The raging topic of discussion almost everywhere in business circles today is the sharp drop in the price of oil and what impact it has on different countries / companies. It is interesting to note here that it is not just oil that has seen such a dramatic fall in price. A number of industrial commodities such as iron ore, coal, and copper have seen dramatic price corrections over the last 2 years. And it is not only industrial commodities – US corn prices have halved over the last 2 years and wheat has seen a similar price drop in international markets.
The reason cited for this is the low economic growth, particularly in resource hungry China. However, if one goes back a long way in time one finds that commodity prices have actually been trending down for the last 150 years. Please see attached price graph published by the Economist, which shows that the overall commodity index has been trending downwards over a very long period of time.

From time to time, such as the bubble of the 1920s and recently from 2000 to 2007, there have been upward spikes in commodity prices but eventually, these have just been contra-trend rallies in a very large bear market. The cause for this relentless downward trend seems to be innovation and improvement in technology over the years.
The price of oil had inexplicably held up for the last few years, despite large incremental supply coming out of the US and slowing demand in China. With the US wanting to pressure Russia for their involvement in Ukraine and the Saudis keen to disrupt fresh investments going into shale oil and gas exploration in the US, the supply has remained intact while demand has clearly slowed in China and Europe. Meanwhile producers like Russia, Venezuela, Ecuador etc are heavily dependent on revenues from oil to meet their budget targets and therefore can’t reduce production. The only player who can potentially reduce production is Saudi Arabia but they have clearly shown their intent not to do so.
India is potentially a big beneficiary of the fall in prices of oil, coal, iron ore and other commodities because it is a large importer of these commodities. Moreover, with subsidy on diesel having been eliminated and the government slowly upping excise duties on oil products, there is a major positive impact on the budget deficit as well. Moreover, with commodity prices falling across the board, there is a significant downward impact on inflation which has been one of the main concerns in India, which has impeded consumer spending at one end, and not allowed the RBI to cut interest rates which have ruled at fairly high levels compared to the rest of the world. The 10 year government bond yield has already fallen over the last few months, and it appears only a matter of time before the RBI begins to cut rates.
So, with a positive impact on the current account deficit due to lower imports, which should be beneficial for the rupee and a positive impact of lower subsidy outgo, which should reduce the fiscal deficit, the oil price drop means significant positives for the Indian macro situation. Add to that, the drop in prices in other commodities and the impact that would have on household budgets and we have a fairly nice cocktail of positives for the Indian economy. True – the drop in oil represents global economic weakness and exports in this environment would be difficult. Fortunately for Indian IT services companies, the big market is the US which in the most recent quarter, reported the strongest growth in several years. Europe too seems to be increasing the extent of outsourcing. That said, we remain focused on our effort to buy high quality companies at reasonable prices.

We want to take the opportunity in this newsletter to talk about one of the stocks we like – Gillette. Gillette has perhaps one of the most durable franchises that one can think of, specifically in shaving systems, where it is the undisputed leader globally with more than 80% market share. Technology and scale are the source of the very strong moat around its business. Many years back, it did get some competition from Bic and Shick, but it was able to quell competition through large investments in technology and stay ahead of the curve.

India is perhaps the only place where one can buy the shaving systems business separately, as the original Gillette has been merged with P&G globally. India is also potentially the largest market for Gillette given the hirsute nature of its population. Penetration of shaving systems in India continues to be very low despite years of solid volume growth by Gillette, as the market in volume terms is still dominated by cheaper double edge blades. Gillette India has been innovating to ease the transition from double edge blades by introducing a number of different products along the price curve. Some of these like Gillette Vector and Gillette Guard have been designed specifically for the price sensitive Indian market. Both have gained significant traction and the Indian consumer has before him a reasonably well laid out path from Gillette Presto to Gillette Fusion and whatever other improvements in technology that may come about in the future. Gillette’s competitors do not have the financial muscle to invest so significantly in technology and one can reasonably expect that Gillette’s value market share in a deeply under penetrated shaving systems market, will grow over time.

Gillette was available at a very attractive price till a few months back because it appeared that investors were focusing on near term profitability, particularly the losses in its recently launched Oral B toothpaste. Besides, Oral B toothpaste, Gillette has a reasonable share of the tooth brush market where it enjoys the No.2 position in the market after Colgate. It also has presence in the portable battery market with the Duracell brand. P&G has got into a transaction globally to sell its Duracell business to Warren Buffett’s Berkshire Hathaway. However, this is a small part of the value of Gillette and will not have much impact on the overall value.

What attracts us to Gillette is its superior competitive position and a highly underpenetrated market which sum totals to a fairly high growth rate for an extended period of time, perhaps extending to decades. Added to that is the fact that anyone who uses a Mach 3 or a Fusion, has a low probability of moving back to a lower grade brand in the Gillette stable because of the difference in experience. This should ensure a gradual premiumization of the market, which can be captured by Gillette because of a near monopoly in the market.

All in all, Gillette meets all our criteria for quality other than its temporary lower profitability. The global management has indicated that it wants to move towards profitable growth globally. Our conviction in the stock increases every time we shave in the morning and whenever we scan the grocery shelves for competition. All in all, a worthy part of a long term investor’s portfolio.

After a correction in the early part of October, the Indian market bounced back sharply and closed the month at record highs. The most concurrent reliable economic data available in India is the monthly automobile sales – the trend in recent months has been encouraging. While the 4 wheeler passenger vehicle sales started turning positive around June, the medium and heavy commercial vehicle sales, which is the most cyclical of all the automobile segments, saw the first positive tick in September. HDFC Bank also suggested in its conference call that they are seeing some signs of economic recovery.

The government also seems to have set the ball rolling on the policy front. One major step taken recently was to de-regulate the price of diesel. While the previous government had done its bit by raising diesel prices gradually over time, the announced deregulation is an important step because the diesel subsidy was a major contributor to the oil pool deficit, which in turn had a big impact on the fiscal deficit of the government. At its peak, the oil pool deficit was more than Rs 100,000 crore and was a big burden on government finances. The money saved due to deregulation of diesel can be better utilized to build out infrastructure in the country.

Along with this major policy change, there have many other small policy steps taken. LPG subsidy would now be directly given to beneficiaries into their bank account. The price of natural gas has been hiked from $4.2 per mmbtu to $5.6 per mmbtu which will incentivize more exploration. The labour policy has been tweaked to reduce inspector raj. FDI in the construction industry has been eased. All in all, the majority that the government enjoys in Parliament is beginning to translate into big and small steps towards economic reform.

What has further helped India’s attractiveness as an investment destination is the falling price of oil internationally. One of the major causes for the fall in oil is that over the last 5 years US’ oil production is up almost 50% and concomitantly the global demand for oil remains weak because large parts of the globe are still struggling with economic growth. India imports more than 70% of its oil requirement and is a major beneficiary from the fall in price of oil.

Over the last few months we have seen inflation in India cool off substantially and the falling price of oil has added further impetus to that. Along with the cut in the fiscal deficit due to diesel regulation, this should strengthen the hand of the RBI to cut interest rates going forward. To elaborate, a reduction in the fiscal deficit reduces the government borrowings from the market and thus has a positive impact on interest rates in general.

All in all, while last year same time, there was complete gloom everywhere, sentiment has picked up in the last few months and the signs are encouraging. Valuations which were very cheap a year back are no longer as cheap and we would best describe them as fair and some of our high conviction large cap ideas are still reasonably priced.

The Indian equity market consolidated during the month, with the Nifty absolutely flat for the month. Our portfolios did much better than the Nifty, due to some strong performances among a few stocks in the portfolio. The market continues to be stock selective with fairly diverse performances among different sections of the market.

Over the last few months, we have seen very sharp up moves among the small and mid cap stocks. While the Nifty is up 18.8% since 31-Mar-14, the Mid-cap Index is up 32.6% and the Small Cap Index is up 51%. There are two reasons for this. For one, the mid and small cap indices were much beaten down during the bear market of the last few years. Also, a feature of the last few months is that the domestic investors, who typically invest in the small and mid cap space deserted the market completely. The phenomenon of desertion of the market by domestic investors, is corroborated by the fact that while the FIIs brought in about $80 billion into India since January, 2008 the previous stock market peak, the market was still at the same level till February, 2014.

Many of these domestic investors who had abandoned the market, began to rush back into the market as they sensed a clear majority for the BJP. Many of these high networth investors prefer the small and mid cap space as against the FIIs who prefer the large cap space due to reasons of liquidity. As a result, there has been a sharp run up in this space and in many instances, it appears that the stocks may have become fully valued. For us, who are agnostic about market capitalization while investing in the market, we are finding very few opportunities in this space and at the margin, we are finding opportunities to sell into this sharp rally.

On the other hand, the high quality large cap space continues to offer reasonably good opportunities as the growth in their prices has been more in line with the intrinsic value growth of these companies. While the poorer quality companies had seen a strong run in the back drop of the clear majority for the BJP, many of these stocks have seen significant corrections in recent months as this is also the space which has seen a large supply of paper in the form of Qualified Institutional Placements (QIPs). Moreover in many of these cases, the balance sheets are broken and they will need significant repair in the form of asset sales.

The big question for the investor today is whether markets have run up too sharply, or is it still a good time to invest in equities. Nifty was up 18% in the year ending March 2014 and is up a further 19% in FY2015. This is a reasonably sharp move, especially in the context of flat markets over the last 6 years. However, when one considers that the revenue growth of the average company in the Nifty is near 17% p.a, the market move is in line with the growth of the average company. Moreover, at this point of time, the margins are below historical levels, suggesting that earnings growth going forward can be higher than it has been over the last 6 years.

In summary, while it does appear that some sections of the market have run ahead of themselves, there continue to be good opportunities in the high quality large cap space and the risk reward ratio continues to be good for the long term investor.

The Indian equity market was up 3% for the month, as the Nifty and Sensex continue to scale new highs. Markets are currently trading at 26% above the peak levels reached in Jan 2008, and it would be fair to say that the 6 year bear market is over. Our portfolios continued to do well during the month, performing well ahead of the Nifty. Some of the stocks that we were buying till a few months back, are now closer to their intrinsic worth. In some cases, we are surprised at the speed at which the re-pricing is happening.

August 2014 is also 10 years since we set up Banyan Tree Advisors. As people running the firm, it has been a wonderful experience for us. What started out as an idea in the minds of two people has now bloomed into an organization. We have been blessed with great colleagues and clients that we get to work with each day. We currently have 16 people in the firm, of which 4 of us handle investments directly. The business development and client relationship team has been strengthened to 3, as it is our endeavor to maintain the same level of client engagement and personal touch that we were offering when we set off on this journey. Our back office team of 4 people is a solid team, some of whom have been with us since inception and help in running a nearly flawless set of processes. For fulfilling the last mile of paperwork involving our clients we have a 4 member team. Our dealer is responsible for efficient execution of trades for our clients. We believe we have the most stable investor base in the industry and we end up learning a lot from our clients. It gives us a great amount of pleasure that we have been able to touch over 300 families and work with them to strengthen their financial future. We look forward to many more decades of being associated with wonderful people.

A quick look at the markets over the past decade – A decade back, the Sensex was trading at 5200, and currently trades at near 26600, up at an annualized rate of 17.7%. Our portfolios were comfortably ahead of the Sensex or Nifty in this period. This period also witnessed a full cycle of the stock market – a bull market that lasted till 2008, 6 years of a consolidation phase and reaching new highs in recent times. We are convinced that equities is the asset class for inflation beating return, with nil tax for long term holding as the icing on the cake. In this period, there were 2 negative years, 4 moderate years and 4 years of great performance for the stock markets. Our sense is that, since returns can be lumpy, one needs to stay invested in equities in order to make inflation beating results.

There were about 4200 companies that were ever listed prior to Sep 2004, of which only 2180 were traded as on Sept 2004 and only 1760 that were filing financials properly. Close to 60% of companies listed prior to Sep 2004 had failed. Corporate failure related risk is high, and an investor needs to avoid this risk, by choosing to invest in high grade companies. Since then, of these 1760 companies, only 700 did better than the market. Nearly 20% of companies have seen negative growth in revenues over the past decade and 20% of companies have seen negative stock price returns. Only 40% of the companies grew in line with nominal GDP growth. The data does suggest a strong case for active selection of high grade companies, buying them at sensible prices and staying invested in them. We prefer to continue doing that for the next decade too, at the least.

The Indian equity market continued on its positive trajectory, with the Nifty up 1.4% for the month. The Nifty is up 15.2% for this financial year, since 1 April 2014. Our portfolio did quite well during the month, well ahead of the Nifty.

Though the Nifty was up 1.4% for the month, the underlying volatility in individual stocks was a lot higher. The strong run up in the stock market in recent times has been led by beaten down stocks where many of the underlying companies had very weak balance sheets. In the current month, many of these stocks performed poorly. On the other hand, the steady performing companies did much better and to a large extent led the market move this month. We believe investors are getting concerned with the spate of QIPs (Qualified Institutional Placements) that are in the offing. In addition, the large scale divestment plans by the government and the clear direction to PSU banks to go to the capital markets for additional equity infusion, will ensure a spate of capital raising by these companies. The market’s logic is – Why buy these companies, when there is large potential supply around the corner? On the other hand, the steady performers and companies that don’t need capital infusion, will continue to have limited supply available.

The other interesting thing is that as per our valuation models, many of the poorer quality companies with weak balance sheets and poor revenue growth, are looking fully priced. The steady performers, on the other hand, while obviously not as cheap as they were, say a year back, still continue to offer a reasonably good reward to risk ratio based on our valuation models. We continue to prefer this high quality universe and see reasonable opportunities in this space.

The recent budget made a major change in the taxation for debt mutual funds, whereby a debt mutual fund now needs to be held for 3 years to be able to claim the benefit of lower tax rate, instead of 1 year as it was earlier. A lot of investors preferred this route to be able to make a higher tax adjusted return. Many of these investors may look at equity as an option since their time horizon has expanded to 3 years. A listed equity investment that is held for 1 year attracts zero tax and India is one of the very few countries to have such a favorable tax structure for investments into equities. We are long term investors and an analysis of the historical churn in our portfolio suggests that we hold a stock for an average tenure of 3.5 years. As a result, we pay very little capital gains tax on our portfolio investments. Moreover, our emphasis on buying high quality businesses, at prices that are reasonable, means that the risk in our portfolios is on the lower side, thus enabling us to make a decent risk adjusted return, especially so after considering taxes.

Equity markets continued to perform well, on the back of continuing optimism that a stable government at the Centre will result in an economic recovery soon. The Nifty currently trades at a level that is 20% higher than the peak level seen in Jan 2008, indicating a break-out from the bearish phase that lasted nearly 6 years. While there is a return of optimism to markets, balance sheet weakness continues to be acute in several pockets.

The recent market recovery has led to a spate of announcements from companies, wanting to raise equity capital. The total QIPs (Qualified Institutional Placements) for which companies have taken permission from shareholders is estimated to have crossed $10 billion, and the number is rising every day. As stock prices rise, it is natural for companies to use the capital markets to raise money, especially companies which have been heavily burdened by debt. Some of the companies, with strong and growing businesses, also need to raise capital to sustain growth.

However, for companies with broken balance sheets, this fund raising may not lead to a lasting solution to their core problem. We looked at the Top 10 companies in India in terms of the size of the debt on their books (excluding banks and NBFCs). These companies have a median Debt / Equity of 1.8x. More interestingly, the median interest / debt for these companies is only 5.7% – note that the Indian government borrows at over 8% currently. Typically private companies which enjoy a credit rating lower than sovereign, are expected to raise debt at higher rates. The median Depreciation / Gross block is 4.8%, indicating assets are being written off over 20 years or more. One can understand that in some industries the depreciation rates can be low, but for the median to be at 4.8% is a bit surprising.

With interest and depreciation, both being likely understated, it suggests that the true equity in these businesses is lower than what appears on the balance sheet. It is a tough situation to be in, and the fund raising from the equity market without substantial dilution of existing shareholders, would not be sufficient to solve the problem. It would be like applying a band-aid to a fracture. Alternative routes, like strategic asset sales would need to be pursued in many situations as promoters wouldn’t want to dilute their stake substantially. As listed equity investors, we continue to stay clear of such situations.

While stock prices have appreciated significantly over the last few months, valuations are not expensive. At least among the stocks in our portfolios, valuations are moderate and in line with historical averages. Needless to say, given the appreciation in stock prices, valuations are not as compelling as they were, say a year back. This is probably a time to be patient, wait for prices to reach your buy points and avoid the broken down balance sheet situations, despite temptation. As the economy recovers, growth opportunities for the companies in the portfolio will improve and for most companies the best years lie ahead. We continue to believe that one should continue to stick with companies with sound balance sheets and that are growing at a reasonable rate.