For investors hindsight can be a frustrating thing. Thousands of individual investors, who are holding speculative portfolios now worth a fraction of what they paid, are ruing not having sold at the market’s peak. This conundrum of fear and greed is as old as the market itself. Unsophisticated investors often end up buying stocks at their peak, carried away by the euphoria and greed, and selling the shares when the bubble has popped.
Ramanan Govindasamy is an investor and Managing Director at People’s Merchant Finance PLC, of which he also owns a substantial stake. He forecasts that some listed firms with strong franchises will see earnings growth touching 30% annually over the next few years. For unsophisticated investors who often end up on the wrong side of the market cycle, he says this is the time to buy fundamentally strong stocks. Excerpts of an interview …
Stock prices have settled after a wild ride. Some people are still trying to make sense of the whole thing. What’s your view?
A: The market went up because of the post-war momentum, the positive outlook and the perceived peace dividend. Those are strong reasons. Early investors who took the big plunge benefited substantially. Then came the positive reports and investors flying in to the country. That was followed by a second wave.
Meanwhile earnings growth was incredibly good. So a huge amount of money was coming into the market on the demand side but the supply side was set. When a market is going up and has more unsophisticated investors, they look for direction. Basic psychology says when we are confused we look for leaders. Whatever the leader does, the rest follow. When we are confident of ourselves we take decisions on our own. So in this market they found direction in certain actions, but their reaction to the leaders’ action was disproportionately more. There were 10,000 individuals taking decisions and following some person or his decision. It is not the fault of the person being followed or the stock. There simply was an oversupply of funds and they wanted some kind of guidance.
But surely there were smart enough people to realize the response was disproportionate and sell overvalued shares?
A: The market is based on a very fundamental principal, a rational investor. When people deal irrationally buying stocks at 50 times earnings or 100 times earnings, a market stops being a market. But irrational behaviour can’t continue for long, the market corrects itself.
The people who are holding onto a share are less sophisticated or those who still think the market has momentum; the extreme speculator. Then the correction automatically happens. That’s when the rational behaviour comes back into the market. Rational behaviour always comes out on top. In this case rational behaviour was suppressed because of a burst of unsophisticated investors. Ideally you should have a mechanism or a way of advising them properly, but it’s a very difficult thing to do.
Are you seeing a shift from fixed income to equities now?
A: We don’t see the average investor doing that but at the top level a lot of people have moved their funds into equity. There are large investors who are fairly leveraged, that’s a better indicator. When they leverage that means they are very positive and optimistic about the market.
So it looks like the market has bottomed out?
A: The market has bottomed out. It has reflected all the negative developments, the human rights issue, the reserve issue, inflation and overall the readjustment to a lower growth country, all that is reflected in the market.
In fact the market may have overreacted. It has over discounted because there is a perception that more negative news is coming. We are at rock bottom, inflation is easing off and restructuring of the CEB and CPC are ongoing. It’s a massive positive development but the market hasn’t realized this. We have an undervalued market, easy pickings.
There is this notion that we should encourage individuals who don’t understand the market by giving them a crash course and getting them to invest. Is this the way to go?
A: We have to get people to look at the market. At the end of the day equities will give far superior returns compared to all other forms of investment. Few people realize this and the ones that do are apprehensive. But a concentrated effort should be made to bring them in to the market.
You don’t think these are the people likely to get carried away? Look for leaders when there is confusion?
A: That risk is always there. I’m sure the SEC will handle it better in future. Last time when they faced it there was no precedent. This time they have a precedent and they will be able to handle it and you will also find these leaders being more conscious of their actions. Not that they have done anything wrong but they’ll be much mellower. Mind you, after what happened in Sri Lanka in the last couple of years the market will always trade at a slight discount to potential.
What are the key macro factors you are watching that you think will be important for the economy and the market?
A: For us the key factor is oil. Oil is the one single issue for the country. If oil was trading at $75 a barrel it would release a huge amount of resources. That’s the only thing I am worried about. That is the only variable I monitor at the highest level. Everything else is good. We have a new generation of entrepreneurs who are going to create great companies in a couple of years.
People have been pointing to the weakness in the government budget for years. Will this continue to hold the economy back?
A: It’s a case of the government revenue catching up with the expenses. They are not spending on luxuries. They are spending on very basic requirements. They are not building palaces, giving mass caviar parties or anything like that. Giving rice and curry, basic education, basic health – that’s what the budget is all about, which should continue. It’s just a case of the revenue catching up. The investment will bear fruit; people will be able to participate in the economy. When revenue catches up the budget will be under control. You can’t, by taking a single dimensional view, say expenses have to come down, there should be a surplus. That will kill the future.
It looks like economic growth is ordinary now considering the potential. Do you agree with that?
A: The economy will surprise people who are very negative. I think sustainable economic growth will be around 8%. In the next couple of years it will get established at 8%. But I’m more interested in the corporate earnings. Corporate earnings of good companies with great brands is going to be 30% plus per annum. That is something people haven’t realized. When a brand is a household name it will benefit from the consumption boom that’s around the corner. They will experience a disproportionately higher growth rate. War time growth rates can be misleading. In my view the growth then came through capital investments like telcos investing large amounts of money and war related expenditure. 6% growth is good enough to push corporate earnings.
With corporate earnings growing at 10% we had economic growth of 5%. Now corporate earnings are growing at 20% plus. When growth didn’t follow through we had issues. Last two years the market corrected itself, corrected for lower expected growth. But the fundamentals haven’t changed. They are still good.
In my view the market correction was too steep. It’s always like that. In a correction the last leg will have forced selling sending the market below its fundamental value. This upswing is going to happen whatever policy makers do, it doesn’t matter. This is 20 million people deciding to move in a particular direction. You can easily select 20% plus growth companies; top line and bottom line.
What are the characteristics of the companies which will out perform the rest of the market or see 30% earnings growth?
A: Market share, brand recognition and how well these firms are managed. There are a lot of companies revamping themselves to capture these opportunities. Consumer goods companies will benefit from the growth but the bigger beneficiaries will be companies in engineering, construction and new services.
You are saying the market has over corrected itself. Historical PEs must be 12 times, something like that?
A: If you look at companies there are very good ones which have 60 to 70% market share run by very astute businessmen priced at 6 to 8 times earnings. That is on the assumption that GDP will grow at 6% over the next five years. But it’s not going to be at that level. With economic activity, the growth is going to be far higher and I think the discount is too steep. Some of these companies can easily trade at 10 times earnings. From 6 to 10 times earnings is a substantial jump in valuation. From 10 times onwards you take in to account the economic risk.
Quite a large number of companies are undervalued on earnings. You have to look at the revenue base, whether they have strong markets, dominant market share. You look at the management, whether you can trust the management – basically, integrity. As long as they are good businessmen and have integrity you should buy into those stocks.
Why was this correction or over correction so controversial?
A: I think a lot of people got burned badly because there was so much of optimism and people expected the market’s momentum to continue for more than five years in one go. When places like Malaysia and Thailand went on the growth phase it was a 10-year saga before there was a market correction, in 1997. Before the correction there was a clear 10 years of market growth and that’s the same expectation, consciously or unconsciously, everybody had here.
We had just finished the biggest problem the country had. But when the correction happened, the market lost its momentum and a lot of people were disappointed. The correction in my view is made to sound very controversial, it was not controversial. We should be happy that we have a good market which behaved rationally.
Does the regulator have a role? Should it be morally bound to encourage rational behaviour when it appears the market is extremely irrational?
A: It can’t. If the market is going up by 20% and people want to be part of that market, how can they stop it? If they stop it they become bad boys because there are such high returns being generated. It’s a bit of a dilemma for them. Either way they will be found fault with. If they don’t tell the people the market is overheating, the market will overheat and there will be a massive disaster. But if they do it, there will be a lot of people saying ‘why are you preventing us from making money’. They can never win in this situation.
We keep talking about more listings. Is this a realistic thing in the short term?
A: Let it come naturally. As the economy becomes more sophisticated and grows there will be more companies better suited to be listed. To compel people to list, I don’t think it is a good way forward. Overall there aren’t many companies that can be listed today but I think it will be different in a couple of years’ time as these companies mature and have higher turnover and profitability. They have informal corporate structures and management structures, the way they handle their finances… it’s dangerous to bring them to the market. They are not ready to be listed now.