We started our previous letter by pointing out that despite its 20%, Indian market is not very special – other countries have rallied as well, some far-far more. The ensuing three months have made Indian equities even less special. Everything seems to be rallying. Economist ran a cover feature recently called The bull market in everything. It had a picture of a bull with Bitcoin hanging from one horn and iPhone hanging from the other. How appropriate.
We see two common reactions to a rally like this one,
Reaction A: I’ll just wait. It’ll come crashing down. It always does. Or the less common,
Reaction B: Can’t miss this one! This time is different. After all, Bitcoins and smartphones were not even a thing a few years ago so don’t let history get in the way of making money.
We prefer reaction C: There’s still so much misery all around. Let’s go shopping.
Consider this, more than one-third of all major US stocks are in the red for the year. Many are close to their 52-week lows. Several, like Exxon and GE, are lower than they were 10 years ago. The situation is no different in India. The problem is not that it’s a bull market in everything. The problem is that what’s good is expensive and what’s cheap is garbage, for most part.
To us it still makes sense sift the garbage and evaluate each situation on its own merit. Like Tolstoy once famously said about the stock market – “All high fliers are alike but each shitty situation is shitty in its own way”.
When we rummage through the trash we ask ourselves some simple questions such as,
Can this particular problem be solved?
Why would anyone solve it?
How long will that take to solve?
Will the emergent entities make money?
Will they make money for us, the minority shareholder?
Most of the times the answers say “do nothing” but sometimes interesting stuff turns up. For example, for years now we’ve been following the non-performing loan circus at the government owned banks. By most accounts the total amount of bad loans at these banks – (INR) 8.5 trillion plus, is higher than their combined net-worth of about 6 trillion. Reasonable people can disagree on the exact numbers but there’s no denying that many public sector banks are de facto insolvent. Miraculously, solvency issues have not yet led to bank runs.
The left side of the balance sheet, roughly 90 trillion, of which 10% is impaired, keeps getting worse. Yet the right side keeps financing it while patiently waiting for things to get better. Depositors, who finance close to 75 trillion, stick around because either,
Government, who directly owns more than 50% of the equity, has little incentive to do things that will lead to turmoil amongst employees and their unions. More than one-fifth of the remaining equity is owned by LIC, the government owned life insurer. Bankers don’t want to just write bad loans off since that will make them look clueless or corrupt, likely both. Besides, there is hardly enough equity to absorb the losses. The central bank is trying hard to move the process along – with constant monitoring, public shaming, forced liquidations, etc., but to little effect. Our starting hypothesis is that until we face a real liquidity crisis we’ll tread water.
In the midst of this milieu, the Modi government recently announced a 2 trillion recap plan with a two year timeline. The details of the plan are not out yet but it’s looking a little bit like the bank recaps done in Korea, Indonesia, and others in late 90s. Net-net the government will end up owning more bank equity. The money required to buy the new equity will be lent by the banks themselves. In exchange for cash-like assets (the banks have more of those than they want after demonetization) the banks will receive government backed recap bonds. Presumably the government will pay the extra interest on this bond issuance from higher tax revenue and dividends received from banks, which in turn will happen because a recap will lead to higher growth. That’s it, problem solved! Call us crazy but we are not biting, at least not before we see more evidence.
Interestingly though we might see other tangential opportunities as a result of this exercise. For instance, we are now getting close to election season with a slowing and (relatively) underperforming economy. It’ll soon be critical for Modi government to start some banner projects - projects like roads and power plants that make for good electioneering platforms. This will require some abandonment of fiscal targets, some arm twisting of banks to make them lend, and some bailouts for the currently hamstrung infrastructure developers. The recap exercise seems like a step in that direction. If we are right then Infrastructure, one of the worst performing sectors of the recent past, will throw spectacular investing opportunities. So far it’s mere speculation but a promising one with enough historical precedent. We continue looking for best ways to gather evidence, express our view in case we’re right, and limit our downside in case we’re wrong.
New investment <private>
Notes & Letters
A collection of our thoughts, views, and excerpts from our investor letters.