December 2016: Regression to the mean to lead to long term earnings growth

The Nifty has been subdued for the second consecutive calendar year, up 3.0% in 2016, after recording a negative 4.1% in 2015. In effect, the total return on the Nifty has been zero over 2 years. Over the past decade, since 31 Dec 2006, the Nifty is up from 3966 to the current level of 8186, a CAGR of 7.5% pa (8.8% pa including dividends). This is way below the historical norm of 14-15% recorded over a longer history. Market returns tend to be lumpy. Over the last decade, the Nifty was negative for 3 years and had sub-par returns for 2 years. Returns in the remaining 5 years were exceptionally good.

Over the last decade, nominal GDP has grown at 14.3% pa. This is a combination of real GDP growth of 7.5% pa and the balance is due to price increases. On the other hand, earnings growth for the Nifty companies has averaged only 7.1% pa over the last decade. This can be partially explained by the fact that Nifty companies witnessed very strong earnings growth in the 2003 – 2006 period, when margins expanded well beyond historical average margins – margins have compressed since then. The Return on equity (RoE) for the Nifty was 24.6% in 2006 – this is down to 14.6% in the current year. The last two years have also been difficult for several large companies due to falling commodity prices as also the PSU banks who have seen earnings declines. Regression to the mean is a strong force in financial markets whereby aberrations from long term averages usually get corrected over time. We therefore expect the Nifty average RoE to trend upwards over the next decade and this should translate to higher earnings growth for the Nifty over the next decade.

Though the Nifty has averaged about 7.5% pa over the last decade, our portfolio returns have been higher at about 16% pa. We believe that this maybe because of a better selection of stable companies and the fact that our discipline allowed us to buy these companies at sensible prices. Though earnings growth for some of these companies may have been slower in the recent past, partly due to lower pricing power, the long run growth potential looks attractive.

In 2000, India was the 13th largest economy in the world, at $ 476 billion, – since then GDP has steadily grown to $ 2.1 trillion in 2016. Over this period India’s GDP has become larger than several countries like South Korea, Spain, Brazil, Russia, Italy, Mexico, Canada and more recently UK (though there is a large currency impact in this, due to the fall in value of GBP, post the Brexit referendum). Prospects for the Indian economy over the next decade look good with the economy expected to reach $ 4.7 trillion by 2025 as per a McKinsey study. This implies a dollar GDP growth of 9.2% which is about 1% higher than the 8.1% dollar GDP growth witnessed over the last decade. Events like demonetization may cause some delays, but long term prospects continue to look good. At the crux of the potential for growth is a favourable demographic profile, high savings rate and the under penetrated nature of the economy vis-à-vis comparable Asian economies like Indonesia, Malaysia and Thailand. While it is difficult to predict when the economic growth momentum will pick up, regression to the mean suggests that it is more a question of when rather than if. Our portfolio companies should also benefit in line with historical trends. Given the current market uncertainty the next few quarters should be a good period to build out a portfolio of companies which can benefit as the economy grows.

November 2016: Demonetisation – short term pain, long term gain

There is no date better marked in recent Indian economic history as 8th November, 2016 – 8pm to be precise – when PM Modi addressed the nation to announce that 500 and 1000 rupee notes would cease to be legal tender from midnight, except for limited purposes. The number that is being tossed around is the 15 lakh crores ($220bn) in these high denomination notes that are outstanding and that they constitute 86% of the total currency in circulation. For at least a few days the whole nation came to a screeching halt as everyone got into queues to deposit, withdraw or exchange their high denomination notes. It is to be noted here that a demonetisation of this scale (in terms of proportion of total currency outstanding) has not been tried anywhere else before – so, a lot of the analysis may be intelligent guesswork at best.

There is no doubt that this measure has resulted in considerable pain for a large number of people, especially those for whom the dominant mode of transaction is cash. People who have suffered, have included daily wage workers, farmers and also small and medium enterprises (SMEs) many of whom, have requirements for cash as a dominant means of transactions. While the opposition has taken the government to task for not being adequately prepared before introducing this measure, the government says that this was a result of the need to maintain secrecy in order for the measure to be effective.

While there is short term pain for many, we expect that there will be considerable long term gain as a result of this measure, and this measure would have to be followed by other measures to combat the black economy. Demonetisation and the war on black money ties in very well with the implementation of GST which has crossed the legal hurdle in terms of the constitutional amendment having been passed by both the houses of parliament, ratified by more than 50% of the states and assented by the President.

These measures by the government are expected to widen the tax base both for direct and indirect taxes. As more and more people realise that their unaccounted wealth is less productive because it sits idle and is also at the risk of being impounded, more people will come into the tax net. With GST everyone effectively polices each other as each producer takes credit of GST for the inputs that s/he pays for. Whether the SME (manufacturing products or selling services) sees the benefit in coming into the tax net, given its cost structure including compliance cost, is still up for debate, but one expects tax compliance to increase over time, as the government is likely to bring more such measures to combat the unofficial or black economy.

One would also expect inflation to trend downwards in a sustainable manner because of these measures. An increase in the tax/GDP ratio can be expected from these measures which should translate into lower fiscal deficits, consequent less crowding out of the private sector and sustainably low inflation over the long term. This in turn should lead to sustainably lower interest rates. The improving tax collections would also permit the government to spend on infrastructure and social sectors.

However demonetisation will not come without its collateral damage. The damage to GDP is already being felt by many businesses, with the damage being greatest wherever the cash element of transactions is higher. These include agriculture, SMEs and logistics among others. The biggest impact could be on real estate prices. Anecdotally one hears of a 20-30% price erosion in land which is located outside city limits – a clearer picture would emerge over the coming months. Traditionally there has been a certain cash component to many land transactions, and a curtailment of the black economy would likely have an impact on real estate prices. How large an impact this could be, is difficult to ascertain, given the many moving parts in this equation. This could in turn have an impact on bank NPAs in terms of their Loan against Property portfolios as also because a large proportion of business loans have land/property as collateral. Should there be a large decline in land prices, although it will be beneficial to genuine buyers of property, it could have a dampening impact on business sentiment.

What one also foresees is that demonetisation along with GST will tilt the balance of trade in favour of the organised sector vis-a-vis their unorganised competition. In effect, the organised sector which pays taxes, will find its position strengthened against unorganised competitors, many of whom could have been using tax avoidance as a low cost edge. As a result, one expects the organised sector to gain market share over their unorganised counterparts. The companies listed on the exchanges are largely more tax compliant and part of the ‘organised’ sector and hence should benefit over the long term.

Having administered a severe shock to the citizenry in terms of demonetisation, we expect the government to lower income tax rates in the upcoming budget in line with the original promise made in the first budget speech of this government. This would not only work as balm, but would also provide an incentive to people to embrace the tax paying economy wholeheartedly. A leader who can take such a massive gamble, is unlikely to stop here. More measures will likely be announced over time, and some of this may once again target the property sector since a lot of the untaxed income is stored here.

Recently, the government has introduced an Amendment Bill to the Income Tax Act in the Lok Sabha. As per this bill a person can voluntarily declare his hitherto undisclosed income at a ‘net tax plus penalty’ of 50%, and additionally 25% of the amount declared to be placed in a non-interest paying deposit for 4 years. This translates into a roughly 55-56% effective tax on income. We think that many people may adopt this method to convert their black money and come into the tax net – this would be a win-win for everybody as these people are likely to be more confident consumers as well as investors.

In sum, demonetisation is likely to have large long term gains for the Indian economy, particularly because of its linkages with GST and higher tax compliance. However, there has already been and may continue to be for a few months, substantial pain for some sectors of the economy as also the citizenry. However, we believe that the patient should take this bitter medicine in the hope of a brighter future. While our portfolios have also taken a hit because of the shock to the market, most of our portfolio companies are high tax paying and would benefit from the expected lowering of corporate tax rates. Moreover, many are leaders in their respective businesses and should benefit from the market share shift to the organised sector.

October 2016: A disciplined capital allocation policy wins in the long term

This month saw a huge controversy surrounding Tata Sons and its chairman Cyrus Mistry who was removed from his position unceremoniously. This has brought into sharp focus the acquisition strategy followed by the Tata group, as also the acquisition strategies followed by Indian corporates.

As investors, we focus on the cash flow statement of a company even more than we do its Profit and Loss Statement. This statement tells us about how cash is generated and how it is utilised during the year. The cash generated during the year, can be invested back in the business, returned to shareholders as dividends and buy-backs or be used to make acquisitions. This, called the capital allocation policy of the company, can become quite important in the evaluation of the total value of the business, over the long term.

Acquisitions can either be made using the cash generated over the years, or they can be funded by a combination of internal accruals and debt. While this is still nascent in India, debt funded buy-outs are quite popular in the developed countries, where a company takes on disproportionate debt to buy out another company. This was precisely what happened when Tata Steel acquired Corus, UK. In a levered acquisition, if the asset (company) purchased has enough cash flows to pay back the debt, it can be a huge win for the acquiring company – however, if the cash flows of the acquired entity are insufficient, it can place an onerous burden on the company making the acquisition. Examples of successful acquisitions in India, in the past include HUL – Kissan, Marico – Kaya, HDFC Bank – Times Bank, and many others. We also have examples of acquisitions which have placed a great burden on the acquiring company often leading to a difficult situation.

Any acquisition funded by a large amount of debt, raises the risk profile of the company making the acquisition. In the case of Tata Steel, in FY2006, the year prior to the Corus acquisition, Tata Steel had 10,000 cr of net worth (equity) and 3,400 cr of debt on its book – this is a reasonable debt to equity ratio of about 0.34 and does not expose the company to a very significant balance sheet risk. However, post the acquisition, the debt equity ratio in FY2008 had moved up to 1.6x. Over the next 8 years, Tata Steel’s India operations have made a total net profit of 41,000 cr – after deducting about 7,000cr for dividend paid out, this should have resulted in Tata Steel’s net worth going up by about 34,000 cr – instead what we find is that in FY2016, Tata Steel’s consolidated balance sheet had seen a contraction of its net worth by 6,000 cr to 28,000 cr and its debt had gone up from 54,000 cr in FY2008 to 86,000 cr in FY2016. It is no surprise that the situation is causing a stir in the Tata Sons’ board room.

For our investments we try to avoid companies that have a lot of debt on their balance sheet. We prefer if the investee company uses the cash it generates to invest back in its business, or make tuck-in acquisitions, with cash accrued over the years. If both these possibilities don’t exist, it would be better for the company to pay back the cash to shareholders as dividends or through equity buy-backs. Large debt funded acquisition are a strict no-no in our view, especially if you are looking for companies that generate shareholder wealth consistently over time. Organic growth, though slower than debt funded growth has the benefit of being slow and steady, and it also has the benefit of helping you sleep well.

September 2016: Oracle Financial – Leader in an under-penetrated market

While the market was steady through most of the month, volatility over the last few days drove the Nifty down 2% for the month. Our portfolios continue to do reasonably well.

The rally over the last 6-7 months has been driven by the laggards of the last couple of years – the PSU banks, commodity companies and others who have been steeped in problems over the last few years. This was led by some recovery in commodity prices, and equity infusion by the government into the PSU banks. The steady performers, who have been leading from the front, took a slight back seat over the last few months.

We wanted to take this opportunity to discuss one of our portfolio holdings – Oracle Financial Services Software (OFSS). OFSS provides core banking solutions to its clients – primarily banks, spread across the globe. It is the market leader in core banking solutions. Many of you would be surprised to know that most US banks do not run on core banking software and are instead still working on legacy systems developed over decades. On the other hand, newer banks like HDFC Bank and now National Australia Bank (among the top 20 banks in the world) are on a core banking platform. Core banking platform allows various conveniences to both the customer and the bank, which allows the bank to offer a superior service efficiently (for instance an SMS telling you that a certain amount has been withdrawn from your bank account, instantaneously) which can be a great help in offering a competitive advantage in a crowded and commoditized banking space. The reason most of the top banks have not shifted to a core banking platform, is that it involves a huge investment both in terms of money and time. An observer compared moving to a core banking platform something akin to changing the engine of an aircraft mid-flight. Hence there is a lot of resistance to move from existing legacy systems to core banking. However in any banking environment, if one player is able to install a core banking platform it allows that bank to establish a competitive advantage over its competitors and thus becomes a driving force for other players in that environment to also adopt core banking.

OFSS’s business model fits in with the characteristics we look for in our portfolio companies. Its relationship with its clients is long term and sticky in nature as changing core banking vendors can be cumbersome. As of now only 1 of the top 20 banks have adopted core banking – the market is expected to grow along with internal growth of existing clients and as also more top banks adopt core banking over the next decade. Such under-penetration of a market and the prospect of owning a market leader with extraordinary business characteristics, are not easy to find. The company is also extremely profitable and cash generative. While current growth rates may be moderate, we are happy to wait until the pot at the end of the rainbow materialises – meanwhile we get paid for our patience with a 3% plus dividend yield at current prices, and steadily growing revenues and earnings.

The Indian equity market remains very stock selective with a mix of over-valued and fairly valued situations among the stocks in our universe. One must add here that the fairly and under-valued situations have thinned in recent months. However volatility is par for the course in equity markets and sometimes opportunity can present itself quite quickly. We continue to tread the path of safety and continue to avoid broken balance sheets and commodity and high capital intensity plays.

August 2016: Glass half full?

Though the Nifty ended on a positive note for the month, equity market returns have been flat-lining for some time. The Nifty peaked at about 9000 in February 2015 and has traded in a narrow range since then. The market remains very stock specific with an existence of both undervalued and over-valued stocks. The economic situation too has a mix of positives and negatives.

On the negative side, one of the significant factors is the large bad debt situation with the banks (many of them PSUs). This continues to plague overall sentiment and credit availability in the economy. Several infrastructure oriented, capital intensive companies have stretched balance sheets and many of these companies are on the verge of bankruptcy. The downstream effect has been a weak capital goods cycle and several payment problems. Weak commodity prices have affected prospects of several companies operating in the commodity space. Many of these are legacy problems, and companies operating in these sectors are likely to see an extended period of pain. We have generally avoided capital intensive business in line with our philosophy to invest in cash generating businesses. The stock price performance of these large troubled companies is weighing down overall Nifty returns.

Over the long term, nominal GDP in India has been growing at about 15% (and real GDP has averaged about 7-8% pa). Over the past few quarters though, nominal GDP growth has slowed down to about 9%, partly due to a weak economy and largely due to lower inflation. The real question is whether GDP growth will revert back to historical trends and when. Though growth rates have not recovered yet, given the favourable Indian demographics, one is fairly sure growth rates will, at some stage, revert back to historical averages. The setup conditions for GDP growth to revert back to the historical mean are falling into place. Firstly, the Indian consumer is beginning to experience tailwinds – interest rates are coming down, and inflation is also down from the heightened levels observed 4-5 years back. Lower interest rates should boost consumption and a well spread, normal monsoon is an added positive. Secondly, the government is taking several administrative reforms, which should remove bottlenecks in the economy. Implementation of GST is a massive reform which should usher in a unified market and help improve tax compliance. Efforts are on to ensure that projects that been stuck for some time due to various reasons, are quickly implemented. This should get the capital goods cycle moving and also reduce the bad debt situation of the banks.

The Indian economy should revert back to its historical nominal rate of growth at some stage, in the not too distant future. In the meantime, our preference is to focus on companies that are currently doing well. Valuations are not very cheap, but neither are they very expensive for the stocks that we own. In the broad market, it is possible that some stocks are stretched on valuations and investors would do well to be careful. We are still finding a few opportunities that are moderately inexpensive, but attractive ideas are definitely far and few. Performance over the coming years will have to be led by growth and we believe the much talked about ‘India Consumption’ story should kick in at some stage.

July 2016: IT Services – Market perception and reality?

The Nifty continues to be strong despite various concerns like the Brexit and the mounting bad debt concerns in the Indian banking sector. Globally, volatility is the norm with big swings in currencies and commodities. However, the market continues to climb the walls of worry and move higher. While most sections of the market have seen some move back to the mid end or high end of their historical valuation ranges, the one sector that remains undervalued is the Indian IT services sector.

The market has been ambivalent about the IT sector for quite some time, despite it being among the best performing sectors in terms of revenue and earnings growth. Over 3 and 5 year time frames, the Indian IT services sector has grown revenues and profits in the high teens – earnings growth for the Nifty during the same period is in the 4-5% p.a. range. Moreover, the IT services companies have enjoyed very high returns on invested capital and continuous free cash generation.

Concerns have been raised in recent years about automation impacting IT services and how that could result in a large number of jobs becoming redundant. The situation is still developing and it is difficult to make definitive predictions, but the Indian IT services sector remains at the fore front of harnessing this technological change, and continues to gain market share from its global counterparts. Moreover, there remains a large opportunity in the transition from legacy systems to the new digital world. Also, automation provides opportunities to squeeze higher margins in the medium term. We note that the Indian IT majors continue to hire at a brisk pace, and in fact, hiring has picked up over the last couple of years – this belies immediate concerns that automation will lead to big redundancies. We continue to watch this space for further developments.

What is puzzling though is the stock performance of this sector over the last 3-4 years. Despite being in a market where growth is at a huge premium, as most sectors struggle for growth, the market has paid scant attention to the robust growth rates that the Indian IT services companies have recorded. Within this sector, the stock price momentum is significantly below earnings momentum where as in, most other sectors, the situation is the opposite. It is no wonder then, that when we scan our universe, we find this sector the most undervalued in relation to the quality of the business and future prospects.

Furrowing the lonely path, where others fear to tread, is part and parcel of being a value investor. We have thought deeply about this space and are unable to find a way to justify whatever fears have been expressed about the IT services space, especially with respect to the top tier names. We are also aware that unfounded fears usually produce great investment opportunities. All one can do in such times is to exercise patience – we remain confident that the market will sooner or later come around to the view that these are great businesses – and more important, the price that Mr Market is placing on them, seems irrational. What is further comforting is that, as these businesses keep generating cash, the cash hoard builds which further adds to the intrinsic value of the business and is the price we get paid for waiting. Meanwhile, we remain comfortable with both the future prospects of the business and the prices at which the respective stocks are trading.

June 2016: Volatility is the friend of an intelligent investor

Despite concerns over Brexit (Britain’s exit from the European Union) and Dr. Raghuram Rajan’s exit as the RBI governor, Indian equity market was up 1.6% for the month. The move, seems strong, given the scale of negative press coverage these events got over the past few days. Nifty is still up 7.1% for the year (Apr – Jun). We believe the positive factors surrounding a possible good monsoon and lower interest rates, along with fair valuations, are making up for the larger negative news. Our portfolios performed in line with markets.

Concerns over Brexit have been reigning high over the past few days. It is difficult to gauge the long term impact of Brexit on equity market, especially so for the Indian markets. What we do know is that over the past decade, equity markets have seen several such crisis, like the Mortgage meltdown in US, Lehman collapse, Russian Rouble collapse, Greece debt crisis and its larger fall out in the Euro zone, Oil market meltdown and a large scale slowdown in China. Despite all these major issues, our portfolios have seen fairly good returns. More importantly, most companies in the portfolio have done reasonably well through this period.

Crisis situations in global markets is an ongoing phenomenon and we will see more of them in the future. What is important is to focus on the companies that one has invested in, and evaluate if the external issues will have any major impact on the prospects of these companies. Many of the companies that we have invested in are expected to benefit from the growth in consumption in India – which, we believe is on the upswing, due to lower inflation and lower interest rates. We do believe this broad theme is intact and will continue over the coming years. Over the past several years these companies have delivered good growth in revenues and profits, despite several ‘crisis’ seen in global markets. There is no compelling reason to believe this trajectory will change in the coming years. Good companies have a habit of delivering, despite uncertainty in the global markets.

What is also interesting is that great companies deliver above average returns over time, with volatility far less than markets – contrary to popular beliefs and ignoring the framework of ‘low risk means low returns’. We studied stock price performance of Nifty companies over the past 20 years. Out of the 50 companies in the Nifty, 32 have traded on the stock exchanges over the past 20 years. The top 10 best performing stocks delivered a median annual return of 31% p.a. over the past 20 years, with lower volatility than the Nifty, and the bottom 10 stocks delivered a median annual return of 13%, with higher volatility than the Nifty. The same is a biased sample, as companies enter and exit the Nifty. What is clear though, is that that the top performing companies have delivered exceptional returns despite a long list of crisis over the past 2 decades with less volatility than the market as a whole.

Our objective has been to collect an array of companies which we believe should deliver exceptional shareholder returns over time. We do believe several companies will grow consistently over time and deliver above average growth in intrinsic value. More importantly, these companies should deliver results despite a constant flux in the macro conditions. If one can put together a collection of such companies, as an investor, one should see satisfactory returns over the coming years. Crisis like these, at best, are an opportunity to buy into these companies as sensible prices.

May 2016: Early signs of a pickup in the economy?

The Nifty continued its recent up move and was up 3.9% for the month – our portfolios continue to do well. In our last newsletter, we had said that “growth seems to be coming back, though grudgingly”. Soon after we sent that newsletter, the monthly automobile sales for April were released which is among the most reliable, current data that one gets about the Indian economy, because it is published by a private body consisting of all the automobile manufacturers in India. We are happy to remove the “grudgingly” from the previous sentence. We will of course look at May and June numbers to conclude whether this is sustainable, but one can certainly see from the data that perhaps the consumer is beginning to open his wallet and spend more.

What has also helped, has been the RBI governor’s sustained battle against inflation, and followed up by some good measures from the government. Because when we reduce inflation, we put more purchasing power in the hands of the consumer, which s/he can then choose to spend on multiple products and services. Also, certainty in the mind of the consumer can help him/her to take decisions which require larger outlays.

The other good positive we see is the RBI’s sustained fight against the scourge of NPAs which has rocked some parts of the Indian banking system. The RBI was quick in telling bankers that they could not restructure any more, through policy decisions taken by the RBI, as early as April of 2015. This was followed up by virtually forcing many big banks to take large hits in terms of provisions in Q3 and Q4 of the year ending 31-Mar-16. A problem can not, in our opinion, be solved unless we first know the dimension of the problem. We give full credit to the RBI establishment in trying to confront the problem of NPAs, rather than kick the can down the road. It makes sense to do the clean-up before we move to the process of government or private re-capitalisation of banks – because then the equity dilution in the banks will happen at sensible prices, making the system more stable.

One is also seeing the first signs of improvement in government spending, particularly on infrastructure. This may encourage private entrepreneurs and investors to also re-start the long moribund capex cycle. The sales growth of commercial vehicles is one lead indicator of the capital expenditure related part of the economy – medium and heavy commercial vehicles sales grew at 30% in the last financial year and the momentum looks like sustaining in April. One of our colleagues was sent on a mission to Andaman and Nicobar islands, to determine the veracity of the rumours that the monsoon was on schedule – he reports Aye! (Just kidding! He happened to be there on a break with his family).

All in all, the signs on the economic front are good – while challenges remain on the global front, and on the effective addressal of the NPA problem, we see signs of optimism, particularly for companies that continue to stick to their knitting and go on with the tough, boring job of increasing the width of their moat vis-a-vis their competitors. While many clients continue to point out to several beaten down stocks that we should invest in, we believe that we don’t understand those opportunities well enough and would rather stick to our knitting – which is finding wonderful businesses, which continuously generate free cash flows, and we hope to buy them at prices that are sensible.