Equity markets in India, and to a large extent across the world, have been on an uptrend since the 2^nd week of March 2009. This trend has been continuing through April 2009 and we saw a fairly strong performance for equities during the month. Foreign money has also started to flow into India after almost 15 months. The uptrend has been led by a belief that the worst of the global recession is over and some kind of bottom has been reached, though this does not necessarily translate to good times in the immediate future. At this stage, I think it is important to visit the sequence of events that has led us to this stage.

The main problem over the past year has been the collapse of the global banking system and several banks perched on the edge of bankruptcy. As per accounting regulations, banks were to carry their investments at market value and several of their mortgage investments are trading at very low prices. The US government changed the accounting rules that allowed banks to value some of these investments, not at market value, but at some other price that they deem fit. This ensured survivability of these banks with just change in accounting norms, rather than any fundamental change in business conditions. The actual bond prices have actually deteriorated further over the past 2-3 months, indicating a worsening underlying reality. Banks also saw some improvement in profitability due to their low cost borrowings. As a result of this change, the dark clouds hanging over the global banking system have started to clear bit, but this will also ensure that it will take a longer time to get out of the real problems. In India too, couple of important account rules were changed. Firstly, foreign currency borrowings were not required to be carried at current conversion prices. Secondly, banks were given some flexibility in value bad loans, as long as they were in the process of getting restructured. A sentimental bottom to the recession due to fundamental factors is always preferred over accounting change led factors, but should assume this to be a start. Interaction with people from the industry also indicates that the worst of the recession may be over, but the environment will continue to remain tough for the corporate sector for the next 2-3 years at least.

The March ending quarter was the first full quarter that was impacted fully by the global recession. Corporate results, especially from cyclical industries, were terrible. On the other hand, stock prices were strong despite weak results, as many of the results were ahead of expectation. Many of the portfolio companies like HDFC Bank, Glaxo Smithkline, CRISIL, Gruh announced respectable results. Companies in the IT sector are going through a rough patch, but outlook should look good if the global economic sentiment continues to improve the way it is.

Based on the quality of corporate results, valuations of several companies and the continuing tough environment, we believe that equity markets will start to face resistance soon. Election related uncertainty is also a deterrent. The most likely scenario over the next couple of year is an equity markets that remains flat and range bound. One should look at moving to higher component of cash as and when markets are strong and look at getting back into some quality stocks as and when we see more panic. It seems almost certain that the last of the panic is yet to come.

The financial year 2009 came to a close today. The year has been one of the worst for stock markets over the past 20 years, with the Sensex having seen a fall of 38%. Over the past 20 years, only 1993 was worse than 2009, with a fall of 47%, but this was on the back of a 247% return in 1992. Though our portfolios have also seen a sharp fall in values, broadly we have done better than the overall market performance. One of the reasons for a relatively better performance was due to the fact that we did not have any investments in the sectors like Construction, Real Estate, Metals, Capital goods that saw a maximum correction. On the other hand, in hindsight, we believe we should have moved more aggressively to cash during the earlier part of 2008 – having seen markets trade at very high valuations.

Since we are at a stage where equity markets are trading at less than half their peak prices, I will try and address a few basic questions on equity investing and possible returns from equities in the coming years. I have also attached a separate, note along with this mail, that provides the underlying data for some of the conclusions in this note. Please feel free to call if you want to see more extensive data on this subject. Firstly, though markets have fallen significantly from its peak levels, Rs 1 invested in the Sensex in 1988 will be worth Rs 20.4 today as compared with Rs 5.1 for a fixed deposit, assuming a 8% post tax return, over the same period. Equities as an asset class has performed well in the past and with markets being closer to their lows than their highs, returns from equities in the coming years should be reasonably good. Given Indian growth and stability of the financial system, there is little reason to believe the future will be significantly worse than the past.

Within equities, returns from individual stocks vary dramatically. Interestingly, returns from all, so called, ‘blue-chip’ stocks vary dramatically. Rs 1 invested in a Tata Motors in 1998 is worth Rs 8 today, whereas the same investment in Hindustan Unilever is Rs 48. Companies like Infosys have shown much better returns with Rs 1 invested in 1993 being worth Rs 870 today. On the other hand, stocks like Indo Rama Synthetic has seen a negative stock price performance since 1992 despite its revenues having grown 37 times since 1992.

Equities as an asset class has been a reliable investment avenue in the past. Buying equities at closer to the lows is a sensible strategy for the long run. Even within equities, companies that shows stable growth, generate consistent free cash and have low debts tend to perform in a more stable manner than others. At current levels, there is very little reason to be worried about investing in equities and in fact, looking at the prices of some of the stocks, one should be excited with the possibilities from investing in equities. Markets may continue to remain weak for the next few month, but this is an opportunity to buy into some high quality businesses as sensible prices.

Equity markets continued to remain weak during the month on the back of continuing global pressures and some poor corporate performance. Earnings growth from companies in real estate, construction, automobile, energy and metals were very weak with average fall in earnings in the range of 20-70%. Companies in other sectors like consumers, finance, IT, utilities and engineering were fairly good. Outlook for corporate performance in the coming months is fairly muted, though some pockets of the economy are expected to continue to do well.

Global investor sentiment continued to be weak on the back of double digit drop in economic growth in Japan, a 6.2% fall in US GDP and continuing pressure across Europe, Middle East, Russia, etc. Consumer confidence in US is the lowest since measurement of such sentiment was started in 1967. Though the Barack Obama administration plan to spend its way out of this recession is expected to give some boost to sentiment, there is wide ranging skepticism on the plan due to increased government borrowings and the after effects it can have on the system. The Indian economy grew at 5.2% during the last quarter and the widely accepted GDP growth of 7% is under question. Our interaction with companies across various sectors indicates a continuing level of concern over economic recovery, though the situation seems to have vastly improved since December 2008. Several companies are also using the current environment to pass through some of the tough decisions, especially on cost control.

A large part of the current problem in India is due to the log jam seen in the banking sector towards the end of 2008 and this pressure has eased over the past few weeks. Despite a continuing fall in inflation to under 4% now, which is expected to fall further, and the RBI moves to reduce interest rates, banks are yet to start lending at lower rates. Interest rates will fall over the next 12 months as the high cost deposits raised by banks over the past year come up for renewal. Banks in general have tightened their lending practice and as a result are flush with funds. We do not believe that there is any concern with availability of funds in India, unlike the rest of the world. To give some perspective, the total deposits raised by State Bank of India over the past 6 months is much more than the sum total of all funds in equity Mutual Funds in India. The average Indian individual continues to save a significant part of their earnings and with savings at 34% of GDP, India is well poised in terms of availability of funds.

We also met with the HDFC management during the month to understand the business in the context of concern over the real estate market and predatory pricing by State Bank of India. Despite the slowdown there seems to be no real threat of bad loans in the home loan market in India. In addition, due to very low penetration of home loans, the company is continuing to see sensible growth.

Challenges for the Indian corporate sector is stiff and immediate term outlooks is cautious. Compared with other major economies including US, Europe, Japan, Russia, etc, India seems to be best poised in terms of growth, availability of credit and prospects over the next 3 years. Slowing exports, weakening Rupee and lack of international investor interest would weigh down on stocks in the coming months. On the hand, prices of stocks in certain pockets are looking extremely attractive for good returns over the next few years.

Equity markets inIndiafell sharply during the earlier part of the month on the back of the Satyam Computers scam and recovered towards the end of the month on hopes that the Obama led stimulus plan can bring some respite to the rapidly deteriorating global economy.

In Oct 2008, markets in Indian fell sharply as the banking sector in India started to clamp down on lending. As a result, the last quarter was one of the toughest quarters for Indian corporate sector. Several large companies saw a sharp deterioration in profits and the quarterly results showed that the private sector has seen one of the worst periods in recent history. Companies in auto, metals, capital goods, retail were worst affected. Smaller companies, were worst affected due to concern on collections. This period is likely to last for sometime as RBI’s efforts to lower interest rates is yet to percolate down real needs.

In this context, several larger portfolio holdings came up with respectable results. HDFC Bank (21% earnings growth), HDFC (15%), Glaxo Consumer (18%), Infosys (34%) and other holdings in rating agencies, pharmaceutical companies have seen some deterioration in business conditions, but the expected growth rates in the coming year is still respectable. More importantly, their balance sheets are strong. On the other hand, results from some of the smaller sized companies have been bad due to their ability to react to deteriorating business conditions. We believe that, as long as their balance sheets are strong and sufficient cash available, these companies should be able to tide over the current tough conditions. Despite the weak results from companies, stock prices did not fall much, as much of the fall was seen in Sept-Oct 2008. Stocks are quite cheap now, and even if they may not go up in a hurry, one should see some stability at near current levels and some upside as and when business conditions turn.

The other large problem during the some was led by the confession letter put out by Ramalinga Raju of Satyam on the non-existence of over $ 1 billion. This incident has been a scary incident for us, as we always believed that the cash in the bank and tax paid are 2 numbers in an annual report that cannot be stated wrongly. This incidents has seen investors move towards companies where there is no doubts on corporate governance issues, and we believe most of our portfolio companies score high on corporate governance issues.

Scams have always been part of any growing economy, and a system needs to be judged not by the existence of scams, but by its ability to adjust to a scam. One should remember that past scams like the Harshad Mehta scam, Ketan Parikh scam led to major changes in the capital markets system including the birth of the National Stock Exchange, electronic trading, electronic settlement system, a much stronger regulatory environment, a more controlled banking system, etc. Effects of the current scam is like to strengthen the audit process in India, which even today is amongst the best in the world. Corporate governance and the powers of the independent directors should also go up. I think the Satyam scandal should lead to a much stronger corporate governance standards in the coming years.