April 2015: Markets Consolidating

Since Aug 2013, the Indian equity market has consistently been on a positive trend, a period commonly referred to as a bullish phase. Over this period, the Nifty is up more than 50%. After more than 18 months, the last three months have been the first real period of consolidation in the market. The Nifty is down about 10% from the peak reached in early February. Our portfolios held up well in the initial period of the correction, but towards the end many of our stocks have also corrected significantly. A period of consolidation is part of any orderly market move, and is essential for the longer term stability of the market.

The correction was partially triggered by concerns over retrospective tax on some FIIs. Based on clarification by the government, the problem seems relatively small and isolated to a few specific funds. The tax amounts are also not large and there is clarity for the future. More importantly, for the larger set of investors, the Indian taxation policy for equities is one of the most investor friendly compared with most parts of the world. Nil tax on long term capital gains, nil tax on dividends in the hands of investors and short term capital gains taxed at 15% is as benign as you can get. If you are not a high volume trader, the impact of STT is negligible. We are also happy to note that our portfolios have had very little short term capital gains over the past several years. The portfolio return over time has been nearly tax free. We don’t have any complaints about the taxation policy for Indian equities.

We believe the current phase of consolidation is part of any orderly correction in markets, and probably an opportunity for investors. Firstly, prospects for the economy are looking up and one should see a strong cyclical recovery in the coming years. Most international investors seem to reflect the view that India is a big beneficiary of lower inflation and lower interest rates. Both these factors will help the Indian economy in a significant manner in the coming years. In the near term, some companies may see lower price increases leading to lower revenue growth, but should get compensated with higher volumes over the coming years. We are fairly excited about the prospects for our portfolio companies in the coming years.

Secondly, markets are also not expensive, compared with historical valuation multiples. While obviously valuations are higher than they were 18 months back, they are still within the historical valuation range and what we might call fair game – that implies that there is as much risk as reward at current levels for the Nifty. However, the assumption here is that the Nifty earnings will continue to grow at the same depressed rate as it has been over the last 4-5 years. Given that the recent past growth rates are well below larger historical trends, there is a case to be made that earnings growth going into the next 3 years may be significantly higher in order for long term averages to remain intact. This implies that valuations at this point may actually be better than fair game.

Moreover, each security has its own trajectory and the recent correction has opened up some good opportunities for us, as we remain bottom-up stock specific investors. We don’t try to time a bottom in the market – we look for opportunities which give us significant reward compared to the risk that we take. It is difficult to predict how long the period of correction would last, but from our perspective the longer it takes, the better – it allows us more time to collect a handful of wonderful companies at good prices.