Equity markets closed the financial year ending March 2010 with one of its strongest closings since 1992. Markets were up 75% during the year and there is a sense of impregnability. Before one can call for celebrations, one needs to note that this was on the back of a 36% fall in the previous financial year. Rs 100 invested in Nifty stocks on April 1, 2008 would be worth Rs 112 today. This is by no means spectacular. Our portfolios over this period have performed much better and we are fairly satisfied with having navigated the last storm. Our single major learning over this period is to focus on limiting loss of capital when markets go through a corrective phase. As several wise men have said in the past, the key to accumulating wealth is to not lose money. We have understood this maxim better over the past 2 years and suspect most secrets of good investments lie in these words.
The aim of our investment process is to look out for opportunities where there is disconnect between where the business value is headed and where the stock prices have gone. Last year the business values were growing but the prices were falling, so we were deploying capital, but this year the prices rose far faster than the underlying business value and so we have been sellers.
The real question to ask now is, how the next year is likely to be for stock markets. There is a sense of optimism surrounding prospects for the Indian economy. We also strongly believe the Indian economy should deliver on its growth promise in the coming decade. On the other hand, there are a few reasons why stock market performance in the immediate term may not be spectacular.
Firstly, equity markets are up over 75% over the past 12 months and stocks are not exactly cheap. The average stock is trading closer to the top end of its historical trading range and history suggests it cannot sustain these levels for too long. Several people claim that this time it is different, but those are the most dangerous words in investing.
Secondly, the inflation & interest rate story is far from comforting. Over 80% of Indian financial savings is in fixed return instruments which earns about 6%, whereas inflation is higher than 12%. No economy can sustain growth with the average investor earnings a negative real rate of return. So far the Reserve Bank ofIndia, which has a significant say in setting interest rates, had its hands tied behind its back as the government wanted to get the economy back on growth track. Now that the economy seems to be on a comfortable road, the Reserve Bank will definitely go on the path of correcting interest rates. The after effects of such a move would be lower demand for several products like housing, cars, etc, and therefore some moderation to the Indian economic growth dream.
Finally, and the scariest fear across the world is the risk of governments defaulting on their loans. With the recession over the past 2 years, many governments witnessed lower tax collections and also had to simultaneously increase spending to give a push to the economy. As a result, most governments were forced to borrow aggressively. Suddenly, the cost of borrowing for governments has been increasing and there is a risk that some countries cannot afford to pay back its borrowings. Greece, Ireland, Portugal were downgraded this month. Even scarier were the warning bells on the safety of debt instruments issued by US and UK governments. Indian government 10-year borrowing rate has also gone up from 6% to about 8% over the past year. Higher interest rates does not augur well for equity markets.