November 20, 2013
The unfortunate reality is that due to the policy actions of central bankers we’re now living in a world distorted by ultra-loose monetary policy. As an investor focused on the Indian market, it’s important to realize that the rapid Rupee deprecation and market swoon this past summer was not a one-time event. Despite the protestations of Mr. Chidambaram, it’s not back to business as usual for India Inc.
As a value investor, I spend most of my time focusing on valuing individual companies and trying to find the rare business with a truly “wide moat” that can produce spectacular returns on capital over extended periods of time. However, we’re now living through an unprecedented monetary experiment that is going to end badly. If you’re a steward of your own capital or that of your clients; I truly believe that you’re doing either yourself or your clients a disservice by not focusing on the wide ranging implications of the current monetary policy being pursued by the FED, ECB, BOE and BOJ. In addition, you need to be aware of how foreign institutional investors in the Indian equity market will respond to the current monetary policy regime.
The bottom line is that the Indian equity market is now dominated by foreign institutional investors. As a former foreign institutional investor, I know how most foreign portfolio managers operate. They don’t really understand the Indian growth story. Many simply don’t believe in it. They still think that India is the victim of the old “Hindu growth rate”. The current slowdown in economic growth only further support their initial biases. These foreign funds are only putting money into India because the liquidity tap provided by quantitative easing is continuing.
The dramatic sell-off we saw in the market and the currency in August were directly the result of the threat of the Fed beginning to “taper” quantitative easing. The surprise decision by Bernanke to not reduce the pace of asset purchases otherwise know as “tapering”, led to a rebound in both the market and currency. The “mini-recovery” is artificial and you’ll again see pressure in the Indian equity market and currency when the discussion about “tapering” heats up again.
My point is that a large component of the FII funds flowing into India is the result of carry trades. Hedge funds can borrow at exceptionally low rates in developed markets and invest in Indian debt securities, which are currently providing much higher yields. If you add leverage to this mix, the returns can be huge. The risk is that the Rupee depreciates significantly, which would undermine subsequent returns when FII’s repatriate their capital. Rapid Rupee depreciation can result in large market volatility as FIIs unwind carry trades and pull money out of India. Thus, Indian investors are at the whims of fickle foreign capital.
If you understand the psychology of foreign institutional investors you can use the volatility to your advantage. A value investing based investment approach is well suited to the distorted market environment we are facing not only in India but globally.
In order to get a read on foreign fund flows you need to understand the likely course of monetary policy in the US. In a recent article in the FT, Gavyn Davies succinctly summarizes the policy outlook being formed by Janet Yellen (Bernanke’s successor). The main takeaway for me was that the decision to “taper” has already been made.
Although I don’t agree completely with this viewpoint, you still need to be prepared for a surprise announcement. If the FED does decide to “taper” it will spark a similar sell-off to the one that occurred in August.
A reduction in asset purchases is the first step in a tightening of interest rates. As a result, we would expect interest rates to rise making carry trades more expensive. Investors, utilizing large amounts of leverage for carry trades in the Indian market, would be forced to sell positions resulting in a sell-off in both assets and the Rupee. The movement of FII flows doesn’t impact the long-term growth outlook for the country. But it does create buying opportunities for investors who have a long-term timeframe.
As investors, we need to be prepared for the day the liquidity will end. I don’t think it’s going to be anytime soon. Possibly not even in 2014 but what happened in August was just a prelude to the actual event. Given the difficult market environment, I’ve always found it helpful to seek out the advice of investment managers who have been able to generate market beating returns over the long-run. When I say the long-run, I mean decades not just a few years. One investment manager who fits this criteria was Bill Ruane. When Warren Buffett shut down his early partnerships, he recommended that his original investors should invest with Bill Ruane. He was literally the only investment manager in the world to be recommended by the Oracle of Omaha. Unsurprisingly, Ruane followed a strategy similar to Buffett. His main outlook on investing could be summarized as follows:
- Buy good businesses. The single most important indicator is a superior return on capital, because it means the company enjoys a unique proprietary position.
- Buy businesses with pricing flexibility, always true but particularly in the inflationary period in which he wrote.
- Buy stocks at modest prices. While price risk cannot be eliminated, it can be lessened materially by avoiding high multiples.
- Buy strong balance sheets. If this rule is violated, none of the others will matter.
- Buy cash generating businesses, those where earnings are truly available to create future growth or for payment to stockholders.
I plan to stick to these criteria when identifying new investment opportunities. The possibility of “tapering” is going to result in increased volatility in the Indian market. The best way to take advantage of this volatility is to buy high quality businesses at exceptionally discounted prices. I’ve already put together a shopping list for my Premium Access subscribers. I’ve done the research and financial analysis on a handful of high quality businesses that I would love to own in the VIIR portfolio at the right price. If the market provides the opportunity, my subscribers will be prepared to strike because I’ve done the legwork for them.
Value investing is fundamentally about being able to separate market value from intrinsic value. Market value is much more volatile because it reflects investors’ emotions. Intrinsic value is more stable because it only reflects the underlying business fundamentals. Market value and intrinsic value will converge over time. The key to success is to buy when market value is below intrinsic value by a wide margin. The cause of depressed market values doesn’t really matter. One day it will be the Fed “tapering”, the next day it will be a the likelihood of an S&P credit downgrade. Emotions will always rule the market but don’t let emotions rule your investing.