Market preparing itself to scale New High

Reference – “Investor’s Delight” on December 12, 2011

From December 12, 2011 to date it’s been a rewarding year for equity investors who have remained patient. The broader indices have delivered double digit returns during this time with most of the high quality businesses delivering returns in excess of 25%. FII’s  were net buyers to the extent of 1 Lac crore plus whereas domestic investors were net sellers and clearly showed lack of faith in the Indian equity market. As we speak we are just 7% away from a new high in NIFTY. The markets have also consolidated in the last few years where most of the weak hands have now been replaced by stronger ones.

Since the high of January 2008, FII’s have invested close to 2.75 Lac crores whereas MF’s have been net negative to the extent of 34000 crores. We have also seen sector rotation where high cash flow generating businesses have made new highs while leveraged businesses have touched new lows. As on January 2008 Reliance Industries and ITC were valued at 4.57 Lac crores and 73000 crores respectively. The same in today’s date stands at 2.66 Lac crores and 2.36 Lac crores.

With every bull market phenomenon we are seeing new leadership in the markets. Consumer, Pharma, Cement, Private Sector Banks and Media & Entertainment are the sectors showing this new leadership. The markets made a low on December 20^th, 2011 and have since been climbing a wall of worry. There were no significant positive news flows between December  2011 to August 2012. In this period of gloom and doom the FII’s were consistently absorbing supply made available by domestic investor’s redemption and we've come to a point where after the reforms announcement in September 2012 the market is gearing for some momentum.

There is a classic difference in return expectations of FII’s and domestic investors. The returns available in developed markets are very low and hence they’re making a beeline to buy Indian businesses which offer better growth. This is in contrast to domestic investors who have made decent returns in gold and real estate in last many years. Their expectation from equities are bench-marked to returns from such alternative asset class. We expect this mismatch to continue and will force domestic investors to sell equities to FII’s.

In our view we may be just 7% from a new high but the journey till then will not be smooth. We are anticipating large domestic selling which means that volatility may increase once we get close to the new high. This is the time for the investors to correct the skewed asset allocation in fixed assets like gold, real estate and fixed deposits. Our allocation to equities has been negative for the last 5 years and its time we take a fresh look at the asset allocation and correct underweight and overweight positions. This will help us to participate in Indian equities if market scales new high. 

Growth Dynamics

We are hearing constant news and views on growth trajectory of Indian Economy. We at JAIN INVESTMENT strongly believe that there is no strong correlation between growth and equity return. One of the best example is INDIA & CHINA. In last decade China has grown at the rate of 10-11% and India has grown at 7-8%. Index return of India in last decade is 13.29% CAGR and China is -4.14%. Following table depicts GDP of India & Index return in last 30 years.

Year	GDP in $ Billion	Growth in GDP	Sensex Return
1980	189.6
1985	236.6	4.53%	18.25%
1990	326.6	6.66%	23.43%
1995	366.6	2.34%	38.03%
2000	474.7	5.30%	4.95%
2005	834.2	11.94%	5.68%
2010	1684.3	15.09%	21.46%
30 Years	7.55%		18.11%

Investing for Dividend Yield

“Sales is Vanity, Profit is Sanity & cash is Reality” – Anonymous


The quote above has been a backdrop of the dividend yield theme. Investing for dividends is a philosophy in itself. Lot of us believe that to make money in stock markets one should invest in great businesses with equally great management. The rationale behind great management is prudent use of capital. We all focus on profits and growth in profits of a company while very little time is spent on finding how much cash is generated out of profits and what the end use of this cash is.


Let’s take Nestle India as a case in point. It is in existence since many decades in India and is one of the most innovative companies in terms of product launches and has a near dominant position across product ranges. Nestle has been the most prudent user of capital for many decades. In the last 10 years they have grown sales from 1900 crores to 7500 crores at a CAGR of 16.15%. PAT has grown from 200 Crores to 960 crores at a CAGR of 19%. In the last 10 financial years it has made a total after tax profit of 4700 crores. Nestle has paid 3200 crores as dividend which is about 68% of their total profit of 4700 crores. Nestle shareholders have been rewarded handsomely by getting 64% of  their capital back in the form of dividends while the stock price has multiplied from Rs. 520 in 2002 to CMP of Rs. 4500.


We can find great businesses with great management around various sectors in India like Auto, Auto Ancillary, Chemicals, Engineering, Consumption and Banking. The mindset of most of the investors in India in the era 1975 to 1990 was to constantly invest in businesses which made prudent use of capital and gave regular dividend to investors. Dividend yield was a powerful concept way back then because capital was scarcely available.


In the year 1991 when the doors to liberalization were opened for foreign capital and competition capital became available more easily. The focus then shifted from prudent use of capital to rapid growth by using financial leverage. As the cost of capital started decreasing companies started showing higher ROCE (Return on capital employed) along with rapid expansion in profit. As India moved to 8% plus GDP growth the focus of investors too shifted from dividend paying companies to high growth companies.


In the year 2010 as the cycle started turning again, the cost of capital started increasing and capital became scarcer. Focus shifted back to cash flow generating business and in the last two years we have seen re-rating in all the cash flow generating businesses with high quality management.


Mutual funds in India started launching dividend yield funds way back in 2003. They didn’t get enough recognition from 2003 – 2007 where capital cost was going down and GDP was witnessing rapid growth. Since 2008 the dividend yield theme started getting focus wherein such funds have delivered positive returns since the peak of 2008 whereas for the same period the index is down by more than 25%.


As we speak the dollar has depreciated by more than 25% in last one year. This will have an inflationary impact with the result that the cost of capital may go up sharply. In this high inflationary environment dividend yield stocks will benefit most because of their healthy balance sheet, good management and gradual easing off of competitive pressures. For investors who have been in the market for a long time and have tracked management and businesses closely they will have the necessary know-how to cherry pick such stocks. For beginners or novice investors Dividend Yield Funds offer a good investment vehicle to participate in high quality cash flow generating business. 

Performance as on May 29, 2012
	Compound Annualized
Scheme Name	1 Year	2 Years	3 Years	5 Years
BNP Paribas Dividend Yield Fund - Growth	-3.02	3.51	15.02	8.71
Indices
S&P Nifty	-8.81	-0.76	3.90	3.05

Budget 2012

Budget 2012 was one of the most watched event. Everyone was trying to guess the way ahead and government stand on fiscal consolidation. He started by saying that we have to be cruel to be kind. In our opinion it will do exactly the same. To simplify GDP

GDP = C + I + G + (EX-IM)

Where

C  = Consumption

I  = Investment

G  = Government Expenditure

EX = Export

IM = Import

In last one year we have seen sharp slowdown in consumption. Most of the corporate are reporting value growth by doing price increases but are not able to do volume growth to that extent. With recent hike in excise duty & service tax by approx 2% which with immediate effect, corporate will find it difficult to pass on this hikes to end consumer. This will also be inflationary in nature and may move inflation in upward trajectory. In our opinion this will keep interest rate elevated for slightly longer period of time. In our opinion very few corporate with strong brands or intellectual property will be able to pass on this hike in taxes.

Investment has slowed down in last one year and due to high interest rate and slowdown it may remain subdued for some more time. Also due to high fiscal deficit, high interest rate and deficit liquidity there is crowding out effect for corporate.

Government is aiming for fiscal consolidation and hence will see slowdown in government expenditure. They may use public sector companies balance sheet and cash surplus to revive growth in public expenditure.

Export has done reasonably well in last one year and India may continue to do well due weak currency & cost advantage. The real challenge for export is weakening European & Chinese growth.

Import has grown at faster pace compared to export due to surge in oil prices & import of gold. Government is trying to curb import of Gold.

If we summarize all of this we can see that India is targeting slow growth to ensure fiscal consolidation.

According to us Joker in the pack is OIL PRICES & imported raw material prices. Any fall in oil prices can bring down (E-I) equation. Which will improve our current account balances. This will strengthen our currency and also bring down inflation at faster pace and improve margins of the companies.

My advice to most of the investors will be show patience and believe in countries ability to come out of crisis. It’s very easy to lose conviction at this time & believe in some other asset class. GRASS IS ALWAYS GREENER ON OTHER SIDE. Most of the investors agree that equities tend to outperform other asset class. But they forgot to mention that returns are made by only patient investors. Equities return for last five years have been zero. This statement should make investor more bullish than bearish. Since GOOD TIMES ARE AHEAD.

Build Equities

We have seen once again sharp rally in 10 year G-sec from 9.00% to 8.15% in period of month. LAF is showing short liquidity of 80,000 crores which reached 1.7 Lac crores in 3^rd week of December. We are seeing sharp easing in long end of curve due to OMO and also borrowing at long end of curve has significantly slowed down. In our view RBI will reverse its stand from short liquidity to surplus liquidity in next 3-6 months.

Market suffered its sharpest fall in December-11 due to very tight monetary condition. Some of the high quality stocks suffered fall in that period. Due to slight easing in liquidity conditions these stocks have already moved up by 4-10%. We are trading near 15000 mark for last 6 months. We have touched 15000 mark in August, October & December-11 month. Market is giving window to buy at these level for long time. My personal view is that market will be constructive for equity investors in 2012. Also market will incrementally move up in middle of all the bad news in the market ranging from lower GDP number, bad quarterly numbers, high fiscal deficit, slow government policies, high current account deficit, muted FII flows etc. etc.

Someone asked me, what is risk for equities in 2012. My answer was – “EVERYONE IS UNDERINVESTED”.