The INR has touched 72.1 versus the USD. A year back it was at 63.94. The prevalent wisdom was that the INR would touch 58-62 range in 2018. However, one year down the line we are at 72.1. That is not a surprise. In the long run, the INR depreciates against the USD in a range of 2.5% to 6% CAGR, depending on the inflation differential and productivity growth differential.
Since India’s long-term inflation rate is around 7% and the USD long-term inflation rate is around 2%, a 5% drop annually is possible. India’s higher productivity gains make the drop lesser.
In the short-term, the demand and supply factors determine the exchange rate. In times of large FPI or FDI inflows, or high exports the INR strengthens and in times of large outflows the INR depreciates.
One of the largest items Indian imports is crude oil. Since the demand is nearly inelastic, as the crude oil prices have a very large impact on the exchange rates. As the crude prices have increased recently, it has caused a large depreciation in the INR in the near term. Of course, there are several other driving factors. However, the fact remains that the rupee depreciates over the long-term.
How to Benefit From a Depreciating Rupee?
The Scientific Investor tries to explore ways of benefiting from events it cannot control rather than complaining about them. How can we position our portfolio to benefit from the declining rupee? One of the easiest way is to invest in companies which sell in dollars and spend in rupees. These are companies whose customers pay in USD, but they pay their employees and suppliers, primarily, in INR. Simply, put invest in export-oriented companies.
Of course, one cannot blindly invest in any export-oriented company. One should focus on the fundamentals first. Is the company profitable even when then INR is strong? Maybe the profits are lower, that is acceptable. But it should not go into losses when INR becomes strong, which from time to time it will. The company should have a strong balance sheet with low or zero debt. The company should be capital efficient. Finally, the company should be available at a large discount to intrinsic value. In short, we have just described an exporter which fits the Scientific Alpha selection process. This means that it is a SuperNormal Company available at a SuperNormal Price. One can invest in a portfolio of such companies to have a robust hedge against the INR depreciation in the long run.
Of course, from time to time the Scientific Alpha (Exporters) portfolio should be reviewed for overvaluation or fundamental deterioration. However, if the overall portfolio remains fundamentally strong and is not overvalued, it can continue providing a hedge against the INR depreciation. In fact, it could gain substantially as INR depreciates.
The Scientific Alpha Multicap Portfolio (ACE Multicap) already includes several exporters in it. However, ideally, a specific pure exporter portfolio should be allocated to on a permanent basis. Possibly, this could be around 20-25% of one’s total capital.
A properly positioned portfolio would have gained from such an allocation. The Scientific Alpha Multicap Portfolio has seen the benefits of its allocation to the export-oriented IT sector. It benefited from the INR depreciation. It further benefited fundamentally through an exposure to the strong US economy. Further, the most important factor which is still not priced in fully in the IT sector is the fast-growing Digital Transformation portion of the business which forms more than 25% of the revenues of most mid-to-large IT companies. The Digital Transformation portion of the revenues is growing in the range of 25-35% CAGR. That part of the business is still not discounted in the prices.
However, there are several other sectors which have exporters and they could benefit from the long-run INR depreciation. Eventually, Make in India will become stronger and one’s portfolio can benefit from continued INR depreciation and more exports.
However, while investing in any sector or theme, always keep the Scientific Alpha investment framework in mind and only invest in SuperNormal Companies at SuperNormal Prices!
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