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India- An Attractive Destination For Long-Term Growth

Summary India is poised for a robust economic recovery on the backdrop of strong fundamentals. Slowdown in China created ripple effects across emerging markets, but India looks like an attractive alternative. Narendra Modi government’s efforts on making India a manufacturing hub to catalyze economic recovery. For those who have been tracking the equity markets, last month has been quite a rollercoaster ride. The global sentiments remained weak with negative news flowing from China with respect to their economy. The Chinese economy grew by 7.4% in 2014, which is the slowest in 24 years. In an attempt to boost its exports and revive the economy, China announced a devaluation of its currency. This triggered panic selloff across markets. Emerging markets got the maximum impact. In an attempt to prevent the falling stock prices, the People’s Bank of China reduced its interest rates twice during the last couple of months. But, this failed to entice global investors and panic prevailed. The story in India looks quite different from its peers. The country is in a much stronger wicket compared to its peers. While the US Fed is mulling over increasing its interest rates, the Reserve Bank Of India (RBI) surprised the markets on 29th September with a 50 basis points (bps) cut in the repo rate. The rationale for the same is as follows. ( RBI’s Policy Statement ) Retail inflation has eased significantly to 3.66% in August 2015 as against 7.73% in the same month previous year. ( India’s Inflation ) The monsoon deficit in India has been around 14% this year. However, the central government has taken resolute steps towards managing food supply. Economic recovery has been slower than expected. This rate cut, combined with the 75 bps rate cut done during this year by the central bank is expected to bring down the cost of borrowing. This can encourage fresh borrowing and can propel capital expansion. For companies that already have significant debt on their books, their interest cost is expected to come down, thereby increasing profit margins. On the backdrop of a slowing Chinese economy, global commodity prices have been low. While this may be a negative for countries exporting commodities, it is a huge positive for India as it is an importer and consumer of commodities. India imports close to 80% of its oil requirements. Crude oil prices have fallen sharply over the last one year, and this will have a huge positive impact on the current account of India. It is evident that an economic recovery is underway. The RBI has also stated this clearly in its monetary policy review on 29th September 2015. It has been 15 months since the Narendra Modi government has taken charge and the fundamentals look robust. The Make in India Campaign – With the government encouraging foreign companies to set up their factories in India, this campaign will definitely boost manufacturing, construction, power, infrastructure, technology and logistics sectors. The government is striving hard to make it easier to do business in India. This can definitely attract more foreign funds to the country. While earnings growth was subdued in the previous quarter, it is expected to be robust. With the domestic demand picking up and global economy recovering (healthier data from US and Europe), earnings are expected to improve over the next 3 to 5 years. Softer commodity prices is a huge positive as it will result in improving margins and increased profitability. China has been witnessing increase in the cost of labour and real estate. In comparison, India looks like an attractive alternative for companies to move into. Considering these factors, Indian equities definitely look attractive as an investment destination. In this light, an evaluation of The India Fund, Inc (NYSE: IFN ) is given below. Fund Investment Objective: The fund’s investment objective is long-term capital appreciation, which it seeks to achieve by investing primarily in the equity securities of Indian companies. Investment Philosophy: Bottom-up stock selection Proprietary research driven Based on fundamental analysis Factsheet Download Performance: As on 31st August 2015 The fund has a well-established track record of over 20 years. As it is evident from the past performance, the NAV has beaten the MSCI India Index over the short-term and the long-term. This superior performance can be attributed to a) Superior stock selection of the fund; and b) Fund manager’s ability to manage sector-wise weightings effectively. Top 10 Holdings: As on 31st August 2015 Sector Allocation: As on 31st August 2015 The portfolio consists of fundamentally strong companies that would be benefited as the economic recovery happens in India. The top 10 holdings constitute 58% of the portfolio. The portfolio is diversified across 9 sectors and has a balance between both cyclical and defensive companies. The fund has highest weighting to financial services. With the central bank cutting the repo rate by 50 bps and the outlook for interest rates moving southwards in the next 12 to 18 months, financial services are expected to play a key role in economic recovery of the country. Information Technology and Consumer Staples have a weighting of around 17.5% each to the portfolio. Information Technology plays an important role in the exports of the country. With the US Dollar strengthening against the INR, these companies can be benefited due to increased US Dollar revenues. The Consumer Staples companies in the portfolio, especially ITC, Hindustan Unilever and Godrej Consumer Products have very low debt, well-established brands and a strong hold in the Indian consumer market. The other key sectors that are expected to contribute to the fund’s performance are Healthcare and Industrials. Healthcare has a weighting of 10.1%. Growth is expected to come from both the domestic markets and exports. Industrials have a weighting of 5.3%. This sector will be benefited significantly as the Make in India campaign becomes a reality and as manufacturing activity improves. The cash level in the portfolio is just 1%. As it is a closed-ended fund, it need not maintain high cash levels to fund redemption requests as they are not allowed. As on 1st October 2015, the closing price of the fund was $24.27 while the NAV of the fund was $27.54. It is currently trading at a discount of 11.87%. IFN data by YCharts Forward Looking Estimates The RBI, in its latest monetary policy review has projected a GDP growth of 7.4% for the year 2015-16. The International Monetary Fund (NYSE: IMF ) too has projected a GDP growth of 7.5% for the same period. This is higher than its estimate of China’s GDP growth which is 6.8%. With an inflation projection of around 5%, the portfolio companies are expected to deliver a robust 13-15% growth in earnings over the next 3 to 5 years. The fund also has a healthy track record of generating superior returns than the benchmark. Considering the robust macro-economic factors in India and with limited number of India-dedicated funds listed in the US, The India Fund, Inc fund looks attractive for long-term wealth creation. Fund Management Team: Asian Equity Team based in Singapore Net Assets: $824.1 million Expense Ratio: 1.47% Shares Outstanding: 29,541,212

Be Careful Holding ETFs Long Term

Friday happy hour conversation in the Village reminds us why holding levered ETFs more than a day isn’t a good idea. Leveraged ETFs can suffer from disproportionate downside. Risks are added from levered ETFs taking on derivatives and exposure to debt markets.. Always consult your personal financial advisor before holding ETFs over the course of the long term. By Parke Shall Today we wanted to go over a topic that we were asked about on Friday at happy hour. Thom and I were having a conversation with someone who was talking about their portfolio to us. This person commented that they had been holding several leveraged ETFs over the course of months, and he did not understand why the moves that the ETFs were making did not seem congruent with the moves in the individual sectors that they represented. This brings us to a topic that we don’t think enough people know about or understand. Not all ETFs are created equal. Some ETFs are designed specifically to be held over the course of the long term. Good examples of these are ETFs like the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) or the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ), two different style unlevered ETFs that we have talked about in our last four or five articles. TLT tracks the yield on treasuries, and IBB is an unlevered ETF that tracks the biotech sector. Each sector has an ETF, or several ETFs, similar to IBB for biotech. We have heard a lot about IBB over the last month because biotech has crashed, so we’re using that as an example. ETFs like IBB are helpful in showing sector moves proportionate to the broader market, like you can see in the below chart. IBB data by YCharts TLT tracks 20 year treasuries and provides a dividend according to their yield. TLT joins a host of other ETFs, like the Vanguards High Dividend Yield ETF (NYSEARCA: VYM ) which are meant to and designed to be hold for the longer-term, and have minimal fees. They take a small management fee, but they can be good to hold for conservative investors over the course of long-term. Any type of ETF for bonds especially makes bond investing a little bit easier, as sometimes buying individual bonds can be too costly for retail investors. So let’s look at what makes leveraged ETFs difficult to hold for more than a day or two, and why they should not be traded over the course of weeks or months. A simple example is this. If you buy a $50 2x levered ETF that goes up 10% you’re going to see a return of 20%, and that ETF will be priced at $60. The next day, the ETF falls back from $60-$50, you would expect the underlying to be the same as it was prior to the first day. The problem is that the drop from 60 to 50 is only about a 17% drop, meaning the underlying would only need to fall about 8 1/2% for you to lose the same amount that you made when the market grew 10% in the day prior. This type of attrition makes these instruments difficult to hold over the course of weeks or months. This is why it is not uncommon to see splits of different natures, including reverse splits, take place in these instruments. Like the gentleman we were speaking to yesterday, one needs to be aware of the mechanics of how leveraged instruments work before making what we believe to be a terrible mistake in buying them and letting them sit in your portfolio unwatched. The same goes for ETNs (exchange traded notes) that have major risk to the debt that’s been issued by a bank (or other institution) that presents counterparty risk. Sometimes with ETFs or ETNs that have these characteristics, you wind up seeing charts like this. UWTI data by YCharts In addition a lot of levered instruments will rebalance or reset on a daily basis, meaning that if the markets are volatile and not moving in one set direction, you could wind up taking losses on a day where the sector or underlying appears neutral. Finally, one needs to realize that these type of instruments may achieve their leverage from utilizing derivatives like options and sometimes debt instruments. These types of risks are not suitable for those looking to buy and hold or those investing for the long term. Before picking up an ETF to hold for the long term, make sure to check with your personal financial advisor.

Southern Company – Rising Infrastructure Assets But Look Out For Some Challenging Quarters

Summary Southern Company is one of the largest utilities in America. Will grow to #2 spot by customer count after the AGL Resources purchase. Southern announced its plan to acquire AGL Resources for $8B cash – fueled by debt and equity issuance. The company is a dividend contender having raised dividends for 15 consecutive years; 5-yr dividend CAGR is 3.7% and Chowder Rule is 8.56. The Southern Company (NYSE: SO ) is one of the largest utilities company in America. The company serves more than 4.4 million customers and has approximately 46,000 megawatts of generating capacity serving the Southeast through its subsidiaries. Subsidiaries include electric utilities in four states – Alabama Power, Georgia Power, Gulf Power, and Mississippi Power; a growing, competitive generation company – Southern Power; a licensed operator of three nuclear generating plants – Southern Nuclear; and fiber optics and wireless communications – Southern Telecom and SouthernLINC Wireless, respectively. (Source: September 2015 Southern Company Overview Presentation ) In August 2015, Southern Company announced that it will be acquiring AGL Resources Inc. (NYSE: GAS ) in an $8B cash deal. This combined company will shift Southern from being an electric-only utility company to an electric-and-gas utility company. The customer base is expected to double with this move and pushes Southern to become the second largest utility company in America (by customer count), if the deal is approved. Corporate Profile (from Yahoo Finance) The Southern Company, together with its subsidiaries, operates as a public electric utility company. It is involved in the generation, transmission, and distribution of electricity through coal, nuclear, oil and gas, and hydro resources in the states of Alabama, Georgia, Florida, and Mississippi. The company also constructs, acquires, owns, and manages generation assets, including renewable energy projects. As of December 31, 2014, it operated 33 hydroelectric generating stations, 33 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 9 solar facilities, 1 biomass facility, and 1 landfill gas facility. The company also provides digital wireless communications services with various communication options, including push to talk, cellular service, text messaging, wireless Internet access, and wireless data; and wholesale fiber optic solutions to telecommunication providers in the Southeast. The Southern Company was founded in 1945 and is headquartered in Atlanta, Georgia. A Closer Look The Southern Company has remained focused as an electric utility company through the years. The company has remained a heavy user of dirty fuels such as coal (accounts up to 42%) for its power generation over the years, but has started transitioning to cleaner resources including natural gas, solar and wind. This move will also be welcomed as the company aligns itself with the US government mandate targeting power plants to cut carbon emissions by 32% (by 2030) on the 2005 levels. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) Acquisition of AGL Resources Inc. In August 2015, Southern Company announced a plan to acquire AGL Resources Inc. for about $8B in cash, fortifying SO’s assets with the natural gas infrastructure. AGL Resources distributes gas in Georgia, Illinois, Virginia, New Jersey, Florida, Tennessee and Maryland. Southern Co. owns utilities in Georgia, Alabama, Florida and Mississippi. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) This move lowers SO’s dependence on power generation and pushes SO to the #2 spot in the utility sector by customer count after Exelon Corp. (NYSE: EXC ). The combined company will operate 200,000 miles of electric lines and 80,000 miles of gas pipelines. The deal is expected to close in the second half of 2016. Southern Company will be issuing $3B in new stock and also tapping into the debt markets to finance the merger. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) The deal is expected to raise the long-term EPS growth rates by 4-5%. In addition, the dividend growth is expected to rise faster than current rates. Dividend Stock Analysis Financials Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations. (click to enlarge) (Source: Created by author. Data from Morningstar) (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The utility industry is resilient and has seen a slow and steady rise over the years. Revenues and earnings are fairly constant with year-over-year growth ranging between -0.3% to +0.15%. The debt load is also stable and SO enjoys a ‘A-‘ credit rating from S&P. SO has a debt/equity of 1.36 and a current ratio of 0.80. Those numbers can be expected to change significantly over the course of next year or two as the AGL purchase moves closer to closing. Dividends and Payout Ratios Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: Utility companies are slow and steady growers and are perfectly suited for long-term dividend investors. Southern Company is a Dividend Contender having raised dividends consecutively for 15 years. The 1-, 3-, 5-, and 10-year dividend CAGRs are 3.5%, 3.6%, 3.7%, and 39% respectively. Coupled with a current dividend yield of 4.86%, SO has a Chowder Rule number of 8.56. The current payout ratio is 89%. Outstanding Shares Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The number of shares have risen steadily over the years and are expected to rise more as the company intends to issue $3B of new equity to finance the AGL deal – approx 66M new shares based on current price, an increase in the number of outstanding shares by ~7%. Book Value and Book Value Growth Expected: Growing book value per share. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The book value is a bright spot in the company’s financials. The book value has steadily increased over the years maintaining a nice upward trajectory, although we can expect this to stumble when more debt and shares are issued in the coming years. Valuation To determine the valuation, I use the Graham Number, average price-to-earnings, average yield, average price-to-sales, and discounted cash flow. For details on the methodology, click here . The Graham Number for SO with a book value per share of $22.22 and TTM EPS of $2.35 is $34.28. Based on the last closing price, the stock is currently 30% overvalued. SO’s 5-year average P/E is 18.92, and the 10-year average P/E is 17.80. Based on the analyst earnings estimate of $2.94, we get a fair value of $55.62 (based on the 5-year average) and $52.33 (based on the 10-year average). SO’s average yield over the past five years was 4.60% and over the past 10 years was 4.61%. Based on the current annual payout of $2.17, that gives us a fair value of $47.17 and $47.07 over the 5- and 10-year periods, respectively. The average 5-year P/S is 2.16 and average 10-year P/S is 2.0. Revenue estimates for next year stand at $21.18 per share, giving a fair value of $45.74 and $42.35 based on 5- and 10-year averages, respectively. The consensus from analysts is that earnings will rise at 3.58% per year over the next five years. If we take a more conservative number at 3%, running the three-stage DCF analysis with an 8% discount rate (expected rate of return), we get a fair price of $36.73. The following charts from F.A.S.T. Graphs provide a perspective on the valuation of SO. (click to enlarge) (Source: F.A.S.T. Graphs ) The chart above shows that SO is slightly undervalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be 2.75%. (click to enlarge) (Source: F.A.S.T. Graphs ) Conclusion Electric utilities in general have seen slower sales industry-wide amid a combination of energy conservation, energy efficiency and shift towards independent power generation/natural gas usage. Coupled with the new regulations from the US government to reduce carbon emissions, electric utilities have started focusing a shift away from dirty fuels such as coal. Southern Company still relies heavily on coal, but has started focusing on cleaner energy alternatives to meet the target. In a move to diversify and fortify its assets, the company is moving to acquire AGL Resources Inc. in a deal financed by new share and debt issuance. While this is good for the overall company’s business, in the short term (over the course of next few quarters/years) some balance sheet damage can be expected as the company takes on more debt and investors see share dilution. An added risk for investors is the potential rise of interest rates by the US Fed. Bond substitutes such as utility stocks suffer the most in rising rate environments. Based on the metrics discussed above, if we give equal weight to all metrics, we get a fair value of $45.31. Full Disclosure: None. My full list of holdings is available here .