Equity markets witnessed a spectacular run in 2009, with the Sensex moving up from 9,647 as on Dec 31, 2008 to 17,464 as on Dec 31, 2009 – climbing up 81% over the past 12 months. Note that in 2008, the Sensex fell from 20,287 to 9,647 – a fall of 52%. Despite the 81% positive return in 2009, equity markets have broadly delivered negative returns over the past 2 years. It is based on this mathematical fact that our investment philosophy is geared towards capital protection.

Last year at about the same time, the global economy was widely considered to be at the brink of a depression. Its state was similar to patient admitted in a hospital with a massive cardiac arrest, requiring urgent and immediate attention by the doctors. With the assistance of the massive and coordinated support by most major governments across the world, the economy survived the risk of a great depression. But the patient continues to be in the ICU, under constant monitoring by the doctors, and the life support systems are still on. The coordinated stimulus programs by the government is largely feeding the global economy. Till the Life support systems are removed and the patient walks out of the hospital, it is difficult to assume all is well. The stock markets, on the other hand, seems to be pricing in assuming the economy has fully recovered. The celebrations following the patient surviving has been massive, whereas one should be heaving a sigh of relief only.

The Indian economy, though still supported, is in a far better shape compared with most large global economies. Apart from the risk of inflation – which continues to be a serious problem – all other economic indicators point to a positive economic momentum. The Finance minister has given strong indications that some of the stimulus measures will be lifted in the next budget, scheduled for Feb 2010. Bond markets are also starting to factor in an increase in interest rates. Given these circumstances, and with stiff equity market valuations, it makes sense to be cautious.

Investments in India by FIIs continues to be strong, partly supporting equity markets. On the other hand, the last few days has seen some strength in the USD globally. This can influence FII fund flows in the coming days and needs to be watched closely.

Over the past few weeks, we have been seeing the mid-cap stocks starting to perform much better than the large-caps. More of the mid-caps are starting to reach the target intrinsic values and we continue to exit stocks that have reached their intrinsic values, those that offer little reward and large risks of price correction. Apart from some pockets of small cap stocks, there is very little value available in the markets. We believe it would be wise to commit capital to equity market only after seeing some sensible prices.

Equity markets were strong during the course of the month, catching up for the weakness seen last month. The Dubai crisis had some impact on the markets towards the end of the month, but so far seems to be shrugging away any major concerns. Sentiment in equity markets has been circumspect over the last few weeks and there is consensus building on the need for a consolidation after a spectacular period of gain during the earlier part of the years. The sense of caution is based on 2 extreme thinking in equity markets.

On the one side, the sense of optimism surrounding the future of the Indian economy is very strong in the eyes of the global investors. India is currently the 12^th ranked economy in the world (see the attached document for more details on rankings), and with the Indian GDP expected to grow at over 7% per annum in coming years, it seems almost certain that India will improve its global ranking by at least about 5 notches over the next 10-12 years. Relative to other economies, India seems like a destination of choice. There are still several infrastructure projects where the return of capital is certain. Global capital has little choice, but to gravitate towards India, rather than risk the capital in other geographies. If the government executes its plans well, equity market returns in India can be very attractive in the coming decade. In addition, the governments of the world are keen on continuing a loose monetary policy that keeps liquidity levels high. The situation seems unlikely to reverse as long as governments can continue to borrow.

On the other hand, all investments needs to be viewed in the context of a price and valuations. Historical data suggests that stocks tend to trade within a certain valuation range and they are currently trading at closer to the expensive end of the historical valuation spectrum. Many promoters and companies are making use of the expensive valuations to raise capital. Amount of equity capital that has been raised over the past 4 months is amongst the highest one has ever seen inIndia. Over $ 20 billion has been raised as equity capital over the past 4 months, and not many of them at sensible prices for investors. Many of the large IPOs in recent times are trading below their issue price, which is a sign of trying to sell issues at expensive prices. Promoters willingness to sell parts of the company is also a sign of expensive markets.

The real question to address now is if equity markets can run up sharply from here onwards. The answer to this would probably be driven by government policy. But one thing is certain. As stocks become more and more expensive, the eventual correction would be equally severe. The probability of making good returns will diminish as markets becomes more expensive. Whenever large doses of liquidity is infused, capital markets tend to fail on its duty of efficient allocation of resources. Current conditions reflects the ill effects of excess liquidity, where untested companies are being provided with significant amount of capital for new businesses. Eventually, capital markets get back to their true role of allocating resources efficiently.

Equity markets finished the month on a very weak note, down 7.3% for the month. Much of the fall was witnessed towards the end of the month and we are seeing strong signs of weakness in equity markets since the recovery began earlier this year. We have increasingly been believing that a large component of cash in the portfolio is the right choice, and because of that our portfolios are broadly not affected much due to the fall in the markets. Many of the portfolio stocks stood up relatively well compared to the market, as there was a distinct shift towards the more defensive sectors.

The sharp sell off in the equity markets has been led by 2 reasons. Firstly, with the increasing risk of inflation, the RBI finally decided to start pulling the plug on the loose monetary policy. The loose monetary policy stand since Oct 2008 was from a combination of low interest rates, low CRR & SLR, certain special provisions targeted at some sectors and some relaxation in accounting policies. In addition, the Finance Ministry had also reduced excise duties and service tax rates. The RBI signaled a reversal in stand by removing most of the special provisions and some stricter accounting norms. It has also clearly stated that it will not hesitate to further tighten liquidity, if inflation continues to rule high. We believe the crutches would get taken away from the patient as the doctor starts to believe the patient can stand on his own. You know what would happen to equity prices, if there is less money available in the system.

We believe this is just part of the reason for equity market weakness. Globally, over the past few months, one has been seeing the US Dollar weaken against all major currencies. As a result, there was a significant shift in investments away from the US markets towards emerging markets likeIndia. It is likely that the USD will start to strengthen in the coming days, which should lead to a slow down in foreign inflows. This can cause significant changes to equity markets in India.

The FIIs hold about 16 per cent of the Indian markets, whereas the domestic Mutual Funds hold just about 3 per cent of the market. Apart from company promoters, the FIIs have the largest impact on Indian markets and any change in the FII appetite towards equities can lead to large changes in equity prices. FII flows towards India is influenced by a combination of attractiveness of equity prices and expectation on currency strength.

Current quarter corporate results season continued to be very mixed, with some sectors like FMCG, Pharma, auto and IT coming out with stronger than expected results. On the other hand, we are definitely starting to see margin pressure across several sectors. The last 3 years has seen significant investments in several sectors and as a result over-capacity is building up in the economy. On the other hand, the current operating profit margins of companies in these sectors are well above historic averages. If one were to believe in history, one may see margin erosion in several sectors where competitive conditions are increasing. One cannot assume the current earnings to be sustainable in several pockets of the economy. Even after the recent correction in equity prices, valuations of large companies are not attractive as yet.

Equity markets continued to be strong during the month on the back of continued strong inflow of funds towards equity markets. Interest in midcap stocks has been even stronger. Equity market strength is partly assisted by Foreign investor inflow of close to $ 4 billion during the month, near its all time monthly high inflows. Even domestic market inflows into equities have been strong.

The general perception, causing strength in equity markets, is the belief that the recession that one saw in 2008 is over and the future should be bright. Our interaction with several companies indicate that the business confidence at the ground level is far from the optimism one witnessed in 2007 and business conditions continue to be difficult. Even in the US, though there seems to be early indications that the economy has started to stabilize, it is difficult to believe that the global recession is over when unemployment in the US continues to be 10%.

One of the main reasons for the strong equity markets is the surplus liquidity and accommodative monetary policy being adopted by governments across the world, including India. When the banking sector in India went through a crisis towards the end of 2008, the RBI implemented several policy measures creating an easy money supply environment. CRR was reduced, the Repo rates and reverse Repo rates were reduced, accounting norms for banks and corporate borrowings were liberalized. Interest rates were kept low, in order to stimulate demand. This accommodative policy can last for some time, but cannot last for ever. If it does continue a loose monetary policy for too long, inflation would start to rise. Already, inflation as defined by the CPI (Consumer Price Index) is past 11%, leading to negative ‘real’ rates of interest. Note that your bank deposit is yielding 7% before taxes, whereas your costs are going up at 11%.

Several people ask why equity markets are volatile at all. If a stock is worth Rs 100, should it not trade at Rs 100, whereas in reality, it trades at Rs 80 sometimes and Rs 120 sometimes. The BSE Sensex has been seeing an annual volatility of over 60% and even developed markets like US,  Japan, UK and Germany have seen annual volatilities of about 30-40%. This is based on the past 18 year data – please see the attached spread sheet for more data. One of the main causes for this volatility is changes in interest rates, liquidity and monetary policy.

We believe the current ‘easy’ monetary policy being adopted by the RBI is way above historical average. RBI will continue with the accommodative policy till the global economy is definitely out of recession. This is part of a conclusion arrived at the G20 summit (the top 20 economies in the world meeting). With some consensus building up on the ‘end’ of the recession, the RBI does not have much of a choice, but to reduce money supply soon. Or else, inflation can go out of control. In the meantime, we are increasingly finding stocks reaching the top end of their estimated valuation range. There is more opportunity to sell stocks, than to buy.

Equity markets in India continued to remain almost flat during the course of the month and have been trading within a narrow range since the day after the elections. Over the past few weeks, large cap companies have been trading in a narrow range, but one has been seeing increased strength in small and mid cap stocks. The fall in small cap stocks was severe last year and the pull back witnessed is very strong, bordering on exuberance. Since the portfolio has a reasonable mix of the large and mid sized stocks, the portfolio has seen some appreciation despite the Sensex & Nifty not showing any major gains.

One should also note that Indian market stability, over the month, in the context of a 23% fall in Chinese markets over the past month. Chinese and Indian markets are broadly clubbed together under the emerging market category by international investors and a steep fall in China, but no associated fall in India is a bit of surprise. Chinese government slowing down on the stimulus measures and been clamping down on bank lending. Over capacity in the system is a cause for concern. With such large fall witnessed in China over the course of the month, one need to be cautious in India too.

Indian markets is also seeing increased risk on valuation. India is among the more expensive markets globally and despite increased confidence, due to the economy coming out of recession, valuations among large stocks is not cheap. Several companies have also been showing inflated profits due to certain accounting umbrella provided by the government. Indian markets typically trade at between 12 – 20 x earnings. At current valuations, Sensex and Nifty companies are trading at closer to the top end of their historical range. Though market do trade above historical range at times, it is not sustainable. More importantly, underlying business sentiment is far from being strong to take equity markets beyond historical averages. Several of the portfolio companies are also trading near the top end of their historical valuation ranges and we continue to reduce holdings in companies that are expensive.

The monsoon has definitely dampened some of the sentiment and the government may have to stretch their deficits, if it were to spend its way out of the drought. The decision to slow down stimulus measures in India may be led by similar action in developed markets. In US, deficits are expected to be far higher than originally envisaged. Tax collections continue to be weak due to the economic slowdown. In India, the RBI governor has already voiced his concerns on the continued high government deficit and the risk of government borrowing having harmful effects on the economy. As and when the government chooses to tighten liquidity in the system, one should see a fall in equities. It is difficult to assess when policy would change course, but it would need to happen in the near future for the long term good of the financial system.

Equity markets continued to be strong during the month, in line with global markets rather than this being just an Indian phenomenon. Globally, the quarterly results was received with a sense of optimism by the analyst community. Though results on an absolute basis have been poor, stocks have rallied as several company results were ahead of expectation. This is one of the strange aspects of the investing world, as the average company’s growth and profit expectation is far from their 2008 peaks. Much of the current global equity rally is more on optimistic expectation from the future, rather than current realities.

One of the unique aspect of the current rally is that it is mostly sponsored by the governments. Governments across the world have told themselves that they will continue to borrow and infuse stimulus into the economy till the day the individual country economies are firmly on a growth track. Most large economies are borrowing more than 10% of their GDP annually now, compared with a 2-4% historically. The after effects of this medicine can last a long time – which is the bigger worry. After effects include high inflation, liquidity dry up and a protracted period of high tax rates. I am sure one knows what happens to people who live on borrowed money for long.

Over the past few weeks, several companies have been raising large amounts of money through one of the quickest routes of raising equity funds – Qualified Investor Placements. Most of these companies are raising money are prices levels that are significantly lower than the historical high prices. Promoters are willing sell parts of their company, at lower prices. This willingness to quickly raise funds indicates some concern among managers that the window of opportunity to raise funds may be short. Why else would one see such a huge queue to raise money at prices much lower than peak prices.

The key question to address now is – is the current rally in equities a start of a sustainable long term equity market rally, or a temporary rally that may fizzle out soon. Firstly, the key catalyst for this rally has been government stimulus and borrowings, which need to be reversed soon. Secondly, corporate results in India seems to have reached a cyclical peak and have started to reverse. We have not seen too many companies that have the same optimism on the future as they had in 2007. Thirdly and most importantly, stock prices of larger companies are not cheap any more. Several companies are trading near the top end of their historical valuation range. In this context, it seems highly likely that this rally cannot sustain into a sustainable bull market.

Though there are several negative news lurking around, equity markets are ignoring all and looking only at the positive possibilities. Risks are not getting priced in. This is an opportunity to reduce exposure to equities and wait for a more opportune time when markets take on a more balanced view on economic conditions.

Equity markets in India has been going through a period of uncertainty over the past month. FIIs, who have been the prime driver of the strong move over the past 3 months, have been selling over the past 2 weeks. There is a serious global debate on as to whether to continue the stimulus programs, or start acting towards bring it to an end. It is a foregone conclusion that at some stage the stimulus programs need to be brought to an end, and all corresponding borrowings paid back. The debate is on the timing of this process. Since we are dealing with unprecedented events, there is no history that could give the economists and decision makers clues as to how to act. As and when the reversal does happen, it will be associated with a serious dry up of liquidity.

In India, the focus is on the ambitious plans of the new government. The budget on the 6^th of July is a keenly awaited event. Large scale plans for investment in roads, power, other infrastructure, rural programs, divestment, freeing oil price subsidy, etc are being mapped out. The ambitious Unique Identification Number project, that would improve the efficiency of several of the government programs, has been initiated. The key bottleneck to implementing all these should be availability of funding for the same. One can have spectacular plans to spend money, but remember that availability of money is limited.

Indian government tax collections to GDP has been constant at about 14% for over 2 decades now. Government’s borrowing to GDP has gone up from about 52% in 1980 to about 86% currently, through a consistently high fiscal deficit. Fiscal deficit in the current year is expected to reach an all time high. It is going to be nearly impossible for the government to achieve all its infrastructure development goals, without improving the tax collections. Would the coming budget bite the bullet is a question. Most likely, the government is likely to focus on higher private sector participation, reduction of subsidies, divestment, etc to manage their goals in an environment where the risk of higher taxes leading to economic slowdown is still present. Despite talks of the world coming out of the recession, and the sharp uptrend in equity markets, underlying performance of companies continues to struggle. Newspapers headlines are full of companies announcing sharp fall in profits, and in a few cases large losses. What is not obvious are several companies that continues to deliver reasonably good performances. Many of these companies have taken the hard choices of walking the right path of sustainable growth, in times when there was great temptation to walk the near sighted path.

I have attached the annual letter by Mr Deepak Parikh, the Chairman of HDFC. It is an interesting reading for all investors and especially for those looking to invest in properties. It is a company that has chosen to walk the path of sustainable growth, taken the difficult choices over years and has done exceptionally over 30 years, transcending several economic cycles. Few more companies with the business integrity of companies like this would make a vast difference in India achieving its potential. It is our endeavor to identify such companies and invest in them when prices are cheap. We believe such a strategy should protect and grow ones portfolio in a satisfactory manner over time.

Equity markets surprised everyone with a staggering performance during the month, on the back of the strong mandate given to the new Congress government and, more importantly, a very strong inflow of funds by foreign investors into the Indian equity markets. Our portfolios also benefited from the sharp uptrend in equities over the month. What surprised several investors was the strength of the rally when all economic indicators points to a continuing tough environment. Stocks that were cheap less than 2 months back are not cheap any more.

The strong mandate given to the Congress government and hopes of sweeping reforms in areas like infrastructure is attracting capital towards India. The Congress government has put together an excellent team to implement some of the policies that got a tame treatment in the previous 5 years. One can look forward to some progressive steps in areas like roads, power, PSU divestment, insurance and few other areas. Focus on rural development will stay. FII fund inflow into India in May 2009 was over $ 4 billion, the highest single month figure seen. This also coincides with a similar movement of funds towards equities across the world, and specifically into emerging markets like India. There is a significant easing in global liquidity after the recapitalization of banks in US. In addition, several foreign investors believe in the domestic demand led growth opportunities in India.

Globally and inIndia, level of consumer sentiment and business confidence has improved. On the other hand, the economy has still have several hurdles to cross and it is far from being out of the woods. Though people are getting back to buying homes, nobody is rushing to buy a house, a syndrome that we witnessed in 2007. Corporate results continues to be weak. The source of the change in global sentiment was the huge fiscal stimulus plan undertaken by various governments including the Indian government. This, in simple terms, is based on huge borrowings by government to dig themselves out of the current problem. The global economy seems to have been fairly successful in digging itself out of the problem, or at the least find a bottom to the global recession, but at some stage the world needs to foot the bill for the stimulus plans.

Though equity markets are currently focusing on the end of the recession, the time is not far when people have to focus again the getting the fiscal situation in order. The Indian government fiscal situation is precarious and the coming budget may have to see some tough decision taken – especially with respect to reversal of some of the recent tax sops given. The finance minister may try and delay some of these measures, but they would need to be faced up to soon.

In this environment, where business environment continues to be tough, not too comfortable a fiscal situation and an increasingly expensive equity market, we believe one should be liberal in selling stocks as and when one sees expensive prices. We have started this process over the last few days.