Equity markets continued on the strength seen over the past couple of months and the Nifty is currently trading about 4% below its all-time high. We are seeing an increased positive sentiment returning to equity markets, but led primarily by only a handful of large companies. The Midcap indices are trailing the Nifty to a reasonable extent this year. Part of the strenght in the Indian markets is led by global events.
Certain interesting events globally seem to point to a renewed interest in capital markets. The S&P 500, which reflects the US equity markets, reached new highs during the month. The S&P 500 reached a prior peak of 1527 in Mar 2000. Since then, the index has been trading below these levels. Despite attempting to scale this peak in Oct 2007, it is only in Apr 2013 are we seeing the S&P 500 trade at above the 1527 levels on a consistent basis. The last time a similar period occurred was between 1968 till 1980 (coincidentally, again a 13 year stretch). In Dec 1968, the S&P 500 was trading at about 108. The Index traded at below these levels, apart from an attempt to reclaim the peak in 1973, till Jun 1980. From the levels of 110 in Jun 1980, the S&P 500 was on a nearly one-way street all the way to the high of 1527 in 2000.
The interesting corollary has been the price of gold. In 1968, around the time the S&P 500 peaked, gold was about $ 40 per ounce. Over the next 13 years, gold prices went up sharply nearing a peak of over $ 700 per ounce in Sept 1980. In the subsequent 20 year, gold prices fell all the way down to $ 265 per ounce around Oct 2000 – during the same period the S&P 500 went through a structural bull market. Since Oct 2000, gold prices climbed from $ 265 per ounce reaching a price over of over $ 1850 in Aug 2011. As you can see, gold prices and S&P 500 have had a reasonably consistent inverse correlation for well over 40 years.
Gold is viewed as a safe haven, when faith in financial markets is low. The performance of S&P 500 is a reasonable indicator of faith in financial markets. In April 2013, the S&P 500 scaled a 13 year bear market. The sharp fall in the prices of gold during the last few weeks indicates a return in positive sentiment towards capital markets globally.
A revival in interest in the global markets is likely to have a positive effect in Indian markets over time. Indian equity markets have been weak for nearly 5 1/2 years. Given the protracted period of weakness, reasonably good corporate performance during this period and valuations that are not expensive, we believe a revival in positive sentiment, though gradual, should return soon. More importantly, equities as an asset class, compared with most alternatives, looks attractive in the coming years.

The Indian equity market was strong during the month, driven partly by lower oil and gold prices in the global market. Gold and oil form a bulk of India’s imports and the price fall would have a favourable impact on India’s current account and budget deficits. The low reading on inflation also raised hopes that the RBI may begin to cut interest rates more aggressively.
We would like to use this letter to discuss our investment philosophy and the process of price discovery in the market place. We have been emphasizing, through various communications with you, that we believe in buying high quality companies at a price that is reasonable (or cheap) with respect to the company’s intrinsic value. A high quality company, in our opinion, is one that has stood the test of time and delivering good operating results over that period in terms of profitability, free cash generation and above average growth.
What brings a high quality company to a price that one can consider investment worthy is a combination of bad news and/or bad sentiment in the market place. To give you an example, let us look at Maruti, which has in the recent past suffered from a lot of negative sentiment due to the poor off-take of its petrol cars, as also the strike at one of its plants. There were concerns on the merit of the investment in the context of the continuous flow of negative news. However its problems were temporary in nature and the price at which it was available was attractive, given its fundamentals. Despite the successive strikes at its plants, the damage to the stock price was not significant. Now, with the positive news on the yen depreciation and the movement to a better mix in terms of higher proportion of higher value cars being sold, the company reported stellar results for the recent quarter. Patience, as they say, is a great virtue.
We are seeing a similar situation emerging in the IT services sector, where the market is not sure whether it loves the sector or hates it – as a result, we are seeing the bellwether stocks in the sector either up 20% or down 20% on a certain given day. This is the state of affairs despite the fact that, through one of the worst periods of global turmoil over the last 5 years, the sector has delivered 18% or more annual revenue growth. And moreover, the bellwethers in the sector meet all our requirements of quality in terms of profitability, free cash generation and integrity of management. While of course, it is difficult to say how long the process of price discovery will be in this case, there are encouraging signs from the US in terms of a gradual economic recovery. US home prices are up 8% yoy which could go a long way in filling the holes in bank balance sheets and the US equity market is also trading strong. Another sign of the times is the speed with which the H1B visa quota got exhausted this year.
The point one is trying to make is that for a value investor, one needs to heed the words of Wayne Gretzky – ‘Skate to where the puck is going to be, not where it has been’.

Equity markets were mostly weak during the month, with the Nifty down 0.2%, on the back of weak market conditions in key emerging markets, and fresh concerns about the potential slowdown in government policy due to political instability. Our portfolios broadly tracked the Nifty. For the financial year ending March 2013, the Nifty was up 7.3%. Our portfolios on the whole were close to the market. Over the past 5 years, the Nifty has seen an annual performance of 3.7% per annum, whereas our portfolios have seen an annual rate of return close to 12.7% per annum. With nil tax on dividends and long term capital gains, the post tax returns on the portfolios is not too different from 12.7%, as most of the gains we have been booking have been long term in nature, unlike debt instruments.
The last 5 years have been one of the tougher periods for equity markets – this period is somewhat comparable to the phase between 1998 – 2002, when the aggregate Sensex company earnings grew 0% over the period. As the markets turned, earnings were up 34% in 2003. This time around, earnings have grown a better 8.6% over the last 5 years, and the Sensex earnings growth between Dec 2011 and Dec 2012 is actually a pretty decent 18%. Even the 8.6% growth trails the long term average of 14%, thus setting us up for some potential regression to the mean over the next 5 years. It is a matter of time before corporate India’s earnings growth catches up with long term averages.
For our portfolio companies, we try and select companies which have a consistent track record of having done well through different market conditions. The top 10 portfolio companies grew their revenues, on the average, at 19.2% per annum over the past 5 years, whereas their earnings growth on the average was only about 12.7%. Note that the earnings growth has been much better than market averages, but even these companies saw their earnings growth trail revenue growth, as margins got compressed below historical levels. Regression to the mean for revenue growth and margins can potentially accelerate earnings growth for these companies, going forward. Five years after an economic slowdown starts, it is often difficult to imagine the catalyst which will drive growth going forward, but history tells us that this usually does happen eventually.
Revenue growth and earnings growth quality alone does not define the attractiveness of the portfolio. Finally, it is all about what price one pays for these stocks. Markets over the past 5 years have become cheaper. The average market PE has come down from a 28x PE, in 2008, to current levels of close to 15x, which is close to median values at the bottom historically. Valuation of companies is an imprecise science and it is difficult to reach definitive conclusions. Based on our best judgement, our portfolio companies are trading, on the average, well below their intrinsic values. The weakness over the past few weeks has expanded the discount to intrinsic value. We have also deployed all our personal investments in exactly the same strategy as our portfolios, and we feel very comfortable with our holdings at this point of time.

Equity markets witnessed a severe correction the month, closing the month down 5.7%. This was on the back of a strong performance seen over the prior 8 month period – to that extent, one can view the current weakness as a period of necessary consolidation. Our portfolios also corrected in line with the market.

Over the past 3 1/2 years, equity markets have been trading in a very narrow range. The Nifty has been trading mostly in the range of 5000 – 6000 levels for the past 3 1/2 years. Based on past trends seen in equity markets, this is one of the periods of lowest volatility. Meanwhile, several companies have been doing quite well and to a large extent corporate intrinsic value has been going up well ahead of stock prices over the past few years. This is like a spring, which keeps getting compressed a little bit each year, waiting to get released at some point.

For example, assume a company whose intrinsic value is growing at 16% annually. For any good company, this should be par for the course, as the GDP growth in rupee terms has been averaging around this number. If in any year the stock price of the company is up only 10%, though intrinsic value is up 16%, then the gap of 6% is like a ‘spring compression’, which should get released at some point of time in the future. To an extent, the job of a value investor is to identify these pockets of ‘spring compression’ and take advantage of the same.

Note that, I had mentioned ‘several companies are doing well’, which also implies there are other companies not doing well. One of the reasons for a weak, range bound, stock market is the negative sentiment emanating from several companies that are struggling. There seems to be a severe log-jam in cash flows for several companies. There are significant delays in collecting money from customers. Many a bank is struggling with its restructured loans, which are not fully recognized. The sectors that are hit hardest with these issues are infrastructure and capital goods. These companies are seeing an annual deterioration in intrinsic value, or an intrinsic value that cannot be determined. We have consciously stayed away from such situations. There is a huge gap between the fundamentals of companies doing well, and those that are struggling.

Recently, the global CEO of P&G was quoted referring to his India business – ‘We have had outstanding year-on-year results….growing at 20% a year for more than a decade’. In most of the portfolio companies too, we are seeing very good business growth, driven by strong underlying fundamentals. The recent correction in the market has led to many of them now trading at very attractive prices. The economic environment continues to be poor, and it may take time to work its way out of the poor sentiment. This also gives us an opportunity to build positions in companies that are doing quite well.

The Indian equity market performed fairly well during the month, up 2.2%. This was on the back of several positive announcements by the government on reforms and the RBI starting to respond with lower interest rates. Our portfolios trailed the market during the month, as during January, the market was led by the large PSU oil majors and other reform sensitive stocks. Companies which have been growing consistently, and have seen strong stock price performance over the past few months, saw some consolidation during the month. The movement of individual stock prices during the month indicates a market that is consolidating around the current Nifty levels.

One of the questions investors have today is whether the strong market over the past few months is sustainable, or whether there is a risk of any severe market correction from current levels. We did an analysis of the Nifty performance over the past 5 years, and also the performance of the underlying companies over the same period. Since Jan 2008, the Nifty is nearly flat. During the same period, the median revenue growth of the Nifty companies has been 19.4% annually. Essentially, if the median company had a revenue of Rs 100 in Mar 2008, its revenue would be Rs 242 as on Mar 2013. This is a reasonably good growth rate. Even if we were to include the 16 companies that were eliminated from the Nifty, their revenues would have been Rs 215. On the other hand, the median profit growth of the Nifty 50 companies increased at 12.1% per annum. Rs 100 of profit in March 2008 is Rs 177 now. The 16 companies that were rejected from the Nifty saw a fall in profit in the same period.

On the average, both the revenues and profits of the Nifty 50 companies have grown fairly well over the past 5 years, whereas the Nifty is trading at nearly the same levels. There are clear signs of margin pressure. We believe margins should expand in the coming years, as the economy comes out of the recessionary environment and capacity utilization improves.

The companies in the portfolio continue to do fairly well, and with the recent minor correction, these stocks are trading at prices levels where the reward far outweighs the risks. Valuations are reasonable and we feel very comfortable holding these stocks over the coming years. With the current financial year coming to an end, the market should also start to discount FY2014 earnings. We believe stock prices in the coming months will be led by increased reform announcements, economic growth triggered by lower interest rates and a valuation rerating.