Preserve Your Capital

Global markets have been destroyed by concerns about the Greek bail-out being a case of “too little, too late”. Add to that melting pot, a growing skepticism about the outlook for growth in the Chinese economy and a nagging fear that despite the SEC initiative to nail Goldman, genuine reforms in the US financial sector are a myth. Given the febrile atmosphere investors are beginning to question the future of the EU. Equally, the prospect of the “Aegean contagion” spreading to larger economies with beleaguered public finances such as Spain and Italy appear potentially catastrophic.

It is even scarier, though, to reflect on what got us here. First, the incredibly high level of government indebtedness in developed markets shows no signs of being on the mend. The realisation that sustainable prosperity is joined at the hip with fiscal rectitude seems to have vanished. Second, the desire by political leaders to protect their own turf rather than act in unison to ensure global stability is mind numbing. It is fair to suggest that their ineptitude is based on a lack of understanding and ego rather than a flawed evaluation of the circumstances. Finally, policy makers seem to consistently under-estimate the need to suffer pain in implementing structural reform in order to see light at the end of the tunnel. Given the extraordinary incompetence of our current leaders, it is hardly surprising that investors have been seriously rattled and appear to be panic stricken.

Despite the gloom, the Greek crisis does have a silver lining! Investors are finally waking up to the fact that de-coupling is bunk and India is significantly dependent on international capital flows to achieve its economic mantra of inclusive growth. The recent turmoil has also led to another positive fall-out – the return of common sense in coping with the challenge of corporate valuation. Thankfully, results for the fourth quarter have met investor expectations and support the hypothesis of a strong recovery in domestic demand and resilient operating margins in future despite the gains from weak input costs last year. Perhaps, the most heartening outcome has been the solid performance of the commercial banks despite a noticeable dent in treasury income and the need to re-structure the loans of weaker borrowers.

Given this backdrop, what is an appropriate investment strategy for 2010? The primacy of capital preservation cannot be over-emphasised. Heightened volatility in global markets and increasing risk aversion will definitely cause international investors to tighten their purse strings. The risk of speculative contagion coupled with the possibility of China going off the boil is a serious cause for concern. Yet the most important mental challenge at this juncture is to guard against the danger of the “reassuring” but simple-minded extrapolation of the existing situation into the future. Based on his experiences of the Great Depression, Keynes summed it up perfectly by saying: “It is largely the fluctuations which throw up the bargains and the uncertainty which prevents other people from taking advantage of them. This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over the long term, does not even require gulls among the public to feed the maws of the professional; it can be played among the professionals themselves”.

Sensible investors should not lose any sleep over determining whether the market is close to its low point. Rather, it is imperative to fathom whether the price is attractive or not in relation to intrinsic value. Three stocks that meet the test of an attractive business run by competent management available at a reasonable price are Allied Digital (219), Deepak Fertiliser (108) and Union Bank of India (290). Each of them is available at a single digit earnings multiple, delivers return on equity in excess of 20 percent and is run by a management team with a commendable record of rational capital allocation. As we come to terms with a world turned topsy-turvy, it is worth considering the genius of Bertrand Russell who pointed out, “Neither a man nor a crowd nor a nation can be trusted to act humanely or think sanely under the influence of a great fear … To conquer fear is the beginning of wisdom.”

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.