to the overall market valuations based on facts. Yet we are positive specific stocks, though, in the current market, these are few and far in between. Our cash position of 15-16% of the multi-cap portfolio in direct equities reflects our caution with regard to the market, yet reflects our readiness to be fully-invested should opportunities present themselves on a stock-specific level.
The argument we hear against our approach especially our huge scepticism of equity mutual fund investing at these levels are as follows:
  • The markets are reasonable in relation to historical average price to earnings or average price to book: The argument is fine if you choose to ignore balance sheet issues. The Sensex today has approximately 80% more debt on balance sheet with ~50% lower margins than at the end of the financial year 2006 if that is just as good for someone to buy at historical averages; we have no arguments to give. To illustrate the point, we would rather buy a 2-year-old Mercedes car at 30% discount than a five-year-old Mercedes car (with a suitably worn out engine/balance sheet) at 30% discount. We will not behave differently in the equity market.
  • Then there are those that think the future is bright so paying any price is fine. Such investors are sold equity mutual fund schemes on systematic investments by distributors saying the equity market with all its fluctuations over 5 to 7 years is bound to generate 15% plus returns. I provide a link to a newspaper article written by an IIM professor challenging such thinking through examination of rolling returns of the equity markets(click the highlighted text). If this doesn't convince an investor of the faulty distributor selling premise, nothing will. The price at which you buy largely determines your investment returns.
  • Most investors think the funds chosen by their distributor has a god given right to outperform the markets. Yet as per factual data sent to you on equity mutual fund performance in the period 13 April 2016 to 11th September 2017excluding sectoral funds and value research not rated or rated 1 and 2-star funds-Click the highlighted text above), we find very few do so over long periods that matter. In fact, none of the methods used by distributors to identify future winners in equity funds have been shown to work historically or otherwise. In fact, most of these techniques like picking current five-star rated funds have been proven to be failures as shown by the published research of the biggest and best mutual fund performance rating agency in the world Morning Star. You will realise with the principal officer having been part of the inside workings of a mutual fund, Zara Investment Advisory brings a level of analysis to the table in regard to mutual funds that could truly make a difference to an investor’s portfolio( please read our Investor memos for the months of October 2016 and November 2016 on our website www.zarainvestmentadvisory.in).
To reaffirm facts that are much misrepresented on corporate performance. I provide a link to a newspaper article interviewing a Credit Suisse India representative on earnings growth. After reading this, you may decide how bright the immediate future seemingly reflected in recent market movements truly is( please click the highlighted text).

Zara Investment Advisory was started with the primary aim of contributing to a more prosperous society through education and wealth creation. It is this intention that will drive every article/thought/action of ours. In this context please do share your views of how you think we can best help you.All your suggestions are welcome.

In your service

Dinesh da Costa, CFA                                                           1st October 2017
Principal Officer & Investment adviser
Zara Investment Advisory
Email:dineshd@zarainvestmentadvisory.in
Phone:(0832)2268252,Mobile: 9822280576

Delivering on an "Investment edge through risk management"


Please leave your comments below or email at dineshd@zarainvestmentadvisory.in 

This blog expresses the views of the author as on date and such views are subject to change without notice. Zara Investment Advisory/Dinesh da Costa (used interchangeably) has no duty or obligation to update the information contained herein. There is no representation made. Moreover, wherever there is a possibility of gain there is also a possibility of loss.
The blog is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services. Certain information contained herein concerning economic trends and performance is based on third party sources, believed by Zara Investment Advisory to be reliable. However, we cannot guarantee the accuracy of such information and have not independently verified the accuracy or completeness of such information or assumptions on which such information is based.

This blog and the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Zara Investment Advisory/Dinesh da Costa.

Thursday, 2 February 2017

Union Finance Budget Financial Year 2018 Review

With the Indian economy developing, we have moved from a tilt towards a command and control economy to a more market determined economy. Consequently, it is only natural for Union Finance Budget’s to increasingly loose prominence and impact. In developing a competitive and free market based economy, government has had to make policy announcements throughout the financial year, to flexibly and effectively respond to challenges that arise. In that sense the budget as a document signifies policy direction.

In terms of policy direction, the current budget provides continuity and steps away from a tax and spend economic approach that is known to fail world-wide. The simple reason why tax and spend doesn’t work is that government is a fairly inefficient allocator of resources, when compared to free market forces.

From a macro perspective
  • The budget is based on an assumed nominal GDP growth of 11.75%. Total expenditure for FY18 is expected at 12.74% of GDP versus 13.36% of GDP as per FY17 estimates.
  • Tax revenues are expected to grow 12.23% based on a steep increase of ~25% in income tax collections. The assumption is questionable considering the budget has no provisions for expanding the tax base and that this increase comes on a base of a 22.7% increase expected in FY17. In addition corporate tax collections are expected to grow only 9.07% while excise duty collections are expected to grow only 5.04%.Customs collection growth is expected at 12.9% year on year, a tough ask in a slow growing and protectionist world environment.
  • Divestment target involves capital receipts of 72,500 crs versus assumption of 45,500 crs in FY17.Most of this is expected to be done through ETF’s. Divestment of government owned insurance companies seems necessary to meet the targeted amount.
  • On the expenditure side, revenue expenditure is expected to grow only 5.9% year on year, while capital expenditure is expected is expected to grow only 10.7% year on year. These proposals mean a fall in share of both expenditures as a percentage of nominal GDP. This is especially significant as world-wide governments are pushing capital expenditure to revive economic growth, while the budget envisages a falling effective spending on the capital account (after adjusting for nominal growth). 


In specific proposals the budget has taken positive steps in the direction of declared policy approach of the government.                                                              
  • In rural areas, the focus continues for more effective spending, through greater focus on creating capital assets like ponds, roads etc. The efforts though seem inadequate when one considers  expected agriculture growth of only 4% in FY17 on top of  a low base of FY16 and FY15( both being years of inadequate monsoons coupled with some natural disasters). The MNREGA scheme allocation itself is flattish year on year.
  • The total expenditure on infrastructure is envisaged to grow by 9.1% over FY17 budget proposals, a clear de growth as a percentage of nominal GDP. However the proposal for streamlining of dispute resolution in infrastructure related contracts is a step in the right direction to expedite completion of contracts and build up.
  • For the financial sector, the budget focus on encouraging digital transaction is a step in the right direction.
  • Direct tax proposals though were mystifying as pointed earlier with the budget taxing, existing large tax payers more while doing nothing to tax the rich in exempt categories like agriculture to increase the tax base.
  • Lowering of property classification of long term to 2 years is a step in the right direction, but is unlikely to cause a rush at builder’s offices, in a clearly weak demand environment. Even the assumed demand for affordable housing is questionable with much of the government stock in the category finding no takers.
  • Capital allocation for recapitalising banks seemed clearly inadequate, in face of increasing NPA’s of the banking system.
  • The non-imposition of any long term tax on equity investments or cash / banking transactions as was rumoured pre budget, clearly helped market sentiment post budget.
  • The proposals to clean political funding is a step in the right direction with the budget reducing allowable cash donations to Rs2000 per person, while enabling a method  of larger donations through electoral bonds. Compulsory filing of returns by political parties also helps in creation of transparency.
  • The update on the Goods and Service Tax efforts in the budget also points to a consistent policy direction.

In conclusion, the union finance budget was good as it didn’t propose drastic changes in government policy direction, thus generating trust in the stability and transparency of such policy.

Impact on your portfolio

Forex: The economic survey before the budget pointed out that the rupee was overvalued by 8% to 10% against some Asian counterparts, indicating to a possible depreciation in the near term.This has implications in terms of higher inflation (in turn impacting interest rates) and forex exposure of corporates (in form of revenues or debt).

The equity markets celebrated post budget as they were relieved at not being at the receiving end of any adverse tax proposals, after the prime minister had earlier hinted that they should contribute more to national development. However the celebration seems premature considering that the markets had already rallied from lower levels expecting lowering of corporate tax and other such favourable proposals, which didn’t materialise (for the listed space). In addition the market has completely ignored the adverse world-wide economic milieu in which companies are operating. Heavily leveraged balance sheets and margin pressures due to surplus capacity are other unresolved problems the markets are ignoring.

With corporate tax rates in  the USA being proposed to be brought down to  20% or below as promised by the new republican administration and expected rupee depreciation ,it will not be surprising to see FII’s( who own ~40% of floating stock) selling into the Indian markets to avoid mark down of their investments.

Zara Investment Advisory looks forward to capitalise on opportunities that are created by the above possible events causing market volatility.

Here’s wishing you and your family, prosperity and health in the year ahead  

In your service

Dinesh da Costa, CFA                                                                                 2nd February 2017
Principal Officer & Investment adviser
Zara Investment Advisory
Email:dineshd@zarainvestmentadvisory.in
Phone:(0832)2268252,Mobile: 9822280576

Delivering on an "Investment edge through risk management"


Please leave your comments below or email at dineshd@zarainvestmentadvisory.in 

This blog expresses the views of the author as on date and such views are subject to change without notice. Zara Investment Advisory/Dinesh da Costa (used interchangeably) has no duty or obligation to update the information contained herein. There is no representation made. Moreover, wherever there is a possibility of gain there is also a possibility of loss.
The blog is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services. Certain information contained herein concerning economic trends and performance is based on third party sources, believed by Zara Investment Advisory to be reliable. However we cannot guarantee the accuracy of such information and have not independently verified the accuracy or completeness of such information or assumptions on which such information is based.

This blog and the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Zara Investment Advisory/Dinesh da Costa.