avant garde wealth mgmt quarterly letter - 1206

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

ContentsExchange rate – Is the sharp depreciation in the Rupee an aberration?Investment vs. consumption growth – History tells us the two do not diverge for longPortfolio positioning – Ongoing search for bargainsStocks in the portfolio – No material changesPortfolio performance – So far so good

Dear investor,

You will notice that we have listed the contents of the letter up front, which will be an ongoingfeature. This will help you select particular sections for reading in case you have limited time on yourhands. Some of you have commented that the text seems lengthy and not everything is focused onaspects of the portfolio. We believe successful investing requires going beyond analysis of individualsecurities and thinking about the broader context and how various pieces of the puzzle fit together.Companies and industries do not exist or grow in isolation, but in particular economic, social andpolitical contexts. In trying to understand these better, with an emphasis on the economic contextwhere our expertise lies, we endeavour to continuously add to our “latticework of mental models”,as Charlie Munger has put it. If we neglect to do this we fear that we heighten the risk of picking thebest houses in a neighbourhood that may be about to turn bad. Through the commentary we aim toshare some of our insights with you.

Exchange rate – Is the sharp depreciation in the Rupee an aberration?

Given the sharp depreciation of the Rupee in the last year there has been a fair bit of discussion onthis topic in various quarters, with an expected diversity of opinion. We do not wish to add to thenoise and certainly will not try to predict how the currency is going to move over the next fewmonths. However, we do attempt to identify a framework that potentially explains currencymovements over longer periods of time.

The framework is referred to as Purchasing Power Parity. The following is an excerpt from acomment by John Hussman1. “An exchange rate is just the price of a currency. So a given foreigncurrency might be quoted as so many dollars per unit ($/FC). If you look at a currency as a means ofexchange, you can say, "this basket of goods costs $20 in the U.S., and the same basket costs FC10 inthe foreign country, so the exchange rate should be $20/FC10 = 2.0 $/FC." And even if you don'thave identical baskets of goods, you can get a reasonable idea of the "long term" tendency of thecurrency by tracking the movements of price indices in two countries. This is what traders refer to asthe "Purchasing Power Parity" (PPP) value of the exchange rate.”

There are multiple theories on exchange rates but purchasing power parity is generally recognized asthe bedrock around which economists have built some variations. Logically, the PPP framework doesmake a lot of sense. However, again quoting Hussman, “PPP is only a tendency that holds loosely

1 John Hussman is President of Hussman Investment Trust (www.hussmanfunds.com). This is from his weekly marketcomment dated Sep 22, 2000

www.hussmanfunds.com



over the long term”. Over the short term, which could run into many years, exchange rates areinfluenced by many other factors such as interest rate differentials, the Balance of Payments, etc.

Below are charts that track the movement of the nominal exchange rate of the Rupee in four majorglobal currencies versus the calculated PPP exchange rate. The PPP calculation has been done usingthe GDP deflator for each country as a proxy for inflation2. Note that the absolute level of the PPPexchange rate depends on the starting point. The implicit assumption in the graphs is that theexchange rate was at its PPP value at the starting date. If the exchange rate was under or overvalued at the starting point the entire PPP line would move up or down proportionately. Hence thegraphs are more useful in analyzing changes in the nominal exchange rate versus the PPP exchangerate rather than pinning down degree of over or under valuation vs. PPP at any given point in time.

Source: Exchangerate.com; Various government agencies

Looked at from this perspective the recent sharp depreciation of the Rupee does not seemparticularly surprising. Focusing on the Rupee-Dollar graph you will observe that from mid-2002 tomid-2011 the exchange rate appreciated by ~10% while the PPP exchange rate depreciated by morethan 30%. The rupee would have had to be ~40% undervalued in mid-2002 in order to be fairlyvalued in mid-2011. It is unlikely that such a high degree of mispricing existed and so the recentdepreciation should be put in the context of the sharp appreciation the currency saw over theprevious nine years relative to its PPP value. The exchange rate movements versus the othercurrencies can be analyzed in a similar vein. The important take away here is that if inflation in Indiacontinues to outpace other countries it should not surprise anybody if the Rupee depreciates over

2 Deflator figures for Q2 2012 are estimates. Exchange rate as on July 25, 2012 is used for June 2012 quarter. Data beforeJune 1996 is not used as the Rupee only effectively became a floating currency in the mid-1990s

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PPP exchange rate (Rs/Yen) Exchange rate (Rs/Yen)

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PPP exchange rate (Rs/Eur) Exchange rate (Rs/Eur)



time. History shows that the moves may come in fits and starts but the long term tendency will betowards depreciation.

Investment vs. consumption growth – History tells us the two do not diverge for long

In our January 2012 letter we had talked about how consumption related stocks had significantlyoutperformed infrastructure and capital goods companies. Digging a bit deeper into the drivers ofthis trend is quite insightful. The chart below plots annualized growth in investment vs. growth inconsumption3. The growth has been calculated on a 3-year rolling basis to smoothen out annualvolatility and identify trends.

Source: Reserve Bank of India database

Note that the change in growth in consumption and investment generally moves in the samedirection, i.e., if growth in investment goes up from say 8% to 10%, consumption growth also tendsto rise in the corresponding period. The shaded areas represent periods in history when thisrelationship has diverged for a period of more than one year. From 1966 to 1968 the growth rate ofconsumption increased while the growth rate of investment decreased. This was followed by a sharpdecline in rate of growth of consumption in the following years. From 1992 to 1994 the growth rateof consumption remained stable while the growth rate of investment declined. This divergence wascorrected by a subsequent sharp pick up in the growth rate of investment. The period from 2008 to2012 has seen growth rate of consumption stay stable while growth rate of investment has declinedsubstantially. While drivers of the divergence may vary in each period, the most recent instance ofconsumption remaining high despite a fall in investment seems to be driven by a substantial increasein government expenditure, as reflected in the sharp increase in the government deficit since 2008.This is something we discussed in our April 2012 letter in the context of corporate profit margins.

If history is a guide this recent divergence in growth rates should correct soon, requiring either asharp pick up in rate of growth of investment or a sharp decline in rate of growth of consumption. Sofar investment does not seem to be picking up and there are signs of moderating consumption

3 The growth in investment, plotted on the RHS, is at a scale of 2x the growth in consumption

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Growth in consumption (3yr roll) (LHS) Growth in investment (3yr roll) (RHS)



growth. Consumer related stocks by and large still command a meaningful valuation premium bothrelative to their own history and compared to other sectors and the broader indices. So while thereare undoubtedly some good businesses that cater to various needs of the Indian consumer it isimportant to keep this context in mind while evaluating these stocks as potential investments.

Portfolio positioning – Ongoing search for bargains

At current prices it remains difficult to find new investment ideas that offer high return potentialover the next few years while at the same time minimizing risk. In other words, true bargains remainscarce. We have emphasized in our past communication that trying to limit risk is a key aspect of ourinvestment process. The best definition of risk that we have come across is “risk means more thingscan happen than will happen”. When evaluating a business it is critical to contemplate the range ofoutcomes that can reasonably materialize in the future, including adverse scenarios, and evaluatethe price of the security in that context. Theoretically, each outcome can be associated with aparticular fair value and the probability weighted set of such values can throw up an estimatedintrinsic value of the security. This is nice in theory but in practice this approach is built on manyassumptions, and arriving at a single precise number for intrinsic value can introduce anchoring bias,where an investor anchors around a particular number and has a tendency to ignore factors thatsuggest any variations from that figure. We prefer to make an investing decision by consideringwhere the price of the security lies within our range of contemplated outcomes. Currently, for manyof the stocks we evaluate, prices are not very far from intrinsic value assuming stable businessconditions. However, under somewhat more pessimistic views of the future, intrinsic values areoften well below current prices. Ideally, we look to buy stocks at prices where the market is alreadybuilding in a pessimistic outlook, allowing us to participate in the upside if the future turns out to bebright, while limiting our losses if the future is indeed unfavourable for the business.

As of quarter end June 2012 we were 41% net long (53% long, 12% short), with 47% of the portfolioin cash and equivalents (the short positions are via futures).

We estimate that the long positions in aggregate have 50%+ upside to their intrinsic value underbase assumptions. Even under stress scenarios the aggregate intrinsic value is only 5-10% lower thancurrent prices, indicating limited risk of capital loss. For our short positions we estimate intrinsicvalues 20-40% below current prices and even in optimistic scenarios we do not see intrinsic valuesubstantially above current prices.

A common thread across most of our current holdings is that they are relatively good businesses,defined as those that can consistently generate high Returns on Equity (or Returns on Capital). Mostof the stocks we own should be able to generate 20%+ ROEs over a period of time. All else equal wewould always prefer to buy a good business as by definition they tend to compound their intrinsicvalue at high rates over time. However, all else is often not equal and sometimes relatively lowerquality businesses can sell for substantial discounts to intrinsic value, making them worthwhileinvestments. So we tend to look for opportunities in both categories.



Stocks in the portfolio – No material changes

Piramal Healthcare is now the largest position in our portfolio given price movements. Gold (bullionplus jeweller) is the second largest position. The other large positions of roughly equivalent size areBlue Star, Noida Toll Bridge, Manugraph, and SunTV. Our past letters discuss the investment thesisbehind each of our positions in detail. SunTV was a small position previously, which we added toconsiderably in the current quarter when the stock price corrected sharply. The investment rationaleis discussed in more detail below.

SunTV is a dominant television network in South India, especially in the state of Tamil Nadu, wheretheir market share is in excess of 70%. Favourable political patronage probably played a large role inachieving this dominance, but it is tough for competitors to now gain share given SunTV’s significantadvantage in content, with exclusive rights to the vast majority of movies produced through the lastfew decades. The business has been a free cash flow generating machine in the past and deliveredROEs in excess of 30% in spite of significant surplus cash on the balance sheet. A change in thepolitical equations in Tamil Nadu in the recent past has created uncertainty. However, the actualimpact on the business seems limited with market share stabilizing after a small decline. With thestock trading at 16x TTM P/E on what are depressed earnings considering the weak advertisingenvironment, the market is clearly discounting significant negative impact on business performancedue to political troubles. This uncertainty provides an opportunity to buy a good franchise at veryattractive valuations. If market fears turn out to be accurate there may not be much money to bemade here but the downside should be limited. If the business emerges unscathed there should besignificant upside from these prices.

Portfolio performance – So far so good

Since we started investing in June 2011 the portfolio is up 10% while our benchmark, the BSE500index, is down 7%.

Barring one exception, all our long positions have generated positive returns so far. This trendshould continue if we are correct in our assessments and prices of our holdings continue to move uptowards their intrinsic values.

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The short positions, however, have been a significant drag on portfolio performance till date. We arewilling to wait out adverse price movements in the short term. However, it does seem that ourassessment of the intrinsic values of these securities was a bit too pessimistic initially and we alsounderestimated the impact of potential positive catalysts and an improvement in overall marketsentiment on prices. However, the core thesis for the short positions does not seem broken yet andso we are willing to have some more patience to see if our theses play out as expected.

So far we have succeeded in protecting capital in adverse market conditions and generatedreasonable relative and absolute returns in the process. We remain optimistic that we can delivermuch better results over a market cycle.

Gaurav JalanAugust 5, 2012

avant garde wealth mgmt quarterly letter - 1206

Economy & Finance