Cockroach in the kitchen

Dated: 7th of March, 2017

 Performance and Portfolio Activity
The portfolio was up 5.88% Dollar terms for the month of February, 2017, compared to the investible Indian index, Nifty, which was also up 5.39%.


Indian  markets saw a continuation of the uptrend that began in late Dec, 2016.  Upbeat global markets dragged Indian equities up although considerable  lot of the flows have been led by domestic investors, a changing dynamic  which might be positive or negative for local equity market stability  depending upon how local market participants behave at times of  volatility. From Dec 26, 2016 till March 6, 2017, overseas investors  have put in about $1 Bn to work while domestic investors have put in  about $1.4 Bn into Indian markets. To consider this a sign of maturing  domestic investors (most of the money came in via SIPs) remains to be  seen. It is easier to go on a low carb, low sugar diet for a day than to  continue for an extended period of time.


Portfolio action wise,  there were no changes during the month. I am confident about the  quality of businesses that we hold in the portfolio and sanguine about  their long term prospects, although it is impossible to determine what  will actually happen next quarter or even six months down the line about  their stock prices. Scientists have found it hard, next to impossible,  after years of dedicated hard work, to predict natural phenomena like  weather even two days in advance with meaningful accuracy. I am no  scientist with super computers. We all seek order among randomness as a  human fallacy and it would be unwise of me to attempt seeking order.


Over  the past one to two years, Indian broad markets have traded in the  range of 19x earnings to 27x earnings on a 12 TTM basis. As you may  assess, such valuations are certainly not mouth watering. However, given  where Indian interest rates are at present, such valuations may not be  dangerous. On the other hand, with the Fed on an upward cycle on rates,  the scenario may change quite a lot if the RBI has to follow suit  although the strength of the INR gives the central bank some cushion.  The earnings yield of the top 500 companies in the country on an average  have ranged from 1.5% at depressed times to 4% on the flip side less  than the RBI base rate. At this point of time, broad markets are neither  depressed nor at the top end and hence are probably in the range of  reasonableness. 

Cockroach in the kitchen: The changed landscape of the banking industry in India.
Almost  everyone is probably aware of the Non Performing Asset issue in public  sector banks in India. This problem had stuck its neck out since 2010  and the situation has worsened since. Without going into a rant  commenting on the lack of care of majority of PSU banking officials for a  job well done (the cases I have personally seen highlights nothing  else), gross corruption, and the inability of the government to  understand that they should mostly have no business in business (listen  to Milton Friedman!), I will try and highlight the nature and scale of  the problem. 


The gross NPA's of listed public sector banks in  India ranges from ~7% to ~22% of their respective total assets. The  total stressed assets of the banks highlighted below combined comes to  around $92 Bn, or in other words, ~4.5% of the GDP of India's ~$2100 Bn  economy, and ~11% of the total assets of these banks. Moreover, the Tier  I capital of these banks are at their lowest, just meeting regulatory  requirements, ranging from 8-9%. If we take into account the  inconsistencies of these public sector banks related to method of  accounting for stressed asset classification, increase in stressed  assets still coming in Q4FY2017, stressed assets in private sector banks  and stressed assets in other unlisted private banks and unlisted public  sector banks, the total NPA's of the country as of date may as well be  around 10% of the GDP of the country. 


While the government has  been infusing capital into these public sector banks in inconsequential  amounts, talked about a bad bank to accumulate all stressed assets in  the public sector banking system, I feel apprehensive that the  government may be behind the curve. RBI's Asset Quality review  implementation will bring in more transparency but may not be enough to  resolve the system. Without credit growth (last data point points to a  multi- year low of ~4.8%) in the system, I fail to see how  the government comes out of this mess without a hard hit on the hand.


Since  more than 60% of deposits are in public sector banks, anyone calling  for a bank run? On a lighter note, it is actually quite humorous to view  interviews of the C- Level executives of these banks. Since the past so  so many quarters, everytime they would come in and say that the worst  is over, that they have killed all the cockroaches and a quarter  forward, more cockroaches come up which again they say they have killed.  Maybe they should take advise from pest control consultants, who would  say, "There is never just one cockroach in the kitchen". 

 While this dynamic has been  happening, Private Banks, Non Banking Financial Companies, Micro Finance  institutions have been lapping up market share form the public sector  banks and deservedly so making the situation worse for the public sector  banks.

Without credit growth to lead capital formation, these  private players have been concentrating on diversified consumers feeding  the Great Indian Consumer Demand. Atleast for now, personal debt to GDP remains pretty low to cause any source of concern.