Q3 2014 VIIR Portfolio and World Market Update

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The global market rally has taken a time out for the majority of September, but the Sensex continues to be the best performing market globally for 2014. We can see from the chart below that among major global markets only the Sensex, Shanghai Composite Index and S&P 500 remain in positive territory on a year-to-date basis.

In my view, the recent performance of the Indian equity market is simply a reflection of the acceleration in GDP growth from the decade low 4.5% level we hit in Q4 2013. The table below taken from the OECD (Organisation For Economic Co-Operation and Development) shows that India is the only major global economy with the exception of the UK, that has experienced accelerating GDP growth in 2014.

In my view, the sustainability of the current rally will be dependent upon corporate earnings accelerating as GDP growth picks up. You may be thinking to yourself that I’m a bottom-up stock picker and that I don’t need to worry about the macro outlook. Unfortunately, you can’t simply ignore the macro outlook and I’ll explain why in more detail below.

Total returns to stockholders can be summed up in the following equation:

Stock Return = current dividend yield + earnings growth + P/E changes

Essentially, your total returns from share ownership are derived through dividends or capital gains. Furthermore, capital gains are the result of either increasing earnings per share growth or other investors willing to pay a higher P/E multiple for the same stream of earnings.

Ibbotson Associates, the publisher of the SBBI Classic yearbook, has estimated that long-term earnings growth in the US has roughly matched long term nominal GDP growth. Why should you care what Ibbotson Associates has to say? The answer is simple. The SBBI Classic yearbook is the definitive study of capital markets data in the United States. It’s used by virtually all professional money managers to analyze asset class performance. It contains total returns and index values dating back to 1926 for large and small company stocks, long-term corporate bonds, long- and intermediate-term government bonds, Treasury bills, and inflation. The data goes back long enough that we can make inferences about certain economic relationships and also apply them to other markets outside of the US.

Thus, long-term nominal GDP growth will ultimately determine long-term earnings growth for the Indian market in aggregate just as it does in the US market. Although in my opinion P/E valuations are not unusually stretched, earnings growth will need to pick up for the current rally in the Indian market to be sustainable. If GDP growth continues to improve, earnings growth will also improve providing support for a continued rally. If growth stalls out, the market will be headed for a swift correction. Thus, the macro outlook will impact the P/E valuation level for the market as a whole. It’s naive to think that secular trends in the Indian economy don’t impact individual sectors or companies. I’m not saying you need to be a macro trader, but you do need to be cognizant of what’s going on at the macro level.

Value Investing India Report (VIIR) Portfolio Update

I’m happy to announce that the outperformance of the VIIR portfolio has continued into Q3 2014. As I mentioned in the half-yearly update, value investors tend to underperform in bull markets as momentum takes over. However, you can see from the chart below that the outperformance of the VIIR portfolio has accelerated since the last update.

We’ve achieved this performance via a concentrated portfolio containing 18 total positions. The returns have been equally impressive since we launched our stock recommendation service in mid-2012. You can see from the chart below that the VIIR portfolio has outperformed on a longer-term basis as well.

Since launching our Premium Access stock recommendation service, our total cumulative return has been 73.8% as of September 30, 2014. Over that same period the Nifty index has produced a return of 50.9%. Obviously, past performance is not an indicator of future performance. But I can guarantee you that my main goal is to keep helping subscribers like you to outperform the market. I’ve been continually hearing from other Indian value investors that nothing is attractive at current levels. Personally, I think it’s a cop-out. There are always overlooked sectors and companies in any given market environment and the current one we face is no exception.

Additionally, I’m not averse to paying up for a high quality business. Value must be measured in relation to the quality of the business you’re purchasing. In 1994 Charlie Munger gave a speech titled A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business at USC (University of Southern California) or the University of Spoiled Children as I like to point out to my younger sister, who is an alum. In the speech Munger stated the following:

“We’ve really made money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.

Over the long-term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

The point of the Munger quote above is that a stock can look expensive based on one year’s worth of earnings, but could still be a great investment if you have a long enough timeframe. Yes, it’s incredibly hard to find compelling investments at current market levels but it’s not impossible. I also think there is a high likelihood for a correction as the Federal Reserve winds down its quantitative easing program. There are always opportunities popping up in the equity markets as the only constant is volatility. Now is the time to be preparing your “buy” list as the market will inevitably produce another buying opportunity. All subscribers to our Premium Access service have access to our detailed watch list in addition to all existing stock recommendations. If you’re interested in learning more about our investment process and current portfolio holdings please click on the following link.

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