Dec 2013: 6th Anniversary of the Bear Market

After 6 long years, the Sensex recorded a new high during the month. The Sensex had peaked at 21206 in Jan 2008 and had been trading below that level since then. In Dec 2013, it finally managed to hit a peak of 21483, and currently trades near its peak level. During the same period India’s GDP in Rupee terms has grown from Rs 4.5 lac cr in 2008 to nearly Rs 9.4 lac cr in 2013, a growth rate of 15.6% pa in Rupee terms. Growth in real GDP has been slower at close to 6.5%.
Over the last several months, most market commentators could talk about little else than the much anticipated QE taper. This refers to the unwinding of the quantitative easing program started by the US Federal Reserve in response to the 2008 crisis to stimulate the economy. In Dec 2013, the Fed finally announced that it would reduce the amount of securities it will purchase by $10 bn to $75 bn a month. Please note that the Fed will continue to buy securities (provide monetary stimulus), but at a slower rate. A large number of market commentators had a cautious stance on equities because of the fear of what would happen, once the Fed decided to taper its QE program. But surprise, surprise, almost all global markets went up after the announcement. We have observed over time, that whenever an event is highly anticipated, the market reaction on the actual occurrence of the event does not correspond to expectations. One of the positives of the Fed announcement is that the event is now behind us and one can get on with our lives.
The Indian stock market has been consolidating near its previous high levels. We have mentioned in the past that the valuations of the market and the technical picture as well point to the end of the bear market in the near future. Over the last few months, one has seen some revival in market sentiment, even though the economic outlook continues to be weak. We do expect the next 6 years to be much better than the last 6 years for Indian equities.
One key contributor to the positive sentiment has been the way the RBI has handled the current account deficit situation. As the RBI governor said in his interview, after the recent monetary policy review, India has demonstrated that it can raise money when required. The large Indian diaspora is more than willing to put money into the country, if it is provided with an attractive return. This was amply demonstrated by the roughly $35 bn that was collected through the FCNR (B) and bank borrowing routes recently.
Another fear dogging the market over the last several months has been the upcoming Lok Sabha election and the possibility of a hung verdict in light of the anti-incumbency that the current coalition faces. One of the key findings of the recent state assembly elections results has been the rout of the small regional parties, who saw their vote share and seat count shrink dramatically. This augurs well for the possibility of a stable government at the Centre in the 2014 Elections. Post the election results, there was fear among market participants that the incumbent government would resort to populist measures to try and secure votes in the Lok Sabha election. On the contrary, what one has seen is the government toeing the line of reform and a number of reform minded steps have been taken recently.
While we are mindful of the fact that there are problems in several pockets of the economy in terms of high indebtedness and the non-performing assets of banks, there continue to be large sections of the corporate sector that have behaved responsibly and grown their free cash flows in a steady manner. These remain our companies of choice for the future.

Nov 2013: Our Investment Process: Maruti – A case study

Some of our clients have been requesting us to talk about the companies we invest in, in our newsletters. So, we want to spend some time in this letter talking about our investment process, with a case study.
We started buying Maruti Suzuki around Sep, 2010 at roughly Rs 1200 per share. We liked Maruti because of its asset light business model and market dominance of an industry that is growing over the long term because of increasing disposable incomes in India. It has very high profitability (core RoE of close to 27% over a 20 year period), largely as a result of its asset light model whereby most of the investments have to be made by its vendors and dealers and Maruti is primarily responsible for core functions like R&D, Assembly and Quality Control. The company has zero debt and is sitting on a cash pile of Rs 6,000 cr which it can use for any future investments in capacity. Much of this cash is as a result of regular cash flows over the years – the sum of the last 10 years’ free cash flow is Rs 5,500 cr. It has raised money from the public only once – at the time of its IPO in June 2003. It has thus used internally generated resources to post a reasonable 17% growth per annum in sales over the last 20 years. Earnings per share have grown at 18% p.a. over the same period.
After we bought the stock, the company has faced a fair amount of labour unrest. Trouble first broke out in September 2011 at its Manesar plant. Subsequently, in 2012, the labour unrest turned ugly and resulted in the death of a key management personnel, which led to a stand-off between the management and its employees. Through this period, the company lost production and had potential market share losses because of not being present at full strength in front of its customers. Further, it had more trouble on another front – the government, in its effort to not have high oil prices affect the common man, continued to heavily subsidize diesel, which distorted the prices in favour of diesel. Maruti had a smaller presence in the diesel car segment, because of its ancestry and limited capacities in diesel engines. As a result, Maruti has had a significant disadvantage against competitors over the last few years.
To add to all this, has been the economic situation in India, where growth has slowed down significantly. Yet at the current price of Rs 1670, Maruti has delivered 11% in price growth over our original purchase price over the last 3 years. While this is below its own averages over the long term and not great in absolute terms, we have managed to achieve our triple goals of capital protection, beating inflation and beating the market index rate of return, with Maruti. One of the primary drivers of stock performance over the medium to long term, is the valuation of the stock at the point of purchase – this was in our favour with Maruti and therefore, despite all this negative news, the stock did not fall a whole lot and has shown moderate appreciation.
What we like about Maruti is, that after 6 long years of slowdown, Maruti offers a quality exposure, to the economic cycle. Just as one can be sure that day follows night, history tells us that a downturn is usually followed by an upturn. It is reasonable to expect that the next 6 years will be significantly better than the previous 6. What will aid Maruti in the future is its established brand, economies of scale and the benefits of dominance in a fragmented market, where a large number of players have very poor profitability. Over time, as the price of a car becomes a smaller proportion of the median household’s annual income, the car penetration will grow and Maruti is well placed as a dominant player.

Oct 2013: Set-up conditions for the next bull market – a technical perspective

Last month we spoke of the fundamental picture of the market, wherein we discussed Sensex earnings over time and what that means for the overall level of the Indian stock market. This month, we will try to understand the longer term technical picture of the market.
Since Jan 2008, when the stock market peaked, FIIs have bought $ 72 bn of Indian stocks. This is roughly 50% of their total investments since 1992 when they were first allowed into the Indian market. During the same period, equity raising by companies totalled roughly $ 32 bn – so roughly $ 40 bn of FII money has flowed into the secondary market since December 2007. However, the current stock market is almost at the same level as what it was in January, 2008. It is therefore reasonable to conclude that this $ 40 bn of secondary market purchases (roughly $ 8 bn a year) must have been met by an equivalent amount of sale from domestic investors, to keep the market trapped in a range.
Let us look at the domestic Indian household, who has displayed remarkably stable behaviour as far as savings go. India’s savings rate has averaged roughly 30% of GDP over the last 20 years. Over a 40 year period, the average is 25%, weighed down by earlier years. Of the 30% number, a bulk, roughly 23% is contributed by household savings. Of the total savings of 30%, roughly half is contributed by financial savings and the other half by physical savings (real estate, gold and other physical assets like factories etc.). The total financial savings over the last 3 years has averaged $ 200 bn. 50% has gone into bank deposits, and the amount allocated to purchases of shares and debentures has averaged only 5% over the last 20 years. Low as this number is, the last 4-5 years paints an even worse picture where with the exception of year ending Mar 2010 every year was close to zero or negative. This has actually never happened in India’s history, since 1980.
Supporting evidence of the fact that the retail public has deserted equity are everywhere – from the number of demat accounts being closed to the number of MF folios being shut down and now to the recent data of the 500 odd stockbrokers who shuttered down in the current financial year. This anecdotal evidence sits squarely with the roughly 3-4% negative investment of financial savings into equities over the last 5-6 years. In order to even make an average 5% allocation to equities over the next 5 years, domestic investors will also have to add back what they have withdrawn over the last 5 years, taking the total allocation to a much higher number. One can also argue for a higher allocation to equities in line with global norms, given that a large proportion of the 35-55 age bracket professionals in India started their working lives post the economic liberalisation, when salaries and work attitudes are more in tune with global norms.
One of the other reasons for poor allocation to equities over the last 5-6 years, has been that competing assets for money that wants to beat inflation – real estate and gold have done exceptionally well over the last 10 years. While we don’t claim to be experts in these 2 asset classes, there is some evidence to suggest that these two asset classes are unlikely to deliver the blockbuster returns that they have delivered over the last 10 years. This may further push investors to allocate more to equity over the coming years.
Broadly, our assertion in last month’s letter that the set-up conditions for the bull market are in place, is complemented by the technical data which seems to point in the same direction.

Sep 2013 : Setup Conditions for Bull market falling into place

The Indian equity market was down over 8% over Jun-Aug due to currency weakness across emerging markets and a domestic economy that continues to face head winds. We had written last month that ‘crisis precipitates action’, and are pleasantly surprised to see a spate of positive announcements during the month. These included measures to encourage FCNR(B) inflows, allowing banks to borrow up to 100% of their networth overseas and freeing up FII debt flows. With the US Fed deciding to delay its ‘QE taper’, emerging markets recovered and so did Indian markets. The Rupee also saw a recovery.

Over the last 4 years, the Nifty has traded in a band of 5000 – 6000 for nearly 80% of the time. Though there is widespread concern about volatility in the Indian market, in reality, volatility in the Nifty has got crunched to historic lows. Here we are using a simplistic measure of volatility – assume the Nifty trades at a low of 100 and a high of 150 in any given year; we measure volatility for that year as 50% (150 / 100 -1). Over the last 20 years, the high-low volatility of the Sensex, as measured above, has averaged 56% per annum. Over the past 4 years, this volatility has dropped down to below 30%. In the current calendar year, despite the market being either up or down 3% on a given day a number of times, for the year as a whole, the volatility is only 17%. Over the past 20 years, the last few years of a bear market has been associated with low annual volatility.

When the market peaked in Jan 2008, it traded at 28.5x earnings. So far, this year’s bottom of 17,450 places the Sensex at 15.5x earnings, which is near the low of the range of 15 – 23x that the market has historically traded on average. Between 2008 and 2013, the revenues of the Nifty companies have been averaging 17% per annum growth. If revenues had been Rs 100 in 2008, then 2013 revenues for Nifty would have been Rs 225, a fairly attractive rate of growth. At the same time, earnings per share (EPS) have grown from Rs 100 to only Rs 138, indicating margin compression. This was partly due to a 35% fall in profits of the 16 companies that were replaced in the Nifty. The new entrants in the Nifty have been averaging 18% annual growth in profits. If we look at the current Nifty basket of 50 companies, EPS of Rs 100 in 2008 would have been Rs 177 today. Thus, the consolidation phase in the Nifty, over the last 5 ½ years, is combination of a price to earnings (P/E) compression and margin compression, which has been compensated to some extent by healthy revenue growth. Also, the poorly performing companies have been replaced by stronger companies.

We believe that the setup conditions for a structural bull market in India are beginning to fall into place. Firstly, the market is trading near the low end of its historical trading range. Corporate revenue growth, averaging 17% over the past 5 years, has been healthy.The surviving companies in the Nifty have been showing brisk revenue growth. We believe the margin compression cycle is nearing its end. The next bullish phase in the markets will be led by a combination of reasonable revenue growth, margin expansion and valuation expansion. Though the current macro-economic conditions are looking difficult, much of it is factored into the low valuations and compressed margins.

Aug 2013 : Crisis typically precipitates action

To say that financial markets are going through stormy weather is an understatement. In the current financial year, since April 2013, the Rupee is down 21.1% and the 10-year government bond is down 7.0%. Currency and bond markets rarely see such violent volatility. The Nifty is down 3.7% for the year, but the Nifty performance to a large extent, masks the performance of the broader market, where one has seen carnage. The uncertain economic environment is causing investors a lot of heart burn, especially the foreign investors, who own nearly 18% of Indian stocks, and who have experienced a double whammy due to the depreciating rupee.
We believe the lack of confidence and poor sentiment are affecting markets a lot more than just the fundamentals are. Even on the currency side, the underlying fundamentals are not so bad to justify such a severe fall. To quote Mr Adity Puri, ‘The fundamentals of the economy are not half as bad as the vicious fall in the financial markets would suggest’. The problems can be fixed, but markets are looking towards the government to make decisive pro-business and pro-reform oriented steps. As a friend put it – the government should manage the economy rather than try to manage the rupee. Crisis typically precipitates action, and we do hope to see decisive steps soon.
As value investors, our main objective is to buy into buy high quality stocks at a reasonable discount to intrinsic value. With the sharp deterioration in the economic environment, severely leveraged balance sheet and cash flow bottlenecks, our ability to ascertain intrinsic values for many stocks has become very difficult. There are several companies which are carrying far too much debt and are facing an uncertain business environment. In such cases, it is nearly impossible to evaluate the intrinsic values of these businesses, and even though stocks prices are down well over 70% from their peak levels, we have not been able to gain sufficient confidence to buy into these companies. Frankly, we don’t understand the balance sheets of these companies. Many of these companies are likely to disappear into oblivion in the coming years.
On the other hand, we do follow quite a few extraordinary companies with sound management. These companies have been doing quite well through the past few years, despite the tight economy. With competitive conditions turning in their favour, as competitors weaken, they not only benefit but are also better prepared for a positive turn in the economy. Even with the markets correcting, valuations have not really collapsed for this basket of companies. We believe the integrity of markets are being maintained, with valuation well within historic range. We do find a few great opportunities to invest.
The Indian economy going through rough weather, and like many such storms, this too shall pass. We do believe we are sailing in a sturdy ship – companies run by management who have a stable head on their shoulders – which will definitely weather the current storm. In the final analysis, every crisis presents an opportunity because it is in times of uncertainty that valuations get crunched.

Jul 2013 : Where is the Rupee headed?

The Nifty was extremely volatile during the month and ended down 1.7% for the month. We believe the Nifty performance is not truly reflecting the underlying volatility in individual stocks – a few strong stocks and sectors with large weightage in the Nifty are masking the carnage among the other stocks in the indices as also in the mid-cap and small cap space. Concerns over the Rupee and the corresponding RBI action were the central theme dominating the business environment during the month. Though we are far from being experts on currency markets, we would like to address the issue over the currency movement, as it is important in the larger context.

2013 marks the twentieth year since FIIs were permitted to invest in Indian equities. In 1993, the rupee traded at 31.60 to the dollar for most of the year. At its current level of 61 to the dollar, the rupee has depreciated 3.3% per annum over the last 20 years. As per economic texts, a country with a higher rate of inflation should experience a depreciation of its currency to the extent to which its inflation is higher than the other country. With the US inflation at roughly 2% and India’s inflation at between 5-7%, the 3.3% depreciation in the currency is within the range of normal expectations. Between 2002 and 2011, the currency remained fairly stable, trading in a band of 40 to 50. This was also a period of relatively moderate inflation compared to the episodes of high inflation experienced in the 1990s. However, over the last few years, inflation in India has climbed as the government has raised minimum support prices of grains and implemented ambitious rural employment and social welfare programs. These coupled with the high current account deficits at a time, when exports are slow all over the world, have contributed to the sharp 33% depreciation of the currency over the last 2 years.

The RBI publishes data of the Real Effective Exchange Rate, which it defines as a weighted average of nominal exchange rates adjusted for relative price differential between domestic and foreign countries. The REER has remained within a band of 95 to 100 for most of the last 20 years. However, by October 2007, it had climbed to about 110, making the rupee at the time theoretically overpriced by 10%. In June 2013, it stands at 89, reflecting a reasonable undervaluation from this theoretical perspective. While it is of course difficult to predict short term movements, a move from an REER of 110 to 89 and after a sharp drop of 33% over 2 years, one is tempted to say that most of the damage to the rupee is done with and any big fall from here should be temporary.

Meanwhile, most of the companies that we have invested in, continue to report reasonably good results. With the benchmark stock indices remaining in the same place for 6 years now, the stock market represents good value at this point of time. For a foreign investor, there is the additional attraction that every dollar they invest fetches 33% more than it used to 2 years ago.

Jun 2013 : Rupee Volatility, FII Flows and CAD

Most major asset classes – equities, commodities, bonds and currencies, both in India and globally, witnessed severe volatility during the month. The scale of events that unfolded was unique. Most of the events were triggered by a statement made by the US Federal Reserve. There is both good news and bad news in the announcement.
The good news is simple – if one were to go by the Federal Reserve’s statement, the global economy has started to show signs of sustainable recovery. Over the past 6 years, post the 2008 financial crisis, the global economy has been crippled by the after-effects of the resultant deleveraging that has taken place. The Fed injected a huge monetary stimulus to prop up the economy. Now, the Fed says, the patient is out of the ICU, so to speak. They feel that they can now reduce the pace at which they will do quantitative easing – mind you, they are going to continue to buy government securities from the market, but they will do it a slower pace.
The bad news in the near term is a bit more complicated. The monetary stimulus in the form of low interest rates and quantitative easing has allowed several market participants to borrow at low rates and invest the borrowed money into different assets such as commodities and emerging market assets. The impact of the Fed’s statement was for borrowing rates to go up sharply – the US 10 year government bond yield has gone up from 1.6% to 2.5% over the past few weeks – with rates going up, leveraged investors are forced to unwind their positions. This led to a severe fall in several emerging market currencies and movement of funds away from emerging market bonds. The Rupee saw one of its worst falls in a matter of weeks partly due to FII redemption of about $ 1.8 billion in equities, but more importantly due to a $ 6 bn redemption of bond investments.
This has brought to light the precarious nature of India’s current account balance. The country runs a Current Account Deficit – exports less imports – of close to $ 85 billion. If this gap is not bridged through corresponding foreign flows, primarily from FII flows in Equities & debt and FDI, the Rupee will not be stable. Due to some of the FII bond investments in India being short term in nature, the stability of the Rupee is being questioned. Though recent policies have created an environment to attract longer term FII Debt as well as some initiatives to get in more FDI, it would be some time before stable money actually flows in.
So, the news from the Fed is negative in the short term, because of its impact on liquidity flows, but the news that patient is out of the ICU is good news for the global economy. Meanwhile, most of our portfolio companies continue to deliver reasonably good results and the valuations of these companies continue to be attractive. Troubled times usually produce good opportunities to do some stock picking because this is when valuations become inexpensive.

Value Investing in India

Value Investing, as a sub-set of investing, is considered to be the process by which an investor buys into an stock at a price which is at a reasonable discount to its intrinsic value, with the assumption the discount will reduce over time. Assume the intrinsic value of a stock is 100, and the current stock price is 70, then the value investor buys into the stock at 70, with the belief the stock price will converge towards intrinsic value over time. There are a few relevant factors to take into account before one chooses to initiate the investment.

a. Intrinsic value and the discount to intrinsic value at which the stock is currently traded
b. Expected time for the stock price to converge to intrinsic value
c. Will intrinsic value grow during this time
d. Inflation rate and opportunity cost of investing in the markets
In several developed markets, where the economy is expected to grow at about 3% per annum and a 1% annual rate of inflation rate, if I get a stock with intrinsic value of 100 at a current price of 70, I will jump at it. Whereas in India, with the nominal GDP (Rupee value of GDP has been averaging a 15% pa growth over several years) growing at 15% per annum and with inflation at 8%, the above questions become far more relevant. To illustrate the point, let us take the following examples.

1. Scenario 1 : The company has an intrinsic value of 100, but intrinsic value is falling at about 10% per annum and current stock price is say 40. This may sound absurd, but one sees such situations very often, mostly in hindsight. For example, MTNL had a net worth of about Rs 10,000 cr in FY2004, cash balance of nearly Rs 5,000 cr, annual profit of over Rs 1000 cr and a market cap of about Rs 10,000 cr. Eight years later, its market cap is down 85%, larges losses and net worth has fallen sharply. There are several examples of such situation. Buying such situations, when intrinsic value is at 100, current market price at say 40, but intrinsic value falling, requires a very short time period for value realization. Else, the investor is better off giving the investment a skip.

2. Scenario 2 : The company has an intrinsic value of 100, intrinsic value is growing at about 5% and current stock price is close to say 60. I have had reasonable experience is getting caught in such situations. The upside from 60 to 100 looks great, but for each year of delay in realizing the value, the investor loses about 3% against inflation. More importantly, the market’s intrinsic value is growing at close to the nominal GDP growth rate of 15%, and the investor loses 10% each year (15% market intrinsic value growth less 5% growth in intrinsic value of the stock) from an opportunity cost basis. I have seen stocks where the value realization has taken 5 years, and in the mean time, though the investor made a return ahead of inflation, has lost out on an opportunity cost basis.

3. Scenario 3 : Intrinsic value of 100, growing at about 10%, which is ahead of inflation, but less then market intrinsic value growth. Stock price is about 75. Such situations are much safer than the above two scenarios, where the investor who aims for absolute return will definitely make a return ahead of inflation. The investor is also getting paid for each year of wait to get value realized. On the other hand, not enough on an opportunity cost basis.

4. Scenario 4 : Intrinsic value of 100, growing at about 18%, stock price is about 85.
The good thing in such situations is that the company’s intrinsic value is growing above nominal GDP growth and the market wide intrinsic value growth. The investor gets to participate in the intrinsic value growth, and at the same time benefit from the market price discount to intrinsic value. On the other hand, such stocks would never be available at valuation that look cheap on an absolute basis.

The above variations in value investing in really not that relevant in many developed markets where the nominal GDP growth and inflation are relatively low. Whereas in India, with a reasonably high nominal GDP growth and inflation, analysing your value investing opportunity in this framework can have a reasonable impact on your decision itself.