14th September 2011

It is very interesting times in the market. All of us invest money to make money and when the markets go down, it causes stress to everyone. So I will talk a little about what is happening in the world and what in my opinion and what the implications are. In the short-term, we all tend to focus very much on what is happening now and tend to forget the big picture. Then I will tell you why I think investing in India is still a very interesting opportunity. I will run you through the process by which I pick stocks and also the key bets in the portfolio.

The global scenario

There are three big concerns which any Indian investor faces at the moment. One is obviously the S&P downgrade of the US and its implications. Second is what is happening in Europe especially to the peripheral countries. Third is the domestic situation with inflation being so high.

What is happening in the US is happening for the first time in the last 100 years. So no one really knows what's going to happen. But we can do a logical analysis of the situation and come up with what the scenarios are. The S&P downgrade from AAA to AA in my opinion doesn't mean much. The US government is still going to honour its commitments. If there is one thing that I as an investor will be watching over the next 12 months it is what's happening in Europe. I think the US will be okay unless there is a big problem in Europe. What is worrisome is the European situation.

The Indian macro story

We then come to the Indian situation where inflation is extremely high. Another change we may see in India is that the future dealings will become more transparent which is very good for the long term. It is only a matter of time before Capex picks up. The longer we don't spend on capacities, the more violent the capacity creation will be whenever it happens. I don't know when that will happen but I do know that markets are down and that we have all lost money in the market and it doesn't feel nice!

Productivity is the biggest wealth creation engine

But I also think markets being down is very good because the long-term story in India which is productivity does not change. There are three ways to create wealth in the long term. One is ownership of resources. If you have the largest oil reserves in the world, you will create a lot of wealth because there is a shortage of oil. We don't have oil, so we do not create wealth with resources. The second is technology. By technology I don't mean Infosys sitting in Bangalore writing software code. By technology I mean the guy who comes up with a cure for cancer, the next nanotechnology application, the next Google, Intel or Apple; that will create a lot of wealth. Again, we in India do not do that because we do not spend enough on R&D to be able to create new technology.

But the third and the most powerful global wealth creation process is the process of enhancing productivity, which means increasing the output per unit of invested labor or invested capital. Bajaj Auto, for example, makes five times the number of motorcycles per employee now than it made 10 years back. That's productivity. Every person is able to produce much more. So productivity is going to be a huge creator of wealth in the coming years.

Consider China. The GDP of China and India were the same in 1980. Their per capita income was the same as ours in 1990. The reason they are so far ahead of us today is productivity. They spent a lot of money on Capex, built up their infrastructure which led to more output from the economy. I think we have just started that journey. As we invest more and more, the output potential of the economy increases. That's what you buy when you buy India today. In the short-term there will be speed bumps, but if you are saving for 5-10 years you are buying productivity in India and I think the US downgrade may slow it down a bit but will not change the story.

The second good thing about investing in India is that when GDP grows, companies make more money because there is more money to go around. Who that money belongs to depends on how a company or a country is financed. If there is too much debt, the cash flow being generated will belong to the debt holders because they financed the assets. In India as a whole, our debt to GDP ratio is very low, which means that when corporates make more money, a lot of that will belong to us as financiers of equity capital. So not only is the GDP going to keep growing at a very healthy pace for the next 5-7 years easily, the cash generated because of that growth will also belong to us because there is not that much debt in the economy.

Should we be worried about inflation ?

People are worried that the inflation rate in India is very high. India's high inflation rate to me is a cyclical problem. The fact is we grow 7-8% with long-term 7-8% inflation. We have to learn to live with that. Now that the government has acted decisively, I am not that worried about inflation. I think the interest rates have peaked because given what's happening in the western world, I don't think anyone is going to be raising rates, not only in India, but even globally. If you think of the next 3-5 years in terms of asset allocation between fixed income and equities, you have to work with the assumption that interest rates from hereon should be coming down.

Are high oil prices really bad news?

The second thing everyone worries a lot about is oil price. The Sensex and the oil price move together and the reason they do is very simple. Oil price goes up because there is more demand than supply. Oil price goes up because more companies are doing business, more electricity is being generated, more cars driven. That tells you that the world GDP is doing well. And oil price comes down when the world GDP is slowing down, which means world economic activity is slowing down. World economic activity has a much larger implication for Indian stock market than the oil price. So next time someone tells you buy the market because oil prices have come down, be very careful!

Projecting a risk-reward for investing in the Sensex

For the last 12-13 years, Sensex revenues grew between 1.5-2 times the nominal GDP. So if nominal GDP grew 10%, Sensex revenues grew 15-20%. That's logical because Sensex is primarily the private sector, leaving out government which generally grows slower than the economy. Now let's think of the next five years. Let's make a bear case for India, let's make a bear case for equities. Let's assume the worst nominal GDP growth for the next five years is the worst in the last 13 years and the worst Sensex revenue multiple on that. Assume the worst case profit after tax margin at 9%. At the moment Sensex PAT margin is 11.5, let's take it to 9%, even in the great financial crisis it went to only about 10.5%. Then the trailing price to earnings ratio is only 11 times, which is the worst multiple of the last 13 years. That means, in five years you get your money back, you don't lose anything! If you put your money in a fixed deposit with, let's say, 5 year rolling rate of 6%, after tax you get say 4.5%. That's your opportunity cost. That's what you lose by putting money in the equity market.

Now let's assume that the worst case doesn't happen, but that the next five years are normal, not fantastic. With an average of last 13 years' nominal GDP growth and the Sensex revenue multiple, the PAT margin is actually only 10.5; your exit trailing price earnings multiple is 15 times. You will more than double your money over the next five years. And this is assuming that there is no up cycle in the next 5 years and you are not able to exit at an even higher price. So I think today the risk reward in the market is fantastic. In the worst case you are not going to lose much more than your opportunity cost over the next five years, and in a good case you can more than double your money and that's a bet I will take any day!

Now, I find a lot of value

Last August I wrote to the fund holders of the Special Situations Fund when I felt people were too sanguine about global problems, too bullish on India. I quote from that letter:

'Now I would like to add a comment on market valuations and corporate profitability. I think in 5 years we will not be saying that the stock market in August of 2010 was a bargain, I feel it is not. I am not saying that the broad indices can't go much higher from here, they certainly can. All I am saying is that we are not in bargain basement territory. My reason for saying this is as follows.

1. a simple analysis of EBIT margins of corporate India over the last 20 years clearly shows that margins are high

2. a quick look at price to earnings ratio for the market shows that investors are paying a fair multiple for profits of corporate India.'

Today, I am in the other camp. I think people are too pessimistic. Can the markets go down 20% from here over the next 12 months? They certainly can. Today, you get a huge safety margin especially in cyclical sectors. Today, everyone owns the same stocks from ITC, Unilever, oil marketing companies, no one is buying stocks in cyclical sectors. They say buy low, sell high; you buy low only when things are tough, no one is going to sell you cheap when things are great. Will you ever sell your house at a cheap price when the locality around your house is doing very well? So I do feel markets are at a very interesting juncture now, and on a 5-year view I am actually quite bullish.

I buy businesses, not the economy

For now, give me the benefit of doubt and agree that the next 5 years are not going to be bad for India. Let's then come back to investing money in the fund. I do not invest in the economy or in the stock market; I invest in businesses. If I want to buy Colgate India today whether I make money on Colgate India or not will depend on how the toothpaste industry in India will evolve over the next 5 years and how Colgate will do within that industry versus Unilever and Dabur and Procter & Gamble. So I need to understand the drivers of this industry, the competitive advantage of the company that I am investing in and why people prefer Colgate over any other brand. Is it the brand? Is it the marketing? Is it their distribution? Is it their technology? That's what I am interested in. Business by business by business, company by company by company, understand the business.

So, the number one rule when buying stocks, understand the business that you are investing in. Number two, buy good companies, but when something has gone wrong. I don't want to buy good companies when everything is hunky-dory. That would wipe me out. So valuation is extremely important. I want to buy good businesses but when they are cheap.

That brings me to my next point, I am wary of companies where expectations are very high. I generally don't want to buy things when CNBC tells you to buy them; I am very curious when CNBC tells you to sell them. I take CNBC as an example of media here. Whenever something is on the front page of a newspaper for a controversy, that's when you are most likely to get a bargain. Understand the business, buy cheap and stay away from market! These are the three basic pillars of what I do. Once that is done, judge the risk of investing in that business and the reward. The risk is how much money I lose if I am wrong and reward is how much money I make if I am right. When you invest in a business, you are always investing in the future and no one knows the future. So try to analyze the scenario, it is not complicated.

Think differently to add alpha

Once you find the right business at the right price, bag them with conviction and take positions in them. When I started running the fund in August 2009, we were just coming out of the previous recession and people were very bullish on the Capex cycle, so was I. But when I looked at the big Capex cycle stocks, I felt that they were very richly valued. You were paying big multiples for these stocks and if you were wrong about the future, you could lose a lot of money and if you were right you wouldn't make that much money. So I started looking for other ways to invest in the capex cycle without investing in the big companies. If you are going to build roads, factories or power plants, everything needs transport. In India the main means of transport is trucks because we have never invested in our railway infrastructure. So I did work on Ashok Leyland which was trading on sub-book value and took a big position in Ashok Leyland. Then I thought if trucks are interesting, everything that goes into a truck should be interesting too. If they sell more trucks, they would sell more bearings, more tyres, more braking systems, more truck finance. I took positions across the supply chain. I bought tyre companies, Apollo and Ceat. I bought bearing companies FAG and SKF Bearings. I invested in a bricks company called Wabco, I invested in a truck finance company called Shriram Transport Finance. Actually 5 out of 6 investments did well. If I can get 5 out of 6 right in every investment decision I make, I will be richer than Warren Buffett. All I need to get is about 5.5 out of every 10 right; if I get 6 out of 10 right I will be very famous.

The same with banks. I took a big position in some of the small banks trading below book value. A lot of times I buy too early and sell too early. That's what a lot of value investors do, they buy when things get cheap and not worry about whether they can fall further; if they fall, buy more. Same thing I do with stocks. That's a process which over time will work and it has worked so far for me.

Sensex is misleading - there is a lot of value in mid and small caps

The second thing on the Indian market is that the Sensex or Nifty is very misleading because today I think the real value is in mid and small-cap stocks. There are a lot of mid and small-cap stocks which are really cheap. A lot of people are hiding in large-cap stocks in safety because no one wants to take decisions which can get them fired. The other thing is because mid-caps have done worse than the large-caps over the last 12 months.

Now the Fidelity Value Fund is much more mid-cap biased than the Special Situations Fund. Hence, the performance hasn't been as good as I would like it to be. Since we launched it in January 2010 it is sub 5% versus 1% for the market, which could be better. The problem has been that value has been amongst the worst performing strategies over the last 18 months globally and in India but value has also been the best performing strategy in the world over 10-50 years. So it is a strategy which works long-term, but will have periods where it does not work. I am surprised that I have outperformed the benchmark by 4% since launch because given how bad value has done, it could have been worse.

The Special Situations Fund does a little bit more large-cap than the Value Fund and hence the performance has been better. I have managed the fund now for about two years and in that time, it has outperformed its index by about 16-17%; over 3 years it has outperformed its index by about 6% per annum, so it has given you 14% per annum versus 9% for the market.

Stock picks - Shriram Transport Finance

In terms of the top positions in the Value Fund, the biggest position I have is Shriram Transport Finance. It is a company which finances second hand trucks, has 25% market share in India of the second-hand truck financing market - the balance 75% is with moneylenders. If you want to borrow for working capital, you have 10 banks who will come forward to lend to you; if you want to borrow for a second-hand truck you have only two options, either Shriram Transport Finance or a moneylender. Shriram Transport Finance lends at 18-19%, a moneylender lends at 35%. That's the competitive advantage of the business. That's why they can do what State Bank and ICICI cannot do. Their first advantage is they know how to value a second-hand truck. If you have two second-hand trucks made in the same year by the same company, their values will be still entirely different. A bank executive cannot tell the difference, their guys can because they have all been trained, they have all come from shops. The second advantage they have is that they know how to collect money in cash from these truck drivers. This is a skill you cannot develop overnight but takes decades. That's why they are the only real organized player in the market and everyone else is a moneylender. It is a fantastic business! People are pessimistic about it because interest rates are high, they feel the economy is slowing down. But I think that's the time you really buy the long-term winners. I know their growth because I know they finance only 5-7-year-old trucks; I know how many trucks were sold in the last 5-7 years, how many trucks are going to come up for refinancing over the next 5-7 years with at least 25% of the market share for Shriram, so I know how much they are going to be making over the next 5-7 years. It is a very simple business to analyze. I think it is going to grow anywhere between 15-20% per annum for 5 years at more than 20% return on it.

Stock picks - FAG Bearings

The second big bet I have is a company called FAG Bearings owned by a company in Germany called Continental. Bearings is an oligopoly industry worldwide, there are very few companies who can do high precision bearings. The bearing that goes into a door or into the wheel of your cycle is a commodity bearing, but the bearing which goes into the gearbox of a truck or into a Harley Davidson motorcycle, or inside an oil ring are high-precision bearings, which means that they have to be right to the millimeter. There are only two-three companies in the world who dominate this industry. In India SKF Bearings and FAG Bearings have 70% market share; if you can add Timken, they probably have 75-80% share of the organized market. Over the last 20 years this business has grown at 16% per annum, it is a net cash balance sheet; I am paying 13 times earnings. When I bought the stock I was paying 8 times earnings. I think over the next 5 years this business can still grow 13-15% per annum at a 35-40% return on equity and I am paying 13 times earnings. I think it is a very interesting stock to own.

Stock picks - ING Vysya Bank

The next one is a bank called ING Vysya Bank based in South India. It is 43% owned by ING from Netherlands and historically it was a community bank for the Vysya community. It is a bank which has had two problems in the past: (i) throughput from its branches was too low, so the productivity of the branches was very low. Just think of a bank like a shop. These guys had these shops which were not selling enough, so they were not able to cover the cost of running the shop. (ii) They had very bad asset quality, i.e. they were making bad loans. A bank basically sells two things, deposits so that you bring your money to them and loans so that you take money from them. They lend you money at a certain interest rate and they borrow money at lower interest rate and the difference is the money they make.

With a management change a couple of years back, four things were expected to change of which three are already done. First, they fixed the deposit engine wherein they get more of current accounts where no interest is paid than savings account where 4% is paid, or an FD where 8% is paid. They fixed the asset quality, so they cleaned up the book, the NPL ratio is low, they are not making bad loans, so the asset quality problem is solved. They raised the capital, and the capital problem was solved. The balance sheet is clean now. What they have not fixed yet and what they have been actually investing is the cost side. Costs are still too high. They have been investing to change the organization so they are able to sell more loans. I think over the next 2 years this problem will get fixed. It is a bank which is trading on sub 10 times earnings; it is trading on 1.3 times price to book. Once its return on assets gets to beyond 1%, which could happen in the next 18 months, it is a bank which can easily trade twice the book value. If I am wrong and they are not able to fix the cost engine, it goes to book value. In the worst case I would lose 20%; in a good case I would make 60-70% in the next 18 months.

Stock picks - National Stock Exchange

The largest position in the Special Situations Fund is a stock called the National Stock Exchange, which is more than 8% of the fund, which is the monopoly stock exchange of India. They have 80% share in cash equities and they have 100% share in the derivatives market. The stock is trading at 12-12.5 times forward earnings and stock exchanges globally trade at about 15 times and in Asia trade at 30 times. If you think of it, more and more of unlisted India is going to become listed India and as the financial sector opens up more and more, the volumes in the market have to go up, plus we will get new products like foreign exchange. They already have a FX product for which they don't charge. We don't have an interest rate curve on the stock market, interest rate curve is controlled by the RBI; sooner or later the interest rate curve will get on the stock market and corporates will be able to hedge themselves on the stock market.

If you were a corporate in India three years back and you wanted to hedge your oil or gold exposure, you had to go to a bank or into a small trading community and hedge yourself, now you can do it on MCX. Similarly, if you want to hedge your dollar exposure, now you can go on to the exchange. Sooner or later corporates too will be able to hedge their interest rate exposure on the exchanges as well. Worldwide it is a huge market, it will develop in India. I think NSE has the best shot of developing that. So NSE can easily trade above 20 times earnings as and when it lists. Hopefully, that could happen in the next 12-18 months. As and when that happens we will make very good money on that position.

To conclude

I have tried to share with you my thoughts about why I think India is now very interesting though people are pessimistic. I have told you how I try to find ideas and tried to give you a flavour of my process with some stock examples. Happy investing !