Thursday, April 26, 2012

Is S&P threat a jackpot for value investors?

The most popular opinion, it is said, is not always the correct opinion. Nowhere else is this truer than in finance we believe. In fact, you will do a lot better in investing if you develop a constant suspicion about the most popular opinions in the field. Take S&P's recent opinion on India for example. The ratings agency believes that India is off to hell in a hand basket. It has thus cut its outlook on India's long term debt and has also warned the emerging Asian giant of a possible downgrade.

We have reasons to believe why long term equity investors have very little to worry about the announcement. The biggest amongst these is the success of the simple strategy of betting against the S&P ratings. Studies have shown that over the long term, a portfolio of stocks rated lower by S&P tends to beat the higher rated portfolio. In other words, stocks with an A+ rating have tended to underperform those with B+ or even C rated stocks over a long term horizon. The outperformance of poorly rated stocks has to do with expectations perhaps. On account of their poor financials and profitability, they happen to be valued so low that even a small improvement tends to lead to a big jump in their prices.

There is no reason why the same analogy cannot be applied to India's ratings. Agreed that India's near term outlook is poor. But with certain degree of reforms, India could easily solve deficit problems and also take its growth significantly higher. Stocks in India though do not seem to be factoring this into their valuations currently. This thus puts the risk reward ratio firmly in favour of a patient long term investor. Any more correction from the current levels and that would be the added icing on the cake we believe.

Thus, a possible downgrade of India by S&P and the resultant reaction of short term investors could actually turn out to be a bonanza in the long term for patient investors.

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