Shivers in Cross-Currency Trades and Bond Markets

Last month saw some major developments in the financial markets. It’s no more confined to equity market but fixed income market, emerging market currencies, gold, crude and what not, is loosing steam. Probably we have come to a pass where asset classes across spectrum are giving disappointing returns. The central theme to focus on was emerging market currencies taking a hard knock and Federal Reserve’s comment on withdrawing stimulus in a gradual manner. These two triggers certainly have had major repercussions on varied asset classes. US 10 year bond yield scaling highs of 2.61% have certainly had the potential to spook emerging market asset class.

Earlier Fed was carrying $85 billion monthly bond buying programme through the QE3, which artificially kept the yield suppressed in US. Now with stimulus withdrawal gaining momentum, yields have started shooting up for different maturities and this in effect have the potential to strengthen USD. Therefore higher yields in US and stimulus withdrawal will certainly pull back liquidity and will seek homeland where rates are hardening. Despite of lower inflation expectation, bond yields have been moving higher. Generally lower inflation leads to lower yields.  But just because of the QE programme, yields were suppressed in order to create inflation in the economy and this lead to negative real yields.  Negative real yields were fuelling cross currency trades with dollar being the funding currency. But now recently with the expectation of withdrawal of QE3 programme, bond yields have moved up sharply and there is a positive real yield. Hence dollar which was earlier used as a funding currency for carry trade (since the dollar funding cost was insignificant) and the liquidity which was seeking higher returns in emerging markets is now coming to a pause. Unwinding of carry trade will certainly knock down emerging market currencies because of the exodus of fund from emerging market to developed market. To add more to the currency decline were the already fragile state of economy of emerging markets and their wide current account deficit. As a result of which, a combination of factor lead to the more swift and furious decline in the currencies like the South African Rand, Brazilian Real, Turkish Lira, South Korean Won, Indian Rupee, Russian Ruble to name a few. In India itself, FII’s have withdrawn more than $5 billion from debt fund in last couple of weeks.

Emerging Market Currencies	USD	5 Day % Change	1 Month % Change	3 Month % Change	6 Month % Change	YTD % Change
South African Rand	10.0876	0.9626	-4.7306	-8.3171	-15.0333	-16.0008
Argentine Peso	5.3615	-0.4085	-1.7812	-4.5454	-8.5405	-8.3186
Indian Rupee	59.855	-1.9046	-7.1506	-9.1722	-8.3702	-8.1196
Korean Won	1153.58	-1.9929	-2.702	-4.161	-6.9609	-7.7307
Turkish Lira	1.933	-1.5934	-4.5318	-6.1873	-7.1961	-7.7289
Brazil Real	2.2139	-1.4635	-7.0825	-9.0835	-6.0482	-7.331
Russian Ruble	32.8349	-1.7874	-4.5107	-5.8758	-6.9094	-7.0349
Phillipines Peso	43.345	-0.4614	-3.922	-5.5785	-5.064	-5.3985
Malaysian Ringgit	3.1945	-1.3461	-5.1964	-3.1586	-3.9474	-4.273
Singapore Dollar	1.2717	-0.228	-0.8493	-2.4377	-3.743	-3.9239
Taiwan Dollar	30.086	-0.7944	-0.7346	-0.7578	-3.367	-3.5
Mexican Peso	13.2176	0.2088	-5.6652	-6.5587	-1.5729	-2.7562
Hungarian Forint	227.14	-1.3736	-1.5013	4.156	-2.4214	-2.7648
Indonesian Rupiah	10007	0.1899	-2.1385	-2.6881	-2.0785	-2.1385
Thai Baht	31.07	-0.1931	-3.8944	-5.6324	-1.384	-1.5449
Honkong Dollar	7.7571	0.0052	0.0825	0.0413	-0.0851	-0.0877
China Renminbi	6.1479	-0.3351	-0.4359	1.0394	1.4233	1.3452

*rates as on 26.06.2013

The tremors of it are felt in emerging market bond funds, which underperformed in last couple of weeks. Selling of debt fund will have larger impact where FII’s have larger share of bond market. Though the impact will be minimal in India as the FII’s have low share in the overall Indian bond market. It is more domestically dominated and hence it could be absorbed by local domestic players with limited impact on yields. But despite of it, the yield on 10-year government bonds has climbed 41basis points from a 44 month low in May to 7.52% as global funds cut local debt by $5.3 billion from a record $38.5 billion on May 21. Depreciation in rupee has put RBI on a pause mode from its softening stance. The difference between one year treasury (7.48%) and repo rate (7.25%) is now 23 basis point above the policy rate which was otherwise 18 basis point below the repo rate in last five months is indicative of a status quo on policy rate in next RBI meeting.

Now the biggest question lies in the fact that if bond funds are seeing redemption, as is evident from the rising yield specifically in US 10-year treasuries to 2.61%, up from historically 2013 low of 1.61% in May 1, which asset class the money will seek to rest in? Clearly, with the scheme of events unfolding, it looks as if treasuries return will be depressed for years to come. Money mangers foresee the end of a rally that began after former Federal Reserve chairman Paul Volcker vanquished inflation in the early 1980s and with the massive injection of quantitative easing for last couple of year’s reverses with economic improvement going forward. In this context stocks are likely going to be the asset class of choice over the course of next couple of years. The trend is already building up and most of the money managers, global influential banks and brokerage houses are recommending stocks over bonds. All these hinges upon economic improvement and inflation again setting in into developed economy otherwise deflationary forces will set in a new dynamics all together. Some glimpse of it is already on the anvil with commodities failing to perform, emerging market using foreign reserves to defend rupee and dollar surging on back of tapering of QE3 and rising yield despite of falling inflation in developed and developing economy.

India probably stands to gain in a lower commodity, gold, crude price regime. Government of India is hard pressed to put a break on gold import in India and last month RBI came out with a notification to restrict the import of gold on consignment basis by both nominated agencies and banks and also all imports will be 100% cash margin basis (will not be applicable to import of gold to meet the needs of exporter of gold jewellery). This is having serious implication for the importers of gold for retailing and along with it raising custom duty has also increased the cost of gold import. Coming months import figure of gold will be significantly lower than the average $8 billion monthly runrate of gold imports and will alleviate some concern on current account  deficit and INR. Not only this, Recently RBI bars loans against gold ETFs, gold mutual funds which will also act as a catalyst to rein in huge speculative gold demand and thereby aid in curbing gold imports.

So it seems that we have a larger complexity of moving parts in global financial market to deal with and time will tell which way the pendulum swung.

Theory of Dividends in Value Investing....

Theory of Dividends in Value Investing:

Dividend season is in full throttle and probably one could base their investment decision on the basis of dividend yield in times when the precarious economic situation and general business conditions are challenged. Because it is in times like this when the business with some sort of competitive advantage and pricing power generally sail through smoothly and dividend for these companies doesn’t gets compromised even during tough times. Though the stock valuation may look depressive because of slowing down of earning growth for extraordinary businesses but the dividend and its yields looks more promising. The classical value investment talks about the intrinsic worth of a business is its present value of all cash flows or the dividend discount model talks about the present value of all future dividends (DDM) which remains applicable in a limited context. But, the fact of the matter is whether it is the investment in bonds or equities, what we can get out of the bond as interest and dividend from equity is the actual return for our principal. And here is the context in which dividend yield comes into play for value investing or for taking proper investment decisions. Difference between investment in fixed income and equities hinges upon the fact that a dividend growth adds on to the yields in the long run and the dividend yield can surpass the bond yield in a meaningful way. But the real context of the difference between equity and fixed income return comes into play when it is permanent investment, not speculative trading, and dividend for years to come, not income for the moment only. For permanent investments into equity market, a stock is worth only what you can get out of it i.e., Dividend.

Experience shows that companies with a competitive moat generally are more liberal with paying dividend out of earnings. The real issue is with the reinvestment of earnings. As the adage goes for certain management that earnings or majority of earnings is required to be reinvested so as aid to tremendous growth potential in the business environment or to keep abreast with its competitive position. But greater experience shows that capex heavy business tends to reinvest majority of earnings and the reinvested capital generally doesn’t bring in greater return on reinvested capital and hence in the process brings in subpar equity return. Majority of the capex heavy businesses tends to reinvest their earnings just to maintain their fixed assets and incremental value addition i.e, in the process Earning Value Added (EVA= RoE-WACC) spread gets eroded significantly. The real crux of the matter is whether the company increases dividend paying power with the reinvested earnings. Companies who can generate return much higher than the Weighted Average Cost of Capital (WACC) with their incremental investments will generate higher equity value in future. If the incremental capital could not generate returns higher than the WACC, it clearly reflects the saturation in the growth dynamics of the business segment and hence it is always prudent in that case to give away as dividend to shareholders (after retaining some to maintain the existing fixed assets) or increase the share of dividends in earnings since the reinvested capital could not add materially to the existing extraordinary return on capital and rather ends up diluting it.

The actual reason for discussing the dividend paying power is the fact that companies with consistent higher dividend payout generally tends to command higher valuation or higher p/e multiples and are also good wealth creators in the long run & the mathematical calculation is given as follows…

Price (Dividend Discount Model) = Dividend/ k-g

Where k=required rate of return i.e, cost of capital; g= dividend growth to perpetuity

The price-earnings ratio for any stock is….

P/E= Price/ Earnings:

Or  Price = P/E * Earnings

Substituting for Price = Dividend/k-g

Or   P/E * Earnings = Dividend/k-g

Or  P/E = Dividend/(Earnings *k-g)

Or P/E = Dividend Payout/ k-g            

(Dividend Payout Ratio = Dividend/Earnings)

Or k-g = Dividend Payout/P/E…………….(1)

For, Dividend Yield = Dividend/ Price

Or Dividend Yield = Dividend/(Earning*P/E)

Or Dividend Yield = Dividend Payout/P/E……………(2) 

or P/E = Dividend Payout/Dividend Yield

Combining both (1&2)

k- g = Dividend Yield and K = g + Dividend Yield

*Hence, it can be concluded that P/E multiple is a positive function of consistent dividend payout ratio and growth and higher dividend payout ratio commands higher P/E multiple.

*Return is a positive function of Growth and Dividend Yield

Companies screened on the basis of higher Dividend Payout and ROE delivering strong CAGR shareholders return over last 10 years:

Sl.no	Company	Payout %	Payout avg %	ROE %	ROE avg %	P/E	Dividend Yield	P/B
1	Colgate-Palm.	69.84	87.03	158.62	95.52	45.71	2.24	60.09
2	Hind. Unilever	63.89	80.46	86.86	86.44	35.76	1.93	32.02
3	Glaxosmit Pharma	85.62	72.81	33.34	31.01	50.94	1.25	16.35
4	ITC	61.18	63.21	35.08	29.73	31.16	1.89	10.8
5	VST Inds.	85.27	62.29	25.59	29.00	17.57	4.95	8.46
6	ALSTOM India	39.43	54.02	26.51	32.08	20.77	1.11	3.87
7	Britannia Inds.	55.40	53.36	54.02	30.04	28.29	1.5	12.41
8	Godrej Consumer	21.58	48.42	25.65	67.87	32.02	0.9	7.25
9	CRISIL	55.59	47.45	46.55	42.93	21.64	2.18	9.59
10	Navneet Publicat	45.96	46.80	22.77	22.89	11.77	3.45	3.06
11	Sun TV Network	60.18	43.94	28.30	28.26	19.97	2.48	5.33
12	ACC	58.76	42.28	16.98	23.73	14.36	2.76	2.54
13	Dabur India	38.85	40.37	41.36	53.08	29.35	1.25	10.23
14	Asian Paints	40.04	39.76	39.39	43.03	34.73	1.21	11.44
15	HCL Tech	36.23	39.09	27.74	27.49	12.56	1.8	3.17
16	TCS	32.30	38.44	40.58	41.08	18.78	1.76	5.84
17	Supreme Inds.	34.64	37.33	37.43	31.61	13.37	2.48	4.18
18	O N G C	30.82	35.83	22.21	23.75	9.64	3.34	1.69
19	Emami	50.57	35.80	37.06	35.90	30.16	1.24	11.56
20	Ambuja Cem.	46.16	34.87	16.92	20.31	14.1	2.4	2.57
21	Infosys	26.72	34.48	27.20	31.51	13.97	2.1	2.95
22	ICRA	39.51	34.34	16.10	19.85	15.67	2.16	2.74
23	Balmer Lawrie	32.48	33.19	20.93	23.25	7.67	2.52	1.32
24	Pidilite Inds.	31.44	32.84	26.76	27.61	28.86	1.03	7.45
25	Kansai Nerolac	20.91	32.47	16.08	20.63	21.92	0.92	5
26	Thermax	22.03	31.93	25.24	32.31	19.29	1.32	3.29
27	GAIL (India)	26.14	30.60	18.47	20.32	8.73	2.94	1.26
28	Tata Chemicals	26.13	29.60	16.34	18.49	8.4	3.52	1.05
29	FDC	28.55	27.96	20.46	22.88	10.41	2.54	2.04
30	Coromandel Inter	32.83	27.90	29.02	35.61	10.08	3.22	2.07
31	Titan Inds.	26.96	26.35	48.19	40.64	30.73	1.02	10.43
32	Godfrey Phillips	23.87	24.35	20.77	18.86	19.69	1.24	3.17
33	M & M Financial	23.52	23.97	23.07	19.85	13.35	1.41	2.53
34	Container Corpn.	25.81	23.89	16.50	21.59	14.51	1.67	2.1
35	Bharat Electron	20.29	20.60	15.33	21.66	11.64	2.04	1.45

* The index (CNX 500) is screened on the basis of following criteria:

•   Payout ratio greater than 20% for last 10 years.
•    ROE greater than 15% for last 10 years.
•  Average Payout Ratio and Average ROE is calculated since 2007.
•   Payout and ROE is taken for FY13.
•   P/E, Dividend Yield and P/B is taken for FY14. 

Paras Bothra

+919831070777