April 2016: Systematic withdrawal plan for retirement planning

The Nifty started on a promising note in the month of April but eventually ended with a mild gain for the month. The Indian equity indices have been flat as a pancake for quite a while now. We are happy to report that things are beginning to stir on the economic front – growth seems to be coming back, though grudgingly. And with the whole world in a new normal, Dr Rajan’s comment about the one eyed King is not misplaced.

We want to devote the rest of this newsletter to a subject which we confront every day, as our investors quiz us about their retirement options. The big mountains to climb, financially, in one’s life are buying a house, children’s education and one’s own retirement. The first two are daunting enough – the third is becoming an ever more complex challenge with increasing longevity. Two decades back, people started work somewhere in their late 20s, hoped to work till 65 (a working life span of roughly 35 years) and were essentially planning to use their savings for a remaining life span of about 10 years. Today, people increasingly want to retire at 55 or thereabouts. And life spans are slowly touching the century mark and may yet go higher. So the average person today may work to 60, an earning life of 30 years and s/he has to use these savings for maybe 40 or more years.

That brings us to what we call our Systematic Withdrawal Plan – there are many among us who are planning for their retirement and have set some date in the future, when they would like to stop thinking about compensation as the raison de etre – wherein they would like to pursue other activities, that may not necessarily compensate them monetarily as their current jobs do – we are certain there are many artists, musicians, photographers, scientists, to just name a few, among us. It doesn’t really matter what the reason may be – there are many of us who would like to retire early. What stares us as an obstacle, to some degree, is our longevity which is only increasing, with technological progress.

We believe that equities are best suited for retirement planning – the obvious advantages are high long term returns and high liquidity. Observations over the last 35 years suggest that the Indian equity market can be expected to deliver about 14-15% per annum over long periods of time. If an investor could withdraw somewhere between 4 to 5% of their portfolio value every year, they could still hope to achieve a 9-10% growth in their portfolio, which would keep such an investor ahead of inflation.

This is of course for a pure equity portfolio – the higher the proportion of debt in the portfolio, the composite return of the portfolio would fall, and one would have to adjust withdrawal rates accordingly. We are conscious that our advice may be viewed as being biased – we eat our own cooking – so that absolves us from the guilt of over-selling.

March 2016: Earnings set to accelerate on account of mean reversion

The Nifty was mostly in negative territory through the year and was down 8.9% for FY2016. Though the Nifty was up 26.7% in FY2015, the fall in the current year has eroded most of the gains of the previous year. Effectively, if one had invested 100 in the Nifty on 31-Mar-14, it would have been 126.7 on 31-Mar-15 and 115.4 today. Our portfolios did substantially better than the Nifty in FY2015 and have managed to protect that gain during the current year.

The Indian stock market, and for that matter, the rest of the world as well, have been in a funk since the Great Recession of 2008. The Nifty has delivered about 6.3% p.a. over the last 8 years and 8.6% p.a. over the past decade – this is way below the long term average of 14-15% p.a. One big reason for the huge under-performance over the 8 year period was the high valuations in Mar-08. Earnings growth since Mar-08 in the aggregate, has also been weaker than historical trends, as margins for corporate India have got squeezed.

It is our belief that the current government, perhaps emboldened by its majority status, has unleashed a series of economic reforms that are necessary for India to get out of its sub-par per capita GDP. Unlike the past, these reforms are driven from a position of confidence, evidenced by record forex reserves and driven by a management team (the government and the RBI) which we believe, understands what is needed to quell inflationary expectations and drive the freeing of animal spirits through ease of doing business and transparency. This has the potential to drive structural change in the economy which could enhance productivity significantly. While most commentators have been lamenting the lack of growth in the economy over the last two years, it appears that much of the work done by the government over the last couple of years is showing up now – in various measures being taken to enhance transparency and remove structural bottlenecks in the economy. Examples of this are the apps that the government has launched for electrification, railways, etc. which allow the populace to track the progress of these departments and also provide access to them.

In finance there is a term called ‘mean reversion’ which implies that periods of lower returns are systematically followed by periods of higher returns and vice versa. A decade of poorer than historical market returns sets us up very nicely for the next decade. India should remain among the top two growing large economies in the world, with a potential to invite huge investments into its infrastructure and in creating jobs for what is perhaps the largest workforce pool in the world today. We believe that the current set of reforms should push up productivity in the economy driving a higher growth rate over the next many years.

Notwithstanding everything stated above, challenges remain in the form of the global economy which continues to suffer from excess leverage over the years and associated risks, if the bank NPA situation does not get corrected, despite much needed recent focus on this, from the RBI and the banks. We are now regularly seeing many promoter equity stakes being put on the block by banks. We look forward to earnings reverting to the mean over the next few years and we like the valuations at which some of the wonderful businesses that we wish to buy over the long term, are trading currently and this, we believe, sets us up well for return expectations into the medium and long term.

February 2016: India unleashes second generation of reforms

This year’s budget is just out and although we have not had time to look at the fine print, we would like to point to some of the key policy measures announced which we think affect India’s long term economic prospects. A good government does not wait for annual events like the budget to make policy changes – we are happy to observe that this government understands that. We have seen some path breaking reform in recent months – the first was when the government made the small savings rate flexible (the interest rate applicable for PPF, NSC etc.) – this rate shall now be linked to the yield on government bonds of a similar tenure, and shall be open to change on a quarterly basis. This may seem like a technical thing, but it is very critical to ensure effective transmission of RBI’s monetary policy – earlier, even if the RBI were to cut rates, it would not get transmitted to the rest of the system because the government was offering a higher rate for small savings, and depositors would simply move to these products, and thus neutralize whatever effect the RBI was trying to achieve. This new move will go a long way in removing distortions in the Indian financial market, and thus move our financial system closer to that which exists in developed markets.

Another significant reform is the proposal for a Railway Development Authority which will become the tariff setting body and will decide on the quantum and timing of tariff changes, for both passenger and freight traffic. This will hopefully remove political interference from the pricing decisions of the Railways. During the budget, we have seen further momentum on the reform path. We would like to point to two key proposals – of according statutory status to Aadhaar and the RBI’s monetary policy committee. The first will significantly enhance social benefit delivery and the second is critical to establish the central bank’s independence from the government. While this has always existed in practice, a statutory status adds far greater comfort both to the RBI and to investors in India. We sense that the government is making a serious effort to remove distortions in India’s financial market. All these measures, along with several others undertaken earlier like the auction of resources, deregulation of fuel prices, extension of Direct Benefit Transfer (DBT) to more areas, and others taken together, can in a true sense be called the second generation of reforms which are needed to unshackle the Indian economy.

Meanwhile, one senses a pall of gloom that seems to have spread to markets over the last few months. Mr Market is in an ugly mood! Mr Market refers to Ben Graham’s personification of the manic depressive market – the man who knocks on your door every day to either sell his share of the business, or buy your share of the business by offering a two way quote. It is our dharma to not be swayed by Mr Market’s moods but to use his ever swinging moods to our advantage. The Indian equity market has delivered 14-15% p.a. over the long run – if one were to extend a 15% trend-line from the Sep-01 value of 850 for the Nifty, one would reach the roughly 2525 low hit in Mar-09. If one were to extend that to now, we would be roughly where we stand today. A pessimistic Mr Market is good news for the intelligent investor as per Ben Graham – because it allows you to buy fabulous businesses at better and better prices.

January 2016: Quality is…What quality does

The Indian stock market took a sharp knock this month – the Nifty was down 4.8% and our portfolios also participated in the fall. For the financial year (Apr’15 – Jan’16), the Nifty is down 10.9% and our portfolios have done much better than the markets.

In today’s world, currency has become the great leveler, driving large changes globally – the number of currencies which have halved in the last 18 months, against the dollar, is now ceasing to be a joke. The second largest currency block in the world, i.e. the Euro is itself down 30% against the dollar – the Indian rupee has held up well in this storm, partly driven by the sharp fall in prices of commodities like oil & gold, which India imports heavily. India is also likely to emerge as an attractive investment destination going forward given its healthy macro-economic fundamentals and world leading growth.

Some market commentators are suggesting that we could be visiting a 2008 like situation again in the world economy and markets, thanks to what is happening in China – we believe that there are some crucial differences between 2008 and now. First and foremost is the fact that, valuations are reasonable now, compared to the extreme levels seen in 2007 – large falls in a market are usually preceded by over-valuation, over-leverage and over-bought conditions. None of these three conditions were satisfied in the current market move, at least from the broad indices point of view. There have been several instances of some small and mid-caps trading at stretched valuations. The froth, if any this time around, is mostly centered in that space – high quality large caps remain reasonably priced.

The other subject much discussed these days is the volatility in the market – we depict volatility in a rather simplistic manner which is the 52 week high divided by 52 week low minus 1. The historical median volatility of the Nifty is 56%. As per this measure, CY2015 was the least volatile ever, in the last 15 years. Low volatility is sometimes a result of the fact that there is not enough economic momentum for prices to tread higher, and the low valuations do not allow the market to fall a whole lot.

Global markets have been in a state of crisis since 2008. In this period, 2008-2015 (the last full year for which data is available), Nifty companies grew their cumulative revenue by 15% pa (in-line with long term nominal GDP growth and Index rate of return) and profits by 10% pa. This has resulted in the profitability pendulum swinging from way above median for the Nifty companies in 2008 to way below median in 2015. The weighted average sales growth of our consolidated portfolio is 18% pa while net profit growth is about 16% pa, for the cited period. If the companies you hold, can deliver this kind of performance through one of the darker periods in the global economy, it gives one a lot of comfort to be able to deal with whatever future crises may come. We feel confident of India’s prospects over the next 5-10 years and even more so for our portfolio companies. The recent correction has allowed more companies in our universe to come close to buy point and we think this provides an excellent opportunity to invest.