Apr 2013 : High quality companies at great price

The Indian equity market was strong during the month, driven partly by lower oil and gold prices in the global market. Gold and oil form a bulk of India’s imports and the price fall would have a favourable impact on India’s current account and budget deficits. The low reading on inflation also raised hopes that the RBI may begin to cut interest rates more aggressively.
We would like to use this letter to discuss our investment philosophy and the process of price discovery in the market place. We have been emphasizing, through various communications with you, that we believe in buying high quality companies at a price that is reasonable (or cheap) with respect to the company’s intrinsic value. A high quality company, in our opinion, is one that has stood the test of time and delivering good operating results over that period in terms of profitability, free cash generation and above average growth.
What brings a high quality company to a price that one can consider investment worthy is a combination of bad news and/or bad sentiment in the market place. To give you an example, let us look at Maruti, which has in the recent past suffered from a lot of negative sentiment due to the poor off-take of its petrol cars, as also the strike at one of its plants. There were concerns on the merit of the investment in the context of the continuous flow of negative news. However its problems were temporary in nature and the price at which it was available was attractive, given its fundamentals. Despite the successive strikes at its plants, the damage to the stock price was not significant. Now, with the positive news on the yen depreciation and the movement to a better mix in terms of higher proportion of higher value cars being sold, the company reported stellar results for the recent quarter. Patience, as they say, is a great virtue.
We are seeing a similar situation emerging in the IT services sector, where the market is not sure whether it loves the sector or hates it – as a result, we are seeing the bellwether stocks in the sector either up 20% or down 20% on a certain given day. This is the state of affairs despite the fact that, through one of the worst periods of global turmoil over the last 5 years, the sector has delivered 18% or more annual revenue growth. And moreover, the bellwethers in the sector meet all our requirements of quality in terms of profitability, free cash generation and integrity of management. While of course, it is difficult to say how long the process of price discovery will be in this case, there are encouraging signs from the US in terms of a gradual economic recovery. US home prices are up 8% yoy which could go a long way in filling the holes in bank balance sheets and the US equity market is also trading strong. Another sign of the times is the speed with which the H1B visa quota got exhausted this year.
The point one is trying to make is that for a value investor, one needs to heed the words of Wayne Gretzky – ‘Skate to where the puck is going to be, not where it has been’.