Written by Baijnath Ramraika, CFA and Prashant K. Trivedi, CFA
“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” – Warren Buffett[1]
While the long expected earnings recovery has continued to push its realization date further out, equity markets have continued to march upwards. As indices have moved up while earnings have largely failed to keep pace, valuations, to the extent that one bases them on the current earnings power of the business, have increasingly extended themselves in the overvalued zone. The willingness of market participants to pay significantly more for the same stream of earnings is also reflected in exuberant behavior in primary markets.
According to an article published on livemint[2], thus far in the financial year 2017-18, INR 265 billion have been raised by IPOs. Importantly, nearly 85% of this amount has been raised through offer for sale issuance. In case of such issuances, the money raised from the sale goes to selling investors including promoters and private equity investors and not to the business itself. The chart below highlights two important points. First, amounts raised via IPO issuances in just six months of this financial year are nearly equivalent to all of the previous financial year. And second, the mix of such issuances is skewed significantly towards offers for sale.
Source: Offer for sale dominate IPOs, Harsha Jethmalani, livemint
While equity markets continue to be buoyant, economic growth has failed to materialize. Indeed, if one were to exclude the impact of government expenditures, the economic slowdown has been significantly worse; an issue that we highlighted in our second quarter 2017 investment newsletter for the India Moats Fund. The economic growth, at least to some extent, has been affected negatively by two government actions; the decision to implement demonetization in 2016 and the implementation of GST this year.
While macroeconomic factors and their analysis can be a rewarding task if appropriately done, we believe that our core competency at Sapphire lies in assessing the quality of businesses and evaluation of the intrinsic value of such businesses. Additionally, at Sapphire, we are focused on a much smaller sub-set of businesses; that of high quality businesses with durable competitive advantages. Accordingly, our concerns around market valuations are largely related to the valuation of this sub-set of businesses.
A rising tide lifts all boats. A similar outcome has shaped up with our target investment universe as well. Over the last few years, these high quality businesses have generated good investment results, much like the broader equity markets. We hypothesize that a significant portion of that performance was driven by the broader equity bull market. At this juncture, the important question that we face is whether our sub-set of high quality businesses is as overvalued as the broader markets and whether that is likely to bode ill for our future investment returns.
