The Indian equity market was strong in May and recovered most of the ground lost in April. It is interesting that between Oct 31, 2014 and May 31, 2015, a seven month period, the market is absolutely flat. Although the market has been volatile – either up or down on the average 3.6% per month, over this period, it has essentially remained flat. Our portfolios have done substantially better than the market in this period.

After racing to new all-time highs in early 2014 and beyond, the market has been consolidating over the last 7 months. Since March 2008 the market has averaged 8.4% pa up to now, which is significantly below its long term average of 15% – though over a 10 year period, the growth is exactly in line with the long term average of 15%. While market participants continue to debate whether the market has run ahead of reality or not, a longer term picture suggests otherwise. Even over the last 12 months, the market is up 16.6%, which is again only slightly above the long term average. And yet, this remains a stock specific market, with many stocks in overvalued territory and many stocks in the undervalued zone. The key as an investor is to understand the underlying businesses intimately and have a reasonable assessment of its intrinsic value.

What return expectations should an investor have over the long term? As an investor in a debt instrument one can make a post-tax return of about 6% pa – an investment of Rs 100 would become about Rs 180 after 10 years (and Rs 320 after 20 years). The Indian equity market has averaged about 15% pa return over the past several decades, and the tax incidence can be minimal if one is a long term investor. At 15% pa return, an investment of Rs 100 would become about Rs 400 at the end of 10 years (and Rs 1600 at the end of 20 years). If one were able to average a return higher than the market, say about 20% pa (note that this is an uphill task, though many high grade companies have delivered such returns in the last 20 years), then the investor’s final gain is substantially higher. Rs 100 invested at 20% pa, would become about Rs 620 in 10 years (and Rs 3800 in 20 years). What one concludes from this is that long term investment in equities is a no-brainer – one only needs patience to ride through the volatility which is inevitable in this asset class, and avoid potential pitfalls.

There is reasonable evidence to suggest that equity returns over the next several years can average about 12-15% or more, particularly for those businesses which grow in line with the GDP and have an ability to pass on inflation to their customers. The goal of the investor should be to clearly maximize the probability of achieving the market rate of return, and have a reasonable probability of doing better than the market. There are 2 temptations that stand in the way of the investor – buying a company that does not grow intrinsic value consistently over time, or buying a company at an expensive price, or God forbid, committing both sins simultaneously. In a rising tide that lifts most boats, temptation is lurking at every corner – the wise investor will steer clear of temptation and focus on the goal at hand – which is to make a reasonable return without taking disproportionate risk. After years of making many mistakes, we have learnt that safety is the better part of valour – high long term returns accrue to investors who stay on the path of quality and who are also mindful of the price they pay. We look forward to another decade and more of safe investing.

Since Aug 2013, the Indian equity market has consistently been on a positive trend, a period commonly referred to as a bullish phase. Over this period, the Nifty is up more than 50%. After more than 18 months, the last three months have been the first real period of consolidation in the market. The Nifty is down about 10% from the peak reached in early February. Our portfolios held up well in the initial period of the correction, but towards the end many of our stocks have also corrected significantly. A period of consolidation is part of any orderly market move, and is essential for the longer term stability of the market.

The correction was partially triggered by concerns over retrospective tax on some FIIs. Based on clarification by the government, the problem seems relatively small and isolated to a few specific funds. The tax amounts are also not large and there is clarity for the future. More importantly, for the larger set of investors, the Indian taxation policy for equities is one of the most investor friendly compared with most parts of the world. Nil tax on long term capital gains, nil tax on dividends in the hands of investors and short term capital gains taxed at 15% is as benign as you can get. If you are not a high volume trader, the impact of STT is negligible. We are also happy to note that our portfolios have had very little short term capital gains over the past several years. The portfolio return over time has been nearly tax free. We don’t have any complaints about the taxation policy for Indian equities.

We believe the current phase of consolidation is part of any orderly correction in markets, and probably an opportunity for investors. Firstly, prospects for the economy are looking up and one should see a strong cyclical recovery in the coming years. Most international investors seem to reflect the view that India is a big beneficiary of lower inflation and lower interest rates. Both these factors will help the Indian economy in a significant manner in the coming years. In the near term, some companies may see lower price increases leading to lower revenue growth, but should get compensated with higher volumes over the coming years. We are fairly excited about the prospects for our portfolio companies in the coming years.

Secondly, markets are also not expensive, compared with historical valuation multiples. While obviously valuations are higher than they were 18 months back, they are still within the historical valuation range and what we might call fair game – that implies that there is as much risk as reward at current levels for the Nifty. However, the assumption here is that the Nifty earnings will continue to grow at the same depressed rate as it has been over the last 4-5 years. Given that the recent past growth rates are well below larger historical trends, there is a case to be made that earnings growth going into the next 3 years may be significantly higher in order for long term averages to remain intact. This implies that valuations at this point may actually be better than fair game.

Moreover, each security has its own trajectory and the recent correction has opened up some good opportunities for us, as we remain bottom-up stock specific investors. We don’t try to time a bottom in the market – we look for opportunities which give us significant reward compared to the risk that we take. It is difficult to predict how long the period of correction would last, but from our perspective the longer it takes, the better – it allows us more time to collect a handful of wonderful companies at good prices.

Although the Nifty was weak in March, it did finish the year with a very strong performance for the year at 26.7%. Over the last decade, this has been one of the better years for equity investors, especially if you discount FY2010, when the Nifty was up 74% following a very weak FY2009 (Nifty down 36%). Our portfolios on the aggregate, performed quite strongly, and were well ahead of the market. This has been one of our strongest annual performances over the last decade. However, one thing is for certain – we will not see a year like this for our portfolios for a long time to come. Such strong performance is rare, especially in the context that the nominal GDP growth is closer to 15% p.a. over long periods of time. It is important for investors to have realistic expectations with regards to long term equity market returns, and the following note should help you form a reasonable basis for setting long term expectations from equity investing.

Over long periods of time, the return from equities would need to necessarily converge to intrinsic value growth of the constituent companies. Intrinsic value growth of companies, which to a large extent is dependent on sales and net profit growth, has been averaging about 15% per annum – in line with India’s nominal GDP growth. Assuming an investor buys a company, which is growing intrinsic value at 15%, at a price that is fair – over time investor returns will converge to that number. Some investors may make more, or less, based on whether they buy these companies at a discount or premium to intrinsic values.

A value investor hopes to buy stocks at a reasonable discount to the intrinsic value. In a typical year, the high grade companies are available, at best, at about a 20-25% discount to their intrinsic values, which over a 3-4 year period, can add another 5% pa, to the value investor’s return, over and above the long term intrinsic value growth of companies.

So, then how does one explain the aberration in returns in the current year. Due to a combination of reasons, markets were very weak from the end of 2011 to mid-2013 – some of the macro reasons seem forgotten now but we have discussed some of these in our earlier letters. As a result, we found some high grade companies at substantial discounts to intrinsic value – far higher than the normal discounts that we see. Because the gloom and doom persisted in markets for quite some time, we had enough time to populate portfolios with some of these high quality companies at very attractive prices. So, the real work was done then – the fruits of that are only apparent now when Mr Market is not so despondent.

Under normal circumstances, companies tend to trade in a band around their intrinsic values – this is especially true for stable, mature companies. There is some volatility around this figure, as intrinsic value itself is not a perfect number – different investors’ estimate of intrinsic value may vary depending on the assumptions made. The job of a good investor is to ensure one buys into companies, where there is a reasonable certainty of intrinsic value growth, and buy these companies at some discount to intrinsic value. When these two conditions don’t exist, your money is better off in the bank, and wait for such conditions to emerge. The market correction over the recent few weeks seems to suggest it is time to give notice to the ‘money in the bank’ and look for some opportunities that may have presented themselves.

Equity market was volatile during the month, closing slightly positive, on the back of weak corporate results for the December quarter. The Nifty was up 1.1% for the month. Our portfolio performed well, with some of our large holdings showing strength in a weak market. Given the strong rally in the markets over the past year, there is some concern among investors about whether the strength in stocks is sustainable. What the future holds is difficult to predict. On the other hand, some statistical evidence and the corresponding actions we take should help you in assessing risks at this stage.

Markets on an aggregate basis are not super-expensive. Compared to the valuations seen in 2008, the Nifty is trading within the historical valuation range, though it is trading above the historic median multiples. It is important to note here that even when markets is expensive, individual stock may trade at valuations very different from the market. Take the example of stocks like Hindustan Unilever, Hero Motors, Nestle or Cipla. These are large and well known businesses, where reasonable amount of capital can be deployed. From Jan 2008, the Sensex fell nearly 65%. On the other hand, these stocks fell less than 15% from their Jan 2008 prices levels in the ensuing bear market and are currently trading nearly 3 times the price that they were trading at in Jan 2008. One has seen numerous instances when some high quality companies can trade at sensible prices, even while the broad market is statistically expensive. We get surprised when we go back in time and review these valuations. We continue to believe that as investors we must focus on the individual quality and valuations of the companies we invest in, rather than try to time the market.

On the portfolio front, we continuously monitor the valuation of companies in our portfolio. Most of the companies in the portfolio continue to be great businesses – in some of these, the stock price may have run up sharply and the current price reflects an exaggerated valuation. In these situations, we either reduce or sell the holding, in order to reduce the risks to the portfolio. Typically these sales are long term in nature and therefore tax free as per Indian tax laws. Meanwhile we continue our search for good companies trading at sensible prices and do this regardless of the market level. If there are no good opportunities available, we can wait. Given the volatility in stock markets, opportunity does knock on the door of the patient money. Since we are interested in buying very few companies, which fit our test of quality, we could see a few opportunities to buy at most points in the market. Just need to be a bit patient at times.

We have repeatedly seen that focusing on individual stocks, and their valuations, makes a lot more sense than trying to take a call on the market. Timing the market is very difficult to do, and it is nearly impossible to get it right consistently. Markets are designed to be volatile – a long term investor must understand that there will be the inevitable mark to market drawdowns, and the patient investor should ride these out, in order to hope to reap the rewards of long term investing. Moreover, excessive trading comes with transaction costs and taxes which beat down the overall return over time.

Equity markets continued to strengthen and our portfolios continue to do well. The strength was led by stocks like HDFC and HDFC Bank, which have been trading, for long, at prices well below intrinsic value, for reasons that have no linkages to business fundamentals – a favorite sort of mispricing for us. The strong portfolio performance in the current financial year is well ahead of the growth in intrinsic value of the holdings as stocks have played catch up with intrinsic value. At this point, opportunities to invest in ‘significantly’ undervalued opportunities have reduced compared to the situation about a year ago.

Apart from intrinsic value growth of companies, and buying stocks at discount to intrinsic value, dividend is another component contributing to shareholder return – a component which is not much talked about. Sensex and Nifty have historically traded somewhere between 1.1% – 1.8% dividend yield on average (compared with a 6% post tax yield on a bank fixed deposit). This seems small when you consider that the aggregate price return for these indices has been close to 15% pa over the long term. Unlike bank interest, dividend from equities grows over time as profits of companies increase with passing time. Companies typically pay out a certain proportion of their profits and free cash flow as dividends.

We looked at a collection of superior companies that we track closely and tried to understand how much dividends contributed to their overall return over the last 20 years. The Sensex is up about 8 times in the last 20 years. For many high quality companies which consistently generate free cash flow and are also growing reasonably, just the dividends received provided a return which is higher than what the Sensex delivered over these 20 years.

For example, HDFC Bank traded at an average price of Rs 8.5 in FY1997 (adjusted for bonuses and splits) and paid a dividend of Rs 0.16 in that year (dividend yield of 1.9%). In FY2014, HDFC Bank paid a dividend of Rs. 6.85 per share (and continuing to grow) which translates to an 80% return on the original investment in FY1997. Hero Motocorp (erstwhile Hero Honda), a high free cash flow generator, traded at an average price of Rs 24.5 in FY1994 and gave a dividend of Rs 0.54 in that year (dividend yield of 2.2%). In FY2014 alone, Hero Motocorp gave a dividend of Rs 65 per share, about 2.5x the original investment. The cumulative dividends of Hero Motocorp over the last 20 years is Rs 546, which is 22x the original purchase price. If one had reinvested all dividends back into the same stock, you would have made 80x the original price on just dividend reinvestment, in addition to the 100x one would have made on price appreciation. Needless to say, we have picked Hero Motocorp to illustrate an example because it is one of the top performers over the last 20 years, but the rate of return provided by dividends alone has outperformed the market indices for a fair collection of high quality companies.

These numbers are fascinating because one often tends to forget the dividend return as a round off number and not pay much attention. But for companies that are growing consistently and generating free cash flows, dividends can add significantly to the overall returns, provided one is willing to invest over the long term.