avant garde wealth mgmt - quarterly letter - 1203

Avant Garde Wealth Management Pvt. Ltd.

Note: “Portfolio” refers to the weighted average of all client portfolios managed by us over the relevant time period. Any metrics such asreturns or portfolio weighting similarly refer to the weighted average of all portfolios. Individual clients portfolios may defer materiallyfrom the blended “Portfolio” and clients should refer to their portfolio statements for details on their portfolios

Dear investor,

The past quarter was characterized by a very sharp rally in the Indian equity markets, and similarrallies across global markets. Sharp moves in markets in either direction are challenging to navigateas changes in sentiment tend to dominate and stocks move more based on factors such as whichsectors they belong to and how much their prices had moved in the recent past. However, suchphases are transient and it is ultimately a company’s underlying value that is reflected in the stockprice over time.

Drivers of corporate profits – Will corporate profits grow in-line with GDP?

A simple way to think about changes in stock price is to break it down into two components, (1)change in earnings, and (2) change in the price/earnings (P/E) multiple. A common line of reasoningused to estimate aggregate earnings growth goes something like this – ‘India’s GDP can be expectedto grow at X%. Since corporate profits track GDP growth over time, they should grow at a similar orslightly higher rate, and hence should grow at X-Y%.’ This conclusion rests on the assumption thatcorporate profits grow in-line with GDP. This is an important assumption and one that deservesfurther analysis.

In a recent paper1 James Montier of GMO (a respected global asset manager) undertook this analysisfor the US economy. He observed that the ratio of US corporate profits to GDP is at an all time highand would likely mean revert to lower levels, implying that future growth in US corporate profits willtrail GDP growth in that country. While that conclusion is interesting, the focus of this discussion isto apply the methodology used by him to the Indian economy.

James uses the Kalecki profits equation for his analysis, which can be derived from the nationalincome accounting identity. Here is the equation:

Profits = Investment – Household savings – Government savings – Foreign Savings + Dividends

In simple terms2 the logic behind this identity goes something like this. Investment spending by anindividual firm is a source of profit for another firm, so in aggregate capital expenditure is equivalentto a profit pool for corporations. From this profit pool some money is paid out to households aswages. Most of these wages return to firms through spending by households. Any money saved byhouseholds (household savings) is money not spent and thus subtracts from the overall profit pool.Firms pay the government various taxes. Again, most of this money is spent by the government andfinds its way back to firms. What is not spent (government savings) subtracts from the profit pool; oradds to it in case the government is running deficits. Similar logic applies to foreign savings, which isessentially the inverse of the current account, i.e., a current account deficit implies positive foreign

1 GMO White Paper, “What Goes Up Must Come Down!,” March 2012 (www.gmo.com)2 For more details about the profits equation and the case for causation, please read “Where Do Profits Come From,” byLevy, Farnham, and Rajan (1997); www.levyforecast.com/assets/Profits.pdf

www.gmo.com

www.levyforecast.com/assets/Profits.pdf



savings. Dividends are paid out by firms to households, who in turn spend it on products andservices, adding to the profit pool.

Using available data for the Indian economy we can plot the path of corporate profits as apercentage of GDP (also referred to as ‘profit margins’ from here on) and how it breaks down intothe various components. The data is not perfect and there are certain classification issues. You mayrefer to the footnotes for details3 but it is important to note that the figure for corporate profits onlyincludes private sector corporations. So it does not include profits of public sector firms,partnerships, proprietorships, etc. Profits for these entities are included in household savings, whichmeans that corporate profits are understated and household savings are overstated. This makes anyconclusions about the absolute level of profit margins less interesting, but conclusions based onchanges in various variables over time are instructive.

Source: Reserve Bank of India

The graph above can be split into four phases. First, from the late 1980’s to 1996, when profitmargin increased from ~2% to 5%. Second, from 1996 to 2002, when profit margin decreased from5% to an interim low of 3.4%. Third, from 2002 to 2008, when profit margin increased from 3.4% toan all time high of 9.4%. And fourth, from 2008 to 2012, when profit margin declined from 9.4% toan estimated 6.8%.

Let us examine the changes in various components in the third and fourth phase in more detail.

3 Profits is “Private Corporate Savings”; investment is “Net Domestic Capital Formation”; government savings is thecombined fiscal deficit for centre and states; foreign savings is the inverse of current account deficit. Household savings is abalancing figure. Some figures have been estimated. FY12 figures have been estimated based on the Q3 FY12 quarterlyprofessional survey carried out by the Reserve Bank of India

0%

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Prof

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Investment Govt savings Foreign savings Household savings Dividends Profits

Fiscal year Investment Govt savingsForeignsavings

Householdsavings

Dividends Profits

FY02 12.8% 10.3% 0.7% -21.0% 0.5% 3.4%FY08 28.4% 4.1% -1.3% -22.9% 1.1% 9.4%FY12 24.6% 8.9% -3.8% -23.9% 1.0% 6.8%



As you can see, the strong expansion in profit margin from FY02-08 was entirely driven by asignificant jump in investment. This was partially offset by a decline in the government deficit, whichis positive from a macroeconomic standpoint, and a slight increase in current account deficit, whichis negative. In contrast, the decline in profit margin since FY08 has been primarily driven by a declinein investment and an increase in the current account deficit, which have been partially offset by anincrease in the government deficit.

Where does this leave us with regard to potential direction of profit margin in the future? Well, thecentral government is now trying to get the fiscal deficit under control. While it may or may not fallmuch, the government deficit is unlikely to increase from here, acting as a headwind to profitmargin. Similarly, unless there is a sharp fall in oil prices the current account deficit is unlikely to fallmuch and may actually keep increasing, again acting as a headwind to profit margin. Dividends areunlikely to change materially. So the only way profit margins can improve or stop declining is ifinvestment picks up or household savings decline. Unless households decide to start saving less, theonly way for profit margin to expand is via an increase in investment. So far there is no sign of apickup in investment spending, and directionless government policymaking is not helping the cause.

The tables below highlight the impact that changes in profit margin can have on earnings growthrelative to GDP growth4. From FY02-08, earnings growth was far ahead of GDP growth due to theexpansion in profit to GDP. On the other hand, from FY08-12 earnings growth has lagged behindGDP growth.

Note: CAGR is Compound Annual Growth RateSource: NSE web site; Blooomberg consensus estimates; RBI

Unless investment spending picks up it may be the case that earnings growth continues to lag GDPgrowth for some time. Assuming consensus forecasts by analysts (in the table below) are reflectiveof investor expectations, such an outcome will disappoint investors and lead to further earningsdowngrades and potentially poor returns.

Note: Nominal GDP growth based on real GDP growth+ WPI inflation + adjustment for GDP deflator

Source: Bloomberg estimates; Analyst estimates

4 The comparison is not perfect as NIFTY includes public sector enterprises while in our analysis profit is only for the privatesector, which includes listed and unlisted companies. However, the comparison should still be directionally appropriate

NIFTY EPS(TTM)

GDP(Rs.billion)

EPSCAGR

GDPCAGR

FY02 62 22,790 FY02-08 24.2% 13.9%FY08 229 49,864 FY08-12 10.2% 15.6%FY12 338 89,122

GDPgrowth

NIFTY EPSgrowth

FY12-13 14.2% 15.3%FY13-14 15.1% 13.8%FY12-14 14.6% 14.6%



The purpose of this analysis is not to predict earnings downgrades but to highlight the drivers behindcorporate profits and the downside risk to investor expectations.

Global deleveraging – Has the process even begun?

Our previous letter (Jan 2012) had highlighted that after significant debt accumulation over decadesmost developed countries would likely go through an extended period of deleveraging, which wouldlead to slow global economic growth with its attendant impact on the Indian economy andcorporates. The graph below highlights that the process of deleveraging has barely even begun, withdebt-to-GDP for most countries having actually increased since the last crisis.

Source: The Absolute Return Letter (Apr 2012); Haver Analytics; national central banks; McKinsey Global Institute

We have no unique insights into how macroeconomic conditions globally will evolve over the nextfew years. However, it is important to recognize that there is a problem of excessive debt. Andpolicymakers, especially central bankers, are engaging in experimentation on a grand scale in orderto try and solve the problem. Irrespective of the merits of any particular policies, this has increasedrisk, with the range of outcomes skewed to the downside. Absent significant increases inproductivity, at best developed economies are likely to muddle through the next few years with sub-par growth, or at worst there may be significant dislocations in the financial system similar to the2008 financial crisis.



Portfolio positioning – Bargains still elusive

When managing your portfolios we have the following objectives in decreasing order of priority (1)to protect your capital, (2) to earn a high absolute return on your capital, and (3) to earn a return onyour capital in excess of market returns. Given the focus on capital protection there is a high hurdlefor an investment to find a place in the portfolio. With each investment we make, while theprobability of strong capital appreciation needs to high, the downside needs to be limited in case weturn out to be wrong. And we do expect to be wrong occasionally. It has been tough to find newideas that satisfy these criteria. As a result no new positions were added in the past quarter and wemerely added to some of our existing positions.

As of quarter end we were 37% net long (49% long, 12% short), with 51% of the portfolio in cash andequivalents (the short positions are via futures).

We remain optimistic about our current holdings. The estimated intrinsic value of our long positionsis about 50-80% above current market prices. Downside from current prices should be limited evenunder stress assumptions. For our short positions, even using optimistic assumptions we don’t seeintrinsic value much above current prices. As a base case we estimate intrinsic value to be 20-40%below current prices.

Stocks in the portfolio – No new positions

Piramal Healthcare and Gold (bullion plus jeweller) remain the two largest positions in the portfolio.Blue Star is now a slightly smaller position on account of price movements. The thesis behind theseinvestments is unchanged and you may refer to our previous letter (Jan 2012) for details. In thefollowing paragraphs we discuss two positions that we added to in the last quarter, both of whichare now reasonably large bets.

Manugraph India is a manufacturer of web offset presses. These presses are essentially used forprinting newspapers and so print media companies are the customers. The company has ~50%market share in India and ~70% in its primary product segment. The competitive environment isstable. Only competition is from imports and given the complex nature of the product there is nounorganized sector. Exports account for ~1/3 of revenues. Most competitors are located in high costgeographies; so as a low cost manufacturer there is room to take share in exports over time. Likemost capital goods the business is cyclical, in this case driven more by demand cycles than changesin supply. The stable competitive environment allows the company to earn in excess of its cost ofcapital over a cycle. The current demand environment for offset presses is not very strong andcurrent earnings probably understate normalized earnings power. On FY12 earnings the stock isselling at a P/E of ~4.5x with a net cash balance sheet, 5% dividend yield, and strong cash generation.We believe that the company’s intrinsic value is significantly higher and are happy to wait for themarket to come around to our point of view.



If a business with the following characteristics were up for sale, how much would you be willing topay for it? The company is a regulated monopoly operating at ~60% capacity utilization. Twocompetitors offering substitute products are running at full utilization and it is not possible to addcapacity. No new substitute products can be introduced. As a result there is a very high degree ofpredictability of demand, pricing, and costs. Revenues can be expected to grow at a minimum CAGRof ~10% (there could be volatility in a given year), driven by 5% volume growth and 5% priceincrease. Costs are mostly fixed, implying operating profit growth of 10-12%. Working capital isnegative and required capital expenditure is only maintenance in nature and well belowdepreciation, ensuring strong cash generation. The current net debt on the balance sheet can bepaid down with less than two years of cash flows. The most likely use of excess cash will be to paydown debt and pay out the remainder to shareholders as dividends. This business is available at~10x P/E, with an expected dividend yield of 8% in two years, by which time the balance sheet willbe net cash. And there is a kicker. The company was guaranteed a 20% compounded return oncapital by the government when it was set up. Based on management estimates (as stated in theannual report) the amount theoretically owed to them is about 5x the company’s current marketcap. If the government were to ever desire to end this monopoly there could be a lucrativesettlement deal. The company is Noida Toll Bridge, which operates a toll bridge between Delhi andNoida. It is not clear why the market is undervaluing this excellent business.

Portfolio performance – Reasonable in challenging market conditions

Since we started investing in June the portfolio is up 6.2% while our benchmark, the BSE500 index, isdown 6%.

The past quarter was particularly unfavourable as our holdings did not participate as much in thesharp market rally and higher prices made it even more difficult for us to deploy cash. In addition,our short positions appreciated significantly, which is not unexpected in such market conditions.While we anticipate declines towards intrinsic value for our shorts, we are well aware of the wisdomthat the market can stay irrational longer than an investor can stay solvent. Also, unless a business isin secular decline its intrinsic value goes up over time, which makes it difficult to be very patient witha short position. For these reasons shorts will remain a small part of our portfolio but we willcontinue to initiate positions if we see good opportunities.

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Cumulative Returns

NAV (pre-fee) BSE500 Index



A return of 6.2% (7.6% annualized) in not up to par. However, we remain hopeful of delivering muchbetter returns over a market cycle. If the estimated intrinsic values of our current holdings turn outto be broadly correct, these positions should drive meaningful appreciation in the value of theportfolio. We also hope to deploy cash in new ideas or to add to current positions in order to furtherincrease the prospective returns of the portfolio.

Gaurav JalanApril 15, 2012

avant garde wealth mgmt - quarterly letter - 1203

Economy & Finance