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This Is Not April Fool. Our Views Have Indeed Dramatically Changed Between Dr Rajan's First and Possibly Last Monetary Policy... - Views on News from Equitymaster
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  • Apr 1, 2016 - This Is Not April Fool. Our Views Have Indeed Dramatically Changed Between Dr Rajan's First and Possibly Last Monetary Policy...

This Is Not April Fool. Our Views Have Indeed Dramatically Changed Between Dr Rajan's First and Possibly Last Monetary Policy...
Apr 1, 2016

"Time to keep money under your mattress?" is what we asked you after Dr Rajan's first Monetary Policy in September 2013.

In my StockSelect recommendation dated 27th September 2013, I exhorted subscribers to be as worried about return 'of' capital as about return 'on' capital.

Here is what I explained....

Irrational times call for rational behavior! So investors must consider keeping some of their wealth in cash and fixed deposits during irrational times. Why are we calling it 'irrational times'? Well, we cannot call the US Federal Reserve's behavior anything but that. Printing money has not yielded any results for the US or global economy since the crash of 2008. Yet, the US central bank's resolve to stick to its ill-conceived recovery plan is nothing but stubbornness. The unwillingness to accept short term pains and do away with the structural problems in the US economy will cost it dearly.

Thankfully for us, the Indian central bank houses more prudent officers. Even the new RBI governor Dr Raghuram Rajan stepped into the shoes of Dr Subbarao with a great deal of maturity. If his maiden Monetary Policy was anything to go by, Dr Rajan too will choose to be unpopular with the government and India Inc. That the RBI's hawkish stance with respect to inflation is back was evident in the review. And in the absence of policy steps to correct India's structural problems, the RBI will not ease liquidity.

One can therefore expect domestic interest rates to remain firm, if not move up, in the near term. Definitely bad news for companies stuck with debt or insufficient cash flows. We would recommend that investors remain wary of fundamentally unsound companies raising deposits at mouthwatering rates.

Now, as globally cheap money continues to chase risky assets, emerging markets are unlikely to go out of favour amongst FIIs anytime soon. The wide gap in the cost of capital in developed and emerging markets will whet the increased risk appetite. This means despite India's structural problems, the low cost of capital overseas will allow FIIs to speculate on Indian equities. And thus the valuations of stocks are very unlikely to reflect the underlying fundamentals in the short term. Here again investors should be wary of investing in stocks where the 'return of capital' is more doubtful than 'return on capital'.

What did we recommend investors to do in 2013?

This is what I wrote...

With both stocks and fixed income instruments showing signs of unprecedented risks, holding some portion of one's wealth in cash and fixed deposits is not an act of cowardice. It could help to know that one of the world's finest hedge fund managers, Seth Klarman, has returned cash to investors recently. Going by the name of Baupost, and in the reckoning of hedge funds with best long term track record, this fund is returning cash for only the second time in its 31 year history.

Thus, while there is no reason to do away with the fundamentally solid companies, good quality debt instruments and gold in your portfolio, do not undermine the importance of cash and liquid assets.

What has changed?

Well, Rahul Shah quoted Jeremy Grantham in yesterday's Wrapup to explain why we are keeping a close watch on profit margins.

  • Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism.

If aggregate profit margin is such a reliable indicator, how about using it in the Indian context?

Indian stocks are famous for giving 15% returns over the long term (provided one does not invest in an overheated market). Can this be improved by a few percentage points by capitalising on the phenomenon of reversion in profit margins? Yes. And the current environment provides a great opportunity to do so.

The aggregate data we have pulled for Nifty companies suggests that profit margins were at a ten-year low at the end of FY15. Even if they were to rise to the average of the last ten years, not immediately, but three years out, the upside would close to 70%.

Put differently, markets could go up 70% over the next three years if profit margins revert to the mean. And we're not even considering the gains from potential interest rate cuts.

Thus while we strongly recommended you to be cautious on stocks at the time of Dr Rajan's first Monetary Policy in 2013, we are now recommending you to consider the possibility of significant earnings upside in stocks. Whether or not Dr Rajan last policy on April 5th is about a big rate cut, we believe the time is ripe for you to allocate more to great stocks.

Tanushree Banerjee

Tanushree Banerjee (Research Analyst), is the editor of ValuePro, The India Letter, and Stock Select, Equitymaster's oldest recommendation service. She is also the editor of Equitymaster's most popular newsletter read by over 200,000 subscribers, The 5 Minute WrapUp. Tanushree started her career at Equitymaster covering the banking and financial sector stocks along with scrutinizing the RBI policies. And over the last decade, developed our research processes that have helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham and Joel Greenblatt.

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