Yesterday's laggards turn leaders

Source: WSJ

After being the best performing asset class in 2016, Natural gas futures have fallen 15.52% YTD. As pointed out in an earlier blog, best performing asset classes of one year can deliver the worst returns the next year and vice versa. The example given of was Natural Gas and it was stated that it was quite possible that Natural gas would significantly underperform.

On the other hand, Cocoa, which was the worst performing asset class in 2016 (-33.8%) has so far outperformed Natural Gas, Crude Oil and Sugar (some of the best performers of 2016).

As has been pointed out by Benjamin Graham and subsequently by Seth Klarman, overperformance generally leads to overcrowding the market and consequently diminished returns. By comparison, underperformance will generally lead to diminished competition and subsequently higher returns.

This trend seems to repeat itself in the stock markets too. As the below chart shows, in 2011 Financials were the worst performers only to emerge on top in 2012. Utilities, after being the worst performers in 2012 and 2013 emerged out on top in 2014. The only sector which remained in the middle was S&P 500. So, investors looking out for stable returns would have been better off invested in an index fund. 

Yahoo Finance

It would help Investors not to get too caught up by high growth figures and future expectations but also rely on Margin of Safety as professed by Benjamin Graham.

Sikka’s $200 million boon to Hasso Plattner turns out to be a big headache for Infosys shareholders.

In the ongoing Infosys tussle with the founder, Narayana Murthy, the present CEO and MD Vishal Sikka has termed himself as “a warrior”. The reasons are not far to seek. Ever since his appointment, Sikka has been pursuing a strategy of employing the huge cash reserves (Rs. 30,367 crores in consolidated BS) to go on an exorbitant shopping spree to boost the value of his 178,195 stock options issued within two years. Coupled with liberal bonus issuances, Sikka has been trying to drive up Infosys’ share price. With so much at stake, it’s no wonder he calls himself “a warrior” out to rake in the animal spirits.

Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: "I will tell you a secret: Deal making beats working. Deal making is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . deal making is romantic, sexy. That's why you have deals that make no sense." (From Warren Buffett's shareholder letter)

One of Sikka’s acquisitions, Panaya, has been a complete failure. Acquired on the brink of failure in March 2015 for a whopping Rs. 1,398 crores, the net assets of the company were only Rs. 47 crores implying a goodwill of Rs. 1,351 crores. This transaction would have been somewhat justified if Panaya was in a top-notch growth phase with substantial revenues. However, a look at Infosys’ annual reports for 2015 and 2016 belies any such conclusions. The revenues accruing are negligible and the profits are negative. For the year ended 31.03.2015, Panaya contributed 12 crores towards revenues and had a net loss of 6 crores. This gets worse in 2016 with a net loss of 67 crores. There is no mention of revenues for 2016. 

The link between Panaya and Sikka’s former employer, SAP, does bring into account a lot of questions. Panaya’s investors include Hasso Plattner Ventures. Hasso Plattner was the co-founders of SAP. Were the shareholders made aware of this obvious conflict of interest. It does seem that Sikka granted a huge lifeline to Hasso Plattner at the cost of Infosys shareholders. Even though the Infosys Annual Report mentioned that Panaya was incorporated in Delware, no SEC filing was found for it.

Infosys has substantially underperformed both Nifty (35%) and TCS (16%). Throwing away almost 5% of the consolidated cash balance for a company on the brink of collapse proved to be a game changer for Hasso Plattner. That same 5% could have been used for stock buybacks greatly boosting shareholder value.          

Asia's oldest stock exchange finds tough love from investors

The Bombay Stock Exchange, Asia's oldest stock exchange founded in 1875, saw dismal participation from investors on the first day of its IPO. Barring retail participation, the issue saw negligible bids coming in from Corporates and no participation from FIIs, DFIs or Mutual Funds. This speaks volumes about the issue quality. Coming shortly within the demonetization exercise, the issue should have seen better participation atleast from the domestic players. However, apart from a measly 1,000 odd shares none of the domestic or foreign players found the issue alluring. 

There are still good chances that the issue may witness last-minute participation from “motivated players” and get filled up as happened with other downbeat issues. However, investors looking to hold the stock over the long term need to be tread very carefully. “Motivated players” interested in the issue due to extraneous reasons can get demotivated very easily and jump to other issues.

Natural gas fires up MGL and IGL

Natural Gas has emerged as the best performing financial asset of 2016. This has provided a huge impetus to companies such as Mahanagar Gas Limited (MGL) and Indraprastha Gas Limited (IGL), both returning 65% and 54% respectively since July 2016.

Source: Yahoo Finance

However, just because an asset/ sector has outperformed in a particular year is no reason why it will continue the winning streak. For instance, energy was the best performing sector in 2007 only to crash 39% the very next year. Also lower valuations for the under-performing asset class will see renewed fund inflows. In 2015 the energy sector was the worst performing sector only to emerge as the best performing in 2016.  It has led the pack after a gap of almost 9 years.

Excepting a few outlier years, sector returns almost resemble a W with outperformance in one or several years and then subsequent downturn only to head back up again.

As Benjamin Graham mentions in Security Analysis, "There are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. In the broad economic sense, there is the law of diminishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth. There is also the flow and ebb of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback."

Further as Warren Buffet mentions, "We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business." In other words, when the security has moved ahead of itself in a very short time it may be time to sell the security. 

Investing in MGL at these levels could be a bit expensive given the 65% return in about 6 months.

Why FIIs can spoil NSE's party

National Stock Exchange of India (NSE) is planning to list its shares on the stock exchanges and has filed a DRHP with SEBI. It is the leading stock exchange in India and has 85% share in Equity cash trading and 94% in Equity derivatives trading. The nearest competitor, BSE, is miles away in terms of technology and trading volumes.

FIIs constitute a 20.9% client base in the Cash market segment and 14.4% client base in the Equity Derivatives segment. As is well known, FII investment can be quite fickle and can change their temperament in a very short period of time. Since Oct 2016, FIIs have been net sellers in the Indian market and have sold off equities and bonds totaling Rs. 76,673 crores. This is almost 6 times the amount sold off in Oct 08 - Dec 08, the height of the financial crisis. There may be several reasons for the FIIs exit, whether it be the Trump factor and subsequent US market jump or India's demonetization drive.

A key difference between the two periods is that in the 2008 period, FIIs were net buyers in the debt
market. However, in the current period they have turned negative on both equity and debt segments.

Trading income drives almost 63% of NSE's revenues. With a bearish FII sentiment towards India, this may come under pressure.

Apart from the recent SEBI probe and corporate governance issues, another aspect to consider would be the returns delivered by major listed exchanges over the past year and their valuations. Of the major exchanges, only LSE delivered positive returns of 6.20% over the past year. The P/Es ranged from 20.6 for the Deutsche bourse to 42.73 for LSE. For a comparative analysis, LSE had revenues of £1.41 bn for the year ended 31.12.2015, whereas NSE had revenues of £281 million for the year ended 31.03.2016.

Although there is not much domestic competition for NSE, what would really matter is the foreign appetite for Indian securities.