Finding Refuge in Arbitrage

Indian market: Is there a way to ride this reckless phase without taking too much risk?

In normal times, bargains come in broader markets, not in blue chips. Broader small and midcaps quote at a meaningful discount to larger blue chips given their low scale and poor liquidity. But when mercury rises and when market moves up manically into a frothy zone, this equation turns upside down to drive valuation multiples into a bizarre zone. Currently we are going thro’ one such phase where small caps are sizzling at a significant premium to large caps. In an intriguing equation, smaller the size, spicier has the valuation become in this new bull-run. Below chart brilliantly captures this valuation conundrum by plotting the multiple across the market-caps. Micro caps have become the new masters when comes to multiples. On one year forward basis, BSE small cap index is at a scary multiple (of over 40+) while their bigger cousins are peevishly behind at 20+ level. As to be expected, the tiny ones (SME platform) are trading at the top of the table.


hese vagaries in valuations are not without any reasons. Changing composition of flows has contributed to this new found charm for the lower and middle rung of the markets. Earlier, flows were dominated by FIIs and hence the skew towards large caps as FIIs usually fancy larger market cap companies. With domestic flows taking the centre stage now, small and midcaps have started shining in a spectacular fashion. Given the long-term drivers for a structural shift in household savings from physical assets to financial assets, dazzle in domestic flows is unlikely to diminish, esp. when the other avenues for savings (fixed income) are much less attractive.

In such a situation, when excess domestic liquidity is expected to keep the valuation elevated for small and midcaps, how does one navigate this reckless run without taking too much risks (till eventual correction sets in).

Here goes the most interesting way one can handle investments in an overvalued market such as the current one:

Go tactical with asset allocation thro’ Arbitrage:

As any value investor would understand, building long term positions in a rapidly rising market, while would make the portfolio shine in the short-run, will dent its long-term performance without exception. As is often said, long-term outperformance comes from short-term underperformance. But there are ways by which one can make the short-term performance little more palatable. The trick is to tout for tactical short-term opportunities, but without taking the market risks. Event based arbitrage is one such tactical model that can help to add glitter to the portfolio without carrying the MTM (mark-to-market) risks. They are primarily short-to-medium term opportunities driven by event based corporate actions like buyback, open-offer and other special situations including mergers, demergers and delisting. The most interesting aspect of this tactical allocation model based on arbitrage is that, while it enhances the portfolio returns in the short-term by serving as a superior substitute for cash parking, it releases the cash at the most opportune time (during corrections) for enabling long-term portfolio building.

Besides arbitrage, there are two other critical ways one can deal with expensive markets. Bull market provides a brilliant opportunity to exit from positions that may not hold huge promise at reasonable prices, so to say to cleanup the past mistakes. Similarly, it also provides a huge window to prune profitable positions by booking profits. Both these actions help raising cash levels which can come handy during the market correction that eventually follows any one-way bull run.

Happy Value Investing!



Time for Catching breath…

Indian markets look tired after stupendous rally which took the indices to life time highs. Market breadth measured in terms of Advance-Decline ratio has turned unfavorable (in favor of Declines) over last two weeks and volatility seems to have come back to the market, which otherwise was running in one direction. Moreover, for the first time since long, broader markets have turned negative on month-on-month returns, with BSE Small-cap index at -3.37% and BSE Mid-cap at -2.89% (as on 29th May). Global cues too seem to have turned. With dollar index back to Nov’8th level (pre-US election) and US ten year yield drifting to six month low( to 2.25% level), there are signs of weakness in the tire-less rally we have seen in the US markets post the US election, famously dubbed as Trump Bump.

With earning season coming to an end and with the news flow on monsoon and GST discounted, we have much less to count on for new triggers. If at all, the news flow only can turn negative with the massive de-stocking expected across channels and across sectors during GST rollover. Given that set-up, markets could turn more volatile with possibility of deeper cuts, esp. in small and midcaps, if the global cues turn negative. On the other hand, if the global cues remain stable, markets could consolidate and spend more time in a range with intermittent weakness.

For value investors who have waited too long on the sidelines, the expected correction (in the best case) or consolidation (in the worst case) will present an entry opportunity soon. Given the increased momentum on domestic flows from the much talked about shift in house-hold savings from physical to financial assets, it may be unreasonable to expect a very sharp correction, though can’t be ruled out. More so, with ongoing surge in monthly SIP book (nearing 5000Cr) for the mutual fund industry. Given this, any cool-off or consolidation can be a good entry point for investors who have been sitting on fence for a while.

Snowball Effect

Reforms : Is there a seamless story behind the seemingly disconnected and discrete set of reform measures?

It has been three years since the current regime took the reins of governance. For anyone who had expected the Govt. to unleash big-bang reforms in the early part of its term, it has been a disappointment to say the least. Much to the criticism of free market enthusiasts, Govt. has been slow on sensitive, yet significant bold reforms such as  privatization of public sector banks and other non-strategic PSUs besides the revamping  of archaic labour and land rules. These are bold measures, if unleashed, could have catapulted India structurally into a higher growth orbit. But to achieve a similar objective, Govt. seems to have chosen much less disruptive path (politically), yet significant in its long-term compounding effect, by systematically scripting a plot connected by seemingly discrete set of incremental reform measures. Strangely, this plot has an equal potential to propel India’s growth structurally into a higher pedigree.

To understand the plot, it is important to decipher what is behind the dots that connect the discrete measures. If there is any common thread that runs across the incremental reform measures such as DBT(targeted subsidy), RERA(Real Estate regulations), Demonetization, Bankruptcy Code, Linking of Aadhaar with PAN, Curbs on Cash transactions, Benami Act and lastly the glorious GST, it is a coherent strategy that runs seamlessly across to structurally swell the tax base and tax/GDP ratio to significantly higher levels. Early signs of such a swell is already visible on the individual tax front with personal tax kitty surging by over 20%+ annually over last 2+ years. GST would do the same magic in indirect tax numbers over time, though in the short-term, implementation hiccups would drag the numbers briefly. Deeper mining on DeMon data trail coupled with effective execution of benami act on the ground would add to the swell,  both in personal tax and in corporate tax.

Crux of all these coherent reform measures is in compliance (tax). With India placed abysmally low on tax base as well as on tax-GDP ratio (ref below charts), these were critical measures to change the structural landscape of the economy. With expected spurt in tax kitty (widening tax net) in the coming years, it will lead to higher fiscal space over time, which will in-turn lead to structural downward shift in inflation / interest rates and thereby changing the structural capacity of economy for higher growth. As the economy shifts to more formalized (from unorganized) one on these reform measures, household savings are expected to see a dramatic shift from physical to financial assets, which will structurally push the potential  growth further.



Over time, with the widening tax net along-with the changing profile of household savings (from physical to financial), India can break out of the 7%+ growth range to join the elite club of 9%+ growth. Though India has seen such a growth rate cyclically (riding on global growth as in the case of 2004-07 up-cycle), to structurally (hence more sustainable) move into that orbit will be a significant achievement for this administration. In summary, the restrained reforms of this Govt., when they play out over next few years, have the potential to have snowball effect to push economy structurally into a higher growth-orbit. No surprise that both FDI and FPI flows are in a rush. Domestic investors too are in a hurry with the trend of changing profile of household savings gathering momentum!

Shaky shift

Monetary Policy : Was RBI too quick to abandon the accommodative stance in its Feb policy?

Back in Jan, when banks were awash with liquidity, thrown in generously by demonetization impact, debate was not about whether there will be a rate cut or not , but how aggressive it will be. Bond Markets were magnanimously marking up the gilts to new highs, as they started factoring in a sizable slice in the rates by RBI (rates and bond prices are inversely related). Some opportune analysts jumped in the fray to make outrageous forecasts on the 10 year yield (on the downside) to feed on to the media frenzy and thereby getting opportunity to hit headlines. Consensus trade was conspicuously long on bonds. Needless to say, traders were sitting on a sizable MTM (mark-to-market) gains in their bond portfolio. So far so good, so it appeared.

But all hell broke loose on 8th Feb when RBI, in an unusual move, decided to change its monetary stance from accommodative to neutral citing following fears.

  • Hardening profile of international crude prices.
  • Volatility in exchange rates on global cues which could impart upside pressures to domestic inflation.
  • Aggressive rate hikes by Fed on positive US outlook as reflected in the rising US yield
  • Impact of 7th pay commission on inflation

For the bond markets, that shift was surreal and bizarre, as they were counting on surging liquidity in the banking system for raving rate cuts. Shift in stance was significant as it ruled out rate cuts for the foreseeable period. That was a blow to the markets that were marking-in large cuts in the bond prices. What followed was mayhem in the bond markets, triggering a huge sell-off. Prices slumped and yield surged by over 50bps in few quick sessions.

Three months have passed since RBI took that significant shift in stance. We now have the real data to assess whether RBI/MPC (Monetary Policy Committee) went overboard on its fears. Here is the chart that captures the movement of those indices (since Feb) that RBI/MPC was tracking closely for its assessment. As can be inferred from the chart, none of them played out the way RBI had feared. In fact, all of them have moved in the opposite direction, much more favourably for a dovish stance than a hawkish one.


Though it is too early to draw any major conclusion, on the evidence of data over past three months, it certainly seems that RBI could have waited for more data before deciding on the shift in stance.  With softening crude and soaring Rupee, fears of spike in inflationary pressures have been proved totally unfounded. With additional support coming from slumping US ten year yield on rising risks for Trump’s reflationary trade ( with increasing fears on Trump’s ability to pump-up bipartisan support for fiscal stimulus or tax cuts), RBI/MPC might find it difficult to sustain its hawkish stance, unless these trends reverse.

For long-term debt investors, the current subdued price in the bond markets is a stellar opportunity given the potential upside in returns when the policy stance swings back to accommodative.  At the moment, data-points (ref chart above) are favourably inclined for such a shift, though timing of which is difficult to predict.


Happy Value Investing!!

When markets see no risks..

As someone wise said, markets are at the riskiest when there is widespread belief that there is no risk, since this makes investors feel it is safe to do risky things. With stock prices surging day-after-day (esp. in the broader markets), Indian markets may be racing recklessly in such a risky zone at the moment. The hardest thing for investors today is to spot where the risk could come from for our markets. When one has to struggle strenuously to spot the risks, investors increasingly feel safe to take higher and higher risks, which eventually makes the market riskiest. We may not be far from that stage.

This does not mean that the markets can’t rally further from here. In all likely-hood, the rally could relentlessly continue and test one’s patience on the upside. But with the rising risks, it is important to understand that valuation will regress to the mean sooner or later. This may be an apt time to remember the golden words of Buffett, “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

This is time for doing nothing, except few selective stock-specific actions with regard to pruning and profit booking. Raising cash levels in the portfolio using such selective actions is critical to capitalize on the correction that would eventually come.


Value from Contrarian Streak

Returns from investments are typically determined more by the price paid than the growth rate – Seth Klarman

Is investing all about identifying great companies or spotting the most mispriced ones? There are no easy answers to this. Growth investing gets glued on to the earnings so much that it exclusively focuses on its attempt to predict earnings growth to the decimal point. Invariably, it ends up spotting opportunities that are priced to perfection. With no safety cushion, any upset, which inevitably happens given the unpredictable business cycles, can dent the projections that have been made with so much precision by spreadsheet specialists. As a result, it becomes one of the most risky investing style in the long-term, though entices the investors with its short-term performance. It is a model designed to deliver short-term out-performance at the cost of long-term under-performance. Value Investing is diametrically opposite. It doesn’t excel in the enticing earnings model, but gets excited with the most mispriced moments. Value investing focuses on opportunities that are most mispriced to long-term intrinsic worth. Since growth is an embedded part of the intrinsic equation, it is a perfect blend of both.

Now, let us look at the more interesting part of investing. What is the inter-play of growth and value in terms of their contribution to the overall long-term returns? This is an interesting question to ponder. Intuitively, one might tend to believe that large part of long-term returns comes from growth. Surprisingly, the empirical evidence suggests otherwise. As the most renowned value investor Seth Klarman says, much of long-term returns come from the buying price ( Value) than the earnings (Growth). Our own experience in this market cycle (from FY13 to FY17) proves this beyond doubt. Below chart from our house research captures this data for stock ideas that we had invested in this cycle. Even to us, it was a big revelation that such a big part of returns (over 75%+ in most cases) had come from mispricing. Change in earnings had contributed far less in the overall returns.


Now comes the difficult part. To act decisively in the most mispriced moments require contrarian streak. For an investor, this is the most coveted asset. The big part of value, an investor or the fund manager brings, stems from this contrarian skill. It is as simple as that. As in life, simple things are the hardest to nurture and develop. More so with contrarian skill, as it encompasses enviable traits such as deep rooted conviction, rationality and agonizing patience. To paraphrase Warren Buffet, investing is less of an IQ game than an EQ (Emotional Quotient) one. Contrarian skill is one  big part of this EQuation. Another chart that captures this value brilliantly is the one pictured below on the behavioral gap. Nothing much to be said further I guess, to emphasize more on the role of temperamental skills (soft traits) on successful investing. “Less is more” is apt here too.



Happy Value Investing!!

The Budget Puzzle


Budget numbers reveal that there is some semblance of “Big Picture” behind the seemingly boring one.

For long-time budget watchers, few things are fairly straight. One, budget is progressively becoming a non-event, notwithstanding the boisterous media buzz ahead of the event and second, the responses from various constituencies are far more predictable. Pressure to be politically right (in their response) outweighs the urge to be out-spoken. Hence, much of the responses are guarded and sugar-coated. This budget was no exception. Media got tizzy around the budget, only to get disappointed with a drowsy one. Much expected cut in corporate tax and personal tax (across the spectrum) did not materialize. Usual hyperbolic statements-of-intent on various rural and infra schemes with throw-in here and throw-out there, dominated much of the budget speech.

Certainly, the budget was a disappointing one (for the immediate short-term at least), given the huge expectations. Beyond the regular ritual, is there a big picture that is popping?. Buried deep, some budget numbers, on closer look, offer hope of a structural shift, if not a grand design.

Central Theme : Broadening the Base by Operation Cleanup and GST

  • The spurt in income tax (personal) numbers over already a high base of last year, seen in conjunction with the upcoming GST, may have clues to the widening tax net in the coming years that will lead to higher fiscal space over time, pointing to structural downward shift in inflation / interest rates and hence changing the structural capacity of economy for higher growth.
  • To understand this, let us start with the basic budget assumptions. The underlying GDP growth assumption in the budget hardly inspires. Govt. expects growth to suffer in FY18 on two counts. First, the lingering effect of DeMo will keep a lid on growth for a while. Second, hiccups in GST implementation can hurt growth in the short-term. Hardly a surprise that the budget has assumed a muted growth of around 6.75% for FY18, much less than RBI’s forecast.
  • With such a sluggish sub-7% growth assumption, subdued tax numbers have been subsumed in the tax arithmetic in the budget, be it excise, service or corporate tax, but with one exception.
  • That exception is on the personal tax numbers. Govt. has assumed a robust 25%+ growth over a high base of last year, in which the personal income tax is likely to have grown over 21%+. Much of this is expected to flow directly from the effects of Operation Cleanup that will be rolled out using demon data mining. This would add up to over 50%+ surge in Income tax over two year period of FY17-FY18. Ref below chart that captures the changing tax mix brilliantly.



  • Add to this the rollout of GST, it is not difficult to decipher that the central thrust for this year is, widening the tax net on both direct and indirect taxes. Former from operation cleanup (DeMo data drive) and later from GST that is likely to galvanize tax compliance from the expected shift from unorganized to organized, gradually though. Proposed limits on cash transactions in the budget will further accelerate this shift from informal to formal economy.
  • Now, let us move forward by one year to FY19. This is when things will turn interesting. Economy would have come out of the clutches of DeMon and would be ready to leap-frog on stabilizing GST implementation. With much delayed capex recovery (private investment) in place by then, growth will gyrate to near 8% level and much more in the subsequent years. Precisely then, widening tax base will work wonder, boosting tax buoyancy and tax-GDP ratio. With huge headroom in fiscal space, macro will move into a much stronger position with inflation and interest rates trending structurally lower.

In summary, the dual reforms of this Govt. (DeMo and GST), when they play out over next few years, have the potential to have a dramatic multiplier effect to push the economy structurally into a higher growth-orbit, leave alone the potential political gains for the current administration on fiscal windfalls (thro’ seductive schemes for poor like the universal income scheme etc). Exciting times ahead for India macro!