CY2018 was marked by the divergence in performance between the large and midcaps stocks. The Nifty was up 3.1% for the year, whereas the Nifty Midcap index was down 15.4% and the Nifty Smallcap index was down 29.1%. Even the median performance of the top 25 equity mutual funds by size was down 4.3%, indicating a fairly tough year for equity investing. This was on the back of a strong year in CY2017, when the Nifty was up 30.3%. Equity market by its very nature is expected to have a mix of strong, moderate and difficult years – but, in our best opinion, long term equity market returns should converge to an annualized return of about 11-13%, which would be in-line with the nominal GDP growth rate.

The year was packed with several extraordinary events. Global events were led by the trade war, mainly between US and China, which also spilt over to the rest of the world. Oil prices shot up during the year and corrected towards the end of the year. This led to a steep fall in the Rupee and rise in interest rates in India, creating concerns over the government’s ability to hold up to its fiscal deficit target. All these events coincided with the NBFC crisis in the last quarter of the year. The tough situation precipitated in intense negotiations between the government and the RBI, eventually leading to the RBI governor resigning from his post – a rare event which will leave a black mark in India’s economic history.

Despite all these events, the Nifty volatility was only about 28% in FY2018 (measured based on Nifty High / Low during the year). Overall volatility in the Nifty over the last 5 years has averaged about 27%, compared with a much higher average volatility of 58% in the decade before 2012. With lower inflation and low overall corporate earnings growth, one would expect overall volatility to reduce. On the other hand, one should also note the maturing nature of the Indian stock market participants. FIIs sold nearly Rs 32,000 cr in the equity in CY2018 and historically such FII selling has led to sharp fall in markets. Unlike the past periods, this sale was compensated by Mutual Fund investments of nearly Rs 110,000 cr. Over the last 4 years, inflows from domestic investors through Mutual Funds has been gaining momentum. The Indian stock market’s resilience is due to a good mix of different classes of investors and this is good for equity investors over time. Ideal equity investing is where one can make reasonable equity market returns above fixed income returns, with as little volatility as possible. Reduced volatility levels are good for investors and only time will tell if this trend would continue.

As we look forward, the general elections in a few months is the big uncertainty for investors – though based on stock market performance in election years over the past several years, there does not seem to be any major cause for worry. There is increased concern on fiscal deficit coming under pressure as we near the election period, though the government is confident of holding up to its targets. The good news is that oil prices have come down sharply and interest rates are also on their way down. The public sector bank capitalization process has also started and corporate earnings growth seems to be gaining momentum. The correction in stock prices over the last year has improved the relative attractiveness of stock prices, though there continue to be several pockets of expensive valuations. The next few months should be a good period to build out some core investment holdings, as uncertain periods tends to create volatility which one can use to buy investment grade companies at sensible prices. We look forward to deploying some capital over the next few months.

The current year, CY2018, has been an interesting year for the Indian stock market. The headline numbers do not do full justice to the actual events in the markets. Though the large cap index – Nifty, is up 3% for the year, the real story lies in the mid and small caps space. The Nifty Midcap index is down 17% and the Nifty Small cap index is down 32% for the year. This has resulted in several investors and funds trailing the Nifty. Some of the stocks that saw the sharpest fall were the ones where questions were raised about their accounting and corporate governance practices.

The negative sentiment in the markets was triggered by multiple adverse factors – sharp rise in the prices of Oil, associated weakness in the rupee, increasing bond yields in India and expectations of higher inflation. To a large extent, all these factors are interrelated. Brent crude started the year at $ 67 per barrel, reached a peak of $ 86 in early October and is currently down to under $ 60. The sharp rise and fall in Crude Oil in a short period has largely been attributed to geo-political factors rather than significant change in demand supply. Given the state of global economy, there does not seem to be any material threat of oil prices spiraling up significantly, the way they did in 2008-2011 period unless there is continued escalation in global political situation. India being a large importer of oil, did get affected, resulting in a rapid weakness in the INR. From about 63 INR/USD at the beginning of the year, it fell to 74 in October and currently trades around 70. Similarly, the 10 year G-Sec rates increased rapidly from 7.3% at the beginning of the year to 8.2% in early October and has corrected to about 7.6% now.

The sharp moves in Oil, INR and the Bond yields created material concerns around the government’s ability to hold up to the fiscal deficit targets and potentially slowing down the economic recovery. Some of the defaults, and the potential stress in credit profiles in the bond markets, were also linked to these moves. Fund flow to NBFCs were also affected as the market became risk averse and started to take note of potential risks of funding profile and Asset Liability mismatch of some aggressive NBFCs. Though not widespread, these factors could indirectly affect businesses and consumption. As per early news flows, the festive season demand seems to have been affected. We will have to wait for a few more weeks to understand the full extent of impact. Markets were expensive earlier this year, especially so in the mid and small caps. Expensive markets tends to correct sharply when faced with material negative news and valuation tends to revert back to normalcy in such periods.

On the positive side, some of these threats have diminished. Since early October, Oil, INR and interest rates – have moved favorably. FPIs (Foreign Portfolio Investors), who were selling aggressively till October have also turned positive. Domestic mutual fund inflows, which had slowed down seem to be gathering momentum again. The broader market correction has led to several pockets of exaggerated valuations turning in favor of the long term investors. Despite the correction, we are not yet seeing cheap valuation across the board like what one would see at the bottom of bear markets. We do see some pockets of attractive valuations and are using incremental capital to invest in these companies. The negative economic factors are not completely behind us. There is an added uncertainty due to the upcoming general elections. Despite these factors, we find comfort in the earnings of good companies which are gaining momentum. We are comfortable buying and holding these excellent businesses at sensible prices. As long as these companies keep growing, time is your friend.

The 6.4% fall in the Nifty last month was followed by another 5.0% fall in the month of October, 2018. The market has been hit by bad news on a number of fronts – the ILFS default and its resulting impact on NBFCs; higher oil prices, which in turn has had an impact on the rupee. Other issues that the market is trying to deal with, are the ongoing international trade war which is having an impact on global trade, a tightening Federal Reserve, which has been raising interest rates in response to stronger core inflation data coming out of the US, which is in turn having an impact on emerging market currencies from Indonesia to Turkey to South Africa and other emerging markets like India. And then of course, there is the matter of the general elections in India, which are scheduled for mid-2019, about 6-7 months from now. While our portfolios were also impacted by the market fall, they fell less than the market and we remain reasonably confident of our holdings.

The fall in the market over the last few months has been tilted towards the broader market – the NSE Mid-cap 100 index is down 18.7% as of 31-Oct-18 for the calendar year and the Nifty Small Cap 100 index is down 33.3%. In the same period, the Nifty is relatively flat at a negative 1.4%. The median stock in the BSE-500 (an index of the 500 largest companies) is down 34.0% from its respective 52 week high. The correction in the broader indices has been brutal – led by high valuations to begin with, and attending factors like SEBI’s stricter classification of mutual funds into large, mid and small cap mutual funds and the proportions that such funds can have in different categories of stocks. What hasn’t helped is the bad news coming from some debt instruments defaulting (eg ILFS) and the resultant liquidity issues among some NBFCs.
Along with all the bad news also came some good news. The Essar group made an offer to repay Rs54,000 crore of its loans and try to regain control over Essar Steel, which had gone into the insolvency proceedings under the Insolvency and Bankruptcy Code (IBC). This offer was higher than Arcelor Mittal’s offer of 42,000 crores. Once it is resolved, Essar Steel will be the 7th of the initial 12 large cases that were sent to the NCLT court for resolution. There are two positives from these developments. First and fore most is that the rules that govern lending by banks has undergone a fundamental shift with the establishment of the IBC. Lenders now have a legitimate means to get a quick settlement of their loans due – this means that promoters need to be careful before they indulge in mischief in their companies – they can easily lose their companies if they do. The second positive is that banks will recoup some of the money they have lent to these large defaulter companies – and this can allow them to lend more effectively to the economy.

Meanwhile the early results that have come in for the BSE 500 companies have been reasonably healthy. We have considered the results ex of the banking and finance stocks because there is a comparison issue with them due to the high losses reported by many banks and financial institutions over the last 24 months. Of the 418 non-financial companies in the BSE 500 Index, 118 have reported results as on date. We have compared the numbers over a 2 year period because of the various disruptions because of demonetisation and GST and done a 2 year CAGR to present the results. The 2 year median revenue CAGR for the BSE-500 has been inching up since Dec-17 from 9.4% to 12.2% as of now (for companies that have declared results so far). This is somewhat close to the middle of the 10-14% range that one expects for Nifty revenues over the long term. Importantly, these numbers are getting back to historical trend after the twin disruptions from demonetisation and GST. What is also heartening is that median PBIT growth (Profit before interest and tax) is currently at 18.1% CAGR over 2 years (though typically the better companies tend to report first), significantly higher than the 10.9% rate recorded in the Dec-17 quarter. While we need to add the caveat that all the results are not declared yet, it appears that the trend of better corporate results that we reported in our August newsletter, seem to be getting more confirmation. The green shoots are taking root perhaps – we shall continue to wait for more signals from corporate performance.

Meanwhile, in the significant corrections in stock prices, both in the large cap and the mid cap spaces, one can see quite a few opportunities emerging for us as long term investors. To paraphrase Benjamin Graham, “Mr Market is in an ugly mood”. The reference to Mr Market is that of a 50% partner in the business that you own together with him, who is a manic-depressive – very ebullient at times and very despondent at others. His endearing quality as per Ben Graham, considered by some to be the Father of Value Investing, is that he will knock on your door every day with a two way quote – one at which he will sell you his 50% of the business and the other at which he will buy out your stake. Our job as a value investor is to use his manic depressive nature to our advantage and not to be guided by Mr Market.
However, we expect to continue to operate in the high quality space that we prefer. It is possible that some of the incremental allocations are in the mid-cap and small cap space (as per SEBI’s new definitions of this term for mutual funds, the small cap space is quite broad at anything which is 251st in market capitalisation and below) because that is the space which has seen some dramatic corrections. Yet we are mindful of the fact that when a stock falls from 3x its intrinsic value, even a 40% correction would bring it only to 1.8x its intrinsic value. There may be some traps in this broad market fall which investors should watch out for. We believe that it is important to stick to the quality end of the spectrum because it provides long term protection of capital and also higher stock price appreciation over the full economic cycle.

September 2018 saw the Indian stock market rocked by volatility triggered by IL&FS, an infrastructure development and finance company, defaulting on its short term debt. The Nifty fell 6.4% in the month, the Nifty Midcap 100 index fell 13.9% and the Nifty Small Cap 100 index fell 19.8%. Such steep falls, particularly the quantum in the mid and small cap indices are unusual, to say the least.

IL&FS is a large wholesale funded company with approx. Rs. 1 lakh crore balance sheet. It is predominantly funded by PSU banks and through some exposure to the bond market. It was a AAA rated company till a few months back and the default took the market by surprise. The IL&FS board did meet last week and put in place a plan to manage the crisis. This includes raising equity funds through a rights issue, plan for sale of some of its assets and some short term infusion of liquidity to tide over the short term debt repayment. The firm is backed by some large shareholders including Orix Japan, LIC, SBI, Abu Dhabi Investment Authority and HDFC Ltd. Despite these steps, given the severity of the problem, it is unclear if this will address the issues at hand.

IL&FS’s default on its debt sent shockwaves across the NBFC space as liquidity has been hit for some of these companies with cost of borrowing going up sharply in many cases too. Some of this has been reflected in sharp price corrections in many of the NBFCs, some to the tune of as much as 50% in one month. Similarly, RBI and market participants sending worrisome signals over Yes Bank has caused a more than 50% fall in the share price of the bank over the past few weeks. On the whole, there is some concern over quality of accounting and funding availability for the companies in the financial sector – especially some NBFCs and HFCs.

Part of the reason for this crisis to emerge now is the rising interest rate scenario, led by risks of increased inflation, weaker rupee, concerns over fiscal deficit and tight liquidity. As expected, the month also saw large withdrawals from the debt market to pay for advance taxes. We need to watch this space closely and see if the liquidity strain eases over the coming weeks. The regulators and policy makers are taking measures to handle the situation. It is also important to note that the current regulatory framework allows for a time bound program for sale of assets and therefore work towards solving challenges like these. Till a few years back, we did not have such time bound remedial measures.

These are testing time for equity markets. From our portfolio perspective, we don’t have much direct exposure to the problem at hand, as we predominantly invest in debt free companies or businesses that can grow without borrowing or taking outside capital. Economic recovery can get affected, if the higher interest rate regime continues and if there are restrictions for Banks and NBFCs to lend. Our portfolio exposure to banks and NBFCs are primarily companies which are untouched by large NPAs or accounting issues. There are virtues in investing in safe companies – companies where there are no excessive borrowings and have clean balance sheets. We strongly believe these companies will withstand challenging times, such as the one we are witnessing now and perhaps even benefit from them in contrast to their weaker peers.

Over the last few years, the Indian economic growth trajectory has been interrupted by various factors such as demonetization, GST and RERA, which have impacted revenue growth for the Indian corporate sector. Some of these measures were reforms which were required, but there was a short term impact on growth. Also, inflation has moderated over the last 3 years. Revenue growth for a typical company has two components – volume growth and price growth. Because of lower inflation, the price growth has been muted and this has impacted overall revenue growth. Inflation in the March, 2008 to 2013 period, as measured by CPI, averaged 10.2% p.a., which moderated to 5.1% p.a. over the next 5 years.

Some of these factors also reflect in the nominal GDP growth that the economy records. In the 5 year period 2010-15, nominal GDP (real GDP plus inflation) grew at an average of 14.7% p.a. Since then, nominal GDP growth has slowed down to an average of 10.1%. The real growth rate in both these time periods is about the same at 7.2%.

Given all these factors, growth rate for companies slowed down over the past 3 years. If one were to look at the companies in the Nifty, the median revenue growth of these companies was 16.3% pa in the period FY 2010 – 2015. The unusual growth partly came from higher inflation. In FY2016, the median revenue growth rate of Nifty companies fell to 6.1%, followed by 8.6% in FY2017 and 11.4% in FY2018. However, because of the disruptions of demonetization and GST, one year growth rates don’t give the correct picture. So we looked at FY2018 over FY2016 and calculated a 2 year CAGR – this comes to 9.1% as the median growth of the Nifty companies.

In the latest quarter ending June-18, we are beginning to see the first signs that growth may be getting back to a more normal trajectory. The median 2 year CAGR of revenues for the Nifty companies for June 2018 results comes to 13.7% p.a. which is a fairly healthy number. However, these are still early signs which would perhaps need to be confirmed over the next few quarters. From individual company results, one gets the sense that consumption demand seems to be stabilizing and indeed picking up. Various initiatives by the government, including low cost housing and investments in infrastructure should further aid the demand growth.

There are some concerns though. The banking sector is continuing to face challenges of NPA resolution. Though the NCLT framework for resolving bad debts is a good long term step, the large NPA recognition has impacted the banking sectors ability to lend further. It is going to take some time for the situation to improve in this space. Some sectors like telecom, airlines, power, etc have their own challenges. Manufacturing in India is yet to gain momentum. With increased oil prices and a weaker rupee, inflation is starting to creep up along with interest rates, which can affect growth over the short term.

Despite the negatives, one factor consistent over the past several years is strong domestic consumption. With the banking sector settling down, hopefully sooner than later, corporate growth rates should pick up momentum in the coming months and years. We believe that with many structural reforms out of the way, the country is poised for a strong period of consumption growth. While there are not many compelling new opportunities to invest; despite some valuation concerns, the growth prospects give us good reason to stay invested in equities.

As fixed deposit rates have been low in recent years and returns from real estate investments have been poor, we are seeing investors allocating more towards equities in their asset allocation. The returns from the Sensex since 1985, have been about 13% pa. If one had invested Rs 1 lakh into the Sensex in 1985, it would be worth Rs 67 lakhs now. Whereas the same Rs 1 lakh invested at 7% pa in a fixed income instrument would amount to Rs 9 lakhs in today’s rupees, without factoring the impact of taxes which favors the argument for equities even further. Despite there being such a vast differential in terms of returns, over long periods of time, a very large proportion of the average Indian investors’ savings continues to be in fixed income, even though it is invested for the long term.

Probably the single biggest reason for this irrational behavior is the volatility in equity market returns. While most people acknowledge that returns from equities are likely to outstrip fixed income returns over the long term, what pushes them towards fixed income is a lack of knowledge about inflation adjusted returns, which for fixed income, on a post-tax basis is very low and also the variability or volatility in equity market returns, which tends to scare people off.

There is some good news on this front. Volatility in the Indian equity market has been coming down. Over the last 25 years that we have been analyzing the Indian equity market, we have observed a trend of greater maturity in the Indian equity market. While this is not the strict definition of volatility, we are measuring volatility, in simple terms, based on high and lows of the market in each year – say if the Sensex trades at low of 100 and a high of 150 in a given year, we then measure volatility as 50% (150 upon 100). In the 20 year period from 1993 to 2013, the average annual volatility in the Sensex was about 60%. In recent years, average volatility has come down to under 30%. It is difficult to say if volatility will spring back to past levels, but one needs to view this in the context of volatility in developed markets. This figure is about 24% pa in mature markets like US. In our opinion, it is fair to assume that investors will have higher confidence to invest in equities – especially when long term returns in equities are better than fixed income – if volatility in equity returns is low.

Reduced volatility is the outcome of an increased depth and breadth of the markets. Over the years, the Indian market has become larger with total market capitalization at close to $ 2.2 trillion now. Also, the variety of companies to invest in, is expanding, thanks to an active IPO market. In recent years, we have seen a number of different kinds of businesses getting listed on the bourses. Some examples of this are asset management, insurance, stock exchanges, depositories, retailing, pathology labs. Though services accounts for a significant proportion of GDP, it has been under represented in the equity market – we are slowly seeing services finding greater representation. Multiple classes of investors can also help reduce volatility. For example, we have seen recently that the selling of foreign investors has been absorbed by the increased inflows into domestic equity mutual funds and insurance companies.

Our objective, while managing portfolios, is not only to maximize overall returns, but also to reduce the volatility of those returns. Reduced volatility gives investors more comfort in investing a larger proportion of their wealth in equities, which we believe is the right thing to do, for the long term.

Many people have asked us about individual stocks in our portfolio and about portfolio construction. Identifying individual stocks in the portfolio, as a process, is very different from constructing a portfolio. We would like to draw a parallel with a sport many Indians are quite familiar with – cricket; even though the same can be applied to any other team sport.

The job of a portfolio manager is similar to the job of the captain (or selectors) of the cricket team.

To win games of cricket consistently, a team can’t afford to just have all Sehwags – who can score very quickly, but also are unpredictable and can get out quickly. Neither can they have all Dravids (who was known as “The wall”) who can hold one end up but may not score as quickly. And similarly, neither can the team just rely on many Tendulkars/Dhonis or just spinners or fast bowlers. This is not withstanding the fact that in reality it is also extremely difficult, if not impossible to the find more than one Sehwag, Dravid, Tendulkar/Dhoni or a Kumble at the same time to make a team. It is important to build a team with complementary skills, so that one can perform when others don’t do as well.

To win consistently over long periods, one has to be prepared for different situations, weather and pitch conditions, opposition strength and so on. Similarly, to deliver consistent performance, the portfolio manager needs to construct a portfolio which can do well in different economic conditions. While selecting a company is a bit of science, the art is in constructing the portfolio with a mix of companies in certain proportions (read weightages).

This mix of science and art is what makes this job very interesting and challenging.

There are various factors like economic headwinds, unpredictable monsoons, currency fluctuation, interest rates spikes, inflation, global or domestic political events, etc. which affect stock prices. These factors are highly unpredictable and can swing in any direction, like the different kinds of pitches the team is likely to play on. What we really need is, not the best 11 players, but the best mix of players who as a team will do well under different economic conditions. One needs a ‘balance’ in the portfolio.

The last few months have been a difficult period for stock market investors – as we pointed out in our last newsletter, the steady performance of the Nifty hides the internals of the market which have seen large drawdowns from the peak for a very large section of stocks. Many market participants have struggled, as new factors have come into play which have changed the performance leaders in the market. The pitch conditions are very different now than a few months back. A weaker rupee, higher oil prices, some degree of political uncertainty and global events have shifted the markets to favour exporting companies – which were cheap – and away from the domestic consumption oriented companies, some of which were quite expensive. Our portfolios have benefited by being patient and having the right mix of stocks, while some strong performers have helped deliver reasonably good portfolio performance.

The current calendar year, CY2018, has been one of muted returns for the Nifty – it is up 2.0% year-to-date. However this somewhat stable picture hides an important detail – the broader market has had a decent size correction. The BSE Midcap Index and the BSE Small Cap Index are down -10.1% and -10.3%, respectively. Most of the diversified equity mutual funds are trailing the Nifty – perhaps because of their exposure to mid-caps and small caps.

For all companies that have a market cap of Rs 500 cr and above, the median drawdown from their respective highs in stock price in the last 12 months, as on end May is 25.1%. Almost ~39% of our sample of 1037 companies are down more than 30% over the last 12 months and 71 companies have halved or more in this period. So the mid cap and small cap correction has been quite steep. We have spoken about the valuations of the mid-caps and small caps in prior letters. The larger cap companies have been relatively steadier and have offered some capital protection in this correction.

One of the reasons for the muted sentiment on India is that oil prices have been climbing quite rapidly and Brent crude oil futures are up more than 50% over the last 12 months. This has obvious implications on India’s current account deficit – the effect of which is visible on the rupee as well. Moreover, if prices continue to rise, the higher prices may prompt the government to consider reducing the excise duty on oil to mitigate the impact on the common man – this can potentially have an impact on the fiscal deficit of the government. Oil prices also feed into inflation which can hurt consumer spending. Interest rates have risen recently, which will impact consumption.

Also the results of the PSU banks in Q4 have been shocking in some instances and are prompted by the RBI’s new strict guidelines for NPA recognition. Many of the PSU banks are unable to lend – this continues to be a drag on the economy.

The valuation of many mid cap and small cap companies have been out of sync with their trading history – and therein lurk some mine fields for investors. In many cases, mid cap companies were trading at valuations that were at a premium to the large cap companies in their own sector – this is a bit unusual from the historical perspective. We are careful to use the past tense with respect to mid-caps because this was the situation a few months back – valuations have changed, price wise, in the last few months. The large cap companies though also a bit stretched on valuations in some cases, still offer a few opportunities to get invested.

Our portfolios have been more weighted towards the large cap stocks and this has helped us in this period of volatility. The results of most of the portfolio companies declared so far have been reasonably good and there have not been too many disappointments. We are fairly comfortable with our current portfolio – we see a few good opportunities. Though there may be near term head winds for the economy, the Indian consumer is on a strong wicket and the capital goods cycle should gather steam in the coming years. Should the correction persist for some more time, we could get some more opportunities to get invested.