March 2011: Weak balance sheets

Equity markets rallied towards the end of March, ending the month up 9.4% and have now reasonably recovered from the steep fall in January and February. The market seems to be digesting most of the bad news with respect to the Japanese earthquake as also the continuing upheaval in the Middle East and North Africa. The Nifty eventually finished up 11% for the financial year ending 31 March 2011. Over the last 3 years, the Indian equity market has provided returns of about 7.2% per annum compounded, lagging the growth in broad company earnings over the same period. As a result, the market which was fairly richly priced in March 2008 is now looking a lot more reasonably priced in March 2011.

Equity markets reached a high in Jan 2008, at which point in time valuations across the board were generally very high. Since then, companies in some of the ‘in fashion’ sectors, like infrastructure, real estate, etc, have seen a sharp deterioration in fundamentals. In light of the relatively more somber mood on Dalal Street, the weakness of these companies’ balance sheets has been exposed. As a result, a large number of companies have seen their stock prices fall over 70% from their peaks posted 3 years ago. A common theme running across these very poor performing stocks is the high level of debt that these companies have on their balance sheet.

On the other hand, there is another set of companies which have continued to report consistent profit growth through the last three years. Importantly, these companies have continued to grow without requiring any additional capital from their shareholders. It appears to us that these companies will continue their stellar performance in the coming years as well. While some of these stocks had become expensive in January 2008, the good growth in underlying earnings and relatively less stock price growth has meant that these stocks are now available at prices which can be called reasonable. We are seeing some very interesting investment opportunities among these companies.

We have been using the opportunity provided by the market over the last few months to get into some of these high quality companies. The recent spate of negative news, both globally and within India, has started to throw up some good opportunities. Our intent is to allocate a significant amount of capital to equities in the coming days.