Avant garde wealth mgmt quarterly letter - 1212

Avant Garde Wealth Management Pvt. Ltd.

Contents
Interest rates likely to decline – Does it matter for equity markets?
The big picture – Fragility + Complacency
Portfolio positioning – Continue to tread cautiously
Stocks in the portfolio – Larger bet on gold
Portfolio performance – Acceptable

Dear investor,

The past quarter has been another good one for Indian equity markets, closing out a very positive
year with about 30% returns on market indices. These positive returns came in the face of
circumspect forecasts by analysts in December 2011 for the year ahead. This is but one example of
why forecasting, especially over short time periods, is futile in the equity markets. One consensus
forecast at this time is that the RBI is on the verge of cutting interest rates and that this will aid
equity returns. We begin this letter by weighing this conclusion against the empirical evidence.

Interest rates likely to decline – Does it matter for equity markets?

It is a commonly held belief that lower interest rates are good for equity returns and vice versa.
Mathematically, changes in equity prices are a function of changes in earnings and changes in the
P/E ratio. So we can consider the impact of interest rates on each of these two components
separately in order to determine how changes in interest rates correlate with equity returns.

The “Fed Model” (referring to the US central bank) is a commonly accepted theory among the
investment community. The theory states that lower yields on long dated government bonds
correspond with a higher P/E ratio and conversely higher yields correspond with a lower P/E ratio.
The underlying logic is simply that a lower discount rate for future earnings implies a higher P/E
ratio. Let’s examine the empirical basis of this claim.

Stock valuation and Bond Yields (1998-2012)
13%

12%

11%
G-Sec 10yr Yield

10%

9%

8%

7%

6%

5%

4%
10 15 20 25 30 35

CNX500 Index P/E (Trailing Twelve Months)

Source: NSE; Bloomberg

The graph above is a scatter plot of the P/E on the CNX500 Index against the prevailing 10 year G-Sec
Yield at various points in time. It should be obvious that for Indian markets there has been no
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


meaningful correlation between interest rates and P/E ratios. In fact, if a trend line is force fitted on
the above data it has an upward slope, implying that historically interest rates have been loosely
positively correlated with P/E ratios. This result may seem counter intuitive but there is a logical
explanation. The discount rate is only one variable that drives the P/E ratio. The other variable is the
future stream of earnings or cash flows. If lower interest rates correspond with a deteriorating
outlook for future earnings, the P/E ratio may not necessarily go up, and vice versa. Even though the
“Fed Model” originated in the US, the suggested inverse relationship between bond yields and P/E
ratios only held in the US for a relatively limited period from the early 1980s till the late 1990s, which
saw a continuous decline in bond yields corresponding with increasing P/E ratios1. However, in the
twelve years since 2000 the decline in bond yields has continued relentlessly while P/E ratios have
also declined substantially.

Common sense suggests that lower interest rates should lead to a lower interest burden for
corporates and also give them an incentive to invest more, thus leading to both higher economic
growth and higher corporate profits, and in turn higher equity prices. Indeed this has been the
argument put forth by various sections of industry, the government and the investment community,
who have been calling on the RBI to cut rates for some time now. Since the evidence suggests that
lower interest rates do not correspond with higher P/E ratios, we can consider next how changes in
bond yields have correlated with corporate profit growth in the past.

Change in Bond Yields and EPS growth (1998-2012)
-Sec 10yr Yield (prior 6 mt hs)

2.0%

1.0%

0.0%

-1.0%

-2.0%
Change in G

-3.0%

-4.0%
-5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

CNX500 EPS growth (2-yr forward CAGR)


For a given point in time, the above graph plots the change in bond yields over the prior six months
against the subsequent two year forward CAGR in corporate earnings2. Again, it should be evident
that there is no relationship between the change in bond yields and subsequent earnings growth. As
an aside it is interesting to note the asymmetry in the y-axis, where the maximum magnitude of
decline in interest rates over a six-month period is double the magnitude of the maximum increase.

1
See John Hussman in “Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios (Aug 2007)” for a
detailed empirical analysis of the Fed Model at http://www.hussmanfunds.com/wmc/wmc070820.htm
2
A two year forward EPS CAGR (using trailing twelve month earnings) is used in order to account for the commonly
recognized lag effect of monetary policy



This shows that policy makers have been much more aggressive in cutting interest rates that raising
them.

Analysis of the underlying drivers indicates that falling interest rates have no correlation with future
equity returns. We can also directly evaluate the relationship between changes in bond yields and
equity returns. Once again, as the graph below demonstrates, no such correlation exists3.

Change in Bond Yields and Index Returns (1998-2012)
-Sec 10yr Yield (prior 6 moths)

3.0%

2.0%

1.0%

0.0%

-1.0%

-2.0%
Change in G

-3.0%

-4.0%
-60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140%

CNX500 Index (1-yr forward return)


There is a prevailing consensus in most quarters that RBI policy has been hawkish. In their latest
policy announcement the RBI has indicated that its focus is shifting from inflation control to growth,
suggesting that interest rate cuts are likely given the slow economic growth trajectory at present.
Before closing an analysis of how a decline in interest rates could impact the equity markets, it is
interesting to consider whether the RBI has been hawkish in the first place.

12%
1-yr G-Sec Real Yield (WPI)
10%
1-yr G-Sec Real Yield (CPI)
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
-12%
Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12
Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12
Apr-01

Apr-02

Apr-03

Apr-04

Apr-05

Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Source: Bloomberg; RBI

The graph above plots real bond yields4 over the last twelve years, calculated both on the basis of
WPI inflation and CPI inflation5. It shows that real interest rates have been below 2% and mostly

3
Note that the cluster of data points on the bottom right relate to the late 2008 and early 2009 period when bond yields
had fallen aggressively and equity markets rose substantially in the subsequent year



negative for the better part of the past decade. While the appropriate level of real interest rates for
the Indian economy may be up for debate, it seems clear that real rates have been much too low
during this period.

35% 7%
Rupee Securities % of Total RBI Assets

Rupee Securities % of Total RBI Assets
Rupee Securities % of GDP
30% 6%

Rupee Securities % of GDP
25% 5%

20% 4%

15% 3%

10% 2%

5% 1%

0% 0%
Ma r-06

Ma r-07

Ma r-08

Ma r-09

Ma r-10

Ma r-11

Ma r-12
Ma y-06

Ma y-07

Ma y-08

Ma y-09

Ma y-10

Ma y-11

Ma y-12
Dec-05
Oct-05

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12
Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12
Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12
Source: RBI

In addition to maintaining low real interest rates, the graph above shows that the RBI has been
monetizing government debt ever more aggressively, significantly stepping up its purchases from Jan
2010 onwards. In the last seven years the stock of government debt on the RBI’s balance sheet has
grown at a CAGR of 40%, in the process increasing from 5-10% of assets to 25% currently. As a result,
over this period the amount of total outstanding central government debt owned by the RBI is up
from about 6% in 2005 to about 16% currently. Through this monetization the RBI has been funding
the fiscal deficit to the tune of about 1% of GDP every year over the last three years. So while the
perception is that the RBI has been hawkish and maybe kept monetary policy too tight and for too
long, these data points suggest otherwise. If monetary policy has already been loose it is
questionable whether further loosening will help or harm the economy, but that is perhaps a topic
of discussion for another letter.

The big picture – Fragility + Complacency

In the past we have highlighted the high and increasing level of debt in the global economy in recent
years, and the fact that this increase in debt seems to be facilitated and supported by rapidly
expanding central bank balance sheets. The future implications of this dynamic continue to be of
great concern to us. This issue is well recognized and discussed by the media and the investment
community. However, for one reason or another it does not seem that these concerns are actually
discounted in asset prices.

4
The real yield is calculated by adjusting the nominal 1-yr G-sec yield at a given time by the subsequent actual increase in
the inflation index over the following year. In order to calculate the real yields from Jan 2012 onwards CPI inflation has
been assumed to decline to 8.5% by Dec 2013 from ~10.5% currently and WPI inflation has been assumed to decline to 7%
by March 2012 and subsequently rise to 7.5% by Dec 2013
5
From 2008 onwards there has been a meaningful divergence between WPI and CPI, with CPI inflation running well ahead
of WPI inflation. For CPI estimates, the CPI (industrial workers) Index has been used till Jan 2011, after which the new
combined CPI Index has been used



Frag•ile (adjective): (a) easily broken or destroyed (b) constitutionally delicate, lacking in vigour

In the words of fund manager Kyle Bass of Hayman Partners, “the total credit market debt-to-GDP
globally is 350 percent. It's 200 trillion dollars' worth of debt against global GDP of roughly 62
trillion”. He also points out that in the past global debt to GDP has only approached 250% when
countries were preparing for war6. And these figures do not include off-balance sheet liabilities such
as social security and unfunded healthcare and pension costs, or unofficial lending (significant in
countries like China), which would take the ratios much higher.

Central Bank Assets % of GDP
35%

30%

25%

20%

15%

10%
Ma y-02

Ma y-03

Ma y-04

Ma y-05

Ma y-06

Ma y-07

Ma y-08

Ma y-09

Ma y-10

Ma y-11

Ma y-12
Aug-02

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12
Feb-02

Feb-03

Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Feb-12
Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12

Note: Countries included in this analysis are USA, Europe, UK, China, Japan, and Switzerland
Source: Bloomberg

The significant increase in global debt levels have probably been facilitated by the fact that central
banks have turned to quantitative easing in a big way and have been buying increasingly large
portions of the debt issuances.

6
Excerpts from a talk given at the University of Virginia Darden School of Business Investing Conference in Nov 2012



Despite this huge debt funded stimulus, global economic growth is tepid and weakening.

Source: JP Morgan Global Manufacturing and Services PMI; Markit Economics

Com•pla•cen•cy (noun): (a) self-satisfaction especially when accompanied by unawareness of actual
dangers or deficiencies (b) an instance of usually unaware or uninformed self-satisfaction

A popular index created by the Leuthold Group7 (an institutional research firm) indicates that risk
aversion is currently at historic lows. Using a more popular measure of risk such as the VIX Index
(plotted below) also indicates very low risk aversion among market participants.

CBOE VIX Volatility Index
90

80

70

60

50

40

30

20

10

0
Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12
Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Jan-13
Apr-04

Apr-05

Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Source: CBOE

7
www.leutholdgroup.com



Howard Marks, Chairman of Oaktree Capital, sums up current investor attitude quite appropriately
in his memo dated January 7, 2013. He writes “...while few people are thinking bullish today, many
are acting bullish. Their pro-risk behaviour is having its normal dangerous impact on the markets,
even in the absence of pro-risk thinking. I’ve become increasingly conscious of this inconsistency in
recent months, and I think it is the most important issue that today’s investors have to confront.”

Portfolio positioning – Continue to tread cautiously

The portfolio continues to reflect our caution when evaluating potential investment opportunities.
As a result the cash position remains high. Among value investors there is often a debate about the
importance of macro trends in investment decision making. The majority view is that prudent stock
selection is all that matters since macro trends are difficult to understand and therefore should be
largely ignored. We differ from this viewpoint. It would be naive to believe that irrespective of the
overall macro environment and level of asset prices, good stock selection will deliver similar results.
It is particularly important, and very possible, to identify unsustainable macroeconomic trends as
these can have a significantly disruptive impact on individual companies, industries, and countries
when they change direction. While the timing of such changes is indeed very difficult to predict, the
outcome is generally not. In the words of Herbert Stein8 “If something cannot go on forever, it will
stop.” As an example, consider what happened to investors in home building stocks in the USA
during the 2008 crisis. Prior to 2008 an intelligent bottom-up focused investor could have picked a
well run home building business that had generated high returns on capital over a long twenty year
history, and looked cheap on various valuation metrics compared to its own past and its peers.
However, by ignoring or overlooking the fact that industry sales had been growing at an
unsustainable rate, at the very time of making the investment it was virtually guaranteed that the
investor would lose money when the trend changed, with only the timing being uncertain.

Despite talk of caution, in our analysis stocks in general continue to price in reasonably optimistic
outcomes for the future. Take the example of the Medium and Heavy Commercial Vehicle industry
in India. With sales volumes declining by more than 20% YoY, the industry has been going through
some tough times to put it mildly. Yet stocks whose profitability is correlated to the industry have
generally not suffered commensurately and are still well above their historical valuation lows. This
indicates that investors are willing to look through the down cycle and are predicting better times
ahead. This prediction may indeed turn out to be accurate. The conundrum, however, is that by
investing at current prices there will probably not be much money to be made if the rebound
materializes. But much money may be lost if the rebound is delayed or the upturn is not as strong as
expected. We prefer to wait for such skewed risk-reward trade-offs to turn in our favour before we
commit your capital.

As of quarter end December 2012 we were 56% net long (71% long, 15% short), with 29% of the
portfolio in cash and equivalents (the short positions are via futures).

8
This statement if popularly referred to as “Herbert Stein’s law”. For more visit http://en.wikipedia.org/wiki/Herbert_Stein



We estimate that the long positions in aggregate have about 50% upside to their intrinsic value
under base assumptions. Even under stress scenarios the aggregate intrinsic value is only about 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.

Stocks in the portfolio – Larger bet on gold

In line with our bullish view on gold, as discussed in our previous letter, we have substantially
increased our allocation to the yellow metal. Now Gold and Piramal Enterprises (previously Piramal
Healthcare) are the two largest positions in the portfolio. The other large positions of roughly
equivalent size are Blue Star, Noida Toll Bridge, Manugraph, SunTV and Thangamayil Jewellery. We
also have a relatively smaller allocation to a company called DB Corp, for which the investment
rationale is discussed below.

DB Corp is a regional newspaper company with dominant share in most of its markets. What sets the
company apart from competitors is it excellent execution. In an industry where barriers to entry are
relatively high the company has expanded into many new markets and successfully challenged
incumbents to go on and occupy a leadership position. This has translated into the ability to both
grow the business rapidly and generate a high Return on Capital. While the challenge of eyeballs
moving from print to online media is present, the transition will probably take a long time in the Tier
2 and Tier 3 towns from where the company derives the bulk of its readership. The stock does not
look cheap at TTM P/E of ~24x and TTM P/B of ~4.2x. However, there is very high operating leverage
in the business given a relatively inelastic cost base. Revenues are currently depressed with
advertising sales suffering in the past year due to soft economic conditions. As and when economic
growth recovers earnings and cash flows should rebound substantially. This leads us to conclude that
this is a high quality business that is somewhat undervalued on normalized earnings, but not a
complete bargain at current price, meriting a small position in the portfolio.

Portfolio performance – Acceptable

From inception in June 2011 till December 2012 the portfolio is up 17.4% while our benchmark, the
BSE500 index, is up 5.5%.

Cumulative Returns
25%
20%
15% 17.4%
10%
5.5%
5%
0%
-5%
-10%
-15%
-20%
-25%

NAV (pre-fee) BSE500

Note: During this period average cash balance is 53% and average net long position is 39%; Figures up to March 31, 2012 have been audited by KPMG



Our returns so far fall short of what we hope to deliver to you over time, which should be well in
excess of 15% annualized (after deducting our fees). However, the performance needs to be
evaluated in context. We have stressed in the past that we do not invest based on forecasts about
the future. Instead we prefer to focus on the available information at any given time, which helps us
determine potential for reward against possible risk, and make our investment decisions accordingly.
So far our analysis has necessitated a cautious approach to deploying your capital. This is reflected in
the fact that over the last one and a half years we have on average held about 53% of the portfolio
in cash and equivalents and maintained an average net long position of about 39%. Despite this
portfolio make up we have still beaten index returns quite handily. We have also managed to better
comparable fixed income alternatives, especially on a tax adjusted basis.

When evaluating returns of any investment manager it is critical to evaluate the risk that was
associated with generating those returns. Risk is present at two levels. First at the level of each
individual investment, where risk is the probability of a permanent and irrecoverable loss of capital
invested, either as a result of impairment of intrinsic value or as a result of overestimation of
intrinsic value. Second is at the portfolio level, where risk is the inverse of the probability that the
portfolio as a whole has limited losses in instances where individual investments suffer impairment
in value. Understanding such risks ultimately boils down to an evaluation of the investment process,
aided by some quantitative measures. What is the thought process behind making a particular
investment or exiting from it and its share in the portfolio? What is the amount of cash or leverage
in the portfolio? How do the various positions in the portfolio come together and how is the
portfolio as a whole likely to respond to various future outcomes? So that you may appreciate the
risks we are taking with your money in order to deliver returns, we try to outline our thinking to the
best extent possible. We hope that you will agree that we have been true to our stated philosophy
of first and foremost ensuring preservation of your capital, even as we strive for high returns.

We remain confident of delivering superior risk adjusted returns to you over market cycles,
especially as compared to alternative investment avenues at your disposal. Thank you for your
patience and confidence!

Gaurav Jalan
January 17, 2013


Avant garde wealth mgmt quarterly letter - 1212

Recommended

Recommended

More Related Content

What's hot

What's hot (15)

Similar to Avant garde wealth mgmt quarterly letter - 1212

Similar to Avant garde wealth mgmt quarterly letter - 1212 (20)

More from Gaurav Jalan

More from Gaurav Jalan (7)

Recently uploaded

Recently uploaded (20)

Avant garde wealth mgmt quarterly letter - 1212