Another financial year has come to a close – the year was a tough one for the equity market as the market had to grapple with a lot of negative news – the European debt crisis, high domestic inflation and consequently high interest rates as also policy paralysis in the aftermath of the multiple scams. The Nifty was down 9.2% for the year and has now been range bound for more than 4 years. In this rather tough environment, last year we were able to achieve all our 3 objectives – protection of capital, beating the risk free rate of return and beating the equity index rate of return – which gives us a fair bit of satisfaction and we look forward to creating genuine value for our investors in the years ahead. More importantly, we are increasingly convinced that our approach to investing in equities is robust and should deliver satisfactory rates of return over time, without taking on too much risk. We might add here that while we hope to achieve our 3 objectives (enumerated above) over time, this degree of outperformance will most certainly not be repeated every year.
As a new financial year approaches, we would like to touch upon the issue of asset allocation. In the context of a weak stock market over the last 4 years, several people have asked us about the ideal allocation between debt and equity for an investor. We believe that capital protection is one of the primary goals of investing. This implies not only maintaining the value of your investment – the aim should be to maintain the true buying power of the capital adjusted for inflation. If you have Rs 100 at the beginning of the year and inflation over the next 12 months is 10%, then one would have to earn at least 10% during the year to ensure that the purchasing power of your capital is protected. Given the high rate of inflation over the past decade, the post-tax return from bank fixed deposits has significantly trailed inflation. For example, a 9% FD will lead to a return of 6.3% after accounting for taxes of 30%. This will hardly be sufficient to protect capital, when inflation is slowly eating away the buying power of your capital. As Warren Buffett pointed out in his recent letter to shareholders, bonds should come with a warning label.
Equities, on the other hand, have historically beaten inflation by a handsome margin over long periods of time and one can expect that trend to continue. The taxation structure for equities is also very favorable for investors in India, with zero tax on long term gains and dividends, and a 15% tax on short term gains. One risk with investing in equities is that the returns are variable from year to year. We believe that our approach of investing in stable high quality companies at statistically low prices has a high probability of doing well through good and difficult market conditions.
A word on market conditions – after a strong rally in January and February, the market has corrected somewhat due to negative news on the UP Elections and the GAAR provisions in the Union Budget. Valuations on a large proportion of our high quality universe are quite reasonable and the risk reward ratios look attractive. While it is difficult to say when the markets will come out of the current range bound trade, the current valuations tell us that the long term rewards from investing in equities today are likely to be quite good.