On the Case for Buying India, US Market Outlook and Tips for Longevity!

From: Aditya Rana
Date: Sat, May 12, 2012 at 4:00 PM
Subject: On the Case for Buying India, US Market Outlook and Tips for Longevity!


Seth Klarman, the famed value investor and manager of the Baupost hedge fund, has provided some sage advice with regards to investing – “be a contrarian armed with a calculator”. With this in mind, let us look at the curious case of India, where the consensus opinion is decidedly bearish (have yet to find a bullish view amongst my friends in the financial area!), based on a long list of ills which currently plague the Indian financial, economic and political system. In recent months, Morgan Stanley’s India research team (headed by Ridham Desai) has produced some excellent notes on the macro fundamentals in India, making the argument for the long-term bull case. In particular, their recent piece titled “ A Macro Framework for Corporate Profits” is one of the best macro research piece I have come across on India (and for that matter any emerging market) and draws on a recent path-breaking note by James Montier of the value manager GMO which provides a framework to analyse corporate profits from a top-down macro perspective. To summarise:

-Corporate profits in India have compounded by 21% per annum over the last 10 years, but have declined to an annual growth rate of 8% over the last 4 years (see graph below) while nominal GDP has grown by 15.6% per annum over the last 4 years. From a peak of 10.7% of GDP in fiscal year 2008, profits have dropped to 8.9% of GDP. At a micro level this can be explained by a big drop in margins. It is also helpful to understand the macro drivers.

-Corporate profits at the country level can be derived from the basic macroeconomic investment-savings identity . Profits equal: Investments – Household Savings – Public Savings – Current Account deficit + Dividends (all expressed as a percentage of GDP). To think of this identity intuitively, all domestic spending (whether consumption or investment) counts towards profits , foreign spending detracts from profits and all savings (private or public) reduces profits. Dividends are paid an income transfer from the corporate sector to households.

-The macro approach tracks reported earnings (of 6,890 companies) closely (see chart below).

-The slowdown in profits has come primarily from a 3.7% (of GDP) drop in the investment rate over the last four years (see chart below). The second biggest drag on profits over the last four years has been the 2.7% increase in the current account deficit, but the 5.0% decrease in public savings over the same period has more than offset this impact. If it were not for the public spending increase, corporate profits would have declined by 5% per annum.

-The case for a premium for Indian equities over other markets rests on the significantly lower volatility of earnings growth (see chart below) . This lower volatility in earnings is explained by the long-term stability in India’s investment rate and household savings, which are the biggest drivers of profits (see graph below). The shorter-term fluctuations in the earnings growth comes from swings in public savings and the current account deficit – but they are relatively smaller drivers of profits in the long-term.

-The outlook for corporate profits over the next 12 months depends on the interplay between public savings (or the fiscal deficit which is a subset of savings and the two track each other very closely) and the current account deficit.

– It is unlikely that the investment rate or household savings rate will change by much. However, there is a risk that the investment rate dips somewhat due to policy uncertainty, low starting point for ROE and the high cost of capital, which will hurt profits. In addition, higher real rates could cause savings to grow and also hurt profits.

-A likely reduction in the fiscal deficit will act as a drag on profits, while the accompanying compression in the current account deficit will provide a boost to profits. While fiscal discipline is good for long term macroeconomic stability , too much and too soon will hurt profits.

-The current account deficit therefore holds the key to profits over the next 12 months. The best way to achieve a reduction in the current account deficit (and an increase in profits) is to boost exports – but that is unlikely in a slowing global economy. The other way would be to reduce imports – not the bad way by reducing domestic consumption (which would hurt profits) but by a reduction in the prices of imports (i.e. lower oil prices) which would increase profits.

-So expecting stable investment and savings rates, and a decline in the fiscal deficit together with an offsetting decline in the current account deficit plus an increase in the dividend payout (which typically increases when profits are low) , would result in a 16% growth in earnings assuming a 13.8% nominal GDP growth rate (see graph below).

-The historically wide gap between the market cap and profits as a share of GDP indicates that the market is very pessimistic in the outlook for profits, making equities an attractive buy from a long-term perspective (see graph below).

A very insightful piece of work, and sorely lacking for most markets outside of the US (would love to see similar work on the Chinese market!). In the investment world, it is critical to look at the trees from time to time, and not get overly bogged down in the weeds. Yes, there are many negative factors facing the Indian market today(too long to list!), but the stock market is cheap and for a long term investor it presents an attractive opportunity to go long (or add to core long positions) over the course of the next few months. Exposure can be taken to the entire market, or to the mid-cap or small-cap sectors which present even more attractive valuations (see relative valuation analysis below). There are funds and ETFs to effect this exposure – both in the domestic market as well as the offshore market.

-The broad market , in US$ terms relative to the broader Asian market, is now at the late 2008/early 2009 lows reached during the financial crisis.

-On a price to book valuation, adjusting for the growth in book value, the market is just 15% higher that the levels established during the end of 2008.

-Small-cap stocks currently trade at 1.1*book which are near a historical low, and the relative price/book is at a multi-year low going back to 2002 and at a 60% discount to the broad market.

Regarding the US market, the economy is showing some clear signs of slowing down which is typically associated with a market correction. The chart below (Citi economic surprises index versus US equities minus US government bond 3 month returns) illustrates this phenomenon rather well:

But with the current easing programme (Operation Twist) expiring in the end of June, it is unlikely that the market will suffer a serious 10-15% correction until after the expiry of the programme, as long as the possibility of an extension or a new QE programme to be announced before the end of June remains. However, if there is no new programme announced, the chances of a subsequent 10-15% downturn will increase substantially. This, if it happens (as noted in previous newsletters), should be viewed as a buying opportunity as it would significantly increase the likelihood of another QE programme!

Tips for Longevity:

I came across a wonderful note from one of India’s best-known writer and journalist – Khushwant Singh, who is 98 years old and still active – earning more money from his writings now than he did as a younger man! He wrote a piece recently on useful tips to attaining a long health-span (as opposed to life-span) which I have excerpted from below. While it is not necessarily realistic to follow the lifestyle of a 98 year old man – it is still helpful to bear in mind the basic principles which I have highlighted.

-Coming on to 98 years and still earning more than I did in my younger days, people ask me how I manage to do it. They regard me as an expert on longevity. I have pronounced on the subject before; I will repeat it with suitable amendments based on my experience in the past two years.

-Earlier I had written that longevity is in one’s genes: children of long-living parents are likely to live longer than those born to short-lived parents. This did not happen in my own family. Nevertheless, I still believe genes are the most important factor in determining one’s life-span.

-It is important to cope with old age and make terms with it. As we grow older, we are less able to exercise our limbs. We have to devise ways to keep them active. Right into my mid-eighties, I played tennis every morning, did rounds of Lodhi gardens in winter and swam for an hour in summer. I am unable to do this anymore. The best way to overcome this handicap is regular strong massages. I have this done at least once a day or at times twice a day. I am convinced that this has kept me going for so long.

-Equally important is the need to cut down drastically one’s intake of food and drink. I also believe that a meal should have just one kind of vegetable or meat followed by a pinch of chooran (digestive) . It is best to eat alone and in silence. Talking while eating does not do justice to the food and you swallow a lot of it.

-Never allow yourself to be constipated. The stomach is a storehouse of all kinds of ailments. Our sedentary life tends to make us constipated. Keep your bowels clean however you can. (The key here is to have enough soluble and insoluble fibre – fruits and vegetables are good but whole grains are critical. Adequate water, particularly one or two glasses on waking-up, is critical. The Ayurvedic herbal detoxing powder – Triphala, is also very helpful).

-Impose strict discipline on your daily routine. I have breakfast exactly at 6.30 am, lunch at noon, a whiskey drink at 7 pm, supper at 8pm.

-Try to develop peace of mind. For this you must have a healthy bank account. Shortage of money can be very demoralising. It does not have to be in crores, but enough for your future needs and possibility of falling ill. – A practice which I have found very effective is to fix my gaze on the flame of candle, empty my mind of everything, but in my mind repeat Aum Shanti (Om, Peace), Aum Shanti, Aum Shanti. It does work. I am at peace with the world.

-Never lose your temper, it takes a heavy toll and jangles one’s nerves. Never tell a lie. Always keep the national motto in mind: Satyamev Jayate, only truth triumphs.

-Give generously. Remember you can’t take it with you. You may give to your children, servants or charity. You will feel better. There is joy in giving.

-Drive out envy of those who have done better than you in life. A Punjabi verse sums it up well: Eat dry bread and drink cold water. Pay no heed or envy those who smear their chapattis with ghee (butter).

-Take up a hobby like gardening, growing bonsai, helping children of your neighbourhood with their homework.

Here is to a long health-span!




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