Equity markets in India rebounded from the weakness witnessed in November, finishing the month up 4.6%, partly supported by a rebound in International markets. The rise in the markets was despite a net selling by FIIs – FII flow having turned negative after several months – and the continuing concerns over the telecom scam. With the US markets starting to respond to the large stimulus programs, there has been some strength in global markets over the past few weeks. One also needs to be note that December is typically a thinly traded month due to the holiday season globally and therefore may not be a true representation of a trend.

The effects of the various scams on equity markets, which led to a certain amount of weakness over the past couple of months, has weaned off a bit. On the other hand, there is definitely an increasing frequency of such negative news being unraveled. Scams are an indication of an inefficient and unsustainable growth, and investor confidence in such a situation normally gets diminished. The government needs to start taking decisive steps to address some of these issues, in order to ensure investor confidence is maintained.

The year 2010 was the strongest years for foreign capital inflows into India, at almost $ 30 billion. As a result of the strong FII flows, despite the domestic Mutual Fund industry being a net seller, Indian markets finished on a positive note. FIIs account for more than 15% of Indian markets and therefore have a significant influence on markets. Partly driven by strong FII flows, equity markets in India are a bit stretched and much is dependent on fresh allocations in 2011. FII flows over the next couple of months would set the tone for Indian markets in the coming months, and already there is some concern over valuations of emerging markets compared with some of the developed markets like USA. The next couple of months should give a reasonable flavor on FII flows in the coming months.

Earnings growth for some of the companies of interest for us have been fairly good and with the year coming to an end, some of the companies are starting to seem reasonable from next year’s earnings perspective. Their stock prices and valuations are not yet compelling, but these stocks are within a reasonable distance from starting to look attractive. We are keen to start buying into these companies, as and when prices become juicy.

Equity markets showed the first signs of weakness in over 5 months, falling 3% for the month. Markets are also down over 8% from the recent all time highs reached earlier this month. FIIs, who have been active buyers over the past few months, started to show first signs of slowing down over the past few days. Market weakness was led by a combination of global events (China tightening, turbulence in Korea and Irish banking industry crisis) and more importantly a series of scams in India, which could potentially have an impact on the economy and the current political stability.

The Indian economy has been viewed as a stable and high growth market, and several investors had taken this for granted. With the recent spate of scams, this hypothesis is being questioned. Chances of a few hiccups in India’s economic growth journey have increased due to the events of the last few days. It is difficult to say if any of these scams will unravel into something dramatic and impact economic growth. On the other hand, what it has done is diminish the confidence of both the global investors and domestic investors. A positive investment climate is required to maintain high valuations, without which valuations are likely to drift back to historical averages. What we are seeing is a correction in the high prices seen over the past few weeks.

Some of the worst affected companies in this correction are companies that have either been directly involved in the scam, or those that have suspect balance sheets or managements. During the past few days, we have broadly seen all portfolio companies hold up well through the correction. The resilience of the stock prices of fundamentally sound companies, with a proven management track record is put to test only during such corrective periods.

The global economy continues to remain weak and concerns have started to build up again over the strength of the Euro zone countries. So far, only the Irish bond market has been seriously affected, but there are severe concerns over bond markets in Spain & Portugal. It is relatively easy to bail out a smaller economy like Ireland, but the task becomes more difficult if the problems spread to other larger countries. Though authorities have tried to solve the problem, it seems clear that what are being addressed are just the symptoms and not the problems itself. If such events do play out, equity markets can face more severe head winds in the coming days.

We believe companies that require low capital to enable growth and also manage their working capital well are companies that deliver great shareholder returns over time. There are several such companies that are listed in India. Some of these companies have also corrected in recent times and we hope to invest in these companies as and when we do see sensible prices.

After the very strong performance last month, October was expected to be a month of consolidation for equity markets. Equity markets traded in a narrow range during the month and finished marginally negative for the month. Continuing strong FII inflows were offset by the massive Coal India IPO during the month, which witnessed record subscriptions. Global events continue to dictate the course of Indian markets.

Over the past few months, there has been a struggle between the US government wanting to weaken its currency, in order to give a boost to its exports, and the Chinese government intent on pegging its currency to the USD, in order to protect its export industry. Combined with the low rates of interest in US and a weakening currency, there has been a record flow of funds towards emerging markets. Several countries like Brazil, Thailand and others have started to take precautionary measures by imposing additional tax on foreign inflows. Despite such moves, global allocations towards emerging markets are at record highs. If we thought the Coal India IPO of $ 4 billion was a record, Brazil had a $ 60 billion IPO recently. Such numbers are staggering. The conflicting problem faced by the RBI is that money is flowing towards countries where inflation is high, and therefore interest rates are high. The increased flow of funds is creating a further inflationary environment. This is likely to lead to an asset bubble environment, which will face severe whiplash as and when the fund flow towards emerging markets reverses. It is difficult to predict when this flow of events may turn the corner, as this is dictated by events way beyond anyone’s control.

We have been looking back over the past 3 years on the performance of individual companies and corresponding stock price performance. There are several companies that are about 30% lower than peak, and several companies that are well over a 50% above the peak levels reached in 2008. One of the factors that stand out among the good performing companies over this period is the ability of these companies to grow at reasonable rates without requiring too much capital to grow. These companies get a special advantage in recessionary periods, as competitors struggle to raise capital for growth. These are the companies defying traditional logic of wanting resources in order to grow, and the stock prices of these companies tend to do well over time.

The current environment, where capital availability is easy, is conducive for companies to raise capital. As and when the capital flow slows down, we believe the Free Cash generating companies will stand apart. We hope to pack more of these companies in the portfolio.

After almost a year of trading in a narrow range, equity markets in India jumped up sharply this month and it currently trades slightly short of its all time highs. Equity markets were up over 10% for the month, and such strong double digit performance in a month is a rarity. The strength in the markets were mainly led by strength in global equity markets, and the increasing belief that the double dip recession is unlikely to occur for the global economy. The market up move has also been triggered by a short covering rally and several skeptics having to change their opinion.

Global investors continue to infuse large sums of money into the Indian equity markets. Inflows by FIIs in September is amongst the highest seen by foreign investors in any month. Domestic Mutual Funds, in the same period, continue to be sellers. A large part of the incremental money coming into the country is being absorbed by IPOs and private placements by companies, but the rush of capital is large and the quality of equity raising is starting to decrease. Typically, such behavior is seen in bull market peaks. Over the rest of the year, there will also be some very large government company IPOs, leading to additional absorption of capital.

Though 2 ½ years has passed since the previous market peak, revenue growth for several companies has come off since 2007-08. Moreover, one is seeing increased pressure on margins, and therefore earnings growth for companies is under pressure. After the earnings releases of June quarter, the SENSEX earnings published by BSE show that earnings have barely budged, whereas the market participants are expecting earnings growth for the year March 2011 to be between 25-30%. The level of optimism surrounding business is far lower than what one witnessed in 2007-08. The potential of the Indian economy, as seen by foreign investors is far ahead of the perception within India. The lack of buying by local investors and continuing selling of equity by promoters, whereas large scale investments by foreigners indicates this perception gap. We believe this is due to weak opportunities for investment in developed markets, rather than attractiveness of the Indian markets. As a result, Indian markets continue to be expensive, triggered by external capital.

Several of the core holdings in the portfolio have been doing well, but trading at the top-end of their valuation range. We may see a bit of a correction in the short run in some of these positions. The portfolio is also positioned to take advantage of any correction, but is likely to under perform if markets move up sharply from current levels. We continue to remain cautious, as the level of exuberance seen in equity markets is ahead of reality. Normally, such exuberance corrects itself, but it is difficult to predict how long it would take for a major change in perception.

Another month has passed by and markets continue to trade in a narrow range, giving no major positive or negative performance. Equity markets in India are up about 4.5% over the past 11 months and Indian markets continue to trade near their recent highs, whereas most other markets like US, Japan, China and Europe trade much lower than their recent highs. Market did trade higher during the month, but corrected towards the end of the month of the back of continuing negative news from other global markets. Earning growth for the last quarter has also trailed analyst expectations, due to margin pressure.

Indian markets are influenced by twin conflicting forces, which currently are balancing out each other. On one side, the Indian economy continues to grow at a reasonable pace and the government fiscal situation continues to be reasonably good. On the other hand, stocks in India are trading at higher valuation levels compared to even the US market – which has traditionally traded at a premium. More importantly, there is a risk of Indian economy slowing down as the RBI continues with its policy of increasing interest rates to counter run away inflationary conditions.

Though large cap stocks continue to remain in a small trading range, small cap stocks remain buoyant, giving us some opportunity to exit from investments that are trading at expensive levels. Liquidity levels have also vastly improved in several of these situations, to a level which historically has not been sustainable. We are also starting to see some value emerge, among companies that we believe one should own for the longer term. These stocks are currently trading at interesting prices, but not compelling enough to commit large amounts of capital, but we look forward to adding these companies to the portfolio soon.

We believe the key driver for the stock markets in the coming months would be interest rates. It has been close to 2 years, where real interest rates have been negative. Inflation on one side is well in excess of 10%, whereas the bank deposit rates have been closer to 6%. Car loans and home loans are available at available at rates lower than inflation rates. Over the past couple of years the scale has tilted in favor of consumers and away from the savers. One can judge the performance of the economy only when this distortion is removed. So far the regulators have been reluctant to address this distortion, due to the need to continue stimulus measures. This stand by the regulators has started to change and we could see a period where these distortions are removed. This period can and will have implications on asset prices, including equity market valuations.

Equity markets continued to trade in a narrow range, closing this month with a 1% up move. The Indian market continues to trade at near its 2 year high while most other major global equity markets have had reasonable corrections from their peak levels. The sense of optimism surrounding the Indian economy continues to be strong, so much so that Indian markets are now stiffly priced compared with several other comparable markets.

Corporate results in India continue to show good growth, but there is a trend of margins coming under pressure. This is due to a combination of reasons – lower demand in some pockets, effect of higher excise duties and higher raw material prices. At the same time, the RBI is continuing to increase interest rates at a measured pace in order to bring inflation under control. These rate increases, which have become inevitable in light of the high rate on inflation in India, could potentially slow down the economy over the medium term especially since the transmission of monetary policy into rate action by banks is much higher now. Some banks have already started to increase deposits rates and one could see borrowing rates for consumers go up soon. Today, consumers are able to borrow at rates which are comparable to those at which the government is borrowing (usually considered risk free) and the real interest rates are currently negative by more than 2 percentage points. It is possible that this scenario may undergo a change in the coming months.

The global economic environment continues to look a bit grim, as unemployment levels in countries like US remain at very high levels. No economic recovery can be construed to be strong when 10% of the workforce are unemployed. Leading indicators out of the US are suggesting that growth rates going forward may be a lot slower than those witnessed over the last 6 months, owing largely due to the effects of government stimulus waning. On the other hand, the risk of collapse in Euro zone seems to have been tempered over the past month.

Several of our portfolio companies continue to do reasonably well in this environment and we are fairly satisfied with the performance of these companies. We have been seeing strong price performance in some of mid-cap stocks that we have been holding for more than a year. A few of these stocks have reached expensive levels and we have been using this as an opportunity to sell down the position – we can always buy them back when prices moderate somewhat.

In the context of a weak global economic environment, continued increase in interest rate to combat inflation and stiff valuations, we continue to remain cautious. Moreover, we are not seeing compelling investment opportunities – at prices where the immediate terms risks compensate for more than attractive returns over the medium term.

After a 3.6% fall in May, equity markets regained most of the losses in June and closed on a positive note. Some of our recent investments continued to do well and some of the older investments reached expensive valuations levels, allowing us to exit some of these holdings. The portfolios continued to do well relative to the markets, despite the high cash levels that we hold. On a Year to Date basis, since 1 April 2010, markets are flat, whereas our portfolios are reasonably ahead of the market.

Indian markets continue to be strong despite the fact that most comparable sized global markets have seen sharp corrections. Among large markets, the US, Europe and China have corrected between 10-25% from their recent peaks, whereas Indian markets are still trading very close to their recent peak levels. Global markets continue to be plagued by the threat of a double dip recession, as most governments are choosing to reduce their budget deficits and their high debt burden. It is important to remember here that the global economy came out of a recession due to large scale government spending, and is likely to get affected if governments pull back on their spending. The relative attractiveness of Indian markets compared with other alternatives stands diminished for international investors. Under normal circumstances, this should translate to some correction in Indian markets, but we are surprised by the relative strength in the Indian equity markets – especially over the past month.

The commitment of the current Indian government to the reform process is probably what is driving the positive outlook towards Indian equities. The government’s bold steps in the oil sector shows the decisiveness with which this government is moving. Deregulation of the oil sector has been in discussion since 1994 and the government’s recent step to deregulate is very welcome as it will have a very positive impact onIndia’s fiscal deficit. While there does not seem to be any immediate threat of that nature, one wonders what the government would do if international oil prices move up significantly to say $120 per barrel when petrol may have to be priced at Rs 100 a litre. One needs to note that the oil sector accounts for over 10% of Indian GDP and we should see some interesting tests ahead on this subject.

The Nifty, after reaching a level of 5100 in Sep 2009, has been trading in a narrow range for the past 9 months. During this period, we have been seeing stocks showing a fair degree of volatility. As and when some of our existing holdings reach expensive valuations – from where we view upside potential to be limited with a significant downside risk we have been selling down our positions. On the other hand, other than in small pockets, we are not seeing stocks reach attractive buy points. As a result, cash is beginning to accumulate in the portfolio. If Indian markets start to move in line with other comparable global markets, we are fairly confident that we should get an attractive opportunity to invest. In the meantime, our portfolios continue to do fairly well and better than the market despite the large cash position in our portfolio.

Equity markets witnessed a sharp correction during the month, and at the lowest point was down almost 9% for the month, before recovering to finish the month with a drop of 3.6%. Our portfolios have broadly been insulated from the fall in the market due to a combination of cash in the portfolio and the equity component doing of the portfolio holding up relatively well. We believe we are well poised for any sharp correction that one could witness in equities.

The correction in markets was led more by international events rather than any reasons specific to India. One may ask how events in Greece, Spain and Korea can possibly impact markets inIndia. The Indian economy seems to be doing fine and apart from some pockets of exports to Europe, most other businesses seem unaffected. Concerns over events in Europe led to FIIs pulling out close to Rs 8,400 cr out of Indian markets over the course of the month. This was the largest single month outflow by FIIs since Oct 2008. Global investor appetite for equities reduced to some extent. Since FIIs hold close to 17% of Indian equities, and a far higher proportion of the actual floating stock, any small change in their inflows or outflows normally has a larger impact on stock prices itself. More importantly, if the concerns over the global economy plays out the way it is feared to, one could see continued FII selling.

The larger fear facing equity markets in India is the risk of a potentially sharper fall in overall markets. Our real concern is to evaluate the risk of markets falling significantly from current levels and to protect the portfolio for such a risk. Given current flow of events, it seems unlikely that one can see any dramatic rise in equities in the immediate term.

Last month marked a shift away from the concerns of the economic recession of 2008 to a current concern of excessive government borrowing across the world. Many countries have announced their intention to aggressively reduce borrowing and give up stimulus measures. If global concerns over Europe continues and governments start to reduce borrowing aggressively, the global economy should go through a period of correction. In such an event, there is a serious risk of equity markets going through a period of correction.

Our portfolios are broadly positioned to handle any major correction, and actually to take advantage of any such major correction. Any major market correction is in reality a great opportunity to buy into high quality companies are great prices. One can do so only if there is sufficient cash in the portfolio. We believe one can put the cash in the portfolio to good use in the weeks to come.

Even after the correction of the past month, we are not yet seeing attractive prices, though the highly priced pockets of stocks seem to have moderated a bit. We continue to closely monitor markets for attractive prices and looking forward to committing capital as and when we do see sensible prices.