The Economy Looks Poised For Strong Growth Ahead

The month of November has brought about some positive changes. The rupee has come down below 70, crude prices have fallen back to below $60 a barrel (from $86!) and overall, the markets worldwide have started to recover. India's seen a very interesting set of results as well, and for the first time in many years, the macro is actually looking favourable.

In October the NBFC carnage took yields up substantially, and market interest rates spiked up to even as much as 10% for many players. Yet, inflation has been down ­ a bit less than 4% in October, and possibly even lower in November as crude prices have crashed.

This leads us to believe, quite strongly, that we will be staring at lower interest rates in a few months. After all, if inflation's at 4% and interest rates are even at 8%, we have "real" returns that are very high. RBI has, in a paper even mentioned that high real rates hurt the economy. Already, yields have fallen nearly 0.8% in the government securities market, which means the market believes the direction on interest rates is likely to reverse.

Add to this the recent crackdown by RBI on non­performing banks and assets. The impact was hard on the public sector banks and some private sector banks too, but as they progress to "resolve" these assets, we see something strange beginning to happen: the banks are actually recovering money!

Take the case of Essar steel. A promoter that was focussed on hitting the banks with heavy losses (nearly 50,000 cr.) has now seen his company being sold to Arcelor Mittal and has made a counter offer at Rs. 54,000 cr. From an estimated 50% losses on this deal (already taken as provisions), banks are now seeing a 100% recovery regardless of which buyer snags the company.

But there's another angle to it ­ the bidder for Essar Steel was Arcelor Mittal. Mittal wasn't going to be allowed to bid, because another company he was involved in, Uttam Galva, had Rs. 8,000 cr. overdue. So Mittal paid up that money, and was allowed into the Essar deal. In one shot, banks had even recovered another Rs. 8,000 cr. from another overdue account.

A number of companies that were used to "forcing" banks to take losses have backed off and paid up as they watch how the new bankruptcy code can snatch their companies if they stick to their old ways. The change is gradual, but real, and it's positive for the economy too.

In the last three years, from 2015, we've seen companies substantially cut their borrowing as well. This "deleveraging" has made for stronger balance sheets overall. And in the process they refused to build more capacity (which usually needs more debt) and increased their utilization. But as they come towards high utilization, we are seeing a slew of capex plans return ­ from industrials to auto manufacturers to chemicals, expansion plans are on.

With these macro tailwinds (lower crude prices, low inflation, bank clean up, deleveraged corporates) and possibly an easing of rates in the next year, our bets are on strong growth in the coming years. We've always been circumspect on the economy in the past (though stock prices were high) but for the first time in many years, the macro is actually in our favour. This will be exciting for markets in the years ahead.

It's been a year since we started and it's time for a quick look at how we've done with respect to our company's in terms of growth. We mapped our companies ­ 35 of them ­ and looked their earnings growth on a trailing twelve month basis. We've had some out­performers and some under­performers, but here's where we are:

Earnings in Last 12 Months Average Median

Nifty 22.7% 14.6

Our companies saw an average earnings growth of 25% on average. But averages aren't useful ­ remember that the average of one stock growing at +300% and 9 other stocks that are contracting (or having negative growth) at ­10% can still show you an average of 21%!

So we also use the median to understand if the distribution is very skewed. The median growth number for our companies is also 23%, which we are happy with.

Another way to measure if the companies are doing okay is to look at the Return on Equity. Here's where we measure how much our companies are able to earn on the equity capital they have. A number that's substantially higher than a risk­free rate is a good thing.

Average Return on Equity: 19.9%

Median Return on Equity: 16.9%

Our companies have about 17% ROEs, as a median though the average is higher. We would be happy with higher, but in general the higher ROE companies tend to be quite a bit more expensive.

In terms of price performance, we haven't been in a great league, to be honest. We have underperformed many of the broad indexes in the last year, specially the Nifty. However the damage in mid and small caps has been much more, and our performance is more linked to those as the companies we hold are smaller. Our debt allocations have helped, but not to the extent we would have liked. November's seen a recovery and we re looking forward to the months ahead.

The strategy going forward is that we will cull positions that aren't looking very good from now onwards. We cut positions in one stock in November, and are considering two more in the coming month. However, in certain stocks where we are under water, we believe the triggers to growth are still ahead of us and we will instead reduce position size to less than 2% of portfolio, rather than remove them entirely. We continue to look to replace them with better positions and to reallocate current portfolios.

The positions in auto and finance have seen a major dip and some recovery, but we believe in the macro tailwind that they will continue to be big beneficiaries in the years ahead. They remain our larger bets, but we'll add other companies in sectors we find of promise. In addition, we will be cutting positions in other stocks which haven't performed.

The way we look at this portfolio is a long­term one ­ that this portfolio will have stocks that eventually grow to 10 times where they are today. Some will not, and that's part of the game. Some will, and in the process give us some grief while they grow. Even a Dabur, which has grown 24x since 2005, has seen big corrections in every year, even though it never saw a major fall in earnings!

The money is made in the sitting, not in the buying, goes a famous saying. While that doesn't mean we keep holding loss making companies (we will get rid of them when fundamentals change) but it does mean that markets may take some time to recognize stronger earnings and meanwhile, investors will need to hold on. The challenges on the investing are ours, and we intend to fix what we got wrong, and move on to stronger companies. Here's hoping for a much better December!

Happy Year­-endingly,

Deepak Shenoy