Bulls And Greater Fools

For the past six months, Infosys Technologies has traded at prices that its founder-ceo N.R. Narayanamurthy describes as unjustified. Infy, to call it by its nasdaq call-sign, is indisputably a great company with a consistent earnings growth rate of 100 per cent-plus. But it has often traded at price-earnings (PE) ratios of over 300 and, across the Atlantic, it usually trades at premiums to its rupee price.

Wipro is another great IT company. But it trades at a PE of 439 and has sometimes hit PEs of 800-plus. Owner-ceo Azim Premji has often professed puzzlement at Wipro’s prices and watched bemusedly as his notional personal fortune outstripped that of the Sultan of Brunei and jumped to within shouting distance of Bill Gates.

Irrational stockmarket behaviour? Certainly. But the irrationality in India follows logically from even greater irrationality across the Kala Paani. By the singular standards of nasdaq, both Infy and Wipro may be good value at current prices! nasdaq technology stocks often trade at infinite PEs. Loss-making Amazon.com is valued at $25 billion, for instance. Market leader Microsoft used to trade at PEs of 400-plus until Judge Penfield delivered his verdict. The tech sector on nasdaq has an average PE of 300-plus, if one ignores the many loss-makers.

As far as most foreign portfolio investors are concerned, Indian IT is a cheap play on American growth. The bulk of India’s $4-billion IT export earnings, perhaps as much as 85 per cent, comes from the US. Ergo, Indian IT stocks can actually be considered American IT companies in disguise. They have better growth records and higher profitability margins than their US cousins. They’re also lower priced at an average PE of 200 on the nse. Investment here makes perfect sense.

If you accept the validity of the fundamental link to the US economy, the correlation between nasdaq price fluctuations and Indian ice stock prices is also perfectly logical. If nasdaq revalues its tech sector, Indian ice must also be revalued. Since the US markets lag India by 11.30-12.30 hours, it is also a very useful trading thumb rule to follow yesterday’s Nasdaq prices. Small wonder then that Indian ice prices have a 0.9 correlation with the lagged nasdaq.

The only sticking point in this whole logical exercise is that nasdaq valuations are made of green moon-cheese. The best companies like Yahoo! will have to maintain 150 per cent growth rates for a decade to justify their current valuations. The second-rankers are hopelessly overpriced. No company can maintain such a pace. It is like asking a 9.8 sec/100 metre sprinter to scorch the track through a 40 km marathon.

Quite apart from the likely invalidity of such high PE ratios, the price discovery mechanism on nasdaq is nowhere near perfect. In fact, the nasdaq is a far less efficient stock exchange than either the nse or the bse. The imperfections start with the ipo process.

The basic criteria for nasdaq listing is only $4 million in company assets. ipos are made via a book-building exercise releasing small chunks of equity. The allotment is totally discretionary. Under Indian laws this would be a scam. This discriminatory allotment policy creates an artificial scarcity. Almost every nasdaq ipo lists at a big profit to the "lucky allotees". Within a year, however, 89 per cent of nasdaq stocks trade below issue-price. With small floats, very small volumes can swing prices enormously. There are no circuit filters cutting off swings. Naturally, volatility is very high on the nasdaq. A stock can move 15 per cent on a 1,000-share trade.

The US economy has also undergone its longest expansion ever (1991-2000) and gdp growth has come almost entirely from IT-induced productivity gains. American investors have forgotten what a bear market smells like and come to expect 20 per cent plus annual returns. Especially in the ice sector. The feedback loop, created by this long bullrun and the expectation of its indefinite continuation, has created the nasdaq bubble. Even after the recent corrections, the nasdaq trades around 20 per cent higher than 12 months ago.

All good things must come to an end sometime. When the nasdaq bubble bursts, Indian ice prices will also swing south. In fact, a nasdaq decline could impact the global economy. America runs record trade deficits that keep the global economy humming. Americans have negative savings rates - consumption is driven by capital gains that compensate for higher spending. If the capital gains disappear, so will the consumption, shaving 200 basis points off world gdp, says an Economist estimate.

The basic irrationality of nasdaq prices has also caused a chain of further irrationalities in Indian stock valuations. The fmcg sector trades at a PE of 49 with average profit growths of 23 per cent. Heavy/medium vehicle manufacturers like Ashok Leyland and Eicher are available at PE ratios of 41 with earnings growth rates of 82 per cent. The pharmaceuticals industry logs an average earnings growth of 21 per cent and gets a PE discount of only 30.

What sins have these industries committed that, in comparison with IT, they all appear to be massively undervalued? In fact, the entire Indian market seems to be undervalued at an average PE of 20 and earnings growth of 10. To understand this paradox, one has to refer to the Greater Fool Theory of investing. The gft suggests that any investment at any price is okay, if only you can find a greater fool to take it off your hands at a higher price. In the case of ice, investors in India are confident about the existence of the Greater Fool. He is paying daily premiums for similar and less impressive ice stocks on the nasdaq. In other sectors, the GF is not in such obvious evidence and he is inherently more cautious about the value for money equation.