As India votes in an election spanning a long, seven phases and the results are awaited on 23rd May, 2019, we have had several conversations with investors about the election result and what impact it is likely to have on our portfolio. About a year back when we spoke to our clients, the persistent question was whether we needed to change our strategy going into an election year. We, as we normally do, expressed our inability to predict these matters and preferred to stick with our existing strategy. What has followed is a volatile sequence of events during the last financial year, whereby the Nifty, after being subdued through much of the year, now stands close to an all-time high, though the internals of the market are battered and the average investor is not feeling too good about his portfolio at the moment. In about 3-4 weeks from now, we should have clarity on the new government at the centre.

Since 1996, we have had 6 general elections in India. At the median, Nifty delivered 14.9% return in the 12 months prior to the elections and 5.1% in the 12 months after the elections. The maximum weakness, during the 12 month period prior to the election, was witnessed in 2009 when the Nifty fell 26.7%. This was primarily due to the global financial crisis. In the 12 months after elections, the Nifty was down 6.6% after the 1999 elections. This was the period when the market was dealing with the aftermath of the dot com peak in April 2000. Apart from these negative observations, the Nifty has been positive or nearly neutral both before and after elections. In general, there is a weak correlation between stock market returns and elections.

Over the past 5 years, we have seen several key structural measures taken by the government which have long term implications – the roll out of GST, which was pending for many years, the Insolvency and Bankruptcy Code, increased automation at the governance level, deepening of direct benefits transfer, etc. We have also seen a period where inflation seems to have been reined in. Over the last 5 year period (2014-19), real GDP growth has averaged 7.0% annually. In the prior 5 year period too (2009-2014), GDP growth averaged 7.1% pa. Apart from the 2000-02 period, when we had 3 consecutive years of weak monsoons, the Indian economy has been growing consistently at about 7.0-7.5% pa. Though some experts have doubted GDP growth calculation numbers, one can’t ignore the fact that the Indian economy has been growing at a brisk pace over several years, and is likely to do so over long periods of time. The Indian economic growth will be led by domestic consumption due to the favorable demographics, and a consumer whose balance sheet is healthy as indicated by overall indebtedness.

As investors, it is important to monitor government policies and how they impact businesses. However, it is more important to stay focused on sustainable business economics, long term growth of the businesses and their valuations. Over the past few years, though the consumer has benefitted in several areas of the economy (examples include telecom, real estate, airlines, etc), one can’t say the same about the businesses operating in these sectors. Many large businesses in these sectors have been wiped out, despite very strong consumer demand. On the other hand, there are several companies which are expected to do well irrespective of key government policy changes. For example, the banking sector has seen several changes and policy impact over the past 2 decades. While some banks like HDFC Bank have done quite well through this period, there are other players whose balance sheets are bleeding. In a nutshell, micro-economics is more important than macro-economics in the business of investing.

As we look back on the financial year gone by, we get the sense that the 14.9% increase in the Nifty for the financial year belies what truly happened in the year. We began the year with the hangover of the long term capital gains tax which was introduced in Feb 2018 and markets had sold off over the prior 2 months. The Nifty shrugged off the capital gains tax and made a peak in August, 2018 when the ILFS crisis surfaced. That caused some tremors in the equity market and the ensuing troubles of the NBFC sector have put the economy on a bit of a back foot, largely because NBFCs were a key source of funding in the absence of PSU banks, because of their NPA problems. After a shake-out in the market during the year, the Nifty rallied 7.7% in March to end the year with a healthy return.

While the Nifty 50 growth at 14.9% looks quite robust, the internals are nowhere near as cheerful. The Nifty 500, which is a broader index comprising the 500 largest companies, grew a more subdued 8.4%. The Nifty Mid Cap 100 Index was down 2.7% and the Nifty Small Cap 100 Index was down 14.4%. Within the Nifty 500 which is one of the broadest Indian indices, the median stock is down 9.6% for the financial year. Further, while the Nifty is off only 1.2% from its 52 week high for the year, the median stock in the Nifty 500 is down 24.4% from its 52 week high. This suggests that the headline Nifty is not reflecting the pain in the broader market.

This is also reflected in the performance of mutual funds. We studied the performance of the Top 25 equity mutual funds in India by size, over the last 12 months, and found that the median performance of these mutual funds, which include funds in different categories, like large cap, mid cap, small cap and multi cap funds, was 6.6% for the year. The top 3 mutual funds have performed in line with the Nifty while the worst performing mutual funds are reporting negative performance for the year. As such, it has been a tough financial year for most equity participants.

On a 5 year basis, the Nifty has delivered 11.6% per annum which is close to its long term averages. However, it has been a 2 tier market – there is one section of the market which during the year was trading at historically high valuations (in some cases, even now) and there is another section of the market trading at between 5 and 10 year lows. The former are the regular growers, and many of them form part of our investible universe, while the latter are the indebted balance sheets and companies with poor corporate governance. In the recent upheaval in the market where the median stock has lost almost a quarter of its value, there are instances of heavy damage to the extent of 50% and more. Some of these could be opportunities to consider and we have seen some new additions to our portfolios over the last 12 months. The volatile nature of the market during the last 12 months, has also presented us some opportunities to trim some holdings where valuations were getting to the expensive side. All in all, we feel comfortable with the companies we hold in our portfolio and look forward to higher growth as India gets through its banking troubles.

The Nifty, which is roughly composed of the 50 largest companies in India, is a closely followed market index and its performance is considered by some as a fair representation of the overall stock market performance. Since inception, in 1995, the Nifty has delivered a return of close to 14% p.a. This correlates fairly with nominal GDP growth of roughly 14% p.a., which is a combination of 7-8% real GDP growth and 6-7% inflation. As inflation has trended down over the last 4-5 years, the observed nominal GDP growth as well as stock market performance has also tended towards the 12% growth number which has a similar real GDP growth number as the past but the lower inflation has dragged the overall number also down. This can be a fair guesstimate of what is likely to happen in the future as well. This also assumes the leading companies in India would grow in line with nominal GDP of the country. Of course, things can change if GDP growth or inflation changes significantly from these levels.

Unfortunately, unlike a fixed deposit, this expected return from the equity market is not going to come in an orderly fashion. There will be negative, moderate and very strong years. We have typically seen in the Indian case that a third of the years are negative, a third are moderate and the remaining third are very strong years. Also it is fair to say that even the best of experts find it difficult to forecast these years.

Over long periods of time, stock prices are slaves of earnings per share changes. In between there are many changes – governments come and go, poor monsoons are interspaced with good ones and interest rates change in one direction or another but at the end, the stock prices of the stocks in our portfolio 10-20 years from now, will be driven by the earnings per share they report in that time period in the distant horizon.

Over a shorter time frame like 3-5 years, stock prices are driven by 2 factors – the underlying earnings growth and the valuation change, which could be upwards or downwards. The median PE Ratio (Price-to-Earnings) of the Nifty has historically ranged between 15 and 23. At present the Nifty’s PE is close to 23, which suggests that further growth in the Nifty needs to be driven more by earnings increases as there is less room on the valuations side. This comes with the caveat that margins for the Nifty are compressed compared to historical levels and this may be dragging down earnings (e.g. banks which have taken a lot of provisions).

However, as portfolio managers what matters to us are individual stocks and how their earnings are shaping up over the long term because this can vary significantly from the Nifty. As such, we spend a fair bit of time thinking about the long term earnings growth of our companies over as long a horizon as one can, with some certainty. Earnings in turn are dependent on the core profitability of the business as represented by the return on equity (RoE) and the underlying growth for the products and services of the company in question. Over years of experience, we have found that we like consistency in earnings and favour that in our investment mix. If we add to that, our maxim of trying to buy companies at a reasonable price, it adds to the probability of making a reasonable return over the long term.

The last 12 months have been a bit atypical in the Indian stock market. At a high level, the Nifty is down 1.8% over the last 12 months, which suggests a difficult year but not out of the ordinary – over long periods of time, the Nifty has been down on an annual basis, 30% of the time. However the internals of the market tell a very different story. In the same period, the Nifty Midcap Index is down 18.7% and the Nifty Small Cap Index is down 30.4%. The median stock in the Nifty 500 is down 33% from its peak and the mood among investors is somber, to say the least. As such, most mutual fund managers and portfolio managers have struggled to even keep pace with the Nifty in this environment.

If we look at the Top 1000 companies by market capitalization, which covers all companies with market capitalization greater than about Rs 400 cr; of these, 25 companies have a market cap of over Rs 100,000 cr, 210 companies have a market cap of over Rs 10,000 cr and 702 companies have a market cap of over Rs 1,000 cr. The remaining companies have a market cap between Rs 400 and Rs1000 cr. The exact numbers will change on a daily basis, as stock prices changes, but this is a good approximation of how the market capitalizations are distributed across the top 1000 companies. For the purpose of simplicity, we can categorize these companies into giants, large, medium and small cap companies.

From a performance perspective, over the last 12 months, the Giants have performed the best, with the median company stock up 3%. The Large caps are down 11%, the Medium sized companies are down 23% and the Small ones are down 38% on the average. What stands out even more is that 82% of the companies closed negative during this period. Though many investors had a great run in the 2013 – 2017 period, it has been a struggle to protect capital since then.

This period has also been characterized by a fairly large number of companies seeing large erosions in stock prices in as short a period as a day. Over the last 12 months, we saw 47 companies (almost 10% of the Nifty 500 constituents) falling more than 15% over their previous day’s price on a closing basis. Further, we saw 23 companies (almost 5% of total) falling more than 20% in a day. When we scan the names of the companies in the above list, it is a familiar story of poor corporate governance and broken balance sheets. In fact, when we look at the performance of different stocks, besides size, which we talked of earlier, the other distinguishing factors are quality of the business and corporate governance. The stocks that have been hit hardest have been those where there is either a question about their corporate governance or an issue with too much debt on the balance sheet.

In an environment like this, our course which is steadfastly focused on high quality companies and regular free cash flows, has been rewarding to the extent that we have managed to protect capital in this difficult environment and even eke out some gains. We intend to continue our existing focus on this area for investment.