December 2011: 4th anniversary of the bear market

The Indian Stock Market ended on a weak note in the last month of the calendar year, down 4.3% for the month. The last 12 months have been among the worst, second only to 2008, in terms of annual stock market performance over the last two decades. Our portfolios have stood up very well in this storm – we believe this is largely on account of the quality of the stocks we hold – as they say, the true test of character is how one performs under adverse circumstances.

We are now completing 4 years of this bear market which started in early Jan 2008 – the Sensex hit a peak of close to 21,000 back then and the market has struggled ever since. At its current level, the Sensex is down 26% from that level, but more importantly 4 years of earnings have flown under the bridge. A spate of problems from high inflation and consequently high interest rates, a severe slowdown in the capex and industrial cycle, policy paralysis thanks to the discovery of high profile cases of corruption and the European crisis have taken the sheen off the India growth story which was such a rage in 2007. So, while we agree with market participants in terms of the problems plaguing the market currently which could possibly contribute to some more downside from here, our observation of history of the Indian stock markets tells us with a fair degree of certainty that we are closer to the end of this bear phase than to its beginning. Somewhere in the not too distant future we expect that markets will bottom out and the bull phase will begin but it is hard to predict exactly when.

You may ask that with such a preponderance of bad news, how we can possibly look forward to a bull phase. The answer to that is Valuation, which in our opinion is perhaps the biggest contributor to future stock market returns. In the midst of a great amount of uncertainty come the low valuations which make for a good entry point. Typically a bull market is caused by a combination of growth and a valuation upgrade.

The bear market of the last 4 years has taught market participants a few lessons. One of the important ones is that not all the growth in revenues gets translated into stock price performance of a company. Take an example of 10 companies, all of which grow revenues at 20% per annum over a 10 year period. Will all these companies have similar stock price performance? The answer is a clear NO. There will be a range of returns, some well over 20% and some even negative returns. What we have clearly seen over the past 4 years is that only profitable growth accompanied by free cash flows gets translated into stock price returns. Unprofitable growth will most likely deliver negative returns. This is equally evident over a 20 year period also but the poor performance of the laggards has put this in sharp contrast over the last 4 years. Bear markets impose the discipline much needed in capital markets by sifting the chaff from the wheat.

All in all, this is an excellent opportunity to pick up high quality companies and we recommend that you think seriously about adding to your equity investments keeping in mind that you are investing over a 3-5 year period which to us looks quite promising.