It is time to start buying stocks

“Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffet.

In reality, be greedy when others are fearful and only when there are valid reasons for being greedy.

The current environment can be best described as fearful. Investors are engulfed with fear, fear of losing money, in most case fear of losing more money. There are valid justifications of such fear. The world economy is slowing down. Many large developed nations are in recessions, people have lost so much money across asset classes. In India, there is an economic slowdown playing out. If all this was not enough, we witnessed the most terrible incidents of terrorist attacks in Mumbai that threatens to adversely impact economic prospects in the medium term. There are many valid reasons to be fearful and people are justified in being afraid of committing capital behind risky assets like stocks.

On the Indian stock markets front, they have corrected over 55-60% from their highs made earlier this year. Some stocks are down 70-90% and this includes many blue chip names as well. A spate of bad economic news has hit us and corporate results have not made us jump in excitement. We probably would continue to see more bad economic news come ahead. In the short run, stock prices are likely to go down further.

Yet, amidst all the gloom and doom, I think it is time to start buying stocks. Why? In this article, we shall look at the facts one by one and then look at the collective weight of the facts put together to try to figure out why investors should start buying stocks.

The markets have already corrected significantly. The market capitalisation:GDP ratio on the NSE now stands close to 0.6, down from its lofty value of 1.5 in Jan 2008. Prices however do not go down to zero, the productive enterprises of India are going to be valued and valuable as long as humanity exists. Yet, a large price correction is never a good enough reason alone to buy stocks. Stocks can fall and keep falling.

But at some point the fall stops as stocks get cheap and value investors step in to buy. Compounding returns by buying cheap assets is a very successful way of building wealth. Are stocks attractive now? I believe they are even as I acknowledge that what is attractive can get even more attractive.

The BSE Sensex quotes at a value of 9092 (28 Nov 2008 trading day end) implying a PE ratio of 11.62, a Price to Book Value of 2.43 and a dividend yield of 1.96% (Source: BSE Website). This compares favourably with previous lows. In fact, this is at the lower end of valuations for the Sensex since 1991. The same is the case with all other indices. The earnings yield of the Sensex stands at 8.6% which is higher than the 10 year Government of India security whose yield is around 7.2%. Stocks are yielding greater in return than government bonds. On a post tax basis, stocks are yielding more than most 1 year Fixed Deposits currently. Stock yields (earnings) rise over time but fixed deposit interests remain the same. Many stocks are currently quoting at ridiculously cheap valuations.

Over the past 17 years, there have only been 4 incidences when the Sensex got to such low valuations. This happened in Nov-Dec 1996, Aug-Oct 1998, October 2002 and April 2003. And what were the returns achieved in one years time post these periods? Here is the data:
Period________Return 1 Year hence
Nov-Dec 1996___25-30%
Aug-Oct 1998___50-75%
October 2002___70% +
April 2003_____100%

While 4 data points can hardly be a statistician’s delight to draw some inference, we have to do with whatever data we have. The data hence can only be indicative. The point to be noted however is that on every single occasion, the 1 year return has been positive, more often quite spectacular.

The PE ratios of stocks are way below their moving averages and trend lines suggesting oversold markets. Of course, you only have to look at the price to see how oversold these markets are.

India is slowing down, but the fears of an economic meltdown seem exaggerated. The last major bear market was the one between 2000 and 2003. Many blue chip stocks are currently quoting at 2003 bear market bottom valuations. And India’s GDP growth in 2002 had fallen to 3.8%. In the current turmoil, not even the most pessimistic analyst expects GDP growth to fall to those levels (although nothing can be ruled out). But stocks are already discounting an outcome as bad as that of 2002, perhaps worse. While that can still happen, it seems a trifle unlikely at this point. Yes, economic growth will be lower, but life still goes on. Good companies will not vanish. Their future profits will not go to zero; in fact they are likely to rise in the long run. We do not stop living because there is an economic slowdown. Life goes on, with some adjustments and some pain. Eventually, humans come out ahead of such circumstances. Since 1991, we have witnessed a Harshad Mehta scam in the equity markets in 1992, bomb blasts in the Bombay Stock Exchange in 1993, a boom bust cycle of 1994-97, the severe South East Asian crisis in 1997, economic sanctions on the country post Pokhran in 1998, a technology bubble meltdown in 2000, a war in Kargil, terrorist attacks on the Parliament in 2001, communal riots and plague epidemic in Gujarat, countless acts of terrorism in various cities in the country including cities like Mumbai and Delhi. And guess what? The markets still gave compounded returns of 15%+ (including dividends) over the last 17 years, even after the current crash! The Sensex still managed to move up from 999 in Jan 1991 to 9092 today! A boom follows a slowdown and at some point, things will again look up.

Let us also not forget that, generally speaking, the corporate sector is in far better shape than it was during all the previous downturns. It is perhaps better placed to endure this downturn. Be it Return on Equity or Return on Assets or other return figures, corporate India is more efficient today than it was in the past.

There are many positive macro economic factors that are going unnoticed, or perhaps being looked at with the glass half empty mindset. After the first crash in Jan 2008, the glass was half full. Now it seems half empty (or maybe almost empty). A few important macro economic variables are turning positive. First, inflation is no longer the enemy, at least for now. The central government and the RBI are trying to get more money into the financial system. This would most likely lead to lower interest rates and lower yields on debt, thereby making stocks even more attractive. A fall in interest rates boosts investments and boosts demand and also boost corporate profits by lowering their interest costs. All is positive for economic growth. Crude oil prices have come down to 2005 levels, down to 50+ USD per barrel. This is a huge boost to the India’s trade account and can perhaps counterbalance the loss in exports. Commodity prices have crashed, which though negative for commodity producers, is beneficial for commodity consumers.

So stocks look cheap on a historical basis; in fact almost as cheap as they ever were. History suggests that such occasions are infrequent but buying done at such levels rewards investors handsomely over time. In addition, today, many macro economic variables that were plaguing India since the beginning of the year have started turning benign.

Don’t get me wrong here. I am not in any way suggesting that the pain is over. More likely that we will see many more negative data points being thrown up. I do not know when good days will be back again. I suspect markets might see some more downside ahead. So would it be a wise idea to wait till all the downslide is over? If you are an investor, the likely answer is ‘no’. Investing is a game always played with incomplete information and uncertain external conditions. One has to make a reasoned judgment and take decisions decisively. One has to accept risk and accept the possibilities of making mistakes or being proven wrong. If you keep waiting for things to clear up or wait to feel comfortable again to invest, you are most likely to miss the boat altogether. Permanent bearishness or caution (or permanent bullishness) does not serve an investor well.

It is generally observed that stock markets lead economic development, what market observers call ‘discounting’, that news gets discounted into the price. We can never know whether the market has fully discounted all future bad news or not. We have to make an educated guess and a reasoned judgment and yet run the risk of being proven wrong. But we know that markets bottom out much before all bad news comes through. Bad news is an investor’s friend. At some point, it allows the investor to buy stocks cheap. If you are an investor, you welcome bad news. And you should buy when stocks are cheap. If you do not buy then, and if stocks run away, you not only look like an idiot. You are proven to be an idiot.

Having said this, bear markets do not end one fine day and then run away like a bullet train. They offer you ample time to spread your buying over time. How long is anyone’s guess, but in my judgment, you could start buying now and keep buying in equal amounts for the next 18 months. You should avoid companies that are highly leveraged or are in weak competitive positions in the marketplace. And then invest with some method of risk control, that if you are proven wrong, you don’t get hurt too much.

For most part of this calendar year till recently, I was advocating cash as king. Perhaps cash is no longer king.

Happy Investing!