Some contemporary OPINION’S become FACTS in future.

When we form an opinion we all hope it will become a fact,

which is why we invest based on our OPINION.

Why do some people achieve a higher degree

of success when it comes to OPINIONS?

Important Lessons in

Economics

- By Sana Securities

© Sana Securities Page 2

Table of Contents

1. Evolution of Money - Use of Gold 3

2. Bretton Woods System – End of the Gold Standard 5

3. US Debt Ceiling 8

4. Currency Trading Basics 10

5. Explanation of Basic Economic Terms Used in India 14

6. BSE Sensex 30 vs. Economy - Wealth effect? 17

7. Economic Cycle and Stock Investing 19

8. Sector Rotation in Stock Market 23

9. Future Prospects of Indian Economy 26

10. Instruments of Monetary Policy in India 28

11. Sensex Target for 2020: Are 40,000 – 60,000 levels achievable? 31

12. Hope, Government and The Next Bull Market Rally 36

© Sana Securities Page 3

Chapter – 1

Evolution of Money - Use of Gold

Imagine a world without cash. That is, without paper money. How would transactions work? Buying

books, coffee, travel or anything you spend on … difficult? How did this work a few hundred years ago?

As mankind evolved, we started exploiting the resources of our planet and produced a variety of things.

Some were essential, others not quite so. We then found ways to share these things with each other, of

course, for a price. For the lack of a developed system we started bartering – you give me some of what

you make and take what I make. As the process of our evolution matured, we realized the difficulty of

this system. Some things take years to make while others take very little effort. Both essential (think of a

house and food – now try to set a swap ratio, i.e. how much food for a house?).

An even bigger problem with the barter system– what if I

don’t accept what you make? Let’s say, I don’t eat fish and I

grow rice. The fisherman then is never getting any rice from

me, at least not directly. So his option is to swap fish for

something I accept and then come to me. Finally, let’s assume

that there was no problem with barter system. Imagine how

this may work in the modern day. A lady with a basket full of

fish standing at a supermarket’s cash counter to pay for a dress

may not be ideal.

Evolution of Money

Rightly so then, we felt the need to put a value to things. This value made market transactions easier. We

developed ways to quantify this value in terms of standard amounts. If you go back on the path

of evolution, you will find that many commodities were used to serve as money and gradually the use

of metals in the form of coins became prominent mainly because they are easy to quantify and carry

around and also because, metals are the same all over the world. Many metals like silver, bronze and even

iron were used as money at different times. Over time, use of gold coins proved to be the standard means

of exchange. Why gold? There are many reasons for why gold became the most popular form or money.

Mostly it was because of its rarity and the ease with which you can identify the yellow metal.

Use of Gold - Drawbacks

As you would imagine, use of gold or for that matter, any metal or commodity as currency has some

drawbacks. For starters, it is inconvenient to store. Would you want to carry big chunks of gold in your

pocket all the time? Also, the value of gold is fixed to the value of the underlying metal so for a larger

transaction size, you may have to carry a very large amount of gold. The solution came in the form of

paper or fiat currency. The idea was to denominate paper to represent a certain value of gold as its

underlying asset or its backing. So for example:

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Rs. 1000 Note = 1 unit of gold

Rs. 500 Note = ½ unit of gold and so on.

Countries started issuing currency notes of various denominations and started tying the value of these

notes in terms of units of gold. People deposited their gold coins with the banks and got paper currency

i.e. notes of different denominations. The Governments in turn promised the depositors that the value of

the paper they hold at any point of time would be equal to its proportionate value of the underlying gold.

This concept which guaranteed that any amount of paper money could be redeemed by the issuing

currency's government for its value in gold was called The Gold Standard. As countries around the world

embraced the gold standard, each national currency (the dollar, pound, franc, etc.) was merely a name for

a certain definite weight of gold.

This had two important outcomes. First, a country would print paper currency based on its gold reserves.

So if a country needs to print more money, it needs to mine more gold. Second, countries could now trade

across borders given that they could redeem the foreign currency in gold from the issuing countries bank.

The Problem with the Gold Standard

As population grew, economies expanded. As more and more people started exploiting the natural

resources of the world, both production and consumption increased rapidly. Problem? Not enough gold to

support this growth. How do governments increase the money supply to pay off for these new goods and

services?

The only way was to mine more gold or to revalue gold. How would revaluation work? By revaluing, the

government could make the gold more expensive thus allowing itself to print more money. So for

example: you deposited 10 grams for Rs. 100, now the government prints and gives out more money to

you and increases the value of your gold to Rs. 200 for the same 10 grams. This would mean constant

revaluation of gold as the population (and effectively the production and consumption patterns) of the

world increased. However, this is exactly what happened for some time in the late 19th and early 20th

centuries.

Think about it, if the government can print as much money as it wants by revaluing the gold to any price,

then why have gold as a backing? Why not just use paper (i.e. fiat money) so that the Government can

print as much as it wants without revaluing anything.

© Sana Securities Page 5

Chapter – 2

Bretton Woods System – End of the Gold Standard

So how did a shift from the gold standard to pure fiat or paper currency happen?

The problem with the gold standard was that if the

government wanted to print more money than its gold

reserves, it was difficult and so it was difficult to increase

the supply of money with increasing population and rising

levels of production and consumption. Moreover,

governments just like individuals have patterns of

unexpected needs. The only difference is that there is little

that individuals can do to check the acts of governments.

This, in fact, is a lesson which history has taught us far too

many times.

During the two World Wars, governments around the world needed more and more money to support

their militaries. They simply began printing more money than the amount of gold that was available.

Eventually, it came to a point that so much money got printed that it could not be redeemed for gold.

There wasn’t enough gold to do that. What remedy did the governments come up with, across the world?

► End the gold standard (i.e. no more currency conversion to gold).

Further, the war inflicted devastation. After all, all of this money was being printed to support wars in

order to inflict devastation. To that extent governments collectively succeeded. They printed a lot of

money and caused a lot of devastation. After the Second World War, the world embarked on a lengthy

period of reconstruction and economic development to recover from this devastation.

What then started was a period of competitive trade policies which resulted in a world which slowly

started retreating. Why did that happen?

Beggar thy neighbour

The name as it suggests comes from the resulting impact of the policy which is making a beggar out of

neighboring nations. The goal of such a strategy is to increase the demand for your nation's exports, while

reducing your reliance on imports. This is often executed by devaluing the nation's currency, which will

make exports to other nations cheaper. How exactly this is done is as relevant today as it was back then.

Let’s say, it takes Rs. 1,000 to produce a pair of jeans in India and it takes the same amount which is US$

20 (assuming 1 USD = 50 RS) to produce the same in the United States. Now if you artificially reduce the

value of your currency (in our case the Rs), in that 1 US$ converts to Rs. 62 instead of Rs. 50, you will be

able to attract more business from the U.S. as Americans would get that jeans for US$ 16 from India,

© Sana Securities Page 6

making India more attractive. So you kill the foreign market to improve your domestic exports. I am sure

that like me, many of you at this point wonder, “What’s so wrong with that?”

Remember, the prices of goods are not reducing. The workers are not able to produce it for any less. It is

the host nation’s government which is devaluing its currency and keeping it at artificially low levels to

condition demand in its market. This leads to currency wars.

Currency Wars

“Currency war, also known as competitive devaluation, is a condition in international affairs where

countries compete against each other to achieve a relatively low exchange rate for their own currency. As

the price to buy a particular currency falls so too does the real price of exports from the country. Imports

become more expensive. So domestic industry, and thus employment, receives a boost in demand from

both domestic and foreign markets. However, the price increase for imports can harm citizens'

purchasing power. The policy can also trigger retaliatory action by other countries which in turn can

lead to a general decline in international trade, harming all countries.”

Now think about this. When international trade declines, aren’t we going back in time? Instead of

exploiting the resources of the world and getting the best things from wherever they are available, we are

closing our economies. Let’s not discuss any other repercussion of such protectionism and think in lay

man terms. Did we not start trading with our neighbours because they could make certain things better

and cheaper? Aren’t we hindering progress of the world by closing ourselves to foreign ideas? Further,

not all countries produce all the goods. Aren’t we starving each other of goods which we don’t produce?

To solve the problems created by the devastation and excessive protectionism which resulted from the

two World Wars, the fighting nations now felt the need to come together in order to devise some

measures to rebuild most of what they had destroyed.

The Bretton Woods System – A return to the Gold Standard?

In an effort to free international trade and fund post-war reconstruction, delegates from 44 countries met

in 1944 at a place called Bretton Woods in the United States in order to device a system to regulate the

international monetary and financial order and signed agreements to set up the International Bank for

Reconstruction and Development (IBRD) and the International Monetary Fund (IMF) which was

designed to monitor exchange rates (i.e. an international basis for currency trading) and lend money to

nations with trade deficits.

American politicians, meanwhile, assured the rest of the world that its currency was reliable by linking

the US Dollar to gold; $1 equalled 35 oz. of bullion. In effect, this arrangement replaced gold with US$.

In other words, the Bretton Woods system made US$ as good as gold. Keep in mind that the United

States was mostly unscathed by the world wars and by the end of the Second World War had the biggest

gold reserves in the world. Even till date, the U.S. remains the country with the highest gold reserves with

almost 55% more gold reserves than Germany which has the second highest reserves of gold.

US Dollar as reserve currency meant that now instead of the governments printing money based on their

gold reserves, the U.S. would print the (reserve) money for the world based on its gold reserves. In case

© Sana Securities Page 7

there was another reckless money printing exercise (like it happened during the world wars), will the U.S.

not suspend the gold standard like most nations did during the wars?

Also, in hindsight don’t you think that the Bretton Woods system was bound to fail given the same logic

we discussed earlier? - As population of the world and effectively the production and consumption would

increase, there would be need to print more paper money and there wouldn’t be enough gold to back this

new paper or there would be a need for constant revaluation of gold.

Bretton Woods System - Collapse

The Bretton Woods system collapsed in 1971, when U.S. President Richard Nixon closed the gold

convertibility window (i.e. disallowed any conversion of US$ into gold). Why? Because, countries had by

now prospered since the signing of this agreement in 1945 and had accumulated enough US dollar

reserves. They started demanding gold for their dollar reserves. The U.S. by then had only a third of the

gold reserve necessary to cover the amount of dollars in foreign hands.

So the inevitable collapse of the Gold Standard came on 15th August 1971 when President Nixon

withdrew it in order to avoid a run on American Gold (if you are interested in hearing about it… watch

this video of Mr. Nixon's speech).

Since then all reserve currencies have been fiat currencies and nothing is backed by gold or anything else.

However one thing which the Bretton Woods system achieved was that it established the supremacy of

the US$ as reserve currency or as I like to think of it, as ‘global money’. Central Banks around the world

came to hold large quantities of US$ to transact with the world at large. Today, even though the U.S.

accounts for only about 20% of the combined output of countries engaged in international transactions,

US$ as a currency reigns supreme. The world trades in it. We buy gold, Oil and other imported items

using the US$. Our conversion rates to other currencies are based on USD/INR quotes……

[i] A reserve currency, or anchor currency, is a currency that is held in significant quantities by many

governments and institutions as part of their foreign exchange reserves.

© Sana Securities Page 8

Chapter – 3

US Debt Ceiling

The US Dollar is the most widely used currency in the world. In addition to central banks, public and

private entities around the world hold the US Dollar in their reserves. In fact, it is true that most US

Dollar banknotes are in reality held outside the United States.

In India we buy our biggest imports namely, crude and gold in US$, a legacy of the Bretton Woods

System.While it is true that the Bretton Woods system had put the US$ in a supreme position, there is a

lot of buzz about changing the reserve currency to something other than the US$ mostly because of 2

reasons.

First, given that the current US Debt Ceiling is getting close to US $17 trillion, questions are being raised

about the ability of the United States to honour its debt.

Second, and more importantly why should countries

continue to hold their US Dollar reserves if the share of the

United States in global trade is constantly reducing? The

world today is dealing more and more with the European

Union and China. The EU nations contribute 12.2 % of total

international trade followed by the United States (10.6 %)

and China (10.6 %). All estimates suggest that the United

States will soon slip below China in this regard (unless that

may have already happened) - See here.

For a more elaborate statistical data you can visit here. It is indeed interesting that despite these trends,

central banks continue to hold US$ reserves more than any other currency. The biggest reason for this is

that over the years the world has become habitual to the use of US$ and habits are difficult to change.

Human nature is such that it is hard to find people who will break away from a fixed norm, irrespective of

its virtues.

The reality is that even if the world does not necessarily trade with the US, whoever else the world trades

with accepts the US$. So isn’t it an easy thing to do to just hold the US$ as reserves than any other

currency? Fair point, but this will be good only until the world keeps accepting the US$.

Consider this example, what if China which owns approximately 10% of US debt or approx US$ 1.17

trillion, demands this money back. What will the United States do? I think the United States may consider

this – print US$ and give it to China. Sure the US Debt Ceiling will have to be raised further, to print

more money. I am equally sure that this will be done.

Now let’s assume that for some reason the whole world looses faith in the US$. Central banks start selling

their reserve dollars. Where will the buyers come from on such a day? Will the United States buy back its

dollars? In short, what will the United States pay back its debt with if the world refuses to accept the US

Dollar?

© Sana Securities Page 9

Euros? Or may be Gold, as the United States does have the largest gold reserves in the world (8,133.5

tons, according to the World Gold Council). Just for comparison, Germany is a distant second with

3,395.5 tons and the IMF is in third place at 2,814 tons. So, the United States has a lot of gold, but is it

enough to back all the debt which the United States owes to the world? Not even in the least.

I do not think that any such drama will happen. What I am sure will happen though is that central banks

and businesses will start holding different currencies such as the Euro or Yuan and reduce their US$

reserves. The process may be gradual but it will happen and slowly the US Dollar will be replaced as the

reserve currency by something else.

Many things will remain unanswered until future events unfold. For example, how will currency

conversions (i.e. pairing) work in the absence of a single base currency? If we return to the gold standard,

will the prices of gold skyrocket?

If all the printed US$ in circulation is used to buy the available gold in the world then you will have to

price the gold a great deal higher than its current price. So yes, if we go back to the gold standard, then

gold may prove to be a multibagger investment. I think the exact opposite will happen. Read here for my

views on gold as an investment option. I have been maintaining these views for a while now.

© Sana Securities Page 10

Chapter – 4

Currency Trading Basics

Currency markets are the most liquid and deep financial markets in the world. The highest amount of

trading both by volume and value takes place in the currency markets. Unlike equity markets, a unique

feature of the currency markets is that it is a 24 hour market. This is because business hours in various

financial centers around the world overlap which makes it possible to trade currencies at virtually any

time. For example, between the four largest financial exchange centers, i.e., Tokyo, Singapore, London

and New York, one of the four, if not more, is open for business at any given time and any currency (pair)

can be traded in either market.

Currency trading is becoming extremely popular in India. Big financial institution and small traders alike,

trade currencies on various exchange platforms. The depth of these markets is such that the exchange

rates of major currencies are virtually the same in all markets at any given time and there hardly exists an

opportunity to arbitrage (i.e. buy in one market and sell in another with a view to earn a price difference).

I do not want to dwell too much into how currency markets work - for two reasons. First, unless you want

to actively start trading currencies, it will be of no help. Second, the subject is so vast that a write-up on it

could turn into many pages; I am not ready to start that project as yet. Nevertheless, given how economies

are coming close to each other, I think it is important to know currency trading basics.

Why have exchange rates for currencies?

With international trade increasing by the day, it is important for businesses which are engaged in trade

across borders to keep their positions ‘Hedged’. What does this mean?

If exchange rates remain stable, business can be conducted across borders without worrying about the

value of local currencies. However, this is not the case. Currencies around the world constantly appreciate

or depreciate against foreign currencies based on many factors such as local countries imports, exports

(i.e. balance of payments) and other factors which cause accumulation and/or outflow of foreign currency.

For this reason, currency rates serve as a major economic indicator highlighting the health of a nation’s

economy.

Take the Example of an Indian Company ("IndCo") which makes an order to buy 1,000 Kg of American

almond for US$ 550. The consignment is to arrive in a period of 1 month. On the date of placing the order

USD/INR exchange rate was @ 52.50 (Cost = Rs. 28,875/-). Let’s assume that over the period of one

month (before the company makes the payment for the order), the US$ appreciates to 53.50 against the

INR. This will increase the cost by Rs. 550 (to Rs. 29,425/-). To avoid this situation, the IndCo can hedge

its position against an appreciation of the US$[1].

In currency markets, hedging typically works as an insurance where you pay a small premium and in

return you get the right to buy the foreign currency at a given price on a future date. In our example above

the IndCo could hedge its position by buying a right to purchase the US$, at today’s rate of USD/INR @

52.50 in a month from now by paying a small premium [1]. For exporters, who expect to receive US$

© Sana Securities Page 11

denominated payments in future and are worried that the dollar will depreciate over that time, thus

making them earn less, the strategy would be the reverse, i.e., they will pay a premium to sell the dollar

at today’s price on a future date.

Apart from hedgers who have an interest in the underlying business/transaction and undertake currency

trading to avoid foreign exchange volatility risks, currency market participants also include arbitrageurs

and speculators, who do not really have any economic or business exposure but trade currencies with a

view to earn money based on price differential or price swings between different currencies.

Reading Currency Quotes

Each currency has a unique 3 letter symbol known as currency ISO code given by the International

Organization for Standardization. The ISO code for Indian national currency is‘INR’ (Indian Rupees).

Currency pairs are in the form of a six letter symbol, represented by two 3-letter symbols. First 3 letters in

the pair represent the Base Currency and the next three represent theQuote Currency (also called terms

currency).

The currency pair quotes indicate – How much of quote currency will 1 unit of base currency translate

into, or in other words, it shows the amount of quote currency needed to purchase one unit of base

currency.

For Example, the quote of US$ versus the Indian Rupees will be stated as:

This notation indicates that 1 US Dollar is equal to Rs. 55.30. In other words you have to pay Rs. 55.30 to

buy 1 US Dollar.

Majors, Minors and cross-currency calculations

The currency pairs which generate high trading volumes are called the ‘Majors’. Six currency pairs are

generally considered major currency pairs. These are:

Euro vs. US Dollar (EUR/USD)

US Dollar vs. Japanese Yen (USD/JPY)

British pound vs. US Dollar (GBP/USD)

Australian Dollar vs. US Dollar (AUD/USD)

US Dollar vs. Canadian Dollar (USD/CAD)

© Sana Securities Page 12

US Dollar vs. Swiss Franc (USD/CHF)

EUR/USD accounts for almost 28 % of the daily trading volume in the currency markets followed by

USD/JPY which accounts for almost 14%.

All other currency pairs are called ‘Minors’, for example USD/INR (US Dollar vs. Indian Rupee) or a

‘Cross Currency Pair’ such as INR/MXN (Indian Rupee vs. Mexican Peso).

Cross currency pairs

Cross currency rate calculation is necessary when the base currency and the quote currency rate are not

quoted by FOREX dealers or banks. For example, if an Indian company imports tobacco from Mexico

and has to make a payment in Mexican Peso (MXN), the Indian Company will have to undertake two

separate transactions:

Transaction 1 – Sell the base currency

(i.e. INR) for US$

Transaction 2 – Sell US$ for the quote

currency (i.e. MXN)

This is because FOREX dealers or

banks may not provide a direct quote

for INR/MXN. As you can see, the

US$ here acts as the vehicle currency

for the transaction.

In practice, cross currency pairs are

always calculated by using a vehicle

currency. The US Dollar is currently

the main vehicle currency.

So a quote which reads GBP/INR 91 is in reality calculated by first selling the GBP for US Dollar and

then selling the US Dollar for INR. This is the ideal way of calculating the exchange rates because the

GBP/USD market and the USD/INR markets are more widely traded (in comparison to the GBP/INR

market) and have much better information availability which makes it easier for FOREX dealers and

banks to focus their research on the US Dollar. Additionally, this approach helps them in limiting the

number of currencies they hold.

[1] This is done by using currency future contracts. In our example above the USD/INR spot exchange

rate was @ 52.50. If this spot exchange rate remains unchanged after one month, the IndCo will have to

pay Rs. 28,875/- to buy US$ 550 to pay for the almonds. However, as we see in the example, if the

exchange rate changes to USD/INR 53.50, then the IndCo will have to pay more. Naturally, IndCo would

want to keep itself protected from any adverse currency movements.

© Sana Securities Page 13

To do so, IndCo will enter into a futures contract to buy US$ 550 at Rs. 52.50 and lock-in the future cash

outflow in terms of INR. By doing this, no matter what the prevailing spot market price be (after one

month), IndCo’s liability is locked in at INR Rs. 28,875/- and the company is protected against adverse

foreign exchange rate movement.

Note: In reality, this will work as a two transactions, first, where IndCo will pay the seller (of almonds) @

53.50 and second, where it will buy US$ @ 52.50 and sell it in the open market at the spot price of 53.50.

In the first transaction IndCo will suffer a loss of Rs. 1,000 on account of adverse exchange rate

movement and in the second it will profit by Rs. 1,000.

© Sana Securities Page 14

Chapter – 5

Explanation of Basic Economic Terms Used in India

In the United States more than 50% of their population invests in the stock markets (directly or via

ownership of funds). In India, this figure is less than 2.5%. Ironically, India remains the fastest

growing market for financial newspapers in the world. Does that mean that people want to research

and stay updated but not invest?

I am sure that as awareness of stocks and financial products increases, as online accounts and faster

internet connections penetrates deeper into the country and as our capital markets develop further, a lot

more people in India will start investing in equity markets.

Recently, I was invited as a guest speaker at a

college in Delhi where I spoke about the

importance of starting early with investing. I

asked the students to raise their hand if they

regularly read a business newspaper. More

than half the audience raised their hands.

Many of them could not explain RBI’s main

job, what basic economic terms like the GDP

and CRR meant, and how RBI’s rate cut

impacts businesses.

I will tell you exactly what I told them that day:

“This cannot be you. You must get on top of these things”.

Below, I will list out some of the most basic economic terms used in India which will help you

understand and interpret key economic indicators and the impact of monetary policy on the economy.

They will also help you extract a lot more information out of financial news.

The primary tools used by the government along with its agencies, to regulate the financial system can be

classified as (i) Fiscal and (ii) Monetary policy tools.

Fiscal policy refers to the policies framed by the government in order to regulate taxation and for

allocation of budgets to various departments for their functioning. The annual economic survey and

the annual budget list out these policies of the government. From paying the income tax, to our

demand for better roads and infrastructure, everything is affected by the government’s fiscal

policies.

© Sana Securities Page 15

Monetary policy on the other hand is a term used to refer to the actions of our central bank i.e. the

Reserve Bank of India (RBI). Besides printing money, the RBI through the use of monetary policy

tools monitors and influences the movement of a number of macroeconomic indicators including

interest rates, inflation rate, money supply and Gross Domestic Product (GDP) (these indicators are

discussed below).

You may think of the RBI and the government as ‘money printers’ and ‘money managers’, both activities

done with some careful planning. RBI prints new money primarily based on growth in the economy (i.e.

the GDP) while the government manages this money to encourage growth in the economy.

Financial media regularly uses some basic economic terms while reporting a variety of data figures like

stock market returns, GDP, inflation, FII flows, interest rates, industrial production etc. These figures are

closely tracked by investors and analysts in order to predict the future health of the economy and make

investment decisions on that basis. All these data points directly or indirectly indicate the state of the

economy and business environment in the country.

Stock Market Returns: Stock market returns are a leading economic indicator and draw attention to the

state of the economy. The stock market usually begins to decline before the economy declines and begins

to improve before the economy begins to pull out of a recession. Sometime back I wrote a detailed article

on what stock market returns really indicate, where I compared the returns generated by the BSE 30

companies with the broader economy, available here- BSE Sensex 30.

Manufacturing Activity: Manufacturing activity is another leading indicator of the state of the economy.

A rise in the manufacturing activity of materials indicates a rising demand for consumer goods which is a

sign of GDP growth. Further, a rise in manufacturing activity creates employment as more workers are

employed in the manufacturing sector. This new employment results in more wages being paid, all of

which drives consumption. In India, the Index of Industrial Production (IIP) data is released on a monthly

basis which indicates the level of manufacturing activity in the economy.

Foreign Institutional Investors (FIIs): FIIs are foreign entities which are allowed to invest in the Indian

share markets and are a major source of liquidity for the stock markets. When FIIs invest large amounts in

the Indian share markets, it is seen as a seal of approval by sophisticated investors who back themselves

with detailed diligence and study of the future prospects of the economy. For this reason FII buying often

indicates a positive economic outlook and vice-versa.

View: The above view on FIIs may well be the one widely accepted. In my experience, FII buying and

selling indicates nothing about long term prospects. FII’s are just as likely as any other category of

investors to indulge in irrational buying and selling. Given the academic nature of this article, I

nevertheless included this as an indicator.

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Foreign Direct Investment (FDI): FDI which is a direct investment into the country from an entity in

another country, either by setting up a new company or by way of a merger, acquisition etc., indicates the

positive sentiment of overseas investors on the future business environment of the country.

© Sana Securities Page 17

Chapter – 6

BSE Sensex 30 vs. Economy - Wealth effect?

Over the last 10-15 years, Indian stock markets have seen about 3-4 crashes and an equal number of

booms. If one were to analyze the boom and bust cycles of the stock market, it would appear that the

economy really did not suffer as badly as the stocks, nor did it outperform the markets. What then is the

relation between the real economy and the stock markets?

It is believed that the stock “markets are always ahead” of the real economy and can indicate beforehand

the state of the economy i.e. they decline before the economy as a whole declines and improve before the

general economy begins to recover. The reason for this belief may well be the fact that the sharpest minds

(for good or bad) work in the financial markets as opposed to the real economy. They are constantly

predicting the future of the stock markets and are able to spot its movement before the real economy

latches on. The other theory which supports stock market’s predictive ability is the “wealth effect” which

argues that fluctuations in stock prices have a direct effect on aggregate spending. When the stock market

is rising, investors are wealthier and may spend more. As a result, economy expands. On the other hand,

if stock prices are declining, investors are less wealthy and spend less. This results in slower economic

growth. On that logic, the real economy always trails the stock market. Sounds logical, but any empirical

evidence to prove this point? So does the stock market always look ahead, anticipating future events?

On 19th March, 2013, the Dow Jones surged to its highest closing level ever. The Dow closed at 14,254,

passing its previous high of 14,164.52 made in October 2007. Where is the so called real economy in the

United States? Far from recovery I would say. Declining corporate profits, federal spending cuts and a

state of high unemployment are all driving down consumption in the U.S. If you believe in the “markets

are always ahead” theory, then could this be an early signal from equities that the U.S. economy is

coming out of a recession?

Analysts closely follow the many economic indicators which influence (or are supposed to influence) how

stock markets perform and as empirical evidence suggests, these indicators certainly have an impact on

equity prices. Whether this impact is justified or not is also influenced. In reality, forecasting stock price

movements is often done on the basis of economic indicators which are themselves being forecasted

ahead of time.

To explain by an example as to how these indicators have an impact - let’s say RBI increases interest

rates because of rising inflation. This increases the borrowing cost of companies which will add to their

cost of production and bring down their profits. This will naturally have a negative effect on the share

prices of those companies. So RBI’s action of increasing the interest rates creates a negative sentiment

which leads to selling.

This article was originally published on our Blog in January 2013.

© Sana Securities Page 18

We tried to compare a key economic indicator – the GDP figure with the BSE Sensex 30 level for the last

7 years, to include the period preceding the 2008 crash and then what followed since then up until now.

One very evident trend which is hard to miss is the current gap between the GDP and the BSE Sensex

30 level. Does it indicate that our economy should start improving? Given that this gap has been ever

increasing (at least in the last 5-6 quarters) it’s hard to believe this. On the contrary, while there is

dissatisfaction amongst the investors about the poor performance of the equity markets, this chart would

show the exact opposite i.e. the markets are overvalued and in a state of unnecessary exuberance. There is

hardly a sign of improvement in the economy. In fact if you look at the historical data, it seems that our

markets are so far ahead of the real economy that one should not be surprised if there is a big correction

from this point. And this is based purely on the GDP. Add to it, high inflation, political uncertainty and

low consumption, you will find little reason to explain this gap.

Indeed, if you believe that “markets are always ahead” of the real economy then could this be an early

signal from equities that the economy is coming out of a recession?

© Sana Securities Page 19

Chapter – 7

Economic Cycle and Stock Investing

I recently read something interesting in William O’Neil’s book titled “How to Make Money in Stocks”.

Based on his research he concluded that three out of every four stocks follow the trend prevailing in the

sector to which they belong. Put in context this would mean that if the automobile sector as a whole is not

performing well, i.e. the ‘stock price performance’ of Tata Motors, M&M and Maruti Suzuki has been

below par, then it is unlikely that Ashok Leyland will do well no matter how good the business prospects

and fundamentals of Ashok Leyland.

While explaining the concept of Economic Cycle, Investopedia states, “During times of expansion,

investors seek to purchase companies in technology, capital goods and basic energy. During times of

contraction, investors will look to purchase companies such as utilities, financials and healthcare”. I may

safely add FMCG companies to that list for an emerging economy like India, with rising disposable

incomes and with the average age of its population being 27.

ECONOMIC CYCLES - DIFFERENT INDUSTRIES REACT DIFFERENTLY TO THEM

Some industries are very vulnerable to economic cycles while others are somewhat unaffected by them.

For example, FMCG and pharmaceutical stocks are considered defensive bets in times of economic

slowdowns as it is believed that demand for these products does not substantially reduce in times of

economic slowdowns. Industries which experience only modest gains during expansionary periods may

also suffer only mildly during contractions (example – agro-products) and those that recover fastest from

recessions may also feel the impact of a downturn earlier and more strongly than other industries

(example – Banking).

© Sana Securities Page 20

Stock Investing and Sector Rotation

So should you be constantly looking at investing in stocks which belong to “Flavor of the month”

industry sectors? Sure, why not, but 2 problems. First, how do you know the current economic cycle? Ask

yourself – are we in a recession or are we recovering? Or, are we yet to fall into a recession? No one

believes that we are in an upswing of any sorts (in June 2013). Second, while it is true that different

sectors of the economy outperform (and/or underperform) the broader markets as the economy itself

moves from one cycle to the other, the performance of sectors is not uniform in every economic cycle. So

the sectors which outperformed in the last upswing may not necessarily outperform this time around.

Nevertheless, the methodology and steps listed below will help you uncover with great certainty, both,

sectors which are likely to outperform and those which will underperform (which to my mind are a lot

more important to identify), the broader markets in a given economic cycle.

Note: The chart at the end expresses only a personal opinion on companies and sectors listed therein. It is

meant for the limited purpose of explanation of the contents of this article. Nothing should be considered

as a representation that investment in any given sector or company is suitable or appropriate at any given

time or to your individual circumstances, or otherwise constitutes a personal recommendation to you.

Steps in industry analysis:

1. Read the available industry reports and statistics available on web.

2. It is important to look at the different market segments in a particular industry. For example, if you

look at chemical industry, you need to understand the sub-industries like fertilizers, paints etc.

3. Look at the demand-supply scenario for a particular product/ industry by studying the past trends

and forecasting future outlook.

4. Study the competitive scenario: There is a framework of industry analysis, called “Porter’s five

forces” model. In this model, five parameters are analyzed to see the competitive landscape. They are:

♦ Barriers to entry

♦ Bargaining power of supplier

♦ Threat of substitutes

♦ Bargaining power of buyer

♦ Degree of rivalry among the existing competitors

5. Find and study the recent developments, innovation in the industry.

6. Look at the industry valuations (P/E)

7. In Industry analysis, it is important to focus and understand the industry life cycle.

Industry Life Cycle is an important parameter in determining the profitability of companies in a given

industry. In other words, no matter how good one is at finding great businesses with improving

fundamentals, if its industry group is out of favor, the stock will most likely to go down anyway.

© Sana Securities Page 21

The different stages of the industry life cycle:

Introduction stage: In this stage, the industry is in its infancy. This phase include the development of a

new product, from the time it is initially conceptualized to the point it is introduced in the market. The

firm having an innovative idea will have a period of monopoly, until competitors start to copy and / or

improve on the product. For investors, during the introduction stage there is significant risk as the

companies will require huge amount of cash to promote their products. The other risks at this stage are:

technical problems in manufacture, packaging, storage, etc., insufficient production capacity, obstacles in

distribution, customer reluctance to new products.

Growth stage: If the new product becomes successful, sales will start to grow and the product may begin

to be exported to other markets and substantial efforts will be made to improve its distribution. During

this phase new competitors will enter the market, slowly eroding the market share of the innovating firm.

Competition will mainly be on the basis of product innovations and price. In the growth stage, companies

require a significant cash outlay towards more focused marketing efforts and expansion. It is during this

phase that companies may start to benefit from economies of scale in production. This stage of industry

growth, while still presenting risk to investors, demonstrates the capability of the industry.

Maturity Stage: At this stage, the product become standardized and widely available in the market and

distribution is also well established. Competition increasingly takes place over cost and production

increases in low cost locations. This is the stage where the industry will start to see slowed growth in the

sales. Late entrants come in this stage seeking to capture market share through lower-cost offerings, thus

requiring the existing companies to continue their marketing efforts. For investors, maturity of an industry

can mean relatively stable stock investments with the possibility of income through dividends.

Decline stage: As the product begins to become obsolete, production and distribution of the product also

decline. Eventually, the product will be outdated, an event that marks the end of its life cycle. A decline is

inevitable in any industry as technological innovations and changing consumer tastes adversely affect

sales. At this stage, some companies may exit the industry or merge and consolidate. An investor should

approach stocks in declining industries with caution.

© Sana Securities Page 22

© Sana Securities Page 23

Chapter – 8

Sector Rotation in Stock Market

A few days back someone, allegedly from one of the most reputed financial newspaper called me for my

views on cement stocks. It was a cold call but at least inspiring that I had reached a point where my views

were sought by the media.

His question was simple – Going forward, what is your outlook on cement sector?

Basically, I had to tell him whether cement shares as a whole will go up or down in the next few hours,

weeks or months. In such situations it often becomes difficult to not commit. I tried my best and came up

with an answer.

Yes the Government is likely to build roads, bridges and buildings; it’s not going to happen overnight. To

the extent, an expectation of all that happening was to drive share prices higher, that already happened

when the results of the general elections were announced. I mean, did anyone doubt that a strong

government with an emphasis on infrastructure and highways will be good for cement companies? I think

cement stocks have run up beyond what they should have, purely on sentiment. It will take a few

quarters for earnings to improve and get reflected in financials.

Sector Rotation – chasing shadows

I don’t think that the enquirer was happy with my views. I know this because he did not publish my views

anywhere. 1 month later cement stocks, across the board are 5-10% down. Though I must admit that on

the day of his call and for a bit after that, they did briefly rally 5-10%.

This is the only truth here – Cement had suddenly become ‘Flavor of the Month’. Everyone in finance

media, from TV to newspapers, to magazines and portfolio managers started talking about cement stocks.

For the most enthusiastic investors, who take heavy doses of finance news, cement almost became a state

of mind.

I realized something interesting.

In the short term, well placed media people are likely to do far better, as portfolio managers. I realized

another thing – When you get a call like that, ask a counter question – “Really, cement? Is that what

you are all talking about?”

In the short term, this is likely to succeed, but how frequently if at all should you indulge in sector

rotation?

© Sana Securities Page 24

8 out of 10 times, sector rotation or buying shares of companies in a particular sector(and abandoning

others) will result in short term losses. The reason is simple, it’s like chasing a shadow, news-makers and

their distributors will always be a step ahead of you. If you can anticipate the news before news-makers

and can position yourself in the sector before them, you will make money. If not, don’t even try.

Enterprising businessmen along with media could really influence your vote and decisions. Has this not

happened before?

The greater fool’s theory

The game is simple, as it has been for centuries. Position yourself by buying into certain stocks. Then,

market those stocks. When others start buying, quietly exit and start positioning yourself in yet another

out-of-craze sector. Then – Repeat! These days, this happens at a well managed institutional level.

So really, sector rotation works only for those who rotate well before others hear about it. The rest are just

chasing shadows.

Can you make money from Sector Rotation?

Sure you can. But you must do one of the 2 things correctly for that:

I. Be first – do it before you hear about it.

II. Set the tone – Be the one who sets the tone for the market.

Now, if you cannot do the 2nd

, there are 3 further rules to be correct with the first rule:

1. Do the Opposite – Instead of buying, try to sell stocks /sectors which are being talked about the

most.

2. Anticipate future events well in advance – Sometime in March 2014, we concluded that BJP

Government was most likely to win a majority on the 16th of May. We zeroed in on 3 sectors

which were likely to benefit the most – Infrastructure, power & defense.

We did a bottom down study of companies in these sectors ignoring power companies (for the time

being) for the reason that no matter what the Government did, it will take a long time for things to

improve for shareholders of these companies, given the amount of debt on their books. On the 25th of

March, we came out with our monthly recommendation of Bharat Electronics Limited (for reasons

mentioned in the report here). The stock doubled within 2 months from then.

© Sana Securities Page 25

____________________________________

I remain very bullish on the power sector, despite the high levels of debt and despite the long gestation

periods and delays. Again, you must be very careful before getting stock specific and must have some

time horizon in mind.

To go back to the point A above, ideally, you should

have sold it by end of June when literally every fund

house and every media channel started talking about

the defense theme.

The important takeaway and what you should think

about at any point of time – What sector will be the

flavor of month in 2-3 months from now?

Right time for sector rotation

There is absolutely no fixed science around this. For

sure, popular media is not the right place to get ideas in

this regard. Anticipation of future should be

differentiated with speculation about future. The

former is based on some level of study and research.

Couple this with the fact that your starting point should

be beaten down sectors or industries.

Based on prices as on 1st April 2014

Infrastructure

Company 6 year 3 year

Lanco Infra -86.70% -60.33%

Jaypee Infra -77.27% -58.79%

BGR Energy -76.54% -60.50%

GMR Infra -63.93% -27.10%

IRB Infra -60.17% -44.27%

Power Company 6 year 3 year

Suzlon Energy -84.42% -55.22%

Jaypee Power -79.64% -65.34%

Reliance Power -53.90% -40.03%

NTPC -41.38% -25.11%

NHPC -35.81% -1.02%

Real Estate Company 6 year 3 year

Orbit Corporation -87.48% -67.05%

Unitech -81.95% -52.94%

HDIL -80.59% -34.17%

Indiabulls Real Estate -62.88% -11.60%

DLF -43.74% -13.13%

© Sana Securities Page 26

Chapter – 9

Future Prospects of Indian Economy

India’s population today is 1.237 billion and growing at 1.3%

every year. This makes India the second most populated

country in the world with China leading the charts with a

population of 1.35 billion. According to the most recent

census survey, India occupies 17 % of the world’s population

and 65 % of these people are below the age of 35.

For years, such large population weighed heavily on the

country’s available resources. Over the years, a lot of emphasis

was placed on skill development and basic education. Today, a

large part of those, who are below the age of 35 are educated

and skilled.

Over the next 4-5 decades, India’s young population will transform the country’s overall demographics

further. A majority or people between the ages of 10-19 are all getting access to basic education. I should

also add the fact that English is widely spoken and understood unlike in some other countries, which

gives an edge particularly to the service sector of India.

In fact, a major push to India’s growth came from the business processes that were outsourced to India

mainly between 1996 -2005. Shashi Tharoor, India’s minister of state for human resources said sometime

back, “If we get it right, India becomes the workhorse of the world”.

With the kind of emphasis India is putting on skill development and higher education, over the next few

decades, India could become to service sector, what china is for manufacturing. What started essentially

as a cost effective software outsourcing industry has today transformed into a full time back office

function for a large number of western businesses. Many of these businesses are continuously working on

training their local staff and have made long term investment plans in the country which is a very positive

sign for the future prospects of Indian economy.

It is expected that by the year 2025, up to 70% of Indian population will be moderately skilled and will of

working age. Given the differential in wage differential, the country will keep attracting more service

oriented work.

For businesses which are looking at an inbound investment into India, a ‘young’ economy with growing

disposable incomes and greater exposure to western lifestyles is a fascinating prospect.

© Sana Securities Page 27

More jobs in future will result in higher wages which will further boost the domestic consumption in the

country. As more and more people in India climb the social ladder, their demands and aspirations for

better facilities will boost spending in most sectors like housing, automobiles, consumer goods,

electronics etc.

By many measures, the domestic story in India is fast replacing the initial boom that was created by the

influx of foreign capital. In fact, it was due to the higher dependence on internal consumption that India

was less impacted by the global financial crisis of 2008 -09 (70% of GDP is contributed by personal +

Government consumption).

As an investor, if you are positive on the future prospects of Indian economy, then consumption oriented

sectors like FMCG, pharmaceutical, consumer durables etc., will still prove to be one of the best place to

invest your money for the long term, despite their current high valuation.

Housing 14%

Food 23%

Entertainment 4%

Education 8%

Auto 5%

Healthcare 6%

Household personal care

6%

Moblie Phones 2%

Miscellaneous 17%

Savings 15%

Monthly spending by category (%)

© Sana Securities Page 28

Chapter – 10

Instruments of Monetary Policy in India

Gross Domestic Product (GDP): National output or GDP is the most important concept of

macroeconomics. When GDP increases, it is a sign that the economy is getting stronger. While a

reduction in the GDP indicates a state of weakening economy. How is GDP really calculated?

One of the most reliable methods to measure the GDP is the expenditure approach which totals up the

following elements to calculate the GDP:

GDP = C + G + I + NX, where:

“C” = total private consumption in the country

“G” = total government spending

“I” = total investment made by the country’s businesses

“NX” = net exports (calculated as total exports minus total imports)

In short, the GDP is the state of the economy in a snapshot. The year on year GDP growth rate is closely

monitored by investors and white it only indicates what has already happened in a previous time period,

every time the GDP data gets published, analysts alter their stance on the future prospects of Indian

economy.

Why?

One reason is because a lot of buying and selling in the stock market happens based on forecasting of the

future (everybody wants to be the first to buy or sell).

© Sana Securities Page 29

Those involved with Indian stock market analysis regularly forecast the GDP figure in advance. Of

course, the actual GDP figure could (and almost always) vary. A below forecast GDP figure indicates that

the economy did not grow as per analyst expectations. On the other hand, a higher than expected GDP

figure would tend to indicate that the economy has strengthened more than analyst expectation.

Inflation: Wholesale Price Index (WPI) measures the price of a representative basket of wholesale goods

including food articles, LPG, petrol, cement, metals, and a variety of other goods. Inflation is determined

by measuring in percentage terms, the total increase in the cost of the total basket of goods over a period

of time. For a list of what is included in the WPI basket you can view this sample report.

Most instruments of monetary policy in India (which are discussed below) are used by the RBI to keep

inflation under check.

Interest Rate: Interest rates act as a vital tool of monetary policy when dealing with variables like

investment, inflation, and unemployment. The Central Bank (RBI) reduces interest rates when it wants to

increase investment and consumption in the economy. Reduced interest rates make it easier for people to

borrow in order to buy goods and services such as cars, homes and other consumer goods. At the same

time, lower interest rates can lead to inflation. When the Central Bank wants to control inflation, it

increases the rate of lending. Banks and other lenders are then required to pay a higher interest rate to the

Central Bank in order to obtain money. They pass this on to their customers by charging a higher rate of

interest for lending money. This reduces the availability of money in the economy and helps in

controlling inflation.

We update the GDP, Inflation and Interest Rate data as it is released: Click here

There are a number of other indicators which are closely monitored by analysts such as income and

wealth data, unemployment rate, annual economic survey etc.

The RBI has numerous instruments of monetary policy at its disposal in order to regulate the

availability, cost and use of money and credit. Using these monetary policy instruments, the RBI must

walk a tightrope between trying to stimulate growth while keeping inflation under control.

Instruments of Monetary Policy used by the RBI

Direct regulation:

Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of their

deposits in the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have

to keep with the RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the

economy or to release additional funds needed for the growth of the economy.

For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have

to keep a lesser proportion of their total deposits with the RBI making more money available for business.

Similarly, if RBI decides to increase the CRR, the amount available with the banks goes down.

© Sana Securities Page 30

Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in

the form of gold or government approved securities before providing credit to the customers. SLR is

stated in terms of a percentage of total deposits available with a commercial bank and is determined and

maintained by the RBI in order to control the expansion of bank credit. For example, currently,

commercial banks have to keep gold or government approved securities of a value equal to 23% of their

total deposits.

Indirect regulation:

Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate.

Whenever commercial banks have any shortage of funds they can borrow from the RBI, against

securities. If the RBI increases the Repo Rate, it makes borrowing expensive for commercial banks and

vice versa. As a tool to control inflation, RBI increases the Repo Rate, making it more expensive for the

banks to borrow from the RBI with a view to restrict the availability of money. The RBI will do the exact

opposite in a deflationary environment when it wants to encourage growth.

Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called

reverse repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer

lucrative interest rate to commercial banks to park their money with the RBI. This results in a reduction in

the amount of money available for the bank’s customers as banks prefer to park their money with the RBI

as it involves higher safety. This naturally leads to a higher rate of interest which the banks will demand

from their customers for lending money to them.

The RBI issues annual and quarterly policy review statements to control the availability and the supply of

money in the economy. The Repo Rate has traditionally been the key instrument of monetary policy used

by the RBI to fight inflation and to stimulate growth.

© Sana Securities Page 31

Chapter – 11

Sensex Target for 2020: Are 40,000 – 60,000 levels

achievable?

A lot of research goes into predicting future prices and Sensex targets. Analysis of past data for such

predictions suggests that analysts are far more accurate over a longer term. Shorter your time frames,

higher are the chances of error. Yet, analysts and market commentators regularly throw out targets for

anywhere between a few years to a few months, end of week targets and end of day targets.

A lot of these projections may well be the result of commercial realities. Brokers and fund managers must

constantly keep their audience engaged. That said, if you are correct with your end of day projections 6

out of 10 times, it makes perfect sense to do it.

While such targets (with their 6 out of 10 winning odds) will work well for traders who follow and trade

the markets on a daily basis, for those who wish to invest systematically over a period of time, a little

more certainty is both, desirable and advisable.

Below, I will share some of my observations and make the most bullish case for Indian equities over the

next 5-7 year timeline. While this may sound a little exaggerated today, I think the projections are fairly

modest.

Note – All calculations were made on the 5th

March 2014 (yearly compounding used).

Since its inception in 1979, the Sensex has grown at an annual rate of 16.55%. Over the last 10 years, the

growth has been at an annual rate of 13.71%. I will not get into any great detail about how the last 10

years have played out. In short, Over the last 10-15 years, Indian stock markets have seen about 3-4

crashes and an equal number of booms, this included a massive bull run (between 2003-2008) followed

by an epic crash (in 2008 -09).

Since I am talking of a 6 year projection (i.e. 2014 – 2020), let’s also look at how much the Sensex has

grown in six year periods going back from today:

© Sana Securities Page 32

What’s the point?

We all probably know this – It’s all Cyclical.

1. Historic Trends

Quiet apart from looking at corporate earnings and macro factors, which I do get into looking at below,

the simple observation above suggests something which I am sure most of us are well aware. Markets

move in cycles. The fact that they have given no returns whatsoever over the last 6 years should if at all

be looked at as a positive sign. Why many investors do not act on this principle is something that has

eluded the smartest fund managers since the beginning of markets.

Stocks and markets regularly rise above and dip below the average PE multiples and usually continue

such trend until faced with a big event. I tried to test this with some more historical numbers.

Click here to read about Index PE Ratios.

© Sana Securities Page 33

About the Chart

The current Price Earnings [PE] multiple for the BSE Sensex = 17.6 (as of today, i.e. 5 March

2014).

It is generally accepted that the Sensex is oversold when Sensex wide PE value is below 13.5 and is

overbought when it rises above 22.5.

The average PE ratio of the Sensex over the last 10 years has been ~ 19.35.

Note: The average PE ratio for the last 20 years is 21.28 but a bit of that is because of the big Bull Run in

the wild Harshad Mehta days which resulted in a massive correction which lasted until 1995-96. During

that time the Sensex wide PE reached as high as 45. I have discounted that in this analysis.

In which direction will the Sensex move over the next 6-10 years?

Nobody can predict when exactly the next hyper bull kind of run-up starts. To that extent I believe that

month end / year end targets are at best an educated speculation. That said, if you have a 5+ year view on

the markets, it would only be logical to allocate money to high quality stocks right now.

Think about it – January 2008 – Sensex @ 21,000. January 2014 – Sensex @ 21,000. What is your

Sensex target for 2020?

21,000? Higher/ lower? Surely, it would depend on growth in corporate earnings which again depend on

a host of other factors.

2. Current Trend in Corporate Earnings

When earnings grow, so do stock prices.

Every time we near the end of a quarter or the financial year, a team of analysts burn a lot of office hours

to up with a projection for corporate earnings. In the last few years, while corporate earnings have been

growing at a moderate rate, the Indian economy has been struggling with high inflation. As a result, the

earnings growth looks even more insignificant.

High inflation, lower consumption particularly in developed economies, lack of policy action on the

domestic front coupled with a twin current and fiscal account deficit and a series of corruption scandals

have all played a part in the stagnant-growth story of India.

Despite that, corporate earnings have been growing (albeit moderately). This surely does not get reflected

in stock prices. This is yet another reason why I am extremely bullish on the Indian stock markets. In fact,

at current levels, I am more positive on Indian stock markets than I am on the Indian economy (not to say

that I am negative on the Indian economy – my views here).

© Sana Securities Page 34

However, for things to change significantly there has to be political certainty and a strong government –

the kind that will not only be able to push reforms and legislation but one that will take the corporate

sector along in policy making. In addition, a marked revival in global economic scenario is also

significant. On the latter, while for now the world looks like a less risky place with some signs of growth

in both the EU and the United States, the rising U.S. debt is sooner or later likely to create another global

mess. While this could take a few years, it is an ever escalating risk which may eventually lead to the

debasement of the U.S. Dollar.

In the more near term however (5-7 years), even marginal improvement in corporate earnings, coupled

with some measure of control on inflation and a strong government will all prove to be a shot in the arm

for stock prices.

Over the last 10 years, corporate earnings for Sensex companies grew @ CAGR of 12.1%.

Sensex Target for 2020

“Moderate growth“– Corporate earnings for Sensex companies keep growing at a CAGR of 12.1% p.a.

over the next 6 years, and the Sensex grows at a rate similar to the rate of growth of Sensex companies

(i.e. 12.1% annually) then by 2020 it reaches – 42,540 points (yearly compounding used).

A more “rational growth view” (based on cyclical nature of markets) -

Corporate earnings for Sensex companies grow at a CAGR of 17% p.a. over the next 6 years, and the

Sensex grows at a slightly higher rate of 19% during this time, then by 2020 it reaches –

54,286 points (yearly compounding used).

© Sana Securities Page 35

Whether you take a growth target in between the above two or you take a moreaggressive view betting on

the strong prospects for the Indian economy, it is unlikely that the Sensex will settle anywhere below the

50,000 point mark by 2020.

I will leave you with a thought I get every time a brave analyst comes out and tries to justify his

projections:

“Saying results missed estimates is like blaming reality for your own imprudence.”

© Sana Securities Page 36

Chapter – 12

Hope, Government and the Next Bull Market Rally

A man can live three weeks without food, three days without water, and three minutes without air, but

he cannot live three seconds without hope

- Lewis Mumford.

3 months ago on the 08 March 2014 one share of Unitech cost Rs. 12.10. Today it is trading at Rs. 36.40 a

share. What changed so drastically so as to increase the market cap of a company from Rs. 3,165.72 Cr. to

Rs. 9,510.25 Cr. in 3 months?

We conducted a poll last week and these were some of the widely specified reasons:

1. We now have a stable and strong government.

2. The PM is pro business and has a track record of delivering on development.

3. Markets are cyclical, they have been down for 6 years, they will turn a corner now.

4. There is improvement in global economy; and the most promising answer-

5. Indian markets have been grossly undervalued. The election result just proved to be a trigger for

stock prices matching their true worth.

I agree with all of the above. Particularly no. 5. Stock prices really were, and in most cases still are,

grossly undervalued.

The biggest truth about stock markets

Stock markets move in cycles continuously undercutting and overshooting the real worth of the

underlying security.

Click here to read about my views about the economic outlook for 2014, as they were in August 2013.

The stock markets have since then risen by over 50%. Yes, the broader markets are 50% up in less than a

year. The point I am trying to make was most eloquently expressed in the Security Analysis by Graham

and Dodd:

© Sana Securities Page 37

General Electric Common Stock Price

Year 1937 1938 1939

Price 647/8

271/4

31

Referring to the above quoted prices, the authors noted -

General Electric sold at 647/8

because the public was in an optimistic frame of mind and at 271/4

because

the same people were pessimistic. To speak of these prices as representing “investment values” or the

“appraisal of investors” is to do violence either to the English language or to common sense, or both.

Is a 50% Appreciation in stock prices justified?

Economic and political outlook play a crucial role in driving market sentiment. While globally things

improved over the last 8-12 months, stock prices in India remained largely dormant mainly on account of

government inaction.

On a lighter note, for most of last year, I believed no matter what the next formation looks like or what

they do, they will find it hard to beat the previous government in terms of absurdity. Coming from that

and then getting the most stable Government in 30 years, the celebration is not without a reason.

Is this the beginning of the next bull market rally?

While I agree that things can only improve from here on, the appreciation of stock prices over the last few

weeks has less to do with a change in fundamentals of the stock and more or almost entirely to do with

the hope of a revival in the economy.

Hope is a good thing. It makes people do amazing things. It defies both rationality and logic, but let’s be a

little more realistic. How quickly can the Government turn things around? Surely, it will take a few

quarters for things to improve? Reforms will have to start again, policies will need to be pushed,

businesses will need to start expanding (and hopefully – increasing), and if potential for higher capital

return can be demonstrated, direct investments will start flowing back into the country. The way stock

markets are reacting, it seems that they have already acquiesced to the happening of all this and more.

Rationality of stock prices has little to do with things right now. The start of the next bull market rally

seems to be built on a sense of hope. Hope is enough and is proving to be the biggest driver of stock

prices*.

What can the Government do to sustain this bull market rally?

Stop Importing, start exporting – I hope we can find crude reserves buried in some part of our

country but there is little doubt that pinning hopes to the happening of such a thing will be as

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pointless as trying to hunt for gold (have we seen that before?). Unless we cut imports, there is

hardly a point in competing with China who literally exports everything but oil to our country.

Control Inflation – Besides hurting the pockets of the common man the ‘big’ problem with

inflation is that it makes businesses and hence the economy of a country less competitive. If input

costs are high so is the price of the final product. When fertilizers and seeds are cheap, we can beat

Thailand and other countries in the southeast region in exporting rice; when steel and other metal

prices go down, our automobile industry will become competitive.

Bring in more Corporates to do government work – This may be difficult as every time a

company is awarded a contract, eyebrows are raised. The truth is that when delivery and execution

is tied to personal profit, highways come about, airports are made and townships flourish.

Encourage entrepreneurship – Transform people from job seekers to job providers. I remember

when I started out and needed a current account for my business, the bank asked me to furnish a

proof of business. When I furnished an electricity bill, it dint bear the trade name of the business

and when my first client paid me, he was concerned why he couldn’t cut a check in my firms name.

A lot of what I had to do in the early days seemed like authorities encouraging irregular work. If the

next Facebook must come from India then this has to end.

Be less absurd / Promote transparency – while the government should maintain secrecy in its

dealings, it must put in charge those who answer on behalf of the government.

Things will take time but I am positive. As for markets, there is plenty of value out there and whether this

is the beginning of the next bull market rally or not, the future looks good. Just buy the right things and

you will do very well for yourself.