The 6.4% fall in the Nifty last month was followed by another 5.0% fall in the month of October, 2018. The market has been hit by bad news on a number of fronts – the ILFS default and its resulting impact on NBFCs; higher oil prices, which in turn has had an impact on the rupee. Other issues that the market is trying to deal with, are the ongoing international trade war which is having an impact on global trade, a tightening Federal Reserve, which has been raising interest rates in response to stronger core inflation data coming out of the US, which is in turn having an impact on emerging market currencies from Indonesia to Turkey to South Africa and other emerging markets like India. And then of course, there is the matter of the general elections in India, which are scheduled for mid-2019, about 6-7 months from now. While our portfolios were also impacted by the market fall, they fell less than the market and we remain reasonably confident of our holdings.
The fall in the market over the last few months has been tilted towards the broader market – the NSE Mid-cap 100 index is down 18.7% as of 31-Oct-18 for the calendar year and the Nifty Small Cap 100 index is down 33.3%. In the same period, the Nifty is relatively flat at a negative 1.4%. The median stock in the BSE-500 (an index of the 500 largest companies) is down 34.0% from its respective 52 week high. The correction in the broader indices has been brutal – led by high valuations to begin with, and attending factors like SEBI’s stricter classification of mutual funds into large, mid and small cap mutual funds and the proportions that such funds can have in different categories of stocks. What hasn’t helped is the bad news coming from some debt instruments defaulting (eg ILFS) and the resultant liquidity issues among some NBFCs.
Along with all the bad news also came some good news. The Essar group made an offer to repay Rs54,000 crore of its loans and try to regain control over Essar Steel, which had gone into the insolvency proceedings under the Insolvency and Bankruptcy Code (IBC). This offer was higher than Arcelor Mittal’s offer of 42,000 crores. Once it is resolved, Essar Steel will be the 7th of the initial 12 large cases that were sent to the NCLT court for resolution. There are two positives from these developments. First and fore most is that the rules that govern lending by banks has undergone a fundamental shift with the establishment of the IBC. Lenders now have a legitimate means to get a quick settlement of their loans due – this means that promoters need to be careful before they indulge in mischief in their companies – they can easily lose their companies if they do. The second positive is that banks will recoup some of the money they have lent to these large defaulter companies – and this can allow them to lend more effectively to the economy.
Meanwhile the early results that have come in for the BSE 500 companies have been reasonably healthy. We have considered the results ex of the banking and finance stocks because there is a comparison issue with them due to the high losses reported by many banks and financial institutions over the last 24 months. Of the 418 non-financial companies in the BSE 500 Index, 118 have reported results as on date. We have compared the numbers over a 2 year period because of the various disruptions because of demonetisation and GST and done a 2 year CAGR to present the results. The 2 year median revenue CAGR for the BSE-500 has been inching up since Dec-17 from 9.4% to 12.2% as of now (for companies that have declared results so far). This is somewhat close to the middle of the 10-14% range that one expects for Nifty revenues over the long term. Importantly, these numbers are getting back to historical trend after the twin disruptions from demonetisation and GST. What is also heartening is that median PBIT growth (Profit before interest and tax) is currently at 18.1% CAGR over 2 years (though typically the better companies tend to report first), significantly higher than the 10.9% rate recorded in the Dec-17 quarter. While we need to add the caveat that all the results are not declared yet, it appears that the trend of better corporate results that we reported in our August newsletter, seem to be getting more confirmation. The green shoots are taking root perhaps – we shall continue to wait for more signals from corporate performance.
Meanwhile, in the significant corrections in stock prices, both in the large cap and the mid cap spaces, one can see quite a few opportunities emerging for us as long term investors. To paraphrase Benjamin Graham, “Mr Market is in an ugly mood”. The reference to Mr Market is that of a 50% partner in the business that you own together with him, who is a manic-depressive – very ebullient at times and very despondent at others. His endearing quality as per Ben Graham, considered by some to be the Father of Value Investing, is that he will knock on your door every day with a two way quote – one at which he will sell you his 50% of the business and the other at which he will buy out your stake. Our job as a value investor is to use his manic depressive nature to our advantage and not to be guided by Mr Market.
However, we expect to continue to operate in the high quality space that we prefer. It is possible that some of the incremental allocations are in the mid-cap and small cap space (as per SEBI’s new definitions of this term for mutual funds, the small cap space is quite broad at anything which is 251st in market capitalisation and below) because that is the space which has seen some dramatic corrections. Yet we are mindful of the fact that when a stock falls from 3x its intrinsic value, even a 40% correction would bring it only to 1.8x its intrinsic value. There may be some traps in this broad market fall which investors should watch out for. We believe that it is important to stick to the quality end of the spectrum because it provides long term protection of capital and also higher stock price appreciation over the full economic cycle.