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Positioning portfolios at present (September 7, 2016)

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Positive sentiment around India and Indian equities, and global liquidity is transmitting into increased inflow into Indian equity markets.   However valuations (measured through trailing ratios) are well above historical average levels.

Should existing investors continue to deploy capital or wait for more favourable entry points?

In this post, we explain different narratives at present and our recommended approach at present

There are contrasting, yet credible narratives (global and local) that will influence market trajectory   

The bearish argument is that global markets could witness a steep fall when sentiment reverses

  • The US markets are trading at very high multiples (on almost all metrics) even as the S&P earnings have been declining.
  • Global growth will remain tepid in the developed world as societies in the developed world have borrowed growth from the future (brought forward consumption) due to excessive disbursal of credit.
  • Reported Earnings have been boosted by stock buy backs and cost cuts rather than been supported by revenue growth.
  • Central Banks actions are destroying business models.
  • Capitalism and democracy are at cross purposes which is resulting in more protectionist steps.
  • Macro head winds (China’s debt burden, Brexit etc)

 

The alternate narrative is that while growth is tepid, markets are unlikely to fall off a cliff.

  • Current high P/E multiples are justified by very low/negative interest rates, which Central Banks intend to maintain
  • Dividend yields on blue chips are over 3%. Why would you sell equities to park money in very low or negative rate bonds?
  • Central Banks, which till recently were only buying debt to reduce interest costs, have now started directly intervening in Equity markets.  Note, the Bank of Japan is amongst the top 5 shareholder in over 80 companies in the Nikkei, and is on course to become the No. 1 shareholder in 55 of those firms by the end of next year.
  • There is clearly no limit to what Central Banks may do to support Asset prices and their stated response to what they will do when the next recession hits is to “double down” on current measures.

 

The Indian perspective to be cautious is

  • Valuations are very high when measured by trailing ratios. At trailing 23.6X, NIFTY is just 10% shy of multiples at the Jan 2008 peak.
  • Mid and small cap indices are at an all-time high.  Consumption is the sole engine of growth.  Exports and the private sector investment cycle remain stressed.
  • If earnings do not increase at a rapid clip, markets will correct significantly.  Caveat Emptor.

 

The contrasting, more supportive, narrative for India is

  • Compared to Jan 2008 when most variables were at a peak and trailing earnings were > 20% CAGR between 2005-2008, the economy at present is operating at sub-par utilization and profit margins and with earnings growth < 5% CAGR between 2013-2016.  (See table below).
  • Our macros at present are well under control.
  • Further, a good monsoon, 7th pay commission and Govt. actions  should result in earnings growth picking up momentum in the coming quarters.
  • As earnings recover, the valuations would come back to fair value within 6-8 months.
  • Hence, markets could witness a correction at this time, but not a rout as fundamental growth indicators are in place and showing traction.

 

As you would infer from careful reading of the above, both narratives have merit

PE multiple

Key things for you to remember

  • The greatest variable that influences long term investors is not your choice of fund manager (I wish it were otherwise !!), but your behaviour during times of euphoria and despondency.  We need to guard against the “fear of missing out” as much as “fear that the world is coming to an end”
  • Take the right lessons from history.  The 2008 meltdown should never be forgotten, nor the euphoria preceding it.  However, we should remember that the collapse was deeply enhanced by the break-down of trust in the banking system and a consequent multiplier shock to economic activity due to non-availability of credit.  PE compression was accompanied a deep cut in earnings.
  • Uncertainty is not new to markets.  Markets tend to forget yesterday’s problems (China’s bad debt, Brexit, Greece anyone) and focus on new ones.   Future returns have no correlation with current uncertainty .  What matters in the long term is the ability of companies to generate earnings growth.

 

What do we think will happen next

  • Short term
    1. We don’t have a clue.  Predicting what will happen over the next week or month is a fool’s pastime.
    2. The market’s short term direction is akin to the trajectory a cricket ball will take as it flies off the edge of a cricket bat on a pitch offering pace and swing.
  • Long term
    1. Even from current market levels, the patient investor in Indian markets can expect 15-18% compounded returns over a 3 year horizon if the Indian economy will grow at ~7%+ , inflation stays between 4-6%.
    2. Our confidence in the above statement stems from our confidence in our ability to identify companies that can generate the above earnings growth
    3. However, markets will take a non-linear, meandering path.
    4. We should recognize we are in unchartered territory in global monetary experimentation, the side effects of which are still unknown.  No one should pretend to have the wisdom to understand the implications of negative interest rates.  Hence, be prepared for global economic accidents, from which India is never insulated.
    5. However, unless economic activity freezes, we should witness corrections rather than meltdowns.

 

Suggested approach

  • Take a comprehensive wealth management approach, rather than focus on Equity investments alone.
    1. Equities is not the only game in town.
    2. Build Optionality and diversification in portfolio through Bonds, Gold and other investment instruments.
  • Given the pace at which markets have risen (~30% in 6 months,  multiples trading well above long term averages) it would be better to wait for more favourable entry points into Equities.  Markets always give you another chance.  Guard against the fear of missing out.
  • If you want to deploying capital at present, provide the fund manager flexibility to hold higher cash buffers rather than be fully invested
  • Recognize you cannot have both the best performing equity portfolio, as well as the most resilient.  You have to make a choice on portfolio design.
    1. Stay with quality companies, or the marathon runners, rather than sprinters.  They are best positioned to both take advantage of growth as well as weather any storm.
    2. Use the current market euphoria to rebalance the portfolio.  This would be a good time to clear out the trash
  • This is not the time to sell.
    1. Valuations are not in euphoric zone and one should not fight momentum/liquidity
    2. Earnings growth in India are on an uptrend, supported by favourable tail winds.    The direction is clear; only the pace is uncertain.
    3. Trying to retime market entry in search of a few percentage points could make one miss out on the greater growth opportunity ahead.

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