Investor Update

Dear Investors/Prospects,

These are interesting times. On the back of media frenzy on demonetization and expected chocking of parallel economy, here are some interesting updates from our side on how we are placed on the portfolio front.

  • It has been home runs for the market for over six months since the “long-on-EM” trade began (Emerging Markets). Markets had been under-pricing the risk of reversal, esp. over last month, on the belief that the negative interests are here to stay and on hopes that Fed rate hikes, even if they come, will be moderate and gradual.
  • Any consensus trade makes us cautious and so was this EM-long trade. We turned extremely cautious on this and that stance was reflected in our portfolio positioning, esp for newer set of clients where deployment was as low as 25 to 30%, rest being on cash equivalents or arbitrages. For older clients, it was pruning rather than buying that dictated our actions resulting in comfortable cash cushions in most of the client portfolios.
  • Refer to our communication “Wait is getting longer” in early Oct (as part of BizNotes), where we had outlined this strategy in detail. Copy is attached below for quick ref.
  • As always, consensus trades end badly. Trigger comes in different forms. For EM trade, it came in the form of  US election outcome. Yields surged amid major sell off in bonds with dollar index hitting new high crippling emerging market currencies including Rupee.
  • With no respite seen on FII sell off, markets have continued to drift lower, in spite of support from local funds. Fears on demonetization’s impact on broader economy couldn’t have come at a worse time. Together, they have put markets on a downward spiral.
  • In our view, while demonetization impact will be limited to short-period for much of the sectors ( leaving the worst hit real estate and associated sectors), after-effects of EM trade reversal will linger longer and will keep the markets in check.
  • As it happens always, valuations are turning attractive precisely when the longer-term structural story is turning more stronger on demonetization (Inflation and hence interest rates are turning lower structurally) . With more fiscal cushion, Govt. is expected to boost spending in the next financial year. Current market weakness, in that sense, is throwing a brilliant opportunity for new investments.

By prudent portfolio positioning and strategy, we are better placed today to capitalize on this correction, though our portfolio had to suffer under-performance in the short-term when the rally was reckless. It was in a way a price to be paid for longer-term out-performance. Needless to say, for new investors, this is a great time to come into our fund, given the strengthening long-term outlook for India.

Attached below is the extract of our strategy shared in early Oct’16.

N. Arunagiri
CEO & Fund Manager

Extract of our strategy shared in early Oct’16

Wait is getting longer!

Fed signaling is clear. They are not in a hurry to raise rates. Market expects the first hike not earlier than mid Dec, given the US elections in early Nov. That gives an ample window for EM rally to race ahead. That said, market runs a grave risk, if it turns into reckless rally. As the wise words go, when you party hard, post binge hangover will be even harder.

It is testing times for investors who are in wait mode. With their portfolios under-performing the markets significantly, the temptation to throw in the towel is growing even stronger. More so, when the wait is getting longer by the day. Yielding to such temptations, needless to say, will be suicidal.

Having said that, there is a way to minimize the pain. Market in its wisdom, has left few pockets untouched by its ferocious rally. Froth is not across. It is limited to few seductive sectors that have great short-term momentum in earnings such as Auto, Auto ancillaries, Banks, Cement, NBFCs and so on. On the other hand, valuations are reasonable in many other individual stocks that are not as fortunate to have short-term earnings momentum,
yet have reasonable long-term prospects. Investors can find solace in such stories though they are only far and few in this overheated market. As far as the frothy segment is concerned, investors should use every rally to prune and raise cash levels.

There is growing view within the investor community that the current rally is on account of strong policy and reform momentum of the Govt. and hence will continue if the govt. keeps the pedal on policy actions. This view is not entirely correct. Much of the rally here in India is linked to EM rally and is on account of carry trade (liquidity). When the EM tide ebbs, it will puncture the local rally as well. It is time for caution.



Shadow Bang!

Indian NBFCs : Shadow banks may hit a bump on frothy valuations.

Every bull market needs a hot theme that can fuel fervor and frenzy among investors. Usually that crown is reserved for an emerging sector that is long on promises, but short on specifics. Internet boom in 2000 was one such classical case. But, this time, bucking the trend, market has latched on to one of the most unlikely sectors for its steroid. It is not a sexy emerging business. It is an age-old dull business that has been around since the time private businesses took roots. Lending is no fancy business, but, by taking NBFCs and other retail financing co’s to lofty levels of valuations, Indian market hasn’t disappointed its ardent followers by showing how insanely irrational it can stoop to.

Like every hot trend, it starts with certain fundamental triggers, but soon gets hijacked by hyper momentum. It is no different in this case. To begin with, the prospects for NBFCs and retail lending brightened with key fundamental triggers such as,

  • Increased credit demand on falling interest rates
  • Improved profit outlook for lending on lower cost of funding
  • Significant market share gains for NBFCs (including HFCs (Housing Fin Cos)) at the cost of large banks such as ICICI, Axis and SBI that are saddled with stressed assets.
  • Increased liquidity to NBFCs/HFCs from alternate source of funding (besides banks) to tap into this growing opportunity.
  • Increased demand outlook for HFCs from rural and semi-urban.
  • Surging demand for microfinance post stability in regulatory norms.

While these factors in isolation may look not very unusual, the combinations coming together conspired a deadly revival in the earnings momentum for this sector. That set the bull case for the sector. Once in control of bulls, soon, momentum morphed into mania leading to froth in valuation in much of the stocks in the sector. Stocks such as Bajaj Fin, Canfin homes, Gruh Finance , Equitas and Ujjivan have surged and are quoting at unsustainable price-to-book valuations. Valuation multiple for most of these companies are much  higher than established and well run larger players like HDFC and HDFC Bank. Take for example, Bajaj Fin is at over 8 times the price to book (FY16) while the multiple for HDFC Bank is less than 4.5. Gruh Fin is at the fanciest level at over 14 times P/B multiple.

Such froth in this sector is scary for the simple reason that the business model of lending is murky at its core. It is a business where profits are front-loaded and losses are back-ended and thus making the business fundamentally risky. Loans are easy to give and so are profits in the beginning. But when loans sour later ( as in most cases), write-offs come back to hit in a back-loaded fashion. This is not to say that this business can’t be run conservatively. But the inherent risks in the lending business make it an average business at best or a fragile one at worse. Valuing such businesses at stupendous multiples like the ones in the current market is fraught with ruinous risks which the investor can ill afford. Froth in this space gives an excellent window for investors to exit positions clinically. While it could impact the returns in the short-term given the daily surge in stock prices in this space, it will prove to be a prudent one in the long-term with these stocks set for major regression in the eventual correction.

Happy Value Investing!