October – December 2006

January 29, 2007

In Greek mythology Lethe is the river of oblivion, from which the souls of the newly departed drunk so that they forget the memories of their past lives. The stock market drinks a punch made from Lethe everyday, forgetting the turbulence and volatility of its past, believing that tomorrow will be different. It never is!

An analyst, like Ulysses in Homer’s Odyssey, is always faced with hard choices. Faced with the choice of living with the nymph Calypso on her island paradise or returning to Ithaca , the island of which he is king, Ulysses chooses to go home, and the epic is about his struggle to do so against divine opposition. The analyst can also choose to remain in the world of fantasy, replete with his spreadsheets and numbers, or he can choose to forge his destiny by doing unconventional things – scuttlebutt, read trade magazines and invert his arguments.

I wrote an article which appeared in an investment magazine at the turn of the year. I titled it “Futuribles” and I’m reproducing it below, believing that nothing really has changed except that some of the cheaper mid-caps have become more expensive since then.

“Investors have to deal in imaginables or in what the late Bertrand de Jouvenel called futuribles, future states that can be projected step by step from the most trustworthy data and the most cogent theories currently available to us.

An assessment of the current market is like attempting to understand the behavior of a schizophrenic person – the valuation differentials between the large cap and the mid cap are so huge that it is difficult to believe that liquidity should command such a premium. In fact, it is difficult to believe that the same market is valuing large caps so richly and mid caps so poorly.

So, where will the market go should be answered with – which market is one looking at? The sensex FY07 eps estimate is Rs.710 which put the large cap market at a forward P/E of nearly 20. This means the risk of large downside and only momentum to provide the upside.

On the other hand, many midcap stocks having large returns on capital employed and foreseeable growth are available at single digit multiples – these are not commodity stocks or capex-heavy stocks which usually deserve the low valuations. My belief is that FY08 will be the year where stock picking will be richly rewarded as it has been for most of calendar year 2006.

The key risks to the market squarely lie in the behavior of interest rates and an investor should not underestimate the potential for an increase in interest rates and inflation rates. The commodity price inflation that marked FY07 will continue in the next year.

If the tempo of economic growth continues in FY 08, then it would be hard to make a case for a bear market. A high growth rate would provide some pricing power to handle inflation in raw materials, capital costs and capital servicing costs. Economic growth can slow down for a variety of reasons – a global recession (which would impact exports), a sharp rise in interest rates (which would impact corporate savings, consumer spending and investment demand) or policy changes.

Just as science has been restructured to favor more holistic and organismic models in the biological sciences and not the reductionist models of physics (witness the rise of complexity theory) and economics has also started rethinking the old equilibrium models based on physics, investors too will have to rethink their assumptions of the business models of companies. Certainly has given way to uncertainty and therein lies the opportunity for profits. A successful money manager, Mohnish Pabrai, restates this simply: “Low downside + High uncertainty = High profits”.

Applying this would mean buying into stories where the magnitude of uncertainty is high but the chances of capital loss in the worst-case scenarios are low. There are many companies whose valuations and business models currently fit the bill. Finding them is not difficult, investing in them is much more so.

The motto for investors for the coming year – relentlessly search and, when you find, courageously invest. Should you go wrong with the story, have the integrity to admit it and like a coward, swiftly exit. To be simultaneously courageous and cowardly is schizophrenic, but then what else can you be when you are dealing with a schizophrenic market.”

An essential component of our investment strategy are “special situations” or what Warren Buffett calls “work outs”. Let me give you one example – Nahar Exports which we bought into in the low eighties. The textile division of Nahar Exports (NE) is to be merged with Nahar Spinning (NS) whilst the investment book will remain with Nahar Exports. The face value of NE and NS was to be reduced to Rs.5 after NS’s investments were transferred to an unlisted company, Nahar Capital. With a holding company discount for NE and a conservative assumption of earnings power of NS, we came to a sum-of-the-parts-valuation of NE at Rs.125/- However there is a period of illiquidity of one month (no trading on the stock exchanges) for effecting the transfers. So we booked some profits at Rs.103 yesterday, and will play out the rest.

Futura is another special situation which is taking more time than anticipated. However, Innovasynth Technologies (which will be spun out of Futura) has recently invested in a 26% stake in Actis Biologicals which we think is worth Rs.200 cr. Futura owns 48% of Innovasynth and the market capitalization of Futura is less than Rs.100 cr. We think that the sum-of-the-parts valuation of Futura is northwards of Rs.50/- and may be closer to Rs.80/-. At Rs.18/- the downside is low, the uncertainty (business model of Innovasynth and the spin-off) is high and so (we think) that the potential profits are likely to be high.

The quarter is likely to result in more sales than purchases in the older portfolios, especially if the market goes higher. Whilst we are hopeful of India ‘s future, the stock market seems to have discounted future growth. Fair values do not excite us. Discounts do!

Let me unequivocally state that the last 9 months have been good for us, but going forward it will be tough and challenging. We must protect these gains before building on them. As the market rises higher, we will be looking at exits.

Should there be any questions, please do not hesitate to call me.

Thanking you,

Warm Regards,

Chetan Parikh