How the Balance sheets of corporates are affected:
1) Take banks and financial institutions.
Calculating their impact is simple. They pay the depositors a particular interest rate and buy treasury bonds, or distribute it as loans. Many of the fixed deposit, bonds have fixed rates which need to be honored irrespective of the present conditions. So a fall in the interest rates causes higher profits and vice versa.
2) Leveraged industries
These are companies which have taken huge loans for their new plant, expansions etc. Any rise/fall in the interest rates has huge impacts in the interest outgo, hence the profitability.
3) Fall in the sales
The real estate is rising because the interest rates are low and it if often cheeper to pay an EMI then to pay a rent. A rise in interest rates greatly effects the spending of consumers and corporates, less houses, machinary and cars will be bought leading to a slowdown in the production and revenues of the corporates and hence lower profits.
Common sense says, most IT companies, and established Business houses have little or no debt, so their valuations should not be impacted much. But no:
1) Growth oriented companies:
They are traded at very high PE ratios, because their revenues are expected to increase by 30-40% each year and this expectation of future earnings beef up their stock prices.
100 rupees 5.5% interest grows by 1.7 over 10 years but will grow to 1.8 if interest rates is increased to 6%. So any change in interest rate changes the present value of the future earnings and hence changes the stock price.
2) Stable companies:
Their impact is also almost the same. If bond market gives 5.5%, you expect that your blue chip stock gives you at least 7% (1.5% risk premium) through dividends and stock price appreciation. Now if the interest rate increase to 6%, the only way you will get (6 + 1.5 = 7.5%) returns is that if the stock value dips from 100 to 99 ( .5% change in interest rate cause a 1% dip in the stock price)
Today’s Sensex value: 9468
Let me continue my discussion over mutual funds
A few days ago there was advertisement of Mutual funds investing contrarily to the market, having hedging features so that you make money even during a downturn, and all sorts of promises. Last weeks crash gave me a golden opportunity to check the validity of these claims.
1) Market fell by 25% last couple of days and there were not even a single mutual fund that had shielded itself and fell by less than 15%. The only ones who survived seem to be the new funds who were sitting with stockpile of cash.
2) Even funds which advertised they had hedging features, or ones which boasted that they invest smartly and do not follow the herd mentality seems to have taken the hit. My question is that are all these promises just on paper or does the investment adviser actually practice what he preaches?
3) I agree that Mutual funds have restrictions on the amount of liquid cash they can carry, so even if they know that the market is overheated, they cannot exit. However, while mentioning that the Mutual fund forgets 3 things:
a) The mutual fund may not keep lot of money in the bank accounts, but nothing stops them from buying bonds/gold or maybe bullion from the cash. Common sense says that if the market is overheated, you invest in safe (low return instruments) and buy when the markets fall as it is been happening for past couple of days.
b) Most of Indian mutual funds do not significant holdings in privately listed companies or have too much stake in a company that they cannot reduce their exposure during boom time profitably.
4) When the market reached its peak, FII started profit booking. In other words doing the same thing which MF were expected to do. Divert the money from the volatile stock market to bonds till the market returns proper realizations. Indian mutual funds start blaming them for the fall rather than learning from them and protecting their subscribers from the downfall. (even tough the value of the stock the sold was trivial when compared to the money they had pumped in over past couple of months)
I might sound a lot abrasive towards stock market today, but I had sincerely hoped that at least a couple of funds would have done good and I would extend my exposure in them. But I was disappointed.
I found a wonderful quote in the Simpson in which the junior was saying:
“I don’t know! I don’t know why I did it, I don’t know why I enjoyed it, and I don’t know why I’ll do it again!”