POSTED BY August 17, 2010 COMMENTS (24)ON
In the previous article, we looked at Stocks@MRP and how a stock can have a price tag. Moving further, we now discuss how the concept of Stocks@MRP has been extended even to the benchmark index :
Sensex . Also there is an example of one stock each considerably above and below its MRP. The inherent volatility in the stock markets makes stock investing to be perceived, by many, as a gamble. However, the Stocks@MRP can help us get a very good idea about the worth of a stock.
Once we know the MRP of a stock, we should buy it at a 50% discount to its MRP and sell it if goes considerably above its MRP. Then, how does Sensex@MRP come into the picture? And why do we need to find out the worth of the benchmark index as well?
Let’s jump back a bit in time. It’s December 2007. The Sensex is close to 20,000. The media is going gaga over the Indian economy and the movement of Sensex (up by 55% in just 9 months) and is saying that the next stop is 30,000. Everybody is eager to jump onto the bandwagon.
Fortunately, you have been a part of the rally since the beginning and have seen a considerable rise in your holdings. So, what do you do? Do you sell off and book your profits? Or do you wait? After all everyone is saying that this is just the beginning.
You wouldn’t want to look like a fool selling too early and missing out on the further upside, would you? You stay in and within a few months, you regret your decision.
The market crashes (falls by 50% in 1 year), your stocks tumble and a large portion of your wealth is wiped away. All your companies are still doing well, they are still fundamentally strong. Yet, you have suffered because of the market’s over reaction to the sub-prime crisis.
You may have not lost your capital, if you bought your stocks at a discount to the MRP, but your profits have definitely vanished!
Warren Buffett, one of the greatest investors in the world has said, “Be fearful when others are greedy and be greedy when others are fearful”. But to do this, you need to be aware when the others are being greedy and when the others are fearful. And this is the quest that exactly led us to finding Sensex@MRP.
The market represented by Sensex is known over react, to both positive and negative news. Be it national or international politics, capital inflows or outflows and favorable or unfavorable monsoon forecasts; the Sensex fluctuates widely because of these.
Even though Sensex is comprised of just 30 stocks, chances are that if these big names get hit, a majority of the other stocks also get clobbered. This thought led us to the logical extension of finding Sensex@MRP so as to enable investors to enter stocks at bargain levels and help them exit when things start getting over-exuberant!
The Sensex companies are some of the biggest and most well known names in the country. They are amongst the favourites amongst the institutional investors and hence are highly liquid. One can then expect these stocks and as a result the Sensex to trade close to the fair value i.e. MRP.
However this has seldom been the case. On quite a few occasions, the market has become irrationally exuberant or highly depressed. Knowing these phases of the market can help you become better investors. The graph below gives you a comparison of Sensex@MRP values plotted against actual Sensex values for a period of 10 years beginning March 1999.
Click on the graph below to have a look.
An example of a company quoting considerably above its MRP is Reliance Infrastructure. In 1999, Reliance Infra was quoting at a discount of 20%. It crossed the MRP in year 2000 and remained close to MRP till 2003 inspite of an inconsistent financial performance. Its earnings infact witnessed a drop in 2002 and 2003.
The company’s performance improved post 2003 and the price zoomed above its MRP. In 2004, the stock was quoting as much as 150% above its MRP. This seemed like a sell signal but the stock rose further to unimaginable levels in 2007. In two quarters i.e. from June 2007 to December 2007, the stock more than tripled.
The irrational exuberance of the market was visible as the stock quoted at a PE multiple of 50 at Rs. 2130. The price crashed soon and in March 2009, the stock was quoting at a 35% discount to its MRP. Again, the prices corrected and the stock is currently trading 50% above its MRP of Rs.746.
Bharti Airtel currently at Rs. 327 is quoting at a discount of 44% to its MRP of Rs. 589. Click on the graph below to take a look at Bharti’s historical valuations. Except for the initial years, Bharti has always traded above its MRP.
Leadership in the telecom industry coupled with high growth in the mobile market, helped the company record great earnings growth over the years. However, since March 2006 as competition intensified, the premium commanded by Bharti has decreased especially after Reliance Communication’s entry.
Further, the telecom sector has been seeing all sorts of problems including an intense price war, detrimental policies and very recently audacious 3G and broadband license bids. To add to this, Bharti also completed the acquisition of Zain Telecom which led to questions being raised about its financial position.
All this led to Bharti tumble to levels seen in March 2009. However, over the last few weeks, Bharti has picked up quite a bit. Bharti’s MRP works out to Rs. 589 considering an earnings growth rate of 18% which is substantially lower than its past growth rates thus making it a value pick.
So, the rule of buying at a discount to MRP (ideally 50%) and selling above MRP would ensure good returns. Once the stock crosses the MRP, the probability of a correction increases. There is however always the chance of error. There is a possibility of the stock running considerably above the MRP as seen in the case of Reliance Infra.
You may miss out on the upside fuelled mostly by sentiments rather than earnings. But provided you buy the stock at a 50% discount, you would already be sitting on handsome, riskfree returns and hence would rather let this risky upside pass!