Equity markets in India continued to trade in a cautious zone, finishing the month on a slightly positive note. Despite continuing negative news from Europe, equity markets have been holding up due to be a combination of positive corporate results and the continuing loose monetary policy by governments. Our portfolios broadly continued to do better than the market, despite the high cash holding, as the value in some of the larger holdings are being recognized.

Over the last 2 years, governments across the world have been borrowing aggressively and maintaining high deficits. In a democratic system of governance, governments will continue to pursue this path unless forced to change. In the case of Greece, the government was forced to change this path with the cost of borrowing going up significantly. The Greece government’s cost of borrowing, for a 10 year bond, has gone up from about 4.5% to over 9% over the past 4 months. Imagine a friend of yours who has borrowed for his house at 8%, and suddenly needing to pay double the EMI. The situation is very similar. The Greece government, if it does cuts is spending, will take the economy further into recession. The only other option left is to default on the loans, unless someone bails them out of the problem. The real concern for the world today is not the problem isolated to Greece alone, but several governments are walking this thin line between survival and holding up the base of their respective economies. Portugal and Spain have also moved a bit closer to testing this thin line. Some other countries may not be too far away from asking this question. If this problem spreads, the global economy may have to face the prospect of another recessionary phase.

The other big event has been the Goldman Sachs related events and the finance industry practice of misleading clients. This is a part of a series of events that leads to a higher levels of regulation. The regulatory whip lash can have certain severe impact of financials markets in the short term, but would work towards building a more durable system over the longer term.

The Indian economy is definitely better poised than many of the developed economies. As a result, there is continuing investor interest in Indian markets in particular, and other emerging economies like India in general. Corporate results in India has been fairly good and the sense of optimism continues. The real risk Indian markets face is that, given the high valuations and dependence of foreign flows, markets will get affected if the global economic problems continues.

From individual stocks perspective, the stock prices of mid and smaller companies have been going up faster than larger stocks. Our assessment is that, though there is some value left in these kind of companies, they are steadily moving towards their full value. Normally, markets correct only after even these stocks are fully priced. Overall risks in the market out weigh the superlative reward opportunities. Given global uncertainties, it seems better to be cautious.

Equity markets closed the financial year ending March 2010 with one of its strongest closings since 1992. Markets were up 75% during the year and there is a sense of impregnability. Before one can call for celebrations, one needs to note that this was on the back of a 36% fall in the previous financial year. Rs 100 invested in Nifty stocks on April 1, 2008 would be worth Rs 112 today. This is by no means spectacular. Our portfolios over this period have performed much better and we are fairly satisfied with having navigated the last storm. Our single major learning over this period is to focus on limiting loss of capital when markets go through a corrective phase. As several wise men have said in the past, the key to accumulating wealth is to not lose money. We have understood this maxim better over the past 2 years and suspect most secrets of good investments lie in these words.

The aim of our investment process is to look out for opportunities where there is disconnect between where the business value is headed and where the stock prices have gone. Last year the business values were growing but the prices were falling, so we were deploying capital, but this year the prices rose far faster than the underlying business value and so we have been sellers.

The real question to ask now is, how the next year is likely to be for stock markets. There is a sense of optimism surrounding prospects for the Indian economy. We also strongly believe the Indian economy should deliver on its growth promise in the coming decade.  On the other hand, there are a few reasons why stock market performance in the immediate term may not be spectacular.

Firstly, equity markets are up over 75% over the past 12 months and stocks are not exactly cheap. The average stock is trading closer to the top end of its historical trading range and history suggests it cannot sustain these levels for too long. Several people claim that this time it is different, but those are the most dangerous words in investing.

Secondly, the inflation & interest rate story is far from comforting. Over 80% of Indian financial savings is in fixed return instruments which earns about 6%, whereas inflation is higher than 12%. No economy can sustain growth with the average investor earnings a negative real rate of return. So far the Reserve Bank ofIndia, which has a significant say in setting interest rates, had its hands tied behind its back as the government wanted to get the economy back on growth track. Now that the economy seems to be on a comfortable road, the Reserve Bank will definitely go on the path of correcting interest rates. The after effects of such a move would be lower demand for several products like housing, cars, etc, and therefore some moderation to the Indian economic growth dream.

Finally, and the scariest fear across the world is the risk of governments defaulting on their loans. With the recession over the past 2 years, many governments witnessed lower tax collections and also had to simultaneously increase spending to give a push to the economy. As a result, most governments were forced to borrow aggressively. Suddenly, the cost of borrowing for governments has been increasing and there is a risk that some countries cannot afford to pay back its borrowings. Greece, Ireland, Portugal were downgraded this month. Even scarier were the warning bells on the safety of debt instruments issued by US and UK governments. Indian government 10-year borrowing rate has also gone up from 6% to about 8% over the past year. Higher interest rates does not augur well for equity markets.

After a sharp 6.1% fall in the month of January 2010, equity markets finished the current month with an up move of 0.8%. Equity markets, though finishing the month on a positive move on the back of the optimistic budget, was plagued for significant part of the month by negative global economic news. Our portfolio broadly has done relatively well, but no major move on the positive side.

The budget presented on Feb 26 is reasonably balanced. The budget continued its initiative on social sector and infrastructure spending. Roll back of tax stimulus measures was done to some extent, keeping in line with the partial and calibrated roll back measures promised earlier. Fiscal deficit is being brought under control to some extent, partly with help from divestments and 3G auction. The changes in the tax rates also needs to be viewed in light of the move towards the new direct tax code and GST regime starting next year. It looks like the new tax code in its current form would get implemented next year. If so, do keep an eye open on developments as investors could be forced to take some serious action in the next financial year to ease their transition to the next tax code.

Concerns about the developed economies’ macroeconomic condition continue to haunt capital markets across the world. Most of the people I know or companies we invest with will be able to tell you the size of their borrowing very quickly. Recently, it was found that a country as large as Greece could not exactly tell what their total borrowing has been. These are scary thoughts. Worse still is the fear that there is never just one cockroach in a kitchen.

Many countries are starting to find that the bond markets are not too keen to finance their mammoth government borrowing programs. If this problem continues, there is a very serious risk of a liquidity tightening across the world. Many experts believe the process of tightening has already started. Foreign investors appetite for Indian markets could diminish in such an event. In such an event, the Indian economy too will get affected and it would be highly unlikely that the Indian government can achieve the divestment target for next year or the budget deficit target of 5.5% of GDP.

As for equity markets, we are not yet finding wide spread attractive investment opportunities. We are monitoring several companies that have the profile similar to Sachin Tendulkar. After almost 20 years of international cricket, his appetite for scoring runs and his recent track record is spectacular. We also like to invest in companies that have been doing well for several years and have not lost their appetite for doing well in the future. There are several such companies and the India economic growth should ensure that the prospects for these companies in the coming years would be good. On the other hand, because of the sharp increase in stock prices over the past year, we are not yet finding these companies at prices where one can take large portfolio positions. Knowing the nature of the equity markets, one is fairly confident that the sensible prices will come soon.

Equity markets witnessed a sharp 6% correction this month. The steep fall corresponded with similar weakness seen across all global markets. Our portfolios were broadly protected against this fall due partly to the large component of cash in the portfolio and partly due to our portfolio stocks performing well relative to the market. We would like to reiterate the importance of protecting capital during severe downturns in this context.

The correction in global equity markets seems to be due to increasing concerns that governments globally could withdraw the economic stimulus delivered at the height of the crisis as also a global investors return to risk aversion. The Chinese government recently clamped down on incremental bank lending, after the ballooning of bank lending over the last 12 months. In the US, following the loss of a key election by the Democrats, the government has started talking about stern bank regulation going forward. It appears that the pendulum of capitalism has started to swing from the extremes of unbridled greed towards excessive government regulation. The recent moves by President Obama indicate the US government’s move towards a regime of stricter government regulations on banks and it is possible that other governments in the West may follow suit. This could have far reaching impact on the conduct of banks in the future. Another big fear in the coming months is sovereign risk, with the risks over the Greek government solvency starting to gain press coverage. All these factors have been leading to foreign investors selling off Indian equities over the past few days.

In India, there has been a sense of caution due to the continuing tightening measures by the RBI and expected actions on taxation in the coming budget. Though the RBI does not want to disturb the economic growth trajectory, and is fairly confident of GDP growth in excess of 7-8%, RBI is deeply concerned over rising inflation. What is of concern to us is while inflation is 8.5%, fixed deposits yielding only 6%. The post-tax 4% that the Cash Funds are yielding is giving us sleepless nights. With its recent credit policy, the RBI has clearly started its journey towards tightening liquidity and addressing inflation on a serious note. We need to watch out for what the Finance Minister would do next month in the budget, but there is consensus building up on the need to increase some of the indirect tax rates to reign in the fiscal deficit.

The key question to address now is whether after this market fall, equity markets have become attractive enough to warrant incremental investments. It is our belief that though markets have corrected, most stocks are still trading at moderate to expensive valuations. There are a few pockets where stock prices are beginning to look cheap, but that situation is not wide spread. Having said that, if the current trend continues, we should start seeing some attractive prices soon. Since we have been building the cash position in the portfolio gradually over the past few months, we are looking forward to a market where stocks prices become more attractive. A falling trend in prices, if it continues, should be to our advantage. The broad India economic growth story is still intact and it would be great if one can buy into the long term growth story at sensible prices.