Avant Garde Wealth Mgmt quarterly letter - 1209

Avant Garde Wealth Management Pvt. Ltd.

Contents
Gold – An investment case for the yellow metal
Bull and bear markets – Where are we in the cycle?
Portfolio positioning – Cash position remains high
Stocks in the portfolio – Some more gold plating
Portfolio performance – Satisfactory so far

Dear investor,

Headlines have been positive in recent weeks. The government is making all the right noises. Market
pundits are increasing their targets for the stock indices and foreigners are showing their confidence
in Indian equities through large FII inflows. Popular discourse is that battles are being won and
victory in the war on slowing economic growth and falling stock markets is at hand. From our point
of view not much has changed from three months ago when we last wrote to you. At the margin we
are more worried about the macroeconomic environment and the stability of the global financial
system. This leads us into our first discussion topic for this letter.

Gold – An investment case for the yellow metal

In the investment world gold is often disparagingly referred to as the barbarous relic, a term coined
by Keynes in 1932. None other than Warren Buffet has sought to warn investors about the risks of
investing in gold. In the 2011 Berkshire annual report he says, “[gold is] currently a huge favorite of
investors who fear almost all other assets, especially paper money...[it] has two significant
shortcomings, being neither of much use nor procreative...if you own one ounce of gold for an
eternity, you will still own one ounce at its end...What motivates most gold purchasers is their belief
that the ranks of the fearful will grow”. Buffet goes on to state that “My own preference...[is for]
investment in productive assets...these investments will remain superior to nonproductive or
currency-based assets.” It is difficult to disagree with an astute investor like Buffett and his reasoning
is certainly sound. However, we believe that there are times when gold deserves a place in investor
portfolios and that we are currently living in such times.

Any currency is supposed to be both a medium of exchange and a store of value. Gold has had an
important historical role, as a currency, and also as part of the “gold standard” when the major
global currencies were convertible into gold. The gold standard effectively ended in 1933 when U.S.
President Roosevelt outlawed the private ownership of gold, which then no longer permitted
citizens to turn in their dollars for gold. There was still a semi gold standard under the subsequent
Bretton Woods agreement, which allowed other countries to sell their gold to the US treasury at
$35/oz. However, in 1971 this agreement was ended by U.S. President Nixon, thus moving to a
complete fiat currency system.

Under the gold standard the growth in money supply was effectively limited to the growth in the
stock of gold. By contrast, in a fiat currency system there are no limits, theoretical or otherwise, to
how much currency can be created. The decision to create money lies with policy makers and they
have used this power quite liberally over the last few decades. In such circumstances a currency

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


ceases to be an effective store of value. In the extreme, in cases when supply of money is so high
that there is hyper-inflation, the currency even ceases to be an effective medium of exchange.

Due to its legacy and limited supply growth gold is considered to be a good store of value by
investors and this is unlikely to change any time in the foreseeable future. So gold benefits from
higher inflation and higher inflation expectations. Inflation, defined as increasing prices of goods and
services, has been relatively low over the past few years in developed economies. However, this
definition is narrow and misleading. Inflation is simply the reduction in the purchasing power of a
given quantity of money over time. Thought of in this manner increase in prices of assets is also
inflationary. Income is either spent on consumption or saved, which is essentially deferred
consumption. Savings are parked in assets. Higher asset prices lead to lower prospective returns
from those assets1, which translates into a reduction in future purchasing power and is therefore
inflationary. So any increase in the quantity of money can lead to inflation either through higher
prices of goods and services or through higher asset prices.

As monetary authorities across the world have cranked up their printing presses, this has led to both
asset inflation and increase in prices of goods and services, albeit to differing degrees in different
countries, contributing to the bull market in gold over the last decade. This is illustrated by the graph
below, which highlights that the rate of expansion of central bank balance sheets picked up pace
significantly in the post-Lehman era.

Assets Total Assets for Major Central Banks (in USD billion) vs. Gold (USD/Oz) Gold
18,000 2,000
Sep'08 (Lehman)
16,000 Fed Asset CAGR (in USD): ECB Asset CAGR (in EUR): 1,800
Jan'95 - Sep'08 = 5.4% Jan'99 - Oct'11 = 9.8%
14,000 Sep'08- Oct'12 = 31.8% Oct'11 - Oct'12 = 34.6% 1,600
(Trigger point = Lehman) (Trigger point = Mario Draghi becomes Chairman)
12,000 1,400

10,000 1,200
Asset CAGR = 14.5%
8,000 Gold CAGR = 17.5% 1,000

6,000 Asset CAGR = 18.3% 800
Gold CAGR = 20.8%
4,000 600

2,000 400

- 200
Feb-02

Feb-03

Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Feb-12
Aug-02

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12
Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11
May-02

May-03

May-04

May-05

May-06

May-07

May-08

May-09

May-10

May-11

May-12

Total Assets Gold

Note: Major central banks include Fed, ECB, BOE, PBOC, BOJ, SNB
Source: Bloomberg, Central Banks, World Gold Council

From a supply perspective total annual gold supply from mines equals about 1.6% of the existing
gold stock. Despite the significant increase in gold prices over the past decade there has been no
supply response. Total annual production from mines is up only by about 10% in the last fifteen
years, primarily due to the lack of discovery of new gold deposits. Central banks have historically

1
Theoretically, it may be argued that although rising asset prices lead to lower prospective returns there may be no loss of
purchasing power if the rate of goods and services inflation itself falls. However, this is circular logic. For a given rate of
inflation lower returns by definition lead to lower purchasing power. The concept of capital gains as a benefit from rising
asset prices is also fallacious. In aggregate, capital gains cannot add to returns as it is merely the transfer of assets from
one owner to another. As long as the underlying value of an asset (derived from cash flows) does not change capital
appreciation merely front loads the returns from an asset



added to supply as net sellers of gold from their reserves. However, central bank gold reserves have
been increasing after bottoming in 2009 (see chart below), which means central banks have become
net buyers of gold and a source of demand in recent years2. Fabrication demand (jewellery and
industrial) has remained relatively stable over the years at ~50% of total annual supply. The
remaining demand comes from investors, which should again hold up relatively well in the current
environment. In short, the physical gold market should remain well supported by lack of material
increases in supply and stable demand growth.

Total Central Bank Gold Reserves (Tonnes)
34,000

33,000

32,000

31,000

30,000

29,000

28,000

Source: World Gold Council

Gold does not produce any cash flows and so is not amenable to traditional valuation tools.
However, there are a few different ways to think about what the price of gold could be in the future.
At current price of $1780/oz, the total gold reserves held by central banks make up about 11% of
their total assets. So theoretically if the entire central bank reserves were to be backed by gold, as
was the case under the gold standard, the price of gold would be greater than $15000/oz3. Another
approach is to look at what the price would be if the total assets of central banks were backed by the
total stock of gold in the world, rather than just the gold owned by central banks. In this case the
price of gold would be greater than $3000/oz4.

History is littered with examples of countries where significant debasement of currencies ended in
disaster. This is because the corrosive effects of inflation tend to increase inequality and make
societies more prone to instability. In the past there have been individual countries that have
suffered from this malaise at any given point in time. It may be for the first time in history that
countries that comprise the majority of the world’s GDP are simultaneously engaged in money
printing on such large scale, and that in a world that is more integrated than ever before. We do not

2
The incremental buying has mostly come from central banks of developing economies (China, Russia, India, Thailand,
Turkey, South Korea, Saudi Arabia, Mexico, etc.). This trend could perhaps be construed as a lack of faith in the monetary
policies of the developed world in the post-Lehman era
3
Total central bank gold reserves as of Q2 2012 is 31142 tonnes (World Gold Council), which translates into 1.1 billion
ounces. Assets of the major central banks (Fed, PBOC, BOE, ECB, BOJ, SNB) is $14.4 trillion as of Oct 2012. Assuming total
global central bank assets is 120% of this figure, the implied gold price is $15729/oz
4
Total stock of gold mined till date is 171300 tonnes (World Gold Council). Assuming 90% of gold ever mined is available,
the gold stock is 5.44 billion ounces. In order to back the entire global asset base of central banks as calculated above the
implied gold price would be $3177/oz



expect economic Armageddon and are not preparing for such an eventuality. However, it would be
foolish to not recognize the risks posed by this huge monetary experiment and to take some steps to
protect the portfolio in case current policy experiments have unintended adverse consequences.

So far we have been focusing on the prospects of the gold price in Dollars. If one owns gold in
Rupees then the Rupee/Dollar exchange rate also plays a role in future returns. This is a topic we
discussed in our June 2012 letter. As long as inflation in India remains ahead of inflation in the USA,
the Rs/$ exchange rate will need to depreciate over time to maintain Purchasing Power Parity.
Hence the probability that the Rupee price of gold will lag the Dollar price of gold over the next few
years does not seem very high.

The analysis of gold as an investment would be incomplete without considering its attractiveness
relative to equities. A crude way of looking at this relationship is via a time series of the ratio of the
Sensex to the price of gold, which is illustrated in the chart below.

Sensex / gm of Gold
2.40

2.20

2.00

1.80

1.60

1.40

1.20

1.00

0.80

0.60

0.40
Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Source: BSE India; World Gold Council

Based on the historic relationship between gold and the Sensex, currently gold looks overpriced
compared to Indian equities. This implies that investors should sell gold and buy equities. However,
the choice is not binary. Investors can own equities and still invest some portion of their portfolios in
gold. This is the path we advocate due to the reasons discussed above.

Bull and bear markets – Where are we in the cycle?

Simplistically, at any given point in time equity markets can be thought of as being in a bull market
or a bear market. A bull market can broadly be defined as one where the indices make new highs
over an extended period of time accompanied by P/E multiple expansion. On the flipside bear
markets can broadly be defined as a significant fall in the indices over an extended period of time
accompanied by P/E multiple contraction. In our Dec 2011 and March 2012 letters we analyzed
historic data to highlight that it is P/E multiples and not earnings growth that are the primary driver
of bull and bear markets.



After closing at a high of 21000 on Nov 5th 2010 the Sensex5 has yet to regain that level. So a bear
market can be said to have started on that date. Let’s look at the progression of the index itself and
corresponding P/E multiples for this bear market as compared to previous ones6.

Sensex Bear Markets Progression
0%
Did the bear market end here?
-10%

-20%

-30%

-40%

-50%

-60%

-70%
108
120
132
144
156
168
180
192
204
216
228
240
252
264
276
288
300
312
324
336
348
360
372
384
396
408
420
432
444
456
468
480
492
504
516
528
540
552
564
576
588
600
612
624
636
648
660
672
684
696
708
720
732
744
756
768
780
792
0
12
24
36
48
60
72
84
96

Number of Trading Days

Sep 94-Dec 96 Aug 97-Nov 98 Feb 00-Apr 03 Jan 08-Mar 09 Nov 10-Present

Sensex Bear Markets P/E Progression
40

35

30

25
Did the bear market end here?

20

15

10
108
120
132
144
156
168
180
192
204
216
228
240
252
264
276
288
300
312
324
336
348
360
372
384
396
408
420
432
444
456
468
480
492
504
516
528
540
552
564
576
588
600
612
624
636
648
660
672
684
696
708
720
732
744
756
768
780
792
0
12
24
36
48
60
72
84
96

Number of Trading Days

Sep 94-Dec 96 Aug 97-Nov 98 Feb 00-Apr 03 Jan 08-Mar 09 Nov 10-Present

Source: BSE India

In the period since Nov 5th 2010 the Sensex closed at a low of 15175 on Dec 5 th 2011 and is higher
since then. So a pertinent question is whether the bear market ended on that date or whether the
index is still in a bear market. If the bear market ended on Dec 5 th 2011, compared to the prior four
bear markets this would have been the shortest bear market at only 277 trading days from high to
low. It will also be by far the shallowest bear market with a peak to trough correction of only 28%
compared to 40% or more in prior instances. Previous bear markets have ended at TTM P/E’s of
between 10-13x7. On Dec 5th 2011 the Sensex TTM P/E was significantly higher at 16.2x.

5
For this analysis it is preferable to use a broader based index that includes a larger number of stocks rather than the
Sensex which includes only 30 stocks. However, the reason for using the Sensex is that it has the longest time series data
available. The difference with other broader indices like the Nifty or CNX500 is also not significant for the purpose of this
analysis over comparable periods
6 th
There was a significant change in the composition of the Sensex on April 10 2000, which caused the index P/E multiple
to rise by 50% on that day. In order to make the data comparable, for the Feb’00-Apr’03 bear market P/E data, the pre
th th
April 10 2000 P/E multiple have been adjusted upwards proportionately. A similar change happened on June 13 1995
th
and the P/E data for the Sep’94-Dec’96 bear market pre June 13 1995 has been similarly adjusted
7
We prefer to use TTM (Trailing Twelve Month) P/E ratios for our analysis. While forward P/E ratios are commonly used,
the accuracy of forward multiples depends on the accuracy of forward earnings estimates. Historically, consensus EPS
estimates have been prone to significant revisions and hence our preference for a more “accurate” valuation metric



It is not by accident that bear markets tend to suffer sharp peak to trough corrections and end only
when P/E multiples contract to low absolute levels. This is the outcome of a process where investor
sentiment moves from extreme optimism to extreme pessimism. Extreme pessimism is reflected in
stock prices in the form of low valuation multiples, with investors fearing what lies ahead and thus
becoming very cautious about the prices they are willing to pay. It is this very fear that then lays the
foundation for the next bull market. Conversely, if investor sentiment does not become pessimistic
enough, as reflected by peak to trough corrections and P/E multiples, then it could be argued that
the underpinnings of a sustained bull market advance are not present.

Using history as a guide it is not clear that the bear market ended in December 2011. But there are a
few reasons why history may not be an appropriate guide. First, the sample size is quite small and
may not truly capture the range of possible outcomes. This is a valid observation. Second, it could be
that money printing by central banks has put a floor under asset prices and limited the severity of
this bear market. This is a more tenuous observation as its theoretical validity is questionable and
historical evidence is limited. Also, the words “this time is different” have proven be quite expensive
for investors historically.

Portfolio positioning – Cash position remains high

We continue to hold a sizeable cash position in the absence of compelling investment opportunities
that meet our risk/return criteria. No new positions have been added during the quarter. This is not
really a cause of concern for us. If we can find three to four compelling investment ideas every year
that should be adequate to help us generate strong overall portfolio returns. Independent of broad
economic trends, at any given time there is volatility in the operating environment of certain
companies, either due to business specific issues or due to industry wide issues. This leads to
changes in earnings trajectories, which translates into volatility in stock prices. We are confident that
this volatility in individual stocks will remain an ongoing feature, irrespective of overall market
trends. As long as we understand the underlying value of a business, and remain vigilant to identify
substantial deviations from that value, we should be able to find investment opportunities
periodically. In the interim we prefer to remain patient.

As of quarter end September 2012 we were 47% net long (62% long, 15% short), with 38% of the
portfolio in cash and equivalents (the short positions are via futures)8.

We estimate that the long positions in aggregate have 50%+ upside to their intrinsic value under
base assumptions. Even under stress scenarios the aggregate intrinsic value is only 5-10% lower than
current prices, indicating limited risk of capital loss. For our short positions we estimate intrinsic
values 30-50% below current prices and believe that the stocks are trading at a premium to even
optimistic estimates of intrinsic value.

8
In our earlier letters we mistakenly understated the long position (and hence also the net long position) by 3-4%



Stocks in the portfolio – Some more gold plating

Piramal Healthcare remains the largest position in the portfolio. We have added to our gold (bullion)
position during the quarter, making it the second largest position. The other large positions of
roughly equivalent size are Blue Star, Noida Toll Bridge, Manugraph, SunTV and Thangamayil
Jewellery. The investment rationale for Thangamayil is discussed in more detail below.

Thangamayil is a retailer of gold jewellery. For some time the company’s only outlet was its flagship
store in Madurai (in the state of Tamil Nadu). However, over the last few years they have been
expanding aggressively into smaller towns in Tamil Nadu, where they are often the only branded
retailer. Their key competitive advantage lies in leveraging the trust associated with the brand to
gain market share. The top line is driven by both volume, which has more than doubled in five years
given the expansion, and gold price. Since the company keeps inventory, the primary driver of
profitability is inventory gain from increases in gold prices. Rising gold prices ensures very high
return on equity, which has averaged 40% over the last seven years, but also makes the growth
trajectory quite volatile. The stock trades at 4.7x TTM P/E and 2x TTM P/B with a 3% dividend yield.
Thangamayil is an indirect way to benefit from our positive outlook on gold prices. In a rising gold
price environment the business should be able to comfortably maintain a 30%+ earnings growth
trajectory along with 40% ROE. Incrementally, the company is leasing most of its gold inventory,
which will mitigate the impact of changes in gold price but also make the business more capital
efficient. This merits a standalone investment case for the company, along with being a proxy for the
gold price.

Portfolio performance – Satisfactory so far

Since we started investing in June 2011 the portfolio is up 11.2% while our benchmark, the BSE500
index, is up 0.2%.

Cumulative Returns
15%

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

NAV (pre-fee) BSE500

Clearly our portfolio did not benefit much during the most recent leg of the market rally. This is
similar to the trend witnessed in Jan-Mar 2012 and is not unexpected. The stocks we own generally
do not tend to be those that market participants rush into in order to benefit from bursts in positive
sentiment. Our substantial cash position also acts as a drag on returns in rising markets. In case the



economy actually shows improvement we expect that to be reflected in the stock prices of the
companies we own, helping drive them up to their intrinsic values.

The two short positions continue to be a substantial drag on portfolio performance till date. As
prices have moved against us we have spent a lot of time revisiting our theses. As discussed before,
our initial evaluation of these businesses was too pessimistic and they have performed better than
expected. Both the short positions also happen to be participants in certain themes that are in
favour with investors. In hindsight we would not have initiated these short positions at the prices we
did. Today, however, the prices are much higher and we would be willing to initiate short positions
at current prices. Hence we are willing to hold on to our shorts for now.

Since we invest in listed equities short term volatility in markets does impact us, either through
changes in the prices of stocks we own or as a determinant of investment opportunities available to
us. The attempt is to use this volatility to our advantage in order to deliver on our goal of protecting
your capital and delivering high absolute returns over market cycles.

Gaurav Jalan
October 14, 2012


Avant Garde Wealth Mgmt quarterly letter - 1209

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