Equity markets continued to inch forward, up 0.43% for the month. Though markets closed up 27.7% for the the calender year 2012, this was on the back of a steep fall of 24.6% for the Nifty in 2011. Nifty was trading at 6135 as on Dec 31, 2010 and 6139 as on Dec 31, 2007. The current levels of the Nifty, at 5905, trails these high levels seen 5 years back. We are into the 5th year of the bear market consolidation phase and one would find it difficult to add the word ‘celebration’ to this anniversary.

Though the Nifty and Sensex have seen such a corrective phase, one should remember that this is just an index and it is composed of individual stocks. A brief look at the performance of individual stocks over the past 5 years gives a dramatically different picture. Of the 50 companies that are currently in the Nifty, 9 companies have seen a fall of over 30% in their stock price. 16 companies have seen their stock price increase by more than 75%. 16 companies which were in the Nifty as on Dec 31, 2007 are currently not in the Nifty and the performance of these stocks over the past 5 years as been worse than the averages. Of these 16 companies, which were removed from the Nifty, 11 companies witnessed a fall of more than 50% in their stock prices. If one had held onto the original basket of Nifty stocks from 2007, the fall in portfolio values would have been significantly worse than the Nifty’s performance. Many of these stocks did see a sharp fall and looked tempting at times, but are yet to show signs of recovery.

It is important to note the divergence in behaviour of individual stocks, despite a market that has delivered nearly nil returns over the same period. An analysis of the financials of the companies that have done well, even during the past 5 years, a few characteristics stand out. Firstly, these companies have been growing revenues consistently over this period. Secondly, they are all very profitable. The average Return on Equity of the stocks that did well is about 20% better than the poor performers. Thirdly, the good performing stocks were trading at reasonable valuations at the beginning of the period. We believe, as long as the investor is willing to be patient, it is possible to make a reasonable rate of return above inflation by sticking with the simple hypothesis of buying into high quality companies, which grow in line with the economy and are very profitable, at prices that are fair.

This experience is best described in a statement by Warren Buffett in Berkshire’s 1989 annual report – ‘It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price’. With the prospects for the Indian economy looking good, led by highly favourable demographics, and a relatively flat market over the past 5 years, we are finding a few wonderful companies at fair prices. We look forward to buying into these companies.

The Indian stock market was steady through most of the month. The rally towards the end of the month helped it close strongly – up 4.6% for the month. After a strong September, driven by policy action from the government, the market consolidated for a good 6-7 weeks and then once again surged upwards. The Nifty hit 12 month highs, despite the continuing negative news surrounding economic growth, inflation and slow policy action. Our portfolios did well during the month, mostly performing better than the Nifty.
The Indian stock market peaked in January 2008 and has pretty much gone nowhere over the last 5 years. Over the same period, the Indian economy has grown from Rs 42.9 trillion in FY2007 to Rs 88.6 trillion in FY2012. The RBI announces GDP in Rupee terms annually (technically called ‘GDP at current market prices’), which interestingly has more than doubled over the past 5 years, averaging an annual growth of 15.6%. Notice that this is very different from the real GDP growth which newspapers talk about, which is closer to 7%. Nominal GDP growth in the prior 5 year period of FY2002-FY2007 was actually slower. GDP grew from Rs 23.5 trillion in FY2002 to Rs 42.9 trillion in FY2006-07, an annual growth rate of 12.8%. The stock market, on the other hand nearly quadrupled from FY2002 to FY2007 while it has been almost flat in the next 5 year period. The reason for this disparate performance over these two time frames, is the valuation at which stocks were trading at the beginning of each period. Today, the stock market is trading closer to the valuations in 2002 than to the valuations in 2007.
Since we invest in companies, or small slices of companies in the form of shares, the prospects of our investments are linked to the respective company’s revenue and profit growth. On an aggregate basis, all companies’ revenues are more correlated to the growth of GDP at current market prices, rather than the real GDP growth. A good bit of the difference can be explained by inflation, but other factors also come into play. We are pleased to confirm that the basket of companies we have chosen to invest in have grown at a rate of about the 15.6%, or better, over the past 5 years.
As you can imagine nominal GDP heading in one direction (and as a corollary the revenues and profits of the companies heading in the same direction) and stock prices not following them is not a sustainable situation. One cannot have companies, with very strong free cash generating capability, growing their revenues but their stock prices not growing correspondingly. Many stocks are bridging this gap and as a result we have seen equity markets perform in the current year. Despite a decent stock market performance for the year to date, we continue to see interesting opportunities on a selective basis.
Economic growth has been fairly strong over the last decade and it is highly likely that growth will continue to be good over the next decade. Stocks, when chosen well, should be able to track this growth and deliver satisfactory rates of return to investors. With markets having stayed flat over the last 5 years, there is an additional margin of safety built into the system at current levels.

After a very strong performance in September, markets were subdued in October and were down 1.5% for the month. For the current financial year, equity markets are up 6.1%. During October, our portfolios also corrected broadly in line with the market. Corporate earnings for the quarter ended September have broadly been weak, with even the consumer oriented companies showing weaker numbers. This is partly due to the delayed Diwali season, and more importantly due to the economy slowing down. The RBI continues to keep interest rates high, with the intent to address the persistent high inflation, and this has had an impact on economic growth.

For the last 3 years, the Indian equity market has been subdued, trading in a narrow range. An analysis of the Sensex’s trading pattern over the past 20 years shows that the annual volatility in the Sensex over the past 3 years has been among the lowest over this period. While there are many definitions of volatility, for the sake of simplicity we are taking the 52 week high low range to calculate volatility. If the Sensex were to trade between 10,000 and 16,000 in a given year, then by our measure the annual volatility of the Sensex for that year would be 60%. Over the last 20 years, the median annual volatility of the Sensex volatility is close to 60%. Volatility over the last 3 years has been averaging 32% and for the first 10 months of 2012, it is only 25%. History suggests that the market should break out of this period of low volatility one way or another.

The low volatility in the market is probably because of a lack of earnings momentum and poor investment sentiment on one side and low valuations on the other side. The lack of earnings momentum and all the negative news regarding the global economic environment, as well as policy issues in India, is not allowing the market to move higher. At the same time, we observe that after years of being in a narrow range, the valuations have become compressed and therefore all the negative news flow is unable to drive stock prices lower.

The last time that we observed this kind of compression of the market’s volatility was in the period 2001 to 2003, towards the fag end of the previous bear market. At the low point of 2012, at a Sensex level of 15,358, the market was trading at roughly 15x earnings which is also the median of the annual lows over the last 20 years. Add to this the fact that the earnings growth of the Sensex over the last 4 years is about 8% which is way below the trend line EPS growth of 15% over the last 20 years. All of this brings us to our thesis, that there is a higher probability that the breakout from this period of low volatility is likely to be to the upside rather than to the downside.

The stock market continues to present interesting opportunities from an investment point of view and we continue our efforts to buy into high quality companies at prices that are reasonable with respect to their growing intrinsic value.

Equity markets charged ahead in September and closed the month up 8.4% – the Nifty is up 7.7% in this financial year. Our portfolios trailed the Nifty for the month and on the average are either in line or ahead of the Nifty for the year. The sharp uptrend seems to be due to a benign global equities environment as well as a number of steps taken by the government which are seen as pro-reform. The upward revision in diesel prices and the move on FDI in sectors such as retail and aviation are welcome moves in an environment where the buzzword was ‘policy paralysis’. There are a number of other small steps which have been announced and more are expected over the next few weeks and months. However, just as important as political intent, is the need to remove bottlenecks in implementation of policy. While the government is making some noises on this front, we hope that these will translate into some improvement in implementation of projects which are stuck due to a lack of government action.

Over the past 5 years, when the environment has been none too cheerful, FDI flows have been averaging over $ 30 billion each year, mostly in sectors where free flow of capital is allowed. Besides, with a savings rate of over 30% of GDP, there is sufficient capital available within India. The challenge has been to attract this capital towards productive assets and to provide investors with an environment which is investor friendly.

Let us take a brief look at the savings pattern of the domestic investor. The Indian households and the corporate sector have about $ 1.3 trillion of their savings in banks and also have significant gold holdings which are estimated (as per World Gold Council estimate, India has about 18,000 tons of gold) to be close to $ 1 trillion at current market prices. Last year alone, India imported gold worth $ 55 billion (note that this is more than the total inflow of foreign capital into India last year). Compare this with the cumulative investments in equity Mutual Funds in India, which is about $ 35 billion. These numbers tell you that the Indian investor seems more intent on protecting capital and hedging against inflation rather than generating a positive real return on their capital.

A quick study of the returns delivered by various assets classes over the past 20 years throws up some surprising facts. Inflation has averaged 8.0% annually over the past 20 years, which means if you had Rs 100 in 1991 you would need Rs 467 today to be able to buy the same basket of goods today. The average term bank deposit rate has been 9.3% over the same period – Rs 100 invested in a fixed deposit in 1991 would be worth Rs 639 today assuming no taxes. However, after taxes, this number would reduce to Rs 372, implying that the inflation adjusted post-tax return from fixed deposits is negative.  Gold has delivered 10.6% annually over the same period (Rs 100 has become Rs 745), despite gold being up 6 times in the last 7 years (something which is unlikely to repeat in the next 7 years). Equities have delivered 14.5% annually since 1991, despite the 5 year bear market (Rs 100 would have become Rs 1490). So, despite equities having delivered significantly ahead of inflation and other asset classes, there is still a huge resistance to investing in equities. As increased trust develops, we believe more of domestic savings will get channeled towards assets that can generate real rates of return ahead of inflation. Meanwhile, after a 5 year bear market, prospects for returns from equity markets continue to look interestingly poised.

The equity market in India was strong through most of the month, but corrected towards the end to close up marginally, by about 0.6% for the month. Our portfolios did fairly well in this market, performing ahead of the market on the average. Many of the larger, core holdings showed signs of strength. Despite continuing negative headline news, especially with respect to governance in India, we see several companies performing well in their respective business and are trading at sensible valuations. The opportunity in these cases continues to be attractive.

Over the past few months the country has been besieged with governance issues and as a result crucial policy decisions are getting postponed. This has had a negative impact on several infrastructure projects, which have been delayed significantly. There are several large companies that have invested significant amounts of capital in these infrastructure projects – like power, roads, telecom, etc. Banks have also lent large amounts of capital to these projects as most of these projects are capital intensive requiring significant debt. When large amounts are capital are invested, it is essential for these projects to get completed on time. Given that Indian interest rates are fairly high, any delay in these large projects adds significantly to the interest cost, in many cases making these projects unviable. At the end of the day, the Indian public needs to bear all these costs in some form. The real challenge facing the country is to ensure no further delay in these projects, and at the same time handle the governance issues plaguing the country. This problem needs to be addressed urgently, as there is no way the country can move to the next phase of growth without efficient infrastructure being made available.

Many companies in the listed market are exposed to the problem of governance and project delays, and this has weakened these companies significantly. Sadly, one is not able to see any easy solution to this mess. Even though the stock prices are down significantly from their peak levels, the large debt exposure means that on an enterprise value level, these stocks are not cheap.

Despite this environment, the Indian consumer remains strong and recent surveys indicate that the Indian consumer is among the best positioned compared to his/her brethren internationally.  Unlike many other countries, the Indian consumer in the aggregate does not have any significant borrowings, has a high savings rate, a stable job and good career prospects. A young population, which is increasingly seeing the benefits of education, is an added advantage over several developed markets. Companies insulated from the government and addressing the needs of the consumer have been doing quite well.

Poor equity market sentiment over the last few years has meant that equity markets have given virtually no return over a 5 year period, vastly trailing the average 15% that the index has delivered over longer periods of time. The consequent compression in valuations offers a lot of interesting opportunities for the patient long term investor.

The Indian equity market was down for most of the month, though it recovered towards month end to close down about 1% for the month. Our portfolios trailed the markets by a bit during the month.

It was in Jan 2008 when the Sensex hit a high of close to 21,000. After more than 4 1/2 years, the Sensex closed July at 17,236, down 18% from its peak level. During this period the Indian economy has done fairly well. The total GDP has increased from Rs 45,82,086 cr in FY2008 to 82,32,652 cr in FY2012, averaging a growth of 15.7% in rupee terms. In dollar terms too, the GDP has grown at 9% p.a. since FY2008 despite the steep depreciation of the rupee over the last 12 months. In the context of how the rest of the world economy has done in these circumstances, this makes one wonder why the Indian stock market has performed so poorly in this period.

The answer to that lies in the valuation of the market at the starting point and at the ending point. In Jan 2008, the Sensex was trading at close to 29x that year’s trailing 12 month earnings per share, which is quite a bit higher than the median 23x that it has typically traded at the top end since 1991. On the other hand, at its recent low of 15,750 the Sensex traded at 15.2x its trailing 12 month earnings per share. In observations over the last 21 years, this is very close to the median lows that the Sensex has traded annually. The key determinant of long term return for an investor is the valuation at the point of entry and we are closer to being cheap than expensive.

Moreover, as compared to nominal growth of 15.7% p.a. in GDP over the last 4 years, the Sensex earnings has grown at only 5.6% p.a. over this period. This compares rather poorly with the 14% compounded annual growth in Sensex earnings over the last 21 years. The point of throwing all these numbers is that not only is the equity market cheap from a valuation standpoint, but there is a potential reversion to the mean of the profitability, which should result in companies reporting higher growth rates over the next 4 years as compared to the last four.

Meanwhile, we continue our efforts in selecting high quality companies which have stood the test of time and are not only likely to perform better than the market average, but also do that with a lot less volatility in their earnings. We continue to remain excited with not only the quality of companies that we have selected but also the valuations at which they are trading.

After a weak May, the Indian stock market rebounded very strongly in June, closing the month with a positive return of 7.2%. Our portfolios did fairly well and are now in line or slightly ahead of the market for the year to date. The strong uptrend in the market was despite continuing negative news both locally and globally.

This can sometimes surprise investors, who expect markets to move in line with the news flow. The Indian economy has slowed down significantly, the Rupee has been on a downward spiral, inflation continues to be high, government policy action continues to trail expectation and the RBI seems keen to wait for action from the government to address the fiscal situation before it considers reducing interest rates. Also, the European situation continues to remain unresolved though there were some positive sound bytes at the recent European summit. The news from the US and China is not very heartening either. In such an environment, many investors have been surprised by the strong rally that the markets have witnessed. As we have been saying over the past few months, markets have been statistically cheap. At such prices, markets are more likely to respond to favorable positive news rather than to any incremental negative news.

In this dark gloomy environment, a bright spot has been a steep drop in global oil prices. India imports a large percentage of its oil requirement and the total oil import bill was close to $ 150 billion last year, contributing significantly to our current account deficit. The current market price of oil is about 20% lower than last year. If global oil prices were to continue to fall, it can have a dramatically favorable impact on the Indian economy – lower fiscal deficit as the oil subsidy reduces, lower inflation which will give the RBI room to reduce interest rates and higher foreign investment flows which would have a favorable impact on the Rupee. We continue to watch oil prices very closely.

Is it still a good time to invest in equities? There are several stocks which we are unlikely to buy at any price, as the balance sheets of these companies are too stretched. On the other hand there are some outstanding companies which are trading at almost the same prices as 4-5 years back, whereas these companies have grown both revenues and profits significantly over this period. They have also been accumulating cash, leading to a stronger balance sheet. The pendulum of valuation has swung from being very expensive to being very cheap. Some of these companies are interesting poised for very attractive returns in the coming years. We continue to accumulate these companies and fairly convinced the risk reward equation is stacked up significantly in favor of a patient investor.