Benjamin Graham is often considered the Father of Value Investing and we as value investors, lay a lot of store by his principles. The three important concepts that Ben Graham talked about extensively are 1) Equities represent a fractional ownership in the underlying business 2) The concept of Mr. Market and 3) Margin of Safety.

As per Ben Graham, a stock is not a scrap of paper whose value fluctuates on a daily basis, but it represents a fractional interest in the underlying business. So if there are a total of 100,000 shares of a company that have been issued, then if a person owns 1000 shares of said company, then they would own 1000 divided by 100,000 or 1% fractional interest in the underlying business. This implies a 1% ownership of the sales of the company, its profits and also the balance sheet of the company i.e. its assets and its debt outstanding. This principle focuses an investor’s mind on the underlying business of the company and its value rather than on its stock price.

In his book, “The Intelligent Investor”, Ben Graham said that investors should imagine that they are in a 50:50 partnership with Mr. Market, who by his nature is a manic depressive – sometimes he is very ebullient and cheerful and feels that all is well with the world and at other times, he is extremely depressed. The endearing quality of Mr. Market is that he knocks on your door every morning with a two way quote – one at which he is willing to sell his 50% share of the partnership and another at which he is willing to buy your 50% share of the partnership. Depending on his mood, Mr. Market offers wildly different prices to investors. As value investors, it is our job to use the manic depressive nature of Mr. Market to our advantage. To be guided by Mr. Market would be a great folly.

This brings us to the concept of margin of safety, which is the difference between a stock’s market price and its intrinsic value. The further a stock is trading below its intrinsic value, the higher is the margin of safety. Warren Buffett calls it “buying 1 dollar for 50 cents”. So, a stock is not necessarily cheap, if it has fallen 30-50% from its high price – it is cheap only if it is trading at a significant discount to its intrinsic value. Needless to say, an analyst must focus a lot of his time and attention on determining the intrinsic value of the business. The intrinsic value of a business can be defined as the sum total of all free cash flows that can be derived from the business from now to eternity, discounted back to today.

We as value investors, focus on buying high quality businesses at prices that are reasonable in comparison to their intrinsic value. While there is no denying that a far greater risk is assumed by investors when they buy poor quality businesses, high quality stocks may also carry risks, if the price is too high. This is particularly important in today’s Indian market context when several high quality stocks have been bid up aggressively by investors and one wonders whether there is adequate margin of safety left in them. Perhaps only time will tell, if this is true. In the past, we have seen that when a stock becomes very expensive, then it fails to generate adequate subsequent returns for investors, despite delivering good sales and profit growth.

In the month of November 2019, the government announced that the Cabinet Committee of Economic Affairs had cleared strategic disinvestment (transfer of government stake including management control) in 5 companies. Two of these are Tehri Hydro Development Corporation (THDCIL) and North Eastern Electric Power Corporation (NEEPCO) in which the government stake in these companies would be sold to NTPC. For Bharat Petroleum (BPCL) the government will sell its entire 53.3% stake to a strategic buyer and also transfer management control. However, BPCL’s shareholding of 61.7% in Numaligarh refinery would be divested to a PSU prior to the strategic sale. The entire 63.8% government stake in Shipping Corporation of India would be divested while the government will retain a 24% stake in Container Corporation of India and sell the balance 30.8% stake along with management control.

This is a significant departure in the disinvestment policy of the NDA government in that till now it had been satisfied with the same path as its predecessors which is that of selling small piecemeal stakes in public sector companies but ensuring that the government retained a majority 51% stake. The last time that a government attempted strategic disinvestment or privatization in India, was when Atal Behari Vajpayee was the Prime Minister, ie almost two decades back. The selling of small stakes in different PSUs which has been the norm until now, was unimaginative and quite often LIC would bail out the disinvestment by putting in large amounts, to save face for the government in power.

This move to privatize 3 PSUs is fundamentally different from the piece meal disinvestment of the past, in that by changing ownership and hence management, one could potentially infuse new life into the underlying enterprise. From telecom to banking to airlines, we have enough and more examples of how public sector companies have trailed their private peers. The tax payer has had to time and again, bail out PSU companies – one wonders whether in this day and age, the government should be in the business of owning airlines, steel companies and many other such commercial enterprises. It is our belief that this transfer of ownership and management will allow the underlying assets to be “sweated” better and should have a salutary impact on the company in question as also the economy.

Further, the valuation that one can expect to get for a strategic sale where you transfer ownership, would likely be at a significant premium to the prevailing market price, while piecemeal disinvestments were often done at a discount to the prevailing market price. This is of value at a time when the fiscal deficit targets are likely to be missed for the current year. We hope however that the privatization that has been approved by the government is a philosophical change in stance by the government towards greater efficiency and not merely to plug a fiscal gap in the budget. Seeing it in the context of the recent drop in corporate tax rates, gives us hope that the government is shedding its overtly socialistic stance on national economics and moving towards a regime that is more supportive to the economy over the long term.

During the month the price of Infosys, one of our holdings, fell sharply after the whistleblower complaint made to the company’s board of directors and to the SEC became public. The complaint covers a whole host of issues from name calling to questioning the accounting policy of the company. The allegation about irregular accounting practices is a serious issue and therefore needs to be looked into. Moreover as Infosys is listed in the US, it can have potential liability towards its ADR holders if it has indulged in accounting misrepresentation.

The profit and loss account of a company is essentially an opinion, as a whole host of assumptions, including some standardized, and some subjective assumptions, go into producing it. Based on the assumptions one makes, the accounting can be conservative, aggressive to outright fraud. Therefore we like to look at the P&L statement in conjunction with the cash flow statement as cash flow is a reality. Free cash flow is the cash left after meeting all the expenses of the company as well as after paying for capital expenditure and working capital requirements. This is essentially the surplus cash left for the shareholders, and the management can do what they deem fit with it, like paying dividends, doing buybacks, making acquisitions or letting the cash accumulate in the company. Infosys through its history has converted 79% of its profits into free cash flow. In the last two financial years since the current CEO took over, this number has edged up to nearly 90%. Even in the first half of the current year the ratio of free cash flow to earnings is in line with the historical average. Based on these numbers we believe that the allegation of accounting misrepresentation is unlikely to be true.

The allegation that the CEO doesn’t spend his entire time in the corporate office is a matter of much amusement to us, when we consider that this is the company that pioneered the concept of global delivery centers and aspires to do digital transformation for its clients. The profitability of each business deal is a business decision which can be based on several considerations, strategic or tactical and if the allegation that some deals have zero profitability is true, then Infosys won’t be the first firm to do that. As such it is not something that warrants alarm. The other allegation about the extent of disclosure to the board is a subjective matter, particularly when one considers the large number of contracts that a company of Infosys’ size writes every year. So it is not a very clear violation of any law or norm without knowing exactly what information was not disclosed to the board.

Infosys has been through a series of corporate upheavals whether it was the nth promoter becoming the CEO or the very public spat between the erstwhile CEO, some board members and promoters. It would bode well for the company if this current situation doesn’t slide into acrimony. One should remember though, that even when the company went through corporate turmoil in the past, its business still delivered – be it revenue and earnings growth or profitability and cash generation during that period.

We must confess that our above analysis of the situation is based on incomplete information as the matter is still being investigated by the company. However, we draw comfort from the fact that there is no significant change in the cash generation in the company, which would likely have been affected if there was some truth to the allegations being made. We hope to see an early resolution to the issue.

The Indian stock market bounced back sharply in September 2019 and the Nifty recovered most of its losses for the financial year. The strong recovery followed the Finance Minister’s announcement on the corporate tax rate. Henceforth, companies that choose not to avail of some specific exemptions under the Income Tax Act, will be taxed on their income at a net rate (including surcharge and cess) of 25.2%, down from an earlier 34.9%. Further, the FM announced that any new manufacturing company set up after 1 October 2019 and which commences production before 31 March 2023, would enjoy a corporate tax plus surcharge and cess rate of 17.0%.

What surprised everyone was the scale of the announcement and that too in the middle of the year (and not part of the annual finance budget). It was partly a response to the economic weakness and partly due to events unraveling globally. Due to the global trade war, especially between US and China, companies globally are looking for alternatives to China as a manufacturing base. Other countries like Vietnam, Thailand, Indonesia are competing to become the alternative locations and are providing suitable incentives. Even countries like USA have significantly reduced corporate tax rates. The reduction in tax rates in India, particularly the steep cut for new manufacturing companies, positions India favourably for global companies looking to diversify out of China as their global manufacturing base.

As we have been discussing in our various newsletters in the past, there has been a palpable slowdown in economic activity in India over the last year or so. The government needed to act decisively to bring the economy back on track and we are glad that it has done so structurally with the cut in corporate tax rates. The private sector investment cycle has been very subdued for some time and the tax cut will go a long way to revive the animal spirits in the economy.

India is a potentially a high growth economy and managing the twin objectives of high growth and low fiscal deficit can be challenging at times. There have been concerns raised about the impact the tax cuts would have on the fiscal deficit. Tax collections for the first 5 months of the year have been slow and the fiscal deficit target was looking a stretch. An accelerated private sector investment cycle, the resultant change in sentiment and possibly some higher receipts from PSU divestment may help narrow the fiscal gap. Given the current slowdown, we would actually encourage the government to let go of the fiscal deficit target as an obsession for some time. They should go further and release all overdue payments from the government and PSUs to their suppliers and other tax related refunds. This would greatly help in easing the working capital situation of businesses and could work as a great support to get the economy back on track. The government has already announced some measures in this regard and we
are hopeful of an improvement in the situation on the ground.

The greatest mathematical benefit of the cut in corporate tax rate is to companies who were paying higher taxes as a proportion of their Profit before Tax (PBT). We are happy to report that a large number of companies in our portfolio will benefit from the new lower tax rates. The Tax to PBT ratio is one of the criteria we use for determining a high quality company. Once again, our faith is reaffirmed in our philosophy of investing in high quality companies.

Equity markets went through a bullish phase between 2013 and 2017, but have been on a sticky wicket since Dec-2017. Nearly a third of the stocks traded on the NSE are down more than 50% from their 2 year highs. The latest quarterly GDP growth print of 5% is a cause for concern. Over the past several years, investors have rarely questioned the continuity of India’s GDP growth potential, at over 7% pa. In recent times, some experts are beginning to suggest that there are structural issues with the Indian economy which are affecting economic growth. Another point of view is that this is a cyclical slowdown which has got extended because of the recognition of long due NPAs.

We have reiterated several times in the past that we invest in high quality companies. A high quality, or an investment grade company, in our opinion is as a first cut, highly profitable when measured on return on equity. Moreover, this profitability should be demonstrated over a business cycle. In essence, we don’t like fair weather friends. We are reluctant to believe in turn-around situations, unless the company has a very consistent track record of delivering profitability, in the past.

Further, the company, should, in our judgement, have a very high probability of survival over the long term. The market accords higher valuations to companies where the market in its wisdom believes that the company is going to be around 20 years or more from now. When you consider that the intrinsic value of a business is the sum total of all the cash that you can get out of the business in the future, discounted to today, you realize that the longer the business exists into the future, the higher should be its value. Long term survival is therefore an essential quality in any company that one wishes to invest in. However, survival by itself is not enough. It must be accompanied by a reasonable amount of growth and we look at the nominal GDP growth as a benchmark. The higher the sustainable growth of a company above the nominal GDP growth rate, the more valuable that company would be. If we have to choose, we think that profitability trumps growth. A company that is growing tremendously but not making profits, does not represent value, in our opinion, while a company that is profitable though growing slowly, is yet an investment worth considering.

Another characteristic that accompanies high quality companies is that they are asset light and generate large free cash flows. As such, these companies are light, on both fixed assets as well as working capital. What allows for profitability and free cash flows to sustain over the future is competitive edge or “moat” of the business. This could come from a variety of factors including low cost advantage, economies of scale, a technological edge, a brand, switching costs, network effects, etc.

So it’s a whole composite really, in terms of the characteristics that one is looking for, to invest in a company. Moreover, there is an element of judgement involved in making this call about the business, factoring in all that we have enumerated above, and therefore it is important for investors to stick to their ‘circle of competence” ie businesses that they understand well. Last, but not the least, it is not only important to buy a high quality company, it is equally important that you pay a reasonable price for it because the long term return that you can expect from a stock is inextricably linked to the price you pay for it.

With the Nifty-50 down 5.7% and the Nifty Midcap 100 Index down 9.8%, July 2019 has been a difficult month for equity investors. This came as a bit of surprise for most, particularly after a very strong election mandate. The negative sentiment in the stock markets really started in Jan-2018 when the government introduced the long term capital gains tax, but the Nifty has held up rather well during this period. Since 31-Dec-2017, the Nifty is up 5.5% whereas the Nifty Midcap 100 Index is down 24.7%. Among the Nifty 500 companies, about 36% are down more than 50% from their 2 year highs and the median stock is down 41%. On the whole, it has been a tough phase for the stock market.

One of the reasons for the recent sell off has been the negative reaction to the recent budget which was announced early July. The provision of higher rates of surcharge on high earners has also included in its net, certain categories of FPIs (Foreign Portfolio Investors) who are organized as trusts. This seems to have resulted in FPIs selling about $ 2 billion of Indian equities in the month. Most countries have a benign tax treatment for foreign capital. Moreover, FPIs have consistently invested in the Indian capital markets over the years and own nearly 20% of Indian stocks. Any major disruption to this flow of capital will have an impact on the market. The tax provisions would require many FPIs to change their incorporation structure, which will take time and add unnecessary costs. The end objective of this provision is not clear.

Also, the tax on buy-backs, will have an influence on dividend payout policies of many companies. Promoters with large holdings in highly profitable companies are likely to change the payout policies. In the process, the tax collection impact may not be material, but it will result in less money in the hands of investors. Higher taxes result in an increase in the pre-tax return that an investor or entrepreneur would require for a particular project to be deemed viable. This is likely to push back the already delayed, revival of the private sector investment cycle.

Economic growth has been weak over the last 9 months – some of the issues can be traced to the ILFS crisis and its resultant impact on NBFCs in general. There is clear evidence of the economy slowing down with the recent quarterly GDP growth rate coming down to under 6% pa. Corporate growth rates have also slowed down. There seem to be bottlenecks in credit flow to businesses. The situation is quite severe in sectors like automobiles, real estate, etc. Given the high potential of the Indian economy and with the budget planning on a nearly 8% real GDP growth, we need private sector investment to get the economy back on track. A sense of urgency is required to get corporate growth rates back, as this will affect tax collections, jobs growth, etc.

While the market as a whole seems to be in a bit of a funk, we find that the high quality space, which is our focus area, has held up reasonably well over the last 18 months, and although we are finding some good opportunities in this market carnage, this is not true across the board. Many high quality companies are still trading at lofty valuations, which make them unattractive as investments. We expect that the next few months should be a good hunting ground for us to scout opportunities for investment. The Indian economy holds a lot of promise for the future, but the recent weakness is a cause for concern. We hope that the recovery shall happen sooner rather than later, and there is sufficient policy thrust on enabling broad based private sector investments in the economy.

Over the last few months, there are increasing signs of stress emanating from the economy. The most visible of these signs was of course the 4th quarter GDP growth which came in at 5.8% which is an 8 quarter low. We thought it would be a good idea to have a look at the quarterly results of Indian corporates (those that are not in the banking and finance sector, because in that sector because of issues with NPAs, there is a problem of relevant comparison) to try and understand the situation in greater detail. For the median company in the Nifty-50 (non-financials) revenue growth rate which had risen to 15.0% in the Jun-18 quarter from 6.7% in Jun-17 quarter, had fallen to 10.4% in the Mar-19 quarter. Net profit growth which was 19.6% in the Jun-18 quarter had slid to 12.8% in the Mar-19 quarter. For the broader BSE-500 companies, the median revenue growth which was at 15.8% in the Sep-18 quarter had slid to 10.4% in the Mar-19 quarter. At the same time, net profit growth which was in the high teens in the Jun-18 quarter had slid to 9.9% and 7.9% in the Dec-18 and Mar-19 quarters respectively. There appears to be a distinct slowdown in revenue and net profits over the last 2 quarters.

Furthermore, the automobile sales data flowing in for April and May does not paint a pretty picture with car sales growth at decade lows. The automobile slowdown is partly driven by new safety regulations whether they are in terms of ABS for 2 wheelers and airbags, seat belt indicators, etc for 4 wheelers. The other reason for the slowdown in automobile sales is that NBFCs have had a tough time raising money ever since ILFS defaulted in Aug-18. NBFCs have been large financiers of automobiles historically and their presence in lending in general has expanded because the PSU banks have been constrained to lend, because of their large NPA problems.

Meanwhile the corporate debt market has been a minefield over the last few months with new disclosures about defaults being announced almost weekly. A large number of these defaults are in the NBFC sector, which has been particularly hard hit over the last few months as liquidity has dried up for the weaker players in the industry. Many of the NBFCs were funding longer term assets through shorter term funding and at this time of stress, this asset liability mismatch has been a source of trouble for many players. The RBI has announced a liquidity coverage provision for NBFCs which it expects to help reduce liquidity mismatches in the future. In the short term though, this could further add to the stress in the sector. On the positive side, we do see promoters of these companies actively selling off assets to repay loans – at a pace and scale we have not seen before in India.

As such the new government has its hands full in terms of economic issues to get a grip of, as it embarks on its second term. The market meanwhile has been showing a schizophrenic pattern whereby there are a large number of stocks trading at all-time highs, and at the same time, a large number of stocks hitting 52 week lows. While the former are typically the high quality businesses which have been bid up by investors, the latter consists of the indebted businesses and the commodity stocks. Given our focus on the high quality space, we are finding fewer opportunities currently than has been the norm over the last few years. The nature of the current market has also provided us with some opportunities to reduce weights in some stocks where valuations are beginning to get expensive.

The Nifty is up nearly 10% in this calendar year and has been steadily climbing apart from a brief blip before the election results. With the election results out of the way, there is a sense of buoyancy. Stock markets like decisive mandates and continuity of policy, but these factors are temporary. Long term returns from equity markets are dependent largely on long term corporate performance and the valuations at the point of purchase.

Over the past 5 years (FY2014-19) the median company currently in the Nifty, has grown revenues at 10.6% pa and profits at 10.1% pa. This compares with a revenue growth of 18.3% pa and profit growth of 20.8% pa in the previous 5 year period (FY2009-14). One of the main reasons for such a stark difference is lower inflation over the period FY2014-19. Inflation over the past 5 years has averaged 3.6% compared with 8.4% in the prior 5 year period. Though real GDP growth over both these periods have been nearly the same, nominal GDP growth over the past 5 years has been 10.8% pa compared with 15.1% in the prior 5 years, primarily due to higher inflation during FY2009-14. Another contributor to the higher profit and revenue growth in FY2009-14 is the low base of FY2009 which was near the bottom of the global financial crisis. As investors, it is important to view growth rates adjusted for inflation.

Many of the larger companies in India are commodity centric and these companies have been among the worst hit in the global economic slowdown that we are experiencing, where commodity prices have been soft. The current margins for many of these companies are less than historical levels. Moreover, PSU Banks, telecom and some industrial companies have also seen poor performance over the last 5 years. Apart from the sectors mentioned above, the overall growth rates have been reasonably good.

With the Nifty near an all-time high, its valuations are on the higher side. On the other hand, the Nifty Mid-cap 100 index is trading nearly 18% lower than its peak levels. The broader market correction is throwing up some opportunities for investors, but this is a market where one needs to be cautious as the average company valuations are not favorable. Investment opportunities are few and selective.

Consumption has a large role to play in India’s GDP and the good news is that the Indian consumption story is strong. First, we have a young population, wanting to earn more and spend more. Second, the Indian consumer is under leveraged when compared to its global peers. Third, across the board we see under-penetration in most product categories compared with other countries which are ahead of India, in terms of per-capita GDP – offering huge and proven growth opportunities for companies over the long term. The role of the government, in many cases, is to remove the bottlenecks in realizing these growth opportunities.

The economy is experiencing some headwinds due to the current NBFC crisis and one expects the new government and the RBI to work towards resolving the issues. Growth pangs are part and parcel of any high growth economy and the good news is that institutionalized systems are evolving which can fix such issues. We are comfortable with the long term prospects for the economy but are keeping an eye on the valuations of companies.