April 2011: A mockery of traditional financial theory?

Equity markets opened strongly towards the beginning of the month, we saw some weakness kick in towards the end of the month and the Nifty closed down 1.4% for the month. For calendar year 2011 the Nifty is down 6.2%. Over the last 3 years the Nifty is up an annualized 7.2%, which is in line with what bonds have been earning – the market is still settling down after the euphoric rise in the years leading upto 2007. Our portfolios finished the month positive as some of the larger holdings did fairly well.

We believe that one of the key reasons for the continuing weakness in the equity market is the high rate of inflation and the possibility of interest rate increases. The current inflation needs to be viewed in the context that fuel prices have still not been revised for the sharp rise in crude prices. When the government decided to liberalize petrol prices about a year back, the objective was to reset the prices of petrol monthly in line with global oil prices. Due to the elections in four states in April and the sharp rise in international prices (about 20%), there has been no reset in fuel prices over the past 3 months. It is likely that there will be a sharp increase in fuel prices towards the middle of May, which is likely to add to the already precarious inflationary situation. Over the last two years, the regulators have been trying to balance the twin objectives of containing inflation and spurring growth and they have tilted towards growth because the economy was coming out of the crisis of 2008. With inflation beginning to get a bit out of control and growth continuing to be robust, the time may have come to shift the stance towards inflation control.

Several of the companies in our portfolio have come out with their results and the performance of these companies continues to be fairly good, though in some cases there is a distinct margin pressure. The good thing about the highly profitable companies is that, even if they do face margin pressure, they continue to generate fantastic free cash. More importantly, their ability to grow is never really affected, as these companies require very little capital to grow. Many of these companies need so little capital to grow that at times they make a mockery of traditional finance theory, where companies are expected to require X amount of capital for a certain Y growth. These Companies stand out when cost of capital rises because they actually benefit from the higher interest they receive on the excess cash lying in their balance sheet. The cost of capital has started to rise and we have started to see growth slowing down in pockets.

In the context of a tight equity market over the past 3 years, we are starting to find several high quality companies at prices that are sensible, where investors can commit to investments without getting unduly worried and with an expectation of a reasonably satisfactory return. Though the coming few months may continue to be tight for equity markets, we are increasingly getting comfortable in committing capital and look forward to collecting a portfolio of high quality companies at sensible prices. In fact, some ideas are beginning to look exciting.