Are we coming to the end of this chapter?

Dated: 1st of August, 2017

Broad market benchmarks climbed to  all time highs with the Nifty 50 crossing 10,000 mark. However, I don't  think there is much to cheer about as valuations remain on the peak side  (compared to 2000 and 2007 peaks) indicating a scenario that the party  might soon end. There was one change to the portfolio in the month of  July. We/ I exited out of Torrent Pharmaceuticals, a Gujarat based  pharma company with significant presence in India as well as the US.  With continuing pricing pressure on drugs in the US as well as changing  prescription environment (mandated by the Medical Council of India) in  the company's home market, it has become hard to determine what changes  the pharma industry in India will go through and who will be the winners  thereof. The exit of Torrent has not been a company specific call but  rather a dimming of the business prospects vision, barring which, any  company specific valuation is just a guess at best.

Now  coming on to the broader picture of where valuations lie, it is but  unlikely that one should notice that the price earnings multiple of the  top 500 companies by market cap in India is above the 2007 peak (figure  below). Of course there may not be any validity in the argument that  multiples generally revert to mean but what if history rhymes? Generally  looking at multiples in relation to government bond yields give a fair  view about the opportunity cost of holding equities. Indian earnings  yield is more than 3% lower than the government bond yields so I don't  think there is much room there as well. 

Earnings growth has been  below 0-5% for broad markets since the past 3-4 years and all the rally  we have seen in Indian equity markets has been multiple expansion  driven. India, which generally trades at 20-30% premium over Asia x  Japan, now trades at about 50%. Earnings growth has been elusive and  everytime  sell side analysts come out with optimistic guidances for  earnings growth (of course they would do so), they have been embarrassed  further down the line with wide off- the- mark reality.

Globally, the US is on an upward  cycle on interest rates and so is Europe reducing its monetary easing,  or indicating to do so. There are some who argue that India has room to  cut interest rates as India's inflation (WPI inflation price index  change at 0.9% vs. 6% just three months ago) has been on a downward  trajectory. However, I believe it is more because of a lack in demand  rather than actual softening of prices. 

Given  where all things stand, I do not think that Indian Reserve bank would  be able to cut interest rates much to revive credit demand and hence  CAPEX in the country, failing which, the heavy lifting for growth has to  be driven by Government expenditures, which also hasn't been visible. 

We  remain cautious therefore, and while we have a policy of not  undertaking a portfolio short position, we have hopefully neutralized  the portfolio via Index hedging to a large extent. Our cash levels are  above 30% and net position is about 7% (not beta net). 

I  am not in a position to ascertain that we are already in a bubble  because even though in hindsight, bubbles are easiest to pinpoint, what  pops a bubble is I think impossible to determine. Adding to that, the  veracity of the cause may not be at times as deep as the most recent one  and therefore price action may be more or less dramatic than in notable  1929 or 2008. Conservative portfolio management mandates that if prices  go to a level where the duration increases to absurd time frames,  appropriate action should be taken. The risk is of course missing out on  possible gains that might still exist.

On a lighter note...  
I  have met managements of various companies, although I don't think it is  mandatory for me to see or talk to management before investing. In  India, it is very entertaining to listen to public sector bank  executives in media after quarterly results. Here is usually how the  interview goes...

Reporter:  "You guided last time that the worst of your NPA issues are behind you.  So what happened? Even this time there has been a significant increase  in your gross NPA..."

Bank  executive (usually the CEO or CFO): "You see... I like to see the glass  half full... even though we have increased our gross NPA, the growth  rate has not been more than our previous quarter... we are in a very  comfortable position... our future is good"

Mind you, I have taken inspiration from a recent interview where the banks NPA was close to 20%.