The Indian stock market displayed significant weakness in the month, down 6.2% for the month, and this time around our stocks also participated in the decline. The weakness in the stock market seems be due to both global and local factors – while the world continues to fret about the Greek election due in mid-June and the possible Greek exit from the Euro and its contagion to Spain and Italy, India continued to be bogged down by growth fears with the fourth quarter GDP growth at 5.3% – the last time Indian GDP growth was this low was in the Oct-Dec 2008 quarter. Also, adding to the nervousness was the rapid depreciation in the Indian rupee which is touching life time lows.

The worries on the rupee front stem from the large current account deficit that India has – in the year ending March 2012, the trade deficit (which does not include IT exports and other services exports) was roughly $180 billion, a large chunk of which is due to oil imports. However, when we add what are called invisibles (IT exports, net service exports and transfer payments) the current account deficit comes to about $75bn which is about 4.5% of GDP. However, one big item of import which escapes attention is about $45 bn of gold imports which is really more of a capital item (being a form of money). If we exclude gold imports, the picture does not look so dire. India’s forex reserves dipped from $275 bn to $260 bn over the financial year which does not seem to warrant a 22% depreciation in the currency. With Indian gold demand beginning to decline and the recent fall in global oil prices, there are positives on the horizon on the currency front.

On the whole it seems that the depreciation of the rupee seems more driven by the poor sentiment on India, thanks to the perceived policy paralysis, as well as a general appreciation of the dollar against most currencies during the period. The latter is also somewhat reminiscent of what happened in the global crisis of 2008. There are many similarities between the current economic environment and 2008 – dollar strength, very low long term government bond yields (both the US and Germany 10 year bond yields are at life time low – this signifies a great amount of fear in the market and hence the crowding into what are viewed as extremely safe assets), negative IIP in India and a general air of pessimism. The only difference is that the last time this happened post the Lehman bankruptcy while this time this seems to be happening even before the Greek exit is a finality. The level of fear in the market seems to be reaching an extreme.

Whether these fears will ultimately be realized is difficult to predict, but we do know that past episodes of such fear such as Sep-01 or Oct-08 have generally resulted in very strong equity performance in subsequent years, because high levels of fear usually create the low valuations from which long term investors can profit. We have also observed in the past that in this phase of the market, high quality companies also fall sharply. Some of our high confidence bets are today trading at valuations similar to those in March, 2009. This has got us quite excited as we are fairly confident that these companies will deliver over the long term. The discount sale on right now is a great opportunity to invest.

After a very strong first quarter, equity markets corrected during the month, with the Nifty down 0.9% for the month. Our portfolios continued to do relatively better than the market. The correction in the market was triggered by continued government uncertainty over taxation of foreign investors’ investment gains, and a general sense of negativity surrounding governance in India.

The economic climate in India seems fairly grim and the popular media has been taking a severe view on the same. The primary factor behind this view is the perceived slowdown in governance. With the likes of IMF and S&P starting to quote this as a problem area for India’s economic development, this issue is becoming more serious. In addition, the uncertainty over taxation of foreign investors is causing a pause in foreign investment flows. This coupled with the high current account deficit has had an impact on the rupee which has weakened considerably over the past few weeks. Given that the RBI has been on a rate increase cycle for some time now, interest rates in India are near their 3 year highs. The capital goods cycle in India is also very weak, with most large scale investment decisions slowing down considerably from their peak levels. In sum, there appear to be very few positives in the economic climate.

From our perspective, one of the significant positives in favor of India is the positive consumer sentiment. Despite all the talk about the government, the average consumer is earning more each year and continues to be in a strong buying cycle. Many of the consumer goods companies we follow are seeing some of their best years. Despite interest rates being at a 3 year high, consumer purchase patterns continue to hold up. One of the reasons for this is that the Indian consumer is much less indebted than his Western counterpart and also has a high savings rate. With inflation showing signs of cooling, the RBI in its latest monetary policy cut the repo rate (the rate at which banks borrow from the RBI) by 50 basis points and signaled a reversal in its prior tightening policy stance. Given the positive consumer sentiment, there is significant pent up demand which is likely to emerge as and when interest rates head lower. Several people have delayed the purchase of a car or their dream home, and are likely to move ahead with their purchase decision soon. This is in sharp contrast with the developed markets, where consumers continue to struggle with over-indebtedness and high unemployment. Companies in India, with their prospects linked to the Indian consumer, have been delivering fairly strong results.

For us, as investors, the macro is just one part of the story. To us, the biggest determinant of future returns from our stock portfolio is the valuation at which we buy these stocks. The pessimism that seems all pervasive at present is perhaps creating the ideal environment in which to pick stocks. The Nifty has been here or hereabout for more than 4 years now and in the meantime although growth has slowed over these 4 years, it is still a reasonably high positive number. That implies that valuations have got crunched and while it is difficult to predict market returns over the short term, it is our expectation that investors in India should achieve reasonably satisfactory returns in the coming years.

Another financial year has come to a close – the year was a tough one for the equity market as the market had to grapple with a lot of negative news – the European debt crisis, high domestic inflation and consequently high interest rates as also policy paralysis in the aftermath of the multiple scams.  The Nifty was down 9.2% for the year and has now been range bound for more than 4 years. In this rather tough environment, last year we were able to achieve all our 3 objectives – protection of capital, beating the risk free rate of return and beating the equity index rate of return – which gives us a fair bit of satisfaction and we look forward to creating genuine value for our investors in the years ahead. More importantly, we are increasingly convinced that our approach to investing in equities is robust and should deliver satisfactory rates of return over time, without taking on too much risk. We might add here that while we hope to achieve our 3 objectives (enumerated above) over time, this degree of outperformance will most certainly not be repeated every year.

As a new financial year approaches, we would like to touch upon the issue of asset allocation. In the context of a weak stock market over the last 4 years, several people have asked us about the ideal allocation between debt and equity for an investor. We believe that capital protection is one of the primary goals of investing. This implies not only maintaining the value of your investment – the aim should be to maintain the true buying power of the capital adjusted for inflation. If you have Rs 100 at the beginning of the year and inflation over the next 12 months is 10%, then one would have to earn at least 10% during the year to ensure that the purchasing power of your capital is protected. Given the high rate of inflation over the past decade, the post-tax return from bank fixed deposits has significantly trailed inflation. For example, a 9% FD will lead to a return of 6.3% after accounting for taxes of 30%. This will hardly be sufficient to protect capital, when inflation is slowly eating away the buying power of your capital. As Warren Buffett pointed out in his recent letter to shareholders, bonds should come with a warning label.

Equities, on the other hand, have historically beaten inflation by a handsome margin over long periods of time and one can expect that trend to continue. The taxation structure for equities is also very favorable for investors in India, with zero tax on long term gains and dividends, and a 15% tax on short term gains. One risk with investing in equities is that the returns are variable from year to year. We believe that our approach of investing in stable high quality companies at statistically low prices has a high probability of doing well through good and difficult market conditions.

A word on market conditions – after a strong rally in January and February, the market has corrected somewhat due to negative news on the UP Elections and the GAAR provisions in the Union Budget. Valuations on a large proportion of our high quality universe are quite reasonable and the risk reward ratios look attractive. While it is difficult to say when the markets will come out of the current range bound trade, the current valuations tell us that the long term rewards from investing in equities today are likely to be quite good.

Following up on the sharp rally in January, the Indian stock market continued to rally in February – it did give up some of the gains towards the end of the month and ended up 3.5% for the month. The market has rallied almost 20% from the lows made in December 2011 largely on account of the huge FII inflows and some short covering. Another factor contributing to the rally is panic buying – from investors who missed the early part of the rally and are feeling left out of a market that is continuing to go up. Our portfolios continue to do well and most of the portfolios are at their all time highs.

Though we were sitting on a reasonable amount of cash in the portfolio through 2011, we did put a fair bit of cash to work during Nov-Dec 2011 – you may also recall our December newsletter where we talked about why the low valuations prevailing at the time were a good reason to buy despite all the gloom and doom all around. Our attempt at that point was not to try and call a bottom but merely a statement that the prevailing valuations placed the risk to reward ratio in an investor’s favor. Frankly we too are a bit surprised by the pace and strength of the rally that ensued. We continue to focus on buying high quality companies at prices which are reasonable – where the probability of a satisfactory rate of return outweighs the risk of the stock price going down significantly and at all times trying to avoid any permanent loss of capital.

This brings us to two key questions – is the worst over for the market? And has the recent run-up left very little room for appreciation going forward? It is difficult to be sure if the worst is over. On the other hand, it has been over 4 years since markets hit a peak, in Jan 2008. Many of the companies that we follow have continued to do well even through these tough times. The continuing earnings growth in these companies has meant that their valuations seem quite reasonable now and our expectation is that the 3-5 year return expectation from these stocks is quite attractive. While of course one would ideally prefer to buy these quality stocks as low as possible, we believe that the recent run up has not dramatically altered the longer term risk return profile of these stocks. With the economy growing at a reasonable rate, and companies delivering satisfactory performance, it would not be long before markets breaks free from the range bound trading zone. We are closer to the end of the bear market, than the beginning. Till then, it continues to be a good opportunity for investors to accumulate good companies at sensible prices.

On the other hand, this rule may not apply to all companies. There are several companies out there which have excessive debt and are close to bankruptcy. Some of these stocks are down over 80% from their peak values. A very sharp fall from peak levels does not mean the stock is cheap. Including the debt, these are some of the most expensive stocks in the market. One needs to be very cautious with these stocks. We believe that there is no point in encouraging poor capital allocation policies. We are staying away from these companies, with a clear intent of protecting capital for our investors.

The Indian equity market had a strong rally in January from oversold levels – the weakest performers of Nov and Dec had the sharpest rebounds. Low valuations and very strong inflow by FIIs (highest monthly inflow over the last one year) triggered the rally in both equities and in the currency markets. Our portfolios delivered a healthy return and for the financial year to date, we continue to be well ahead of the Nifty, which is down 11% in the same period.

The sharp rally in stocks has taken the prices of some of the high quality companies that we like away from the ideal buy zone – however, these companies are performing well and are still looking quite interesting based on next year’s expected numbers. As we move towards the end of the current financial year, the market should begin to factor in next year’s revenues and profits. The upside for our high quality universe continues to look attractive looking 12 months forward.

We are committed to buying into highly profitable, consistently growing companies which have a track record of having done well through time. An interesting event during the month further brings focus on this approach to equity investing. Eastman Kodak, a 120 year old company filed for bankruptcy this month, giving a different meaning to the ‘Kodak Moment’. In an environment, where a large majority of companies fail to survive 15 years in business, Kodak was able to perform well for over a century. Yet, the bankruptcy of Kodak highlights that even exceptional companies can fail to keep pace with competitive forces and can miss the next wave of changing customer habits. One can soon expect a few case studies of how and why Kodak failed. In a competitive world, where some exceptional minds are continuously at work, giving shape to new ideas, one can expect more such Kodak moments to occur.

From our point of view, where we aim to buy into great companies when things are not necessarily going their way, we need to be aware of the possibility that one of our companies can fail. We try our best to manage these risks through continuous monitoring of our investments as well as choosing businesses where the rate of change is low. However, despite this due diligence we are aware that we could face a similar situation in the future – this is the reason we follow a reasonable degree of diversification to limit the impact of such an event on the portfolio. The other learning we have had over the years is to limit the size of our investment in companies where there may be a possibility, however remote, of a ‘Kodak moment’.