Performance and Portfolio Activity
The portfolio was up 4.83% Dollar terms for the month of March, 2017, compared to the investible Indian index, Nifty, which was also up 6.34%. A poor month on relative standards, the portfolio ought to have done better. M&A speculative activity on two of the holdings of the portfolio created an environment of high stock volatility unrelated to the broader market environment. I will be eluding to this further below.
In an environment of low credit off-take in the country, lack of energetic industrial activity, and which has been continuing since 2010, it has become difficult for investors to identify sustainable growth stories (at a reasonable price) in the country. Most of those businesses which seem pure value plays, are not really so, as their balance sheets are riddled with high debt. Without an expeditious bankruptcy and shareholder protection system in place, most of these value plays would be money suckers without a visible or even possible exit in sight. I am pretty sure that any asset play investing would in case of value unlocking would find most of the assets made of thin air while the debt of extremely high tangibility. The auditing firms and their processes are not nearly enough to provide confidence.
What is left for investors who demand sufficient safety of capital, is to hunt for those business which are consumer facing and and with visible tangible businesses which they cannot fake. Hence, we see heightened valuations of banks, non banking financial companies, consumer product companies currently. Yes there are smaller companies which are not yet in the spotlight of major investors which may be attractive but try and find one at less than 20-25 years reasonable discounted cash flow, and the process becomes akin to finding a needle in a haystack, that is, if there is a needle at all.
Call it an error in judgement, I added to a micro finance company three months ago with a prognosis that their business practices provide those at the bottom of the pyramid with better credit mechanisms than the local loan sharks. However, my ongoing analysis highlighted a ponzi scheme like arrangement (albeit at a moderate level). As investors, it is better to stay away from such businesses I have concluded therefore. Moreover, I missed to appreciate the fact that these micro finance companies have been growing their profits with lesser and lesser growing base of borrowers, meaning that the same borrowers have increased their loan amounts. This dynamic never ends happily. Exit was the only rational action even though the exit was with a positive return.
The portfolio has added to two powerful brand names (and leaders in their respective categories), Maruti Suzuki (a passenger vehicle business), and Eicher Motors (a two wheeler business), in replacement of Bharat Financial Inclusion (the micro finance company). I do not expect either to provide extraordinary shareholder returns but their brand identities provide sufficient cushion for future business prospects. Bharat Financial Inclusion has been in an effort to sell its business to banks creating much speculative activity. However, it is interesting to note that nothing has happened thus far, maybe pointing to an indication that the due diligence process carried out by the banks interested shed light on worrying credit standards. Moreover, the company has been shedding its non performing book to ARCs (Asset reconstruction companies) at an increasing level. Something is cooking there which may upset the stomach.
Counting chickens before they hatch: the elusive hunt for profit and sales growth
I can broadly speak for two markets and I believe the same would more or less apply to other markets as well. Developed markets, especially the US, has been on a share buyback spree since 2008 almost. It is no secret that most of the earnings growth in companies in the US market have been affected by reduction in shares outstanding (which is looking increasingly bad capital allocation wise). Shiller PE of S&P 500 companies is at 29x, above the peak in 2007 and TTM PE is at 26.5x, a level only beaten by peak of 2000 and 2007 TTM PE levels looking more than a century back.
It is worthwhile to note that the two PE levels above is inspite of the rampant share buybacks which means that net profit growth of S&P 500 companies are probably on a decline (Shiller's data already shows sales growth has been on a decline from about 10% in 2012 to almost 0% now). Yardeni Research shows Net Income of S&P 500 companies touched ~$250 Bn around late 2013- early 2014 and currently stands at ~200 Bn (at almost the same level as 2007 peak). While that number has rebounded from lows of ~$150 Bn observed in mid 2016, it remains to be seen whether this is just a technical rebound or it has some structural legs to it.
The reason I talk about the United States is because without the US showing robust profit and sales growth, it would be awfully hard for global markets to show strength. India, my universe of investments, have and continue to be influenced by US market optimism and pessimism. India's earnings recovery has also been elusive as well since 2012- 2013 and almost all market gains equate to earnings multiple expansion, which are well above 1 standard deviation compared to historic mean levels. The multiple play is more pronounced in mid caps and small caps (the multiples are well into all time highs).
The more I look at data, I am convinced that either we will see a sales and profit recovery across the globe or we end up creating the next bubble. With the Fed increasing interest rates, the low interest rate theory also seems to be breaking apart. I would like to be an optimist and hope for a general upward movement in business activity. After all, sales, profits and cash flows are what we should use to value companies. EPS doctoring via buybacks and multiple expansions do not increase business value.
Everyone is counting their chickens before they hatch, or sometimes, even before the egg has been laid. It would be good to see the chickens...