By all traditional valuation measures the Indian equity markets are now looking expensive. The reasons are two-fold.
First, there’s a flood of liquidity that’s inflating asset prices across the world. Global discount rates are now at unprecedented levels – a dozen or so countries have negative short term rates. A few of these are fast approaching negative long term rates (imagine buying a bond and having to pay interest for the next few years!). Surely, some of this liquidity is finding its way into the Indian markets. Foreign Institutions currently hold 50% of the entire free float for the 200 biggest Indian stocks – an all time record. We are concerned.
Secondly, most traditional valuation measures are backward looking and, the last few years have not been kind to Indian corporates. The outlook for India’s future is perceived to be vastly different form its immediate past. We agree with this prevailing opinion.
Notwithstanding the justifications, a lot of good news is priced into these valuations. This is especially true for high quality companies that compound their earnings at high rates without using much capital. We own a few of these but are loath to buying more at these prices. In other words, the days of easy bargains are gone.
Our focus has accordingly shifted towards good, though not great, businesses trading at deep discounts. Severe, and sometimes unwarranted, mispricings exist amongst companies scarcely followed by the investor community. Investing in these situations requires considerably higher effort; the corresponding reward being performance that’s largely independent of the market. A large proportion of our time is now spent on researching and trading these idiosyncratic situations.
Thus far, our results have been mixed. As discussed in our Q4 2014 letter, we had invested in J&K Bank. One terrible quarter later, the stock is down 30%. Contrast this with another investment we made this quarter, Infinite Computer Solutions, which is up 90%. While these results are diametrically opposing, our underlying decision framework when buying these stocks was very similar. They are both severely mispriced situations, involving companies going through temporary problems. The problems are fixable and, there are people in place who are committed to fixing them. Also similar is the volatility of these stock prices. We are OK with that. As long as we pick more winners than losers and carefully size our positions, we’ll come out fine. The portfolio volatility will somewhat mask what lies beneath but we’ll make every effort to reveal what’s important. Fasten your seatbelts!
We are also getting more and more involved with risk-arbitrage situations. Typically, a risk-arbitrage focused fund spreads its bets over 20-30 situations. At Willow, we invest in a small subset, where we believe that the likelihood of losses is extremely low. Such opportunities don’t come by often. So far this year, we have traded two risk-arb situations. One of those, a rights offering, was a flat trade. The other, involving a tender offer, will most likely result in high single digit return over a 3-4 month period. Our intent here is to generate market independent returns and keep our cash in rotation until we find better longer-term opportunities.
In summary, while our job has become more challenging, it has also become more fun. Our current strategy is a slight departure from our recent framework and, in some sense, a return to our roots. We started out as bargain hunters, moved towards buying high quality names at fair prices and now have gone back to bargain hunting. When the market conditions change - they change quickly in India, we’ll change accordingly. As always, we’ll keep you informed.
Letters to Investors
A collection of our views, thoughts and ideas, as we communicated to our investors.