Feb 2012: Is the worst over?

Following up on the sharp rally in January, the Indian stock market continued to rally in February – it did give up some of the gains towards the end of the month and ended up 3.5% for the month. The market has rallied almost 20% from the lows made in December 2011 largely on account of the huge FII inflows and some short covering. Another factor contributing to the rally is panic buying – from investors who missed the early part of the rally and are feeling left out of a market that is continuing to go up. Our portfolios continue to do well and most of the portfolios are at their all time highs.

Though we were sitting on a reasonable amount of cash in the portfolio through 2011, we did put a fair bit of cash to work during Nov-Dec 2011 – you may also recall our December newsletter where we talked about why the low valuations prevailing at the time were a good reason to buy despite all the gloom and doom all around. Our attempt at that point was not to try and call a bottom but merely a statement that the prevailing valuations placed the risk to reward ratio in an investor’s favor. Frankly we too are a bit surprised by the pace and strength of the rally that ensued. We continue to focus on buying high quality companies at prices which are reasonable – where the probability of a satisfactory rate of return outweighs the risk of the stock price going down significantly and at all times trying to avoid any permanent loss of capital.

This brings us to two key questions – is the worst over for the market? And has the recent run-up left very little room for appreciation going forward? It is difficult to be sure if the worst is over. On the other hand, it has been over 4 years since markets hit a peak, in Jan 2008. Many of the companies that we follow have continued to do well even through these tough times. The continuing earnings growth in these companies has meant that their valuations seem quite reasonable now and our expectation is that the 3-5 year return expectation from these stocks is quite attractive. While of course one would ideally prefer to buy these quality stocks as low as possible, we believe that the recent run up has not dramatically altered the longer term risk return profile of these stocks. With the economy growing at a reasonable rate, and companies delivering satisfactory performance, it would not be long before markets breaks free from the range bound trading zone. We are closer to the end of the bear market, than the beginning. Till then, it continues to be a good opportunity for investors to accumulate good companies at sensible prices.

On the other hand, this rule may not apply to all companies. There are several companies out there which have excessive debt and are close to bankruptcy. Some of these stocks are down over 80% from their peak values. A very sharp fall from peak levels does not mean the stock is cheap. Including the debt, these are some of the most expensive stocks in the market. One needs to be very cautious with these stocks. We believe that there is no point in encouraging poor capital allocation policies. We are staying away from these companies, with a clear intent of protecting capital for our investors.