State of Indian stock markets and Indian businesses

Turbulence has hit all classes of asset markets, be it equities, commodities or currencies. No market, either
developed or emerging has escaped being ravaged. Leaving aside global markets, we focus on Indian
markets and Indian businesses here. Briefly we will consider broad overall implications ( country and
markets) and then some specific companies.

A) Overall : Over the last 5 years and culminating this fiscal, i.e. March 07, Indian GDP would have
grown by an average of 8.5-8.8% per year in real inflation adjusted terms. The business plan for
the next 5 years has been submitted by the Planning Commission and vetted by the Prime
Minister’s advisory council. This plan envisages GDP growth in the range of 8-9% per annum
over the entire 5 year period. This growth will be driven by various infrastructure activities
( power, railways, roads, ports, telecom and airports).

Therefore macro conditions for sustained GDP growth on the back of investments alone are in
place.

Favourable demographics will ensure that momentum in consumer spending and related
confidence, apart from temporary setbacks, remains on track.

Seen in tandem, investments in the Indian economy along with consumer spending growth, should
create stable demand and operating conditions for businesses.

Does that mean India is totally immune to events in the developed world? No. Certain sectors ( eg
IT) will definitely be impacted. But the structure of Indian exports is moving in a way that its
biggest export market is no longer the US, but countries such as China, UAE and Saudi Arabia
and the Eurozone. And each of these has significant appetite for Indian origin imports.

Let’s consider the negatives here… Heading the list is inflation especially in commodities. Oil
shows no signs of relenting and neither do industrial and agricultural commodities. Rising prices
will have an impact on general behaviour and India by and large will not be immune to this.

Large sections within the Indian corporate sector have been complaining about high interest rates
and the adverse effect they have been having on demand. If inflation were to increase it would be
highly unlikely that interest rates would come down. Infact in real terms ( adjusting for inflation),
interest rates have rarely been this low. It is also true that real interest rates are negative in China,
proffering an advantage to those manufacturers.

The third negative is currency appreciation. True, the INR has appreciated against the USD but not
so against other major currencies especially the Euro. And now that the US is not the most
important trading partner, export billing can happen in Euros while at the same time if most major
commodities are priced in USD, a strengthening INR against the USD has its advantages. Then
again, the INR appreciation against the USD has been far less as against some other currencies
such as the Brazilian Real.

Still, overall these 3 factors, inflation, relatively high notional interest rates and an appreciating
currency will remain on the operational canvas for quite a while and both, investors and
businesses will need to live with them.

To conclude, achievement of a GDP growth rate in the 8-9% range over the next 5 years in the
face of these headwinds, will be an accomplishment of sorts.

How this GDP growth gets translated to business value growth will be the key for investors. This
also leads us to the next point, viz. the markets
B) Stock markets: During every bull market phase there are certain sectors that drive the rally. For eg
it was the IT sector in the pre 2000 rally. This recent one was driven by realty and financial
services companies. A spate of issues from these sectors along with huge media coverage ( Real
estate barons amongst the richest Indians ever etc) got every lay speculator on the wagon ( a point
to note here. If someone buys a stock today solely to benefit from a price rise at the end of the day
is not an investor but is a speculator). To do this on borrowed money is speculation at its most
intense.

A spreadsheet on some key real estate and financial services IPO’s and their performance is
attached. Now for a moment consider the implications. A large part of speculation in DLF for
example happened at or around its peak price of Rs 1200. Subsequently the price has fallen to half
that level. Wealth has been wiped off, that much is clear. But lets take a look at the Price earning
ratio for DLF. At its peak valuation of Rs 200000 crores, its March 07 net profit of Rs 1000 cr was
valued at a whopping 200 times ! Even after the fall to the current market cap of Rs 115000 cr, the
P/e multiple is still a high 120 on March 07 profits. And real estate prices have already started
softening. Are investors alive to the fact that the company’s net profit could grow but market cap (
and investor fortunes) could still plunge even as the P/e multiple corrects itself ? Time will tell.

So what has happened in this process ? Brokerages ( such as Kotak, Motilal Oswal) actively
pursue clients by offering products on the margin. A client can engage in any activity on the back
of a 10% margin ( could be cash or related stocks). The balance is funded by the brokerage which
in turn enjoys a line of credit from the banking system ( in this case aggressive private banks such
as Kotak, Yes Bank and ICICI). Now as an isolated example and because it concerns one of our
portfolio companies, a group of investors had hypothecated Hester Pharma stock on the back of
which they had ventured into the derivatives market. As those prices collapsed, this group, to meet
margin calls, put up the additional cash. As the year end approaches, brokerages prefer to cut their
credit lines with banks and to extinguish that debt, clients either have to front up with more cash or
the brokerage has no other option but to liquidate whatever stock that has been pledged with them.
This is what has happened in the case of Hester. Without any change in the business fundamentals,
the price of the stock has collapsed.

Therefore this divergence in the pricing of the stock and the intrinsic valuation of the business has
intensified.

Lets now take a look at some individual companies as they stand today

C) Company valuations;

Company Sales Net profit OPM(%) MCap P/E Current price

Shanthi Gears 250 45 36% 420 9 53

Investment Prcs 100 12 18% 45 4 89
Hester Pharma 36 9 52% 66 7 130
Enkei Cast 340 10 10% 62 6 60

Apart to some small extent Enkei Cast, all the other companies above will be showing a
significant increase in crucial operating parameters. And yet for each of them the value has fallen.

I am reproducing Benjamen Graham’s version of Mr. Market and would leave you to form your
own judgement.
Whenever Charlie and I buy common stocks for Berkshire's
insurance companies (leaving aside arbitrage purchases,
discussed later) we approach the transaction as if we were
buying into a private business. We look at the economic
prospects of the business, the people in charge of running it,
and the price we must pay. We do not have in mind any time
or price for sale. Indeed, we are willing to hold a stock
indefinitely so long as we
expect the business to increase in intrinsic value at a
satisfactory rate. When investing, we view ourselves as
business analysts - not as market analysts, not as
macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since

it periodically presents us with mouth-watering
opportunities. But by no means is it essential: a prolonged
suspension of trading in the securities we hold would not
bother us any more than does the lack of daily quotations on
World Book or Fechheimer. Eventually, our economic fate will
be determined by the economic fate of the business we own,
whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described

the mental attitude toward market fluctuations that I believe
to be most conducive to investment success. He said that you
should imagine market quotations as coming from a
remarkably accommodating fellow named Mr. Market who is
your partner in a
private business. Without fail, Mr. Market appears daily and
names a price at which he will either buy your interest or sell
you his.

Even though the business that the two of you own may
have economic characteristics that are stable, Mr. Market's
quotations will be anything but. For, sad to say, the poor
fellow has incurable emotional problems. At times he feels
euphoric and can see only the favorable factors affecting the
business. When in
that mood, he names a very high buy-sell price because he
fears that you will snap up his interest and rob him of
imminent gains. At other times he is depressed and can see
nothing but trouble ahead for both the business and the
Risk is a concomitant part of equity investment. At all times it will be our endeavour to be in those
companies that we understand from all perspectives of the business and buy them at prices where we find
value. At the same time, any event can take values away from our perception of business value.
Furthermore, there is no time frame for the period for this divergence to continue. As long as we are
comfortable with the operating characteristics of the business we will continue to hold on and ride out such
periods.