Wodehouse Capital Investment Strategy Outlookwodehousecapital.com/Monthly Newsletters/Investment...6 Investment Strategy Outlook, November 5, 2013 Third Quarter CY 2013 - Sector Sales

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Investment Strategy Outlook, November 5, 2013

Dionysius was a very rich fourth century B.C. tyrant of

Syracuse, with all the luxuries money could buy. He

even had court flatterers to inflate his ego. One such

was the court sycophant, Damocles. Damocles used to

make comments to the king about his wealth and

luxurious life. One day when Damocles complimented

the tyrant on his abundance and power, Dionysius

turned to Damocles and said, "If you think I'm so

lucky, how would you like to try out my life?"

Damocles readily agreed, and so Dionysius ordered

everything to be prepared for Damocles to experience

what life as Dionysius was like. Damocles was enjoying

himself immensely... until he noticed a sharp sword

hovering over his head, suspended from the ceiling

by a horse hair. This, the tyrant explained to

Damocles, was what life as ruler was really like.

The Tyranny of Taper If you’re an investor today, you’ve got a sword of

Damocles hanging on your head as well. The man

holding the sword is Ben Bernanke.

We had a taste of what Tapering feels like this

summer. It’s downright painful and has nothing to do

with fundamentals. We’re all hostage to the whims

and fancies of an academic. It looms maybe next

month, maybe never. Thank the Fed for wresting

global free markets away from investors for the

foreseeable future.

Missed the Rally? Don’t Lose Sleep The real Nifty 50 adjusted for inflation is 44% below

its 2007 peak. In order to get back to its 2007

purchasing power, the Nifty would have to rise

another 71%. That’s the negative impact of high

inflation and six years of flat performance.

The One Indicator You Need To

Determine the Direction of the Nifty In the 20 plus years we analyzed markets in the U.S.,

we never found a direct correlation between market

movements and fund flows. That’s the way things

should work in a liquid and diversified market.

Equity FI Flows Are The Perfect Leading Indicator For Market Direction…

… And These Same FI Flows Are Suggesting We Are In the Sell Zone

Wodehouse Capital Investment Strategy Outlook

Sunil Sharma, Chief Investment Officer

Krish Shanbhag Equity Advisory

Leads the Nifty

SELL ZONE



Debt FI Flows (Inverse) Are Highly Correlated to the Nifty As Well & FIs Have Been Actively Selling Indian Debt…

… This Chart Is Signaling A Divergence & Sell As Well

If anything, flows were a contrary indicator, with the

maximum number of investors expected to sell at

bottoms and buy at tops.

Not true for Indian Equities in 2013. We present two

charts showing the close correlation between Equity

FI flows and the Nifty50, and also Debt FI flows and

the Nifty 50 this year.

The correlation is strong and flows are actually leading

the market as the charts clearly demonstrate, So

arguably, you can throw out the fundamentals,

throw out earnings, valuation and just look at what

the foreign investors are doing to see where the

market is headed.

FI Flows Are In the Historical Sell Zone We show is a 4 period moving average of Equity and

Debt flows. The Debt flows are shown on an inverse

scale. The underlying flows index is also shown in

light red and it leads the market even more clearly.

One could surmise that foreign investors are more

astute than their local counterparts. But that

hypothesis is shattered to bits when one considers the

past record of foreign investors in 2003, 2007, 2009

etc.

What’s a far more rational explanation is that FIs are

flush with liquidity, courtesy Bernanke, and are

dominating our domestic market.

Domestic investors have for the most part watched

this rally mystified, and from the sidelines. The retail

investor lost faith in 2009 and just hasn’t returned.

The other very interesting observation is that Debt

flows are inversely related to the Equity market. So

there is a significant portion of FI money playing the

asset allocation game and rotating between Equity

and Debt but staying in the country.

Which makes complete sense given the circuitous

route money has to take to leave the country and the

red tape involved in doing so.

Our Market Timing Indicator Says Sell We mentioned in last week’s commentary that our

proprietary Market Timing Indicator was close to a

Sell signal as well. We got the official signal on

October 28th.

We’ve been using this indicator for about a year now

and it’s usually reliable in predicting shorter term

moves. There was been one false signal that occurred

in late 2012.

SELL ZONE



Yet Another Warning, Our Market Timing Indicator Got A Sell Signal On Oct. 28th…

Relative to Equities, Bonds Are at the Most Attractively Priced In 18 Months…

… Are We Perilously Flirting With Another Multi Year Top?

It’s currently at the highest reading it’s been at in the

past two years. This strong momentum is unlikely to

sustain. But then again, we’re dealing with an

unrestrained entity with a blank check book in the

Fed, so these are uncharted times.

Asset Allocation Model Update –

Bonds Way More Attractive Sometimes, models speak louder than words.

Our asset allocation model looks at the relative

attractiveness of Equities versus Bonds. Those are the

two major classes of investment for almost all

investors. Real estate is the third asset class but given

the lack of uniform reliable data, we deal with Real

Estate separately.

Today, the 10 Year Government Bond offers a yield of

8.7% today. Corporate bonds offer a yield of 10%+.

In contrast, the implied yield of Equities is a meager

5.5%. Applying a 13% growth rate to Earnings, we can

reasonably estimate that the forward earnings yield

on Equities is 6.2%.

Highest in 19 Months

Headed for Danger



Either way you look at it, this simple comparison tells

you that bonds are far more attractive an asset class

with a much higher yield and lower volatility than

Equities.

Whenever the difference in yield between the two

asset classes has touched 4%, it’s signaled a major

top in Equities. The three instances the model

reached these levels were 2000, 2007, and 2010, all

major tops in the market.

Currently, we’re a scant 78 bps away from the 4%

differential. One must ponder the implications of this

scenario, particularly in the wake of the Great Unwind

/ Taper that will soon – or never - begin in the U.S.

We’re not ready to forecast a major top ahead and

dead money for Equities just yet. The requisite selloff

we expect may bring things into a better balance. But

a continuation of this frenzied move will certainly

take us into valuation levels that spell danger for

investors.

Our job with this commentary is to be unbiased in

terms of the direction of the market. We’re not tied

into having our clients be fully invested at all times.

We’re not looking to sell a product. Rather, because

we offer a holistic approach to wealth preservation,

and look for multi-generational relationships while

providing a spectrum of services, we’re able to share

opinions most brokerage houses would shove into a

drawer never to be mentioned again.

Real Estate - Worries Intensify

Woeful Deliveries Till July this year, according to real estate research

firm PropEquity, only 35% of a committed supply of

406,000 housing units had been completed amongst

the listed developers they track.

In Gurgaon, the committed supply was 22,500, but

only 7,650 units, or 34% have been delivered by

developers. In Noida, of the 36,000 units promised,

21% delivered. Mumbai fared a little better, delivering

43% of the 18,700 promised units and Pune at 44% of

59,500 units.

Developers have received the money from

buyers but are unable to deliver on projects…

There’s a shortage of capital, very high mezzanine

interest rates, over-leverage and a debt crunch. And

the only solution developers have to generate cash is

to announce new projects and have greedy investors

rush to buy units.

Defaults Have Started…

Orbit Corp defaulted on Rs. 96 cr. of loans from LIC

Housing Finance. So has Hiranandani on a 76 cr. Tata

Capital Loan in July. And Indiabulls Housing Finance

has declared Rakeshkumar Wadhawan and Sarang

Wadhawan, promoters of realty company HDIL, as

loan defaulters.

Inventory Is Rising…

Developers are sitting on upwards of Rs 58,000 cr of

unsold inventory. Just DLF accounts for over a third of

that number, up 18% from two years ago.

Meanwhile, sales for DLF declined from Rs 9,500 crore

to Rs 7,775 crore during the same period

Faulty Assumptions Always Spell Trouble…

With mezzanine financing, realty companies pay as

high as 24% interest. As prices have risen, project

fundamentals and viability have suffered.

Leverage Works Both Ways…

What most players always forget in an uptrend is that

real estate is the most leveraged of investments.

Leverage cuts both ways. And a slowdown in sales,

overleverage, a rise in costs or a shortfall in projected

revenues will kill a project’s viability very quickly.

Prices are starting to come down or have already

come down in most areas.

We’re seeing the possible beginnings of India’s real

estate train wreck. We’ll keep a close eye on this

sector. If the correction picks up steam, the impacts

to the economy are worrisome and wealth

destruction will be substantial.



Nifty 50 Earnings Growth Got Off To a Strong Start, But Has Fizzled Of Late…

And the Pattern Possibly Suggests Another Selloff

It’s Early Days With a Third Of Companies Reported…

… Sales Appear to Have Bottomed In CY Q2 & Bounced Nicely in Q3…

… However, Earnings Growth Barring Select Large Caps Remains Anemic

Deceleration… Selloff



Third Quarter CY 2013 - Sector Sales & Profits After Tax

Third Quarter Earnings Review

Nifty 50 Earnings Growth Is Decelerating Again

The last two instances this has happened, a market

correction has ensued. Add this to the list of

warning signals.

We track trailing twelve month earnings growth on

the Nifty 50. The quarter started off with a bang and

year on year earnings growth touched 16%, which

happens to be precisely the same level earnings

growth have touched the past couple times before

the market corrected. Does that mean the market

corrects again?

Forecasting is a game of probabilities. There is no

certainty about the future. What we attempt to do is

set the odds in our favor by avoiding over valued

markets where the probability of a loss is high and

hopefully be aggressive when the scales for winning

are tipped in our favor.

Certainly, the pattern certainly suggests that earnings

are now headed for another deceleration, and if the

market’s reaction from the past two instances is any

indication, a sell off is a likely possibility.



Based On Reports to date, Sales Appear to Have

Bottomed

The good news though is that roughly a third of

companies have reported earnings and so far, sales

appear to have bottomed.

Unfortunately earnings have not followed suit. While

sales have averaged an impressive 15.1% growth year

on year, earnings growth is a far more anemic 1.4%

year over year.

That tells us precisely what we’d expect in a high

inflationary low growth scenario. Companies are

passing on price increases to customers, and demand

is suffering. As a result of demand destruction,

companies are unable to pass on the entire price

rise, leading to margin erosion.

Since the leaders historically report stellar results and

the laggards look to sneak by, we expect this

deceleration in earnings growth rates to continue and

the market will likely settle around 12% growth by the

end of the reporting season.

Sector Review

Theme 1 – Logistics

We believe that as ecommerce grows, we are

increasingly going to move to a delivery based

economy. And the picks and shovels to facilitate this

are the logistics companies. We think the long term

prospects of this sector are stellar.

Theme 2 – Exporters

We’ve been saying for a long time now that the Rupee

is on a secular weakening cycle. In this environment,

exporters benefit. The market believes this summer

was a one off event. We’re saying exporters are going

to continue to benefit from an ever weakening Rupee.

Add in the prospects of a Taper by the Fed, and

exporters are a longer term attractive prospect. IT,

Auto exporters, Pharmaceuticals, Textile exporters

would be areas to focus on.

Theme 3 – Media

One additional theme, and borne out by stellar results

is Media. As mobile smartphones proliferate, the add

on revenue opportunities are enormous. The thirst

for content is going to grow enormously and the

bottom of the pyramid has the same aspirations as

the rest of us do.

Theme 4 – Telecom

Telecomm has turned the corner and the

infrastructure for 4G and data services is in place. The

time for margin expansion and revenue expansion

seems to be at hand.

Avoid Real Estate & Finance

We’d avoid real estate companies and finance

companies, because we believe a worsening

correction lies ahead in these sectors.

Banking & FMCG – Overvaluation a Concern

Banking is certainly feeling the effects of rising rates

and a slowing economy. The heady days of 20% plus

growth are gone and the industry is now looking at

low teens on revenues, with only a handful of

standout corporates able to deliver higher.

The few FMCG companies that have reported are

looking very overvalued, sporting PEs in the 30s and

40s, while delivering single and low double digit sales

growth and slightly higher earnings growth.

Consumer Durables will continue to perform, the only

concern being valuation, with PE/Gs of greater than

1.5 for most larger cap companies.

Energy companies delivered stellar top line growth

with the benefit of price hikes during the quarter.

Fertilizers is another area that is intriguing. Given the

inflationary focus on agriculture, a global marketplace

and supposed food shortages, the area is ripe for

larger players to reap benefits. However regulatory

supply chain and global dynamics continue to dog the

industry.

Detailed Results of Reporting Companies to date are

provided at the end of this commentary.



The CAD is under control for now… The CAD is under control, for now. Were more

significant outflows to occur, the pressure area would

the Rupee.

The Trade Balance came in at just $6.8 billion for the

month of September 2013. This is the lowest in two

years. Imports were down 18% from Sep 2012, from

$42 bn to $34.4 bn though while exports grew 11%.

The CAD Is Coming Under Control

But Inflation Isn’t Inflation, as expected, is rising, a direct impact of the

weakening Rupee and rising oil prices. It remains the

bane of our economy. The critical components of our

lives - food, transport and housing - are spiraling out

of control, hovering near double digits.

Inflation Continues To Rise…

HSBC Services PMI Is Bottoming… The HSBC Services Purchasing Managers' Index (PMI),

rose to 47.1 last month from 44.6 in September,

which was the weakest reading since April 2009.

The HSBC Markit survey also showed there was no let

up in price pressures, suggesting India's inflation rate

is unlikely to ease for some time.



But Bank Credit Growth Is Up 18% YoY We’ve seen a nice spike up in bank credit in the past

couple months. Whether this is green shoots or a

repackaging of sour loans plus interest remains to be

seen.

Bank Credit Growth Is Up 18%

Manufacturing Remains In the Doldrums Manufacturing, whose contribution to the GDP has

remained stagnant at 15 to 16 per cent for over three

decades, has long been dogged by issues such as

declining competitiveness, archaic land laws and red

tape.

The auto sector, in particular, is on slippery ground.

Car sales in India fell 4.7 per cent in the first six

months of 2013-14, the sharpest decline in half-year

sales since 2002-2003, and September sales inched up

by just 0.7 per cent.

Manufacturing, employs around 48.5 million people

accounting for 11 per cent of total employment, has a

share of 78 per cent in India's non-oil exports.

This, in turn, is impacting the financial sector too.

Deceleration in manufacturing impacts a sizeable

portion of revenue and also increases the risk of non-

performing assets (NPAs) in the sector. Gross NPAs

are likely to.

Sentiment Among Corporate Leaders

Lowest In 2 Years The latest edition of the Business Today Business

Confidence Survey for the July-to-September period

of 2013 found that sentiment among corporate

leaders is at the lowest since BT started this survey in

2011. On a scale of 100, the confidence level is at 48.2

in the second quarter of 2013/14, down from 48.7 in

the April-to-June period and 54.4 in the three months

before that.

Industrial Production Remains In the Doldrums

Election Risks Are Looming Upcoming general elections, due by next May, are

compounding uncertainties. Both the ruling Congress

party and the main opposition Bharatiya Janata Party

(BJP) are expected to fall short of a majority.

That means India may be heading for a coalition

dependent on regional parties, which could spook

investors further as regional leaders often hold policy

hostage to their local agendas.

On the other hand, the BJP is expected to perform

strongly in upcoming state elections. If the BJP

emerges stronger from the state elections, this would

be seen as increasing the likelihood of a BJP-led

government at the center. Sentiment could improve

as a result, since the BJP is seen as more market

friendly and more amenable to structural reforms.

Credit Growth +18.2%



Rate Watch The RBI is likely to keep raising rates to tackle

inflation. It should.

We’d love to see inflation’s back broken and people’s

expectations about embedded inflation revised. We

hope that the RBI maintains its resolve to tackle

inflation. There really is no other choice. The tax that

inflation has imposed on the Indian economy is real

and damaging.

Global Economy

Pickup in Global & Asian Demand

There are clear signs of a pickup in global demand.

Global PMIs are showing upticks and Asia's factory

sectors grew at their fastest pace in months in

October led by China.

China's PMI rose to an 18-month high and South

Korea's index pointed to expansion for the first time

in five months. Taiwan's PMI reached its highest level

since March 2012, and Indonesia's index hit a four-

month high. Japan's PMI rose to its strongest level in

over three years.

India remains the exception among the group of

generally upbeat PMI reports in Asia. Although new

exports orders picked up sharply, the HSBC PMI for

India showed manufacturing activity shrank for a

third straight month, a further sign of a slowdown in

Asia's third-biggest economy.

Input price inflation accelerated further despite the

weak growth backdrop, as the effects of the

weakening currency continue to pass through the

economy.

China's official PMI rose to 51.4 in October from 51.1

in September.

Factory activity in major exporter Taiwan, key to

many global tech supply chains, was running at its

fastest pace since March 2012.

Japan reported that its factory activity grew at the

fastest pace in more than three years as its PMI rose

to 54.2, adding to hopes that the world's third-largest

economy is pulling out of two decades of stagnation.

The Impact Of QE

We’ve reported on this subject before, but an analysis

put out recently by Forbes attributes over 100% of

equity market gains since January 2009 to the Fed’s

QE initiatives. Conversely, during the weeks when the

Fed did not buy Treasuries or mortgage backed bonds,

the stock market declined. Chart attached below.

As We All Know, Over 100% of Market Gains Since 2009 Are Attibutable to QE

Source: Forbes.com



Meanwhile, Margin Debt in the U.S. Has Hit An All Time High Alongside Market All Time Highs

Does Gold Belong In Your Portfolio? If you have doubts about whether Gold should be part

of an investor’s portfolio, consider this.

Suppose you started with three investments in 2007:

an investment in the most tax efficient and secure

investment, the PPF, an equal investment in Equities

via a Nifty 50 fund, and finally a third equal

investment in Gold.

Today your PPF investment, adjusted for inflation,

would be down about (11.5%) since 2007. In other

words, you would have lost purchasing power and

made a negative return.

The investment in the Nifty 50 …. Down 44%.

And Gold… up well over 50% adjusted for inflation.

Gold is an inflation hedge and in India that’s the best

thing you can say about an asset class!

Outlook for Bonds With Bond Yields offering a far more attractive return

than Equities, as discussed earlier, we’re going to stick

with our position in Bonds.

The government is reported to be in talks with various

international fixed income index providers for

inclusion of its sovereign bonds in their indices. Any

positive outcome on this front will have a positive

impact on the domestic debt markets, particularly on

the long end of the curve.

Outlook for Equities In a world with high inflation, our view is that a long

term buy, hold and forget is a questionable strategy

except for the investor with nerves of steel.

Particularly with the Fed playing havoc with global

money flows and causing mass hysteria and panic at

will.

Investors need to stay on top of their investments

more than ever, or have trusted and competent

advisors that do.



Unfortunately, Equities cannot be avoided as they

represent one of the few wealth building asset classes

that beat inflation handily.

The far better strategy is to be patient and

opportunistic and act when the odds are strongly in

your favor.

We look to invest aggressively during up cycles and

limit risk during the down cycles rather than staying

invested at all times. We look to preserve wealth first

and foremost and limit risk as much as possible.

The macro environment drives markets today. We

combine macro views with sector views. Tactical

asset allocation changes as the business cycle evolves

and sector rotation are the key to wealth

maximization. The ability to avoid crippling losses is

always paramount in our minds.

Finally, we look to create well-diversified portfolios

across asset classes, so that an unexpected event does

not ride roughshod over your investments and leave

you scrambling.

The odds of a correction in coming days or weeks are

high. Secondly, valuation has reached levels where

past selloffs have occurred. So the risk reward is

nowhere close to optimal to consider Equities today.

Asset Allocation Changes The RBI is in a rate hike mode but we don’t anticipate

this to be a prolonged rate hike cycle as the pass

through effects of the weakening Rupee are likely to

be transient and the additional slowdown in the

domestic economy is likely to have rates heading

down in coming weeks.

We’ll stick with our longer term high duration bond

allocation. For conservative investors, a move to

shorter term 5 year paper would be advisable. The

same applies to investors with a shorter term

investment horizon of two years or less.

Outlook We believe a market correction is a likely scenario

for the coming weeks. We’ve also articulated some

of our reasons clearly in this commentary.

We shall always aim to be unbiased in terms of the

direction of the market. We’re not tied into having

clients be fully invested at all times. We’re not

looking to sell a product.

Rather, we offer a holistic approach to wealth

preservation and growth, and look for multi-

generational relationships while providing the full

spectrum of services a family needs, we’re able to

share opinions most brokerage houses would shove

into a drawer never to be mentioned again.

If you’re an investor and missed this rally, don’t feel

too bad. The real Nifty 50 adjusted for inflation is

around 44% below its 2007 peak. And in order to get

back your 2007 purchasing power, the Nifty would

have to rise another 71%.

This is the world we live in now. A world where

markets are driven by bankers, and race ahead on

expected and leaked announcements by Fed officials.

There are going to be surprises ahead. The bigger

concern, however, may be the threat of policy errors

in response to these dynamics.

Indian corporates have done a decent job in the third

quarter. But even here, the impact of inflation is

showing heavily on margins.

The worst is likely behind us. The market is either

right and sees green shoots ahead, maybe a Modi

victory. Or it’s driven by greed and ficititious money

backed by a government’s guarantee.

Either way, the sword of Domocles hangs over our

heads and FIs with blank checks rather than

fundamentals control our markets. Welcome to the

new normal.



Third Quarter Earnings Scorecard

*









Asset Allocation

Performance and Allocation Data is as of June 30th, 2013 Notes on Performance: Potential investors should note that investments involve significant risks and the value of an investment may go down as well as up. There is no guarantee of past or projected performance is not necessarily a guide to future results. This material does not constitute a prospectus, request, offer, recommendation or solicitation of any kind to buy, sell, redeem investment instruments or perform transactions of any kind. The performance figures are provided for comparative purposes and track the asset allocation recommendations made available to clients in our monthly newsletters. The commentary is also an amalgamation of news, data and analyses from various public sources of information, the accuracy of which cannot be vouched for.

Wodehouse Capital Advisors

Manmohan Tiwana, Chief Executive Officer

[email protected]

Sunil A Sharma, Chief Investment Officer

[email protected]

Sanghamitra Mukherjee, Director

[email protected]

Krish Shanbhag, Equity Advisory

[email protected]

Sraboni Haralalka, Director

[email protected]

Offices

Mumbai 1-2, Shubhada Commercial, Pochkhanwala Road, Worli, Mumbai – 400030 P +91 22 66336600

Delhi #168, Taj Palace Hotel Sardar Patel Road New Delhi – 110021 P +91 11 65682100

mailto:[email protected]







Disclosures

Different types of investments involve varying degrees of risk, and past performance is not indicative of future results. Do not assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by us) will be profitable. Results may vary over time and from client to client. Any projections or other information illustrated in this presentation which may have been provided to you regarding the likelihood of various investment outcomes are hypothetical in nature, and do not necessarily reflect actual investment results nor should they be considered guarantees of future results. Historical performance results for investment indices and/or categories have been provided for comparison purposes and index returns may vary substantially from past performance in the future. Other investments not considered in the analysis and the recommendations resulting from this analysis may have characteristics similar or superior to those being analyzed. Please remember to contact Wodehouse Capital Advisors if there are any changes in your financial situation or investment objectives or if you wish to impose, add or modify any reasonable restrictions to our services.

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Wodehouse Capital Investment Strategy Outlookwodehousecapital.com/Monthly Newsletters/Investment...6 Investment Strategy Outlook, November 5, 2013 Third Quarter CY 2013 - Sector Sales