Saturday, January 31, 2015

Moktan Capital LLP
Date: 28th January 2015 
Quarterly Letter Q4 (Oct-Dec 2014) 

Dear Investors, 

Here’s wishing all of you a very happy 2015. 2014 turned out to be a very interesting year for investors and markets worldwide. In this letter, I will try to capture some of the key economic and political updates in 2014 and see what we can learn from them going into the New Year. I will attempt to analyse how various asset classes performed in 2014. In my analysis, I will cover stock markets, commodities like gold and crude oil, government securities and bonds and currencies. 

A. Financial Markets: 
Let us start-off by looking at how financial markets performed around the world and how much returns investors made last year investing in them.

If you had invested $100 in the big markets of Europe in 2014, the maximum you would have earned is $2.7 in Germany. The FTSE London would have made you poorer by $2.7. Looking further east, the same $100 invested in Hang Seng would have returned just $1.3. If you had invested in Brazil, one of the key emerging markets, you would have been poorer by $0.7. Clearly, investors who bet on these markets in 2014 were left with very little to show for their effort. 

On the other hand, if you had invested in the world’s biggest market, the US, you would have been rewarded with $11.4, a significant return given the risk profile of the country. An investment in Japan’s Nikkei would have yielded $7.1. However, the star performers of 2014 were those who bet on India. Indian markets returned $30 for every $100 invested, the most around the world. In the same time, Moktan Capital LLP returned $33.4, 10% over the Sensex. 

B. Commodities: 
Let us turn our attention now to a couple of commodities. 

a) Gold
$100 invested in gold in 2014 would have yielded a loss of $7.3. Gold is a strange commodity, which has no value in itself. Unlike oil, it cannot be used to power cars or manufacture goods. Its only source of value is what somebody else thinks it should be worth. In tough times, people do not trust governments, their own currencies or the companies driving their economies. During these times, Gold’s value increases as investors buy something that has universal value and is independent of market cycles. 

When the EU crisis happened in Greece, Italy and Spain, people of these countries withdrew money from banks and put it into gold because they did not trust where the country was headed or what their deposits in the bank would be worth. If we look at returns of gold in the last 5 years, we will see how it becomes attractive during periods of crisis. 

In the crisis years of 2010 and 2011, Gold returned 23.3% and 32.1% respectively. In 2012 it returned 12.1%. As the global economy recovered, people thought less of gold and started selling it to buy stocks, bonds and real estate. In 2013, gold prices fell by 4.1% before falling another 7.3% in 2014. Going forward too, I would not recommend buying it as the next 3-4 years are going to be good years for alternative asset classes. 

b) Oil 
The biggest story of this year has been the dramatic fall in the price of crude oil. $100 invested in crude would have been reduced to $53 by the end of 2014. As we speak crude is trading at $47, the biggest fall in its history. So what went wrong with crude? Why did it go into a free fall? Let me explain a few of the reasons: 

Reason 1: Recession in Europe and China: Since 2013, Europe has entered into a deep recession reducing global demand for oil. Similarly, China is one of the biggest importers of oil but a slowdown in the housing sector reflected in its slower GDP growth has reduced the Asian country’s demand for oil. 

Reason 2: Rise of Shale Oil: From becoming the largest producer of oil in the 1970s, the US oil production had declined by 50% in 2008 as output from oil wells reduced. However, a new technology for drilling oil that used fracking and horizontal drilling increased output in the US by close to 80% from 2008 levels. With oil at $150 per barrel, this relatively more expensive method of drilling became profitable for oil companies thus increasing the supply of oil. 

Reason 3: Geo-political power play: Saudi Arabia is the biggest producer of oil today and commands a very powerful position in international politics thanks to the world’s dependence on its production. As the most powerful member of OPEC, Saudi Arabia has historically calibrated production in order to keep oil prices stable. However, the rise of shale oil was making the US less dependent on the Middle Eastern power. The higher price of oil was also massively profiting countries like Russia, Venezuela, Iran (even with sanctions), Brazil, Libya etc making their economies stronger. 

OPEC reasoned that cutting production would keep prices high and encourage further drilling of shale oil thus reducing member countries’ bargaining power while simultaneously making others stronger. As oil prices fell, OPEC actually increased their output flooding the market with more oil. As prices fell, countries like Russia, Venezuela, and Nigeria, which were highly dependent on oil exports, plunged into recession. As we speak, the S&P has downgraded Russia’s government debt to “junk” status meaning that the country is unlikely to be able to service its own debt. As a result, the Russian Rouble has fallen 106% from 32.87 / US$ at the end of last year to 67.8 currently. If you held your investments in Roubles, you would have seen them fall by 106% with no fault of your own – a scary prospect. With the fall in the price of oil, many of the shale oil refineries in the US are also shutting down as it has become uneconomical to drill for oil at these low prices. 

Reason 4: Speculation: As is the case with most commodities today, speculation played a big role in the price fall. Hedge funds with billions of dollars of capital had predicted that OPEC would cut production to keep prices stable. However, when that did not happen and prices plummeted, the same hedge funds had to sell their positions to cut losses. Since most hedge funds use debt to leverage their capital, the fall was even more pronounced, leading many of them to shut shop. 

C. Government Bonds: 
Most people think that the only returns you can make out of bonds are interest payments. However, this cannot be further from the truth. In a falling interest rate environment (meaning when interest rates are forecasted to fall), bonds also provide capital gains. This is because a bond with a 10% coupon bought one year ago is more valuable today if the interest rate on the same bond is 8%. Last year, US interest rates on 10-year government bonds (also called treasuries) fell from 3.04% to 2.17%. This mean that an investor who had invested $100 in a 10 year US bond would have made 40.1% return excluding interest (43.1% including interest). Interest rates in the Indian government’s 10-year bond fell from 8.924% to 7.860% during the same period returning 13.5% (22.4% including interest). 

That is a phenomenal return considering the fact that these bonds are risk-free when it comes to return of capital. Obviously in an environment of increasing interest rates, the reverse will be true. Going into 2015, interest rates on Indian government bonds are set to fall 75-100 basis points (0.75 – 1.0%). This is because the RBI had increased rates or kept them the same for the last few years as inflation continued to be high. With inflation moderating to below 5%, the RBI cut interest rates by 0.25% in January with further rate cuts forecasted in 2015. As an investor, investing in long duration government securities will be a good strategy in 2015. 

D. Currency: 
Let us now look at how various currencies performed in 2014 and how much investors would have made by trading them. 

The picture is pretty much one-sided. The US$ has performed very strongly against almost all currencies in the world. The table above captures how well it performed in 2014 compared to Europe, UK, Japan and India. $100 invested in the Indian rupee would have been worth $98.2 at the end of 2014 (excluding interest if any). Similarly $100 invested in Pounds, Yen and Euros would have returned $93.7, $86.3 and $86.4 respectively with the Euro being one of the worst performing currencies. Conversely Rs. 100 invested in US$ would have returned Rs. 101.8 and so on. As a European investor, it would have been best to convert your Euros into US$ and hold tight. That itself would have yielded a return of 13.6% in 2014 (excluding interest). 

2015 should show a similar picture as the US economy has rebounded very strongly while Europe continues to lag behind with lower growth, higher unemployment and continuing debt crisis in member countries. The Indian currency should either strengthen a little or depreciate similarly to last year, as foreign investors will continue to invest in equities. With oil below $50, India’s import bill will also be lower leading to lower dollar payments. Further, if the government is successful in selling its stakes in government companies to raise money and reduce its fiscal deficit, it will do even better. I would not convert INR to US$ in 2015. 

Political Update: 
There were two Assembly elections held in December in J&K and Jharkhand. As expected, the BJP juggernaut continued to roll in these two states with a landmark performance in J&K, where it has historically been reduced to single digits. In Jharkhand, BJP won 42 of the 81 seats gaining a simple majority while in J&K, it was the second largest party winning 25 seats out of 87 seats. With no clear majority, the state is headed for a coalition government between People’s Democratic Party (PDP, 28 seats) and the BJP. The next state to go to the polls will be Delhi in February where a keen contest is expected between BJP and AAP. In the last elections held in 2013, AAP had emerged just 3 seats behind BJP (31 vs 28). However, with Narendra Modi’s strong leadership at the centre, voters may well be swayed to vote for the ruling party. 

As I write this letter, there has also been a significant political change in Greece. Alexis Tsipras, leader of the anti-austerity Syriza party was voted to power and sworn-in as the country’s new Prime Minister. Having come to power on the promise of restructuring Greece’s loans with the IMF, EU and the ECB, he is set to drive hard bargains with the ECB on Greece’s debts. Greece had a total debt of Euro 316 billion, which is close to 176% of its GDP (highest among EU countries). The stock markets, predictably, reacted very negatively to the news as investors expect greater uncertainty in the EU following Tsipras’ election. 

Recent New Purchases: 
In Q4, 2014 the LLP made 2 new purchases: 

1.Karnataka Bank Ltd: 
The partnership purchased 7,000 shares of Karnataka Bank Ltd at Rs. 124 per share on 24-Sep-2014. I have been looking at the private banking space for the last one year but was unable to find any company that met our stringent Price/Value metrics. In Karnataka Bank, I found both a low price and a high embedded value. Karnataka Bank is one of the oldest private banks in India. It has been in existence for more than 90 years. It has 1,390 service outlets with 10 regional offices, 618 branches and 758 ATMs in 401 centres across India. 

Let me put down a few points on why I like this company: 

i) Price /Value: At a price of Rs. 124, our cost basis implied a purchase price of Rs. 2,337 crores for the entire company. In the year ended March 2014 the bank earned a total net profit of Rs. 311 crores, implying that we paid 7.5x the profit to purchase the company. In the 6 months ending on 30-Sep-2014, the bank’s profit increased to 210 crores implying a full year profit of around 420 crores (35% higher than FY14). This would mean that we purchased the stock at 5.6x forward profit. I believe this is a very competitive price to pay for this stock. Other private sector banks trade at very high multiples as seen below: 

HDFC: 27x | Kotak Mahindra Bank: 61x | ING Vysya Bank: 31x | IndusInd Bank: 27x | ICICI: 20x | Federal Bank: 13x | City Union Bank: 15x 

All of the above banks are not strictly comparable to this one as it is a smaller regional banking player. However, other similar players like City Union bank, ING Vysya Bank, Federal Bank etc also trade at very high multiples. 

ii) Favourable Interest Rate Environment: All banks in India have to compulsorily invest 25% of their deposits in bonds issued by the government (G-Secs). Thus, in a falling interest rate scenario (like we spoke about earlier) this investment increases in value leading to higher profits. As the RBI reduces rates over 2015 and 2016, profits of the bank are bound to go higher. This is an interesting way of playing the G-Sec market in India.

iii) Dividend History: The Company has a long and consistent dividend paying history in both good and bad years. 

iv) Balance Sheet and Financial Ratios: Karnataka bank operates at a net interest margin (difference between deposits and lending rate) of 2.4%, which is lower than other more profitable peers but not altogether bad. 75% of its deposits are retail term deposits that provide dependable longer-term capital. Its loan portfolio is evenly distributed between retail customers and corporate customers. Gross Non Performing Assets or NPAs (where interest has not been paid for >90 days) in Sep-14 were Rs. 1,061 crores or 3.5% of total loans. Of these the Net NPAs (gross NPAs minus dues received or recovered) were Rs. 702 crores. 

NPAs are something banks have become very good at hiding. Thus one has to be a bit careful in their analysis. How much of the loans are truly bad is something only the bank knows. As investors, the best we can do is to estimate a probable loss and compare it with the bank’s net income (1.7x in case of Karnataka Bank). So, if all NPAs turn bad, it will wipe out 1.7 years of the bank's profits. The present value impact of this at 20% IRR would be close to Rs. 570 crores. If we factor this into our purchase price, the forward P/E still works out to 6.2x. 

While one can never really be sure of the exact extent of bad loans, as investors we can take a calculated guess as to whether they will increase or decrease. I believe the worst of the write-downs for Indian banks are over and things can only get better from here. Needless to say, if we believe the country is headed for more prosperous times, as I do, lenders are bound to pay on time. It is in times of economic malaise that one has to be greatly worried about loans turning bad. 

Current status: 
Post our purchase; Karnataka Bank is up 17.3%, which has made us a profit of Rs. 150,000 in 3 months. 

2. Suzlon Energy: 
In my last letter, I had mentioned that the partnership purchased additional 40,000 shares of Suzlon as I believed the market had punished the stock more than was warranted. This purchase has proved to be a lucrative one so far as the stock is up more than 28% since our purchase netting us a profit of Rs. 144,000. 

Note: Last week, Suzlon sold its subsidiary Senvion to a private equity fund. I will present my analysis of this sale and its impact on our investment in the next quarter's letter.

Portfolio Performance:
Our portfolio performed strongly in Q4 rising 9.8% vs only 3.3% for the Sensex. Except Bharti, which fell 12.7% since my last letter (Bharti is however currently trading at 394 vs 353 used in this letter), all stocks increased significantly in value.  

[Investor Portfolio and LLP Portfolio follows]

will write back again next quarter. As always, do not hesitate to call or mail me if you have any questions or comments.  
Kunal Moktan
(Managing Partner)