One of the common questions that we get asked, when we meet with investors, is whether one should be concerned given that equity markets are at records high levels. Moreover, should one deploy additional capital into equity markets when markets are trading at near their all-time high levels. To understand this better, one needs to understand how markets have moved in the context of the growth in the economy.

Over long periods of time, since the 1950s, nominal GDP in India has grown at an average of about 13.5% pa. This is a combination of real GDP growth and inflation. Over the past 5 years, nominal GDP growth has slowed down to about 11.2% pa, partly led by lower inflation and partly due to a cyclical slowdown in real GDP growth. GDP was also affected by demonetization, GST roll out, RERA, etc. There is reasonable consensus that real GDP growth will pick up momentum, as some of the critical structural reforms, which had caused short term pain, are behind us.

Though the Nifty performed strongly in the current year (up 28.6% in CY2017), this was on the back of two consecutive weak years prior to 2017. In reality, the Nifty has delivered a CAGR of 8.3% pa over the past 3 years and 12.3% pa over the past 5 years. As one observes, Nifty has been growing in line with nominal GDP growth over the past few years. One needs to be concerned when there is a dramatic outperformance of the Nifty growth over nominal GDP growth (or become greedy when Nifty dramatically underperforms nominal GDP growth, but we can leave that story for another day). Though valuations are not exactly cheap, and in a few cases irrational, there are a reasonable number of large cap companies trading at rational valuations. Moreover companies should benefit as the economy picks up momentum.

On the other hand, the midcap story is quite different. The BSE Midcap Index, which we believe is a good proxy for the mid cap companies in India, has been averaging close to 20% pa returns over the past 3 and 5 years. The BSE Midcap Index has actually performed far ahead of nominal GDP growth. This is partly due to mid-cap valuation being exaggerated currently, as against valuations which were relatively cheap 5 years back. What is important to note is also that, over the past decade (since Dec 2007), the BSE Mid-cap Index has performed nearly the same as the Nifty. The Nifty has delivered an annualised rate of return of 5.5% pa over the past decade, compared with 6.2% pa for the BSE Midcap. Over the past 5 years, the Midcaps have been catching up for the weak performance over the prior 5 years to a large extent, and valuations in the mid-caps are well ahead of rational behaviour. We do suggest caution in this space, especially when 50 plus Price-to-Earnings ratio has started to become the norm.

It is a bit tricky to invest in the current equity market, especially with valuations beginning to look stretched and the cyclical economic revival yet to kick in. We do see some companies trading at valuations that are reasonable, but it is fewer than normal times. Moreover, with some of the key reforms behind us, there is reasonable hope that one should see a protracted period of strong economic growth. With lower expected returns in alternatives like fixed income and property, and reasonable prospects for an economic recovery, it does seem to make sense to invest in stable companies trading at sensible valuations.

Of late, you may have observed many companies doing buy-backs of their shares from the shareholders. A buy-back is essentially the inverse of an issue of shares (in which companies raise money from the public or their shareholders to meet their capital needs). In a buy-back, a company returns excess money to its shareholders. It can be done either through a fixed price tender offer (as in the recent cases of TCS, Infosys and Wipro), where the offer is made to all shareholders, or through market purchase by the company via the stock exchange. In many ways, a buy-back is similar to a dividend payment, except that here the company returns money only to those shareholders who wish to sell their shares at the price offered by the company. The remaining shareholders, who do not offer their shares, find that their proportionate holding in the company stands increased because the total number of outstanding shares go down after the buy-back. Eventually shareholders need to look at their holdings in a company as a fractional interest in the underlying business – anything that increases their beneficial interest at a discount to intrinsic worth is welcome.

Buy-backs are typically done by companies which generate lot cash and to the extent they have sufficient money left behind after business requirements and normal dividends are taken care of. Such surplus cash can either be paid out as special dividends, or in the form of buy-back of shares from existing shares holders, at near market price or at a premium to current market price. Unlike dividends, where dividend distribution tax (DDT) is payable by the company and hence the total amount available to be paid out as dividend stands reduced to the extent of the DDT, there is no direct tax impact on the company for the buy-back of shares. On the other hand, the value that accretes to investors is not in the form of cash flows directly into their bank account (like a dividend), but indirectly by a combination of purchase of shares at a premium to market price and the resultant increase in the intrinsic per-share value of a company by extinguishing some part of its outstanding shares. Since these shares are tendered by investors through the stock exchange, long term capital gains is tax exempt and short term capital gain is taxed at 15%, making it very tax efficient for the investor too.

Another reason that buy-backs have received a fillip of late, is that the government has made dividends received beyond Rs. 10 lakhs a year, taxable at 10% in the hands of the shareholder. This has presumably been done to ensure that high income earners have to pay a higher tax on the dividends received. This has prompted many promoters to opt for buy-backs rather than pay high dividends as a more tax efficient strategy to pay out to shareholders, and more so for the promoters. The net result has been that some companies are paying out less dividends and instead preferring to pay out the cash to shareholders in the form of buy-backs.

As shareholders of free cash generating companies, we welcome buy-backs because not only does it represent management’s confidence in the business of the company that they are running, it also allows for draining out the excess cash on the balance sheet of the company, which is typically invested in low earning avenues such as fixed deposits or liquid mutual funds. These funds can be better deployed by the investors in either buying more of the company’s stock or in other areas which may yield a better return.

The Finance Minister recently announced that the government plans to recapitalise the PSU banks to the tune of Rs 211,000 crore – of this, 135,000 crore will be funded by recapitalisation bonds and the balance through a mix of budgetary sources and market borrowings. Recapitalisation bonds are bonds issued to the PSU banks by the government in lieu of cash which they normally would have to pay for infusing capital into the PSU banks. This method of recapitalisation has been used before, in the 1990’s under similar circumstances when the PSU banks were saddled with large losses. The woes of the PSU banks have been a regular subject of our newsletters in the past and we would like to take this opportunity to discuss this further. As we have pointed out before, the Indian economy is unable to reach its full potential because PSU banks are unable to lend because of insufficiency of regulatory capital.

The Indian banking sector is dominated by the PSU banks which form 70% of total advances in the system. There are very few sectors of the economy which have been privatised for more than 20 years and the public sector continues to hold such dominance. Over the years the PSU banks have always had higher gross non-performing assets (NPAs) than the private sector. As on 31-Mar-17 the average PSU bank had gross NPAs of about 11.8% of their advances, while the average private sector bank had gross NPAs of 4.8%. There are a large number of reasons for this poor performance of the PSUs – some of them are legacy issues related to political interference, inability to hire the best talent due to restrictive government pay scales, lack of operational freedom and lack of incentives to control credit costs. Meanwhile some of the private sector banks have also had to report a larger NPA problem than previously reported as the RBI has become increasingly strict about NPA recognition. Yet, the problem is contained in the private sector and they are also better capitalised than the PSU banks.

Banking is a capital hungry business which is likely to grow faster than the rest of the economy and it is not advisable over the long term that the government continuously pump in capital into PSU banks which controls a dominant 70% of the total market, given its implication on the fiscal deficit. We think that the long term solution to this problem lies in reducing government stake in PSU banks below the 51% mark. This will take them out of their public sector character and has attendant benefits in the form of operational freedom and ability to attract appropriate talent. In order to ensure that the banking sector does not fall in the hands of foreigners as may be feared by some, the government can impose a 5 or 10% limit on the shares that people acting in concert can buy into the PSU banks. We believe that privatisation would be a more efficient way to deal with the ills of the banking sector.

Having said the above, we do note that the size of the recapitalisation is sufficiently large and addresses the capital needs of the PSU banks. Moreover, the government has announced that it would introduce reforms in PSU banks – we would watch out for these reforms and see how effective they are in ensuring that lending decisions in the future are more prudent. Meanwhile we retain our preference for those private sector banking and finance companies which have a history of controlling their credit costs better.

Of late, there has been a lot of talk about the slowdown in India’s economic growth, particularly after the June 2017 print for GDP growth came in at 5.7%. At the same time, we are witnessing the Nifty scale new heights during the month, though the market did correct towards the end of the month.

There are many reasons for the slowdown in growth – some commentators have laid the blame on the lagged effect of demonetisation as also the glitches related to GST. With currency levels in the economy back to near pre-demonetisation levels, it is expected that the impact of demonetisation on GDP growth should be more of a thing of the past. GST is going through its teething troubles which was somewhat expected given the historic nature of this reform and the complexity of the project. The government’s readiness for GST has come under some criticism from different quarters as industry is forced to deal with considerable blocking up of working capital due to the glitches with GST.

Another reason for the slowdown in economic growth is the inability of the PSU banks to lend because of the large NPA problem that they are facing. With the RBI moving quickly on the larger NPAs, one hopes that we can find a lasting solution to this thorny problem over the next few quarters. This needs to be coupled with an effective recapitalisation of the PSU banks by the government, so that the banks can provide the much needed capital to borrowers. The strength of the rupee in recent months is also one of the reasons for the slowdown in domestic growth as it encourages import and discourages exports.

At the same time, one is witnessing increasing inflows into domestic equity mutual funds. This seems to be driven by the fact that interest rates on deposits have fallen over the years and the real estate market is also offering lower returns to prospective investors. The IPO market has shown a rebound and a number of different kinds of companies have been raising money from the primary market. The flow of funds has also raised equity values and this is particularly visible in the mid cap and small cap stocks.

The economic cycle which peaked around FY2012 has been weak for 5 years now and it seems to us a question of time before we see an end to the current phase of slowdown. The capex cycle is moribund and needs a push from the government. We did observe some pick up in the automobile sales in August and await confirmation of automobile sales during the festive season as one of the first few green shoots that the economy may be on a path to recovery. A number of issues still need to be addressed, related to GST and the NPA issue and the government needs to kick-start the economic cycle by front ending investments in infrastructure and related areas. India’s central fiscal deficit is now a very respectable number – we can afford small slippages on this front for now, in order that the government may front end the capex cycle by investing more in capex.

The increased equity prices in recent times have made our jobs more difficult in terms of how to invest the new money that we receive. We hope that the current correction in the market gives us a better opportunity to invest. We hope to continue to exercise discipline in our purchases so that we continue to meet the triple objectives of protecting capital, beating inflation and beating the market over the long term.

Over the past few years, there has been a large cloud hanging over the Indian corporate sector and the Indian banking system, in the form of the large non-performing assets (NPAs) on the balance sheet of the banks. This has resulted in the impairment of the equity that the banks have on their balance sheet, which in turn severely affects their ability to lend to the economy. The result has been that the economy is growing below potential partly due to inability of the banks, particularly the PSU banks (70% of the banking sector), to lend money to borrowers who require capital for their businesses

The size of the bad debt problem is estimated to be about Rs 8 lakh crore ($125bn) and it constitutes roughly 10% of the banking sector’s advances. Much of the problem has arisen because of the excesses of the 2007 boom and the continuous kicking the can down the road by bank managements. Moreover, the process of resolving many of these NPAs did not have sufficient regulatory backing, leading to an endless resolution process, which neither helped the businesses nor the banks. It is heartening to see the current government take a bold stance of tackling the root of this problem. In May 2016, the parliament passed the ‘Insolvency and Bankruptcy Code’ and it became effective in December 2016. The code establishes the Insolvency and Bankruptcy Board of India, to oversee the insolvency proceedings and the National Company Law Tribunal (NCLT) is the adjudicating authority before which a plea for insolvency can be submitted by the lenders. Once an insolvency plea is accepted, there is a 180 day window (extendable by 90 days) within which a resolution plan has to be drafted. The process is to be managed by licensed Insolvency Resolution Professionals who will control the assets of the debtor during the Insolvency process. Developed markets like the US have the concept of Chapter 11, which can lead to swift resolution of bad debts. A functioning bankruptcy law will not only help lenders to recoup their loans but more importantly save many businesses.

On June 13, the RBI came out with a list of 12 large defaulters which have been referred to the NCLT. A deadline of 180 days has been set for the presentation of the draft resolution plan of these 12 cases, failing which these cases will move ahead towards liquidation. This has been followed up in the third week of August with a second list of 40 more large defaulters against which the banks can initiate insolvency proceedings. Together with the initial list of 12 defaulters this constitutes about 60% of the total non-performing assets in the banking system. The RBI seems determined to get a swift resolution of the NPA problem – this will also prevent NPAs from building up in the future as promoters realise that they can end up losing control of their businesses, if they don’t behave prudently.

Flow of capital is important for the economy to grow – the large NPA issue had clogged up the system preventing banks from lending effectively. The swiftness with which the RBI is acting in this regard is encouraging and we hope that we have a resolution to this thorny problem in sight. More importantly, these steps will go a long way in ensuring future NPAs are fixed quickly rather than fester for several years. An effective addressal of this problem will allow the economy to get the necessary capital to grow closer to its potential.

With the Nifty scaling the 10,000 mark, several investors have concerns as to whether the market is beginning to get overvalued and whether we are approaching a bull market peak. Typical bull market peaks are characterized by high earnings growth in recent years, high corporate profitability and high valuations as measured by some standard metrics like ‘Price to Earnings’, ‘Price to Book value’, etc. Let us examine how these factors stack up in the current bull market in Indian equities.

Aggregate earnings growth for the Nifty has been fairly poor in recent years. The aggregate earnings growth of the Nifty over the last 5 years is close to 6%, which is significantly below its historical average growth of 12-14%. Part of this can be attributed to the low inflation in recent times – this has had an impact on the nominal growth and hence the reported numbers. Volume growth being reported across industry segments is below trend.

We try to get a sense of aggregate profitability of the corporate sector by looking at the Return on Equity (RoE) reported for the Nifty 50. Currently the median Nifty company’s RoE is at 14.6% which is the lowest recording for this parameter over the last 18 years. The current economic cycle peaked roughly around the financial year ended 31-Mar-12 and we have now seen an economic slowdown for nearly 5 years. This is also the period when there have been some short term disruptions caused by demonetization, GST and implementation of RERA. Many of these will be good over the long term but the economy needs to take a short term hit.

On the valuations front, the aggregate valuations are now above the median of the tops recorded historically, as the Nifty is trading close to 26x trailing 12 months earnings. This is the one signal that is flashing red on our monitors and does bear watching. The low RoEs discussed earlier are a mitigating factor to the high valuations, which suggests earnings growth should be faster in the coming years as the economy recovers. Yet one can’t get away from the fact that many stocks, especially in the mid-cap and small cap category are beginning to see some levels of froth build up, which can be a cause for worry for investors in these situations.

What we have observed right through this bullish phase in the market is that it has remained very stock selective. For a bottom-up stock picker, it has been a good period because one has seen a reasonable number of stocks available at sensible prices to build a quality portfolio. That balance is beginning to get disturbed a bit now, as we are finding it increasingly difficult to populate new portfolios as compared to the past. Our mature portfolios still have low cash because the stocks we own have still not reached their sell points but if the current market trend continues we may look to pare some holdings in order to reduce risk in the portfolio.

However at the big picture level, since only one of the three conditions for a bull market peak, is satisfied ie of high valuations, we would believe that the market is anticipating growth to come through over the next few years on a cyclical basis and we are not close to a bull market peak yet. Yet, it may be time for investors to be cautious and have a good look at the stocks they own and whether their valuations are reasonable.

After witnessing five months of positive momentum, markets consolidated in June. One of the reasons for the correction was the concern over the GST roll out, which should be good for the economy in the long run but will have some impact in the immediate term. Moreover, valuations of several stocks are high despite muted growth in their respective core businesses.

We are living in an era, where several business models are being disrupted. The global start-up eco-system is riding on a rapidly evolving technology landscape, to deliver better products and services to customers. The likes of Whatsapp, Amazon, Flipkart, Uber, Make-My-Trip, Book my show, PayTM, etc have changed the common man’s way of life in a short span of time. In India, there are additional elements like the Aadhaar, GST, India Stack, etc which are further catalyzing the way business is done. All this rapid change is likely to benefit the end consumer, with a wider array of choices at lower prices. Such a rate of change also has a far reaching impact on several businesses. Many businesses need to adapt to these changes to survive. Others are likely to become redundant. Of course, not all business will be directly affected and many will actually benefit by using the changing environment to their advantage.

In this context, investing in equities becomes an interesting challenge for long term investors. Businesses with just a long track record of having done well may not necessarily ensure future success. We believe one should be picking and choosing companies which are either good at adapting to these changes or are in businesses which are unlikely to get disrupted.

Though change appears more rapid in recent times, it is actually a continuing journey for most businesses. The best companies are those that can harness the forces of change. We have companies like HDFC Bank in the portfolio which are rapidly adapting to these changes, and are in fact utilizing these disruptive tools to their advantage. Several new offerings by these companies would not have been possible a few years back. The best companies are able to adapt to change faster than their competition, which gives them an advantage in the market place. However, companies which are unable to keep pace with these changes face the risk of falling by the wayside and need to do some serious introspection.

There are other businesses where it is far more difficult for disruptive forces to create a major dent in their long term business economics. There is a lot of comfort in holding such businesses in your portfolio, as the rate of change in consumer behavior is slow here. We have companies like Gillette and Nestle in our portfolio where it is difficult to envisage people changing their consumer behavior in any significant way despite all the technological change around us. A collection of such durable businesses can give solidity to your portfolio, especially so in current times where the disruptive forces of new technology are trying to change nearly everything.

The world of business is a difficult world, where the best of minds work hard to deliver the right products and services to their customers in the most efficient manner. This world becomes even more challenging in times like we are witnessing now, where rapid change is the norm. In such a scenario, we believe it is important to stick with the best of the best.

Equity markets continued to gain in strength, with the Nifty up 3.4% for the month. After several months, we saw the small and midcaps weaken while the Nifty continued to forge ahead. Though corporate results continue to be a mixed bag, the strength in the markets seems to be based on the optimism around a cyclical economic recovery. This optimism also seems to reflect in domestic investor preference to invest further in Indian equities.

Equity markets were weak during the months of November and December 2016, due to concerns over the impact of demonetization as well as global factors, and since then been gaining in strength. One of the interesting behavior during this phase has been strong inflows by domestic investors, despite patchy flows from foreign investors. Historically, the Foreign Portfolio Investors (FPI) have been investing about $ 20 billion every year (2010-2015), and these flows had slowed down over the past two years (outflow of $ 2.1 billion in FY2016 and inflow of $ 8.6 billion in FY2017). On the other hand Domestic Institutional Investors (DII, which mainly includes Mutual Funds and Insurance companies) had invested negligible amounts in the 2010-15 period on a net basis, due to redemption pressures from domestic investors, but have been averaging about $ 10-15 billion over the past 2 years.

This increase in investments in equity markets by domestic investors is to an extent due to lower returns in the fixed income markets (bank deposits, liquid funds and other debt products), which is forcing investors to look for higher yielding instruments. In addition, continued weakness in real estate prices is further assisting these positive flows. Distribution reach of equity linked savings products is also becoming more efficient. We are likely to see increased flows toward equities in the coming years.

Despite the recent strong flows into equity markets, equities continue to be a relatively small proportion of savings for most Indian investors. The total equity linked assets with Mutual Funds is slightly less than $ 100 billion, which is relatively small compared to GDP of about $ 2.1 trillion, annual savings of USD 300 bln and penetration of equity Mutual Funds in other developed and emerging markets. This gap should reduce in the coming years, as awareness increases. Increase in distribution reach, a more efficient investor onboarding process, efficient payment infrastructure are likely to further aid the participation of investors in equity markets.

As Indian markets mature, we believe more domestic savings should gravitate towards equities, reducing the volatility and dependence on foreign investors. Moreover, with reduced return expectation from both fixed income markets and real estate, investor have little choice but to increase allocation towards equities. The recent market strength, has reduced the gap between intrinsic value and the market price and has exaggerated valuations in several pockets of the markets. In addition, a broad based corporate growth is yet to take place. On the other hand, a reasonable possibility of a cyclical recovery in the economy over the medium term makes equities a must own asset class.