Conversations with partners over the past few days suggest some partners are not appreciating the change in monetary policy underway and what that means for future returns.
Hence, some points we have made earlier merit repetition.
- Stock price returns can be explained simply as: Earnings or Cash Flow growth * Change in Valuation Multiple of those Earnings + Dividends
- The 2008 Financial crisis led to monetary experimentation as Central Bankers paid more emphasis to job creation. Central Banks started printing money and buying their own bonds to keep interest rates low. Hence, interest rates stayed low for an extended period of time.
- Covid led to further monetary support.
- RBI too has kept monetary policy loose for many years to support growth, although it has been more conservative vs developed world Central Banks
- As interest rates declined, valuation multiples expand. India’s Market Cap/GDP is at present 110% vs long term average of 80%.
- These conditions are now reversing as excessive money printing is resulting in higher inflation. Central Banks across the world are tightening policy, including the RBI.
- This means the tail winds to Equity returns are turning into head winds as valuation multiples (in aggregate) will decline as valuations normalize. What we borrowed from the future has to be returned.
A mature mind can balance two opposing constructs and still function.
- Very high probability that returns in Debt will be lower than Inflation.
- While we are cautious, we are not bearish. While returns in Equities may be lower than the past 5 years, they can still be attractive as long as Earnings trajectory remains broadly intact and can withstand some valuation decline. These are the type of companies we are invested in.
- A period of flattish markets will blow away a lot of the valuation froth. However, one should not attempt to time market entry as individual companies can move in a manner uncorrelated with markets. Example, market valuations are very high, but HDFC Bank at lower than I standard below mean multiples vs last 5 years.
So in summary
- We are batting in English conditions and not on a dry pitch in Rajkot.
- We will not take on excessive risk to try and juice up returns. The question is not only whether an investment is a wonderful business, but also what expectations of earnings/cash flow are stock prices reflecting?
- One can still outperform the Index by concentrating the portfolio in sectors where growth/valuations are in favour and by being patient and not chasing prices. Banking, Life Insurance are examples which provide very attractive opportunity.
Enclosed are few slides that explain the above