We had mentioned in our last newsletter about a second wave of covid in India – in the month of April 2021, this wave intensified and it looks like a crisis situation with respect to the ravage of the pandemic in India’s second wave of infections and deaths. Several state governments have announced various degrees of lockdown and the health infrastructure appears to be severely strained. Yet there does not seem to be the same level of panic in markets, as we had witnessed in March-April 2020. The Nifty closed April down 0.4% over its value on 31st March, 2021. We will try to explore the reasons why this may be so.

For one, in February-March 2020 the virus was still very new to all of humanity – there was a lot of the unknown and the stock market reacts badly to the unknown – data and analysis was sketchy and fear ruled in markets where investors dumped stocks without regard for valuations like heading for the exits when a cinema hall catches fire. Today, we know a lot more about the virus in terms of treatment methods and importantly, the vaccination drive has started – a quick vaccination can be the best antidote we can have for the spread of covid. The vaccination drive which was quite impressive a few weeks back, has slipped recently and we hope it gains momentum in the coming months.

Businesses have also learnt to cope with the pandemic and have figured out ways and means out of the situation. Restrictions on manufacturing and construction are also far less this time around. We expect that as the vaccination picks up pace over the next few months, infections and deaths will level off and we can get some semblance of control over the pandemic in India.

At the same time, the results from corporate India have been quite encouraging. As we reported last month, EBIT for Dec-20 quarter was up 27.9% in aggregate and 19.0% for the median company. We now look at the few early birds who have reported so far for the Mar-21 quarter. As usual we looked at the non-financials in the BSE-500 index – 69 companies have reported so far. These 69 companies comprise 31% of the market cap of all the non-financials in the BSE-500 and predominantly are in the sectors of IT, FMCG and Auto. Since the March 2020 quarter was affected by the nationwide lockdown, we decided to look at a 2 year CAGR for revenue and EBIT (Earnings before interest and tax) growth to get a better idea of the numbers. For the early birds who have reported so far, the 2 year CAGR in revenues is 8.0% in aggregate and 7.1% for the median company. This compares with 6.5% and 4.4% respectively for the quarter ended 31-Dec-20 – so it appears that there is some further improvement from December to March. The 2 year CAGR for EBIT is 13.1% in aggregate and 11.8% for the median company – these are impressive numbers in the context of the pandemic and while it would still need to be confirmed by the other companies that have not reported yet, it does signal an important development for corporate India that revenues and profits are getting back to a normal trajectory.

On the valuations front, as we mentioned in our last newsletter, we are finding it difficult to invest for our new clients and at the same time the sell opportunities are also few in number. For a brief while in April, the Nifty had dropped about 8% from its recent peak and that gave us some opportunities to buy within our high-quality universe. We continue to remain focused on the reward to risk ratio offered by the different stocks in our universe to decide what to do for our portfolios.

It has been a tumultuous year for the world as it has grappled with covid – the year began as lockdowns were introduced across the world in response to the threat of covid, with global equity markets down sharply. We end the financial year with the threat of covid very much still there with the second wave of infections hitting India but there is relief at hand as the vaccination drive will likely limit the damage. The markets, after the shock of the lockdowns and the resultant collapse in economic activity, recovered through the year and made new highs towards the latter part of the year. So, it may be a good idea to explore possible reasons for the market strength while the pandemic is still not behind us.

One reason for the strength in the markets has been the gush of liquidity which has got released by central banks across the world to counter the ill effects of the pandemic on the economy. This has also been accompanied by a large fiscal stimulus provided by the government. In our last month’s news-letter we had explored the role that interest rates play in the theoretical valuation of a company and thus how very low interest rates prevalent world-wide are pushing up valuations of companies.

One of the other features of the last 12 months has been an interesting trend of people beginning to invest on their own while at the same time mutual funds have seen outflows over the last several months. 1.2 cr depository accounts were opened in the last financial year till end February, against 0.53 cr depository accounts opened last year (growth of 128% yoy) on a base of 4 cr accounts at the beginning of the financial year. The fewer opportunities to spend could be resulting in savings for the higher middle classes which could be resulting in incremental flow into the equity market.

What is also interesting is the trend of corporate results, with corporates showing very strong profitability during the December 2020 quarter. As we have done in the past, we looked at the non-financials part of the BSE500 index to tabulate our results. While aggregate revenues for this sample set were down 0.5%, the median company’s revenues were up 7.4%. The aggregate EBIT (Earnings before Interest and Tax) was up 27.9% for the December quarter and the median company’s EBIT was up 19.0%. The EBIT margin for the sample set is at 13.1% which is among the highest recordings in the last 20 years. These are very strong numbers indeed and the quarterly EBIT is the highest ever for corporate India. There have been significant productivity gains for the corporate sector during the pandemic and it is likely that some of these gains will be retained even when things return to normal. This is particularly true for high-quality companies because of the pricing power they enjoy.

As the market has marched higher through the year, we have been talking about how it has become increasingly difficult for us to invest the new money that is being entrusted with us. Opportunities are few in number in our universe of high-quality companies and most of our new accounts have a significant proportion of cash. At the same time, we are not finding too many sell ideas in our portfolio either and the cash levels in our older portfolios are quite low. It appears that while the reward to risk ratios for the stocks that we like, are not good for buying they are not that good for selling as well. We expect to continue to keep a keen eye on the reward to risk ratio in terms of deciding what to do with our portfolio.

The strength in equity markets, despite the devastating effects of covid on the economy, can be directly linked to the loose monetary policies of various central banks and the fiscal stimulus provided by the governments. This has been repeated several times in the past that whenever we face recessionary conditions, central banks have stepped up and loosened monetary conditions significantly to cushion the impact of the recession. This essentially means availability of a lot of extra liquidity and low interest rates. This has also often been accompanied by fiscal stimulus from the government. This helps get demand back, reduces job losses, etc in the short term.

In India too, we have seen the government run a record high fiscal deficit – led by lower tax collections and higher spending by the government, to get the economy back on its feet. The RBI has also cut interest rates significantly and the repo rate is now at the lowest in its history at 4%. These lower rates have likely contributed to increased consumer demand over the last few quarters. Lower rates also can help boost investment because it lowers the hurdle rate that a project needs to cross to be considered viable. In the face of the unprecedented decline in economic growth during the covid lockdowns, the large monetary and fiscal stimulus was perhaps necessary given the situation.

Interest rates also play an important part in the valuation of equities. The intrinsic value of a company can be defined as the sum total of all free cash flows that can be derived from the business until eternity, discounted at an appropriate discount rate. The prevailing interest rate in the economy has a strong linkage with this discount rate and Warren Buffett has said that he uses the risk free rate (the yield on long term government bonds) because he expects clockwork like certainty of cash flows from the businesses that he invests in. One can choose some premium to the risk free rate depending on how certain one is about the free cash flows from the business one is investing in. Thus, there is a good inverse linkage between interest rates and equity valuations ie the lower is the interest rate, the higher the theoretical valuation of any company.

One needs to be cautious with this thesis though, because interest rates are not static and can move in a volatile fashion. We got a glimpse of this towards the end of February when global markets corrected violently in response to the jump in the US 10 year bond yield to 1.6% (it had gone to as low as 0.3% in March 2020 and was at 0.9% as on December 31, 2020). The spike in bond yields could be because of the prospect of increased inflation in the US post vaccination for covid. As things slowly get back to normal post vaccination, the economy is expected to recover strongly and given all the stimulus, both monetary as well as fiscal, this may stoke inflation. While the US Fed has maintained that it would be willing to tolerate higher rates of inflation and will likely keep an accommodative stance, a large increase in the bond yields could force the Fed’s hand,

Predicting interest rate movements is very hard to do consistently and we as investors try to stay away from this minefield. We would rather spend our time focusing on the performance of the businesses we own, their competitive position in the market place and the valuations that they are trading at, with respect to their history. This has worked well for us in the past and we hope not to deviate from this in the future also.

We thought it would be a good time to look at aggregate corporate performance, even though only about a third of the companies in the BSE500 have reported so far, just to gauge how we are recovering from the pandemic in terms of corporate performance. Our sample set is those companies that are non-financials (ie excluding banks, finance, insurance), are part of the BSE500 and have reported results for the quarter ended December 2020 as on date.

The aggregate revenues of the 145 non-financials that have reported so far, are up 0.3% yoy (median: 7.0%), which is not too different from last year same quarter, when revenues for these same companies were down 0.5% yoy (median: 3.8%). One standout among these companies is the heavyweight Reliance Industries whose revenues are impacted by the steep fall in oil prices (Brent crude is down 30% on average over the comparable quarters). So we excluded Reliance from the sample set and found that aggregate revenues for the December quarter are up 5.8% and the median company’s revenues are up 7.1%. This compares with a 0% aggregate revenue growth for the Dec-2019 quarter for the same companies (median: 3.8%). So, what we are seeing is that revenue growth in the Dec-20 quarter is stronger than the same quarter last year, which was a pre-covid period. Admittedly, the Indian economy was going through a tough phase pre-covid and we have discussed some of that in our prior newsletters and we do recognise that the early reporters are typically those with better numbers but the numbers do evoke some surprise from us. The operating profit (Earnings before Interest and Tax) growth for the median company is an even more surprising 23.4%, as corporates seem to have seen expanding operating margins on account of productivity increases.

There are various ways to explain this spurt of growth. One possibility is that we are experiencing some sort of pent up demand which has got pushed through from prior quarters and we will need to see these numbers sustain over the next few quarters to make more definitive conclusions about the same. Yet there are a few factors which are pointing in the positive direction. For one, interest rates are extremely low – RBI’s repo rate which is the rate at which it lends money to banks, is the lowest in history at 4.0%. The RBI under Shaktikanta Das has cut interest rates aggressively – from 6.5% at the beginning of his term in December 2018 to 4.0% now. Interest rates on home loans and other consumer loans have also seen a concomitant fall, potentially boosting demand. Travel and dining out costs have been curtailed for a vast number of people and this could possibly be routed towards other spends, besides overflowing into investing.

One also wonders whether the long-awaited economic recovery could be around the corner. The Indian economy has been through a prolonged slowdown over the last several years and at some point, one can expect an economic recovery on the back of the many reforms undertaken by the government such as GST, the Insolvency and Bankruptcy Code, RERA and others. There are also other positive steps, like the cut in the corporate tax rate, the new Production Linked Incentive Scheme, and the attractive interest subvention for home loans, which can push growth. While these are still early numbers and we will need confirmation from the other companies, as well as over the next few quarters, one can perhaps engender some hope that economic recovery may be on its way.