July 2014: High Quality offers a good reward to risk ratio

The Indian equity market continued on its positive trajectory, with the Nifty up 1.4% for the month. The Nifty is up 15.2% for this financial year, since 1 April 2014. Our portfolio did quite well during the month, well ahead of the Nifty.

Though the Nifty was up 1.4% for the month, the underlying volatility in individual stocks was a lot higher. The strong run up in the stock market in recent times has been led by beaten down stocks where many of the underlying companies had very weak balance sheets. In the current month, many of these stocks performed poorly. On the other hand, the steady performing companies did much better and to a large extent led the market move this month. We believe investors are getting concerned with the spate of QIPs (Qualified Institutional Placements) that are in the offing. In addition, the large scale divestment plans by the government and the clear direction to PSU banks to go to the capital markets for additional equity infusion, will ensure a spate of capital raising by these companies. The market’s logic is – Why buy these companies, when there is large potential supply around the corner? On the other hand, the steady performers and companies that don’t need capital infusion, will continue to have limited supply available.

The other interesting thing is that as per our valuation models, many of the poorer quality companies with weak balance sheets and poor revenue growth, are looking fully priced. The steady performers, on the other hand, while obviously not as cheap as they were, say a year back, still continue to offer a reasonably good reward to risk ratio based on our valuation models. We continue to prefer this high quality universe and see reasonable opportunities in this space.

The recent budget made a major change in the taxation for debt mutual funds, whereby a debt mutual fund now needs to be held for 3 years to be able to claim the benefit of lower tax rate, instead of 1 year as it was earlier. A lot of investors preferred this route to be able to make a higher tax adjusted return. Many of these investors may look at equity as an option since their time horizon has expanded to 3 years. A listed equity investment that is held for 1 year attracts zero tax and India is one of the very few countries to have such a favorable tax structure for investments into equities. We are long term investors and an analysis of the historical churn in our portfolio suggests that we hold a stock for an average tenure of 3.5 years. As a result, we pay very little capital gains tax on our portfolio investments. Moreover, our emphasis on buying high quality businesses, at prices that are reasonable, means that the risk in our portfolios is on the lower side, thus enabling us to make a decent risk adjusted return, especially so after considering taxes.