Yin and Yang – Indian style

When DIIs sold, FIIs bought and when FIIs sold, DIIs bought. This was almost mistaken for some kind of Yin and Yang phenomenon. Investors and analysts reduced it to a complementary system, where the two counterbalanced each other. This would work well for the overall market. But, the two aren’t complementary enough to create a more dynamic market.

Often, one tends to overwhelm the other and the net effect is to weaken the system. In this case, the system happens to be the Indian market ecosystem. We could soon find out that the DIIs overestimated their ability to provide market stability. To make matters worse, we might face a situation where their indiscretions and indiscipline on the buy side will hurt their own performance.

FIIs have held a steady and stable approach in the past month. They are not seeing value in our markets and are relentlessly selling. Indian investors – institutional, HNI and retail, are living under a fallacy. They believe that they can sidestep the challenges created by overvaluation by simply coming together and buying whatever FIIs offer for sale.

Experience shows that fallacies in stock markets rarely last long and inflict swift and heavy costs on those who are not disciplined enough. This time, Yang could well take Yin down.

Disruption Returns

The last week saw a heated debate on electric vehicles. This brought back intense focus to the threat, disruption poses to the automobile industry. Advancements in technology can disrupt the world much more in the next ten years than it has in the last fifty.

This is not just restricted to the automobile industry. In fact, the threat to traditional BFSI (banking , financial services, and insurance) due to the triangulation of telecom, data analytics, and automation is much bigger. Consumers clearly stand to benefit. But, investors may have a lot more to lose than imagined. The reason is simple.

Disruption creates deep change at double-speed. It can hit an industry and make it irrelevant to the future. The threat of obsolescence can force businesses to cede pricing power, give more to consumers, and pay to retain their relevance. It can completely take away profitability. Bankruptcy will also need to be seen as a logical extension when all else fails. These are new to the Indian milieu. We are yet to see listed companies wind up, simply because they don’t have a reason to be. In such a scenario, discounting earnings for a longer time horizon may not be prudent.

This brings the investment focus firmly back to consumption and essentials. These are likely to remain more stable over longer periods of time. The risk markets run in every bull cycle is, that they tend to overstretch valuations of sectors just before they face massive disruption.

This time is no different.

“The number one problem in today’s generation and economy is the lack of financial literacy” – Alan Greenspan 

Priced to perfection

The investors are always more obsessed with knowing who is buying a stock than who is selling. The natural inclination is to follow buyer behaviour.

Bull markets bring this more sharply into focus as large deals start taking place between large investors. Sellers of bigger parcels seek to exit stocks and buyers find it easier to buy such parcels than to labour in the markets to buy enough.

Naturally, scarcity premiums come into the pricing of such parcels. We are now experiencing a sellers market. While it will take a long while to judge who was the smarter one in the transaction, some pointers are clear.

Domestic mutual funds are buying and foreign investors like PE funds are selling. Clearly, there is a flight of foreign money out of Indian equities and last week’s sale figure of Rs.3425 cr only reinforces the prevalent trend.

Domestic investors must also develop a sellers perspective before they go ahead and buy a stock. Knowing why somebody sells a stock is just as important as knowing why he buys a stock. At prevailing higher valuations, knowing both perspectives will bring the right balance into one’s investing. Choices will be measured and rightly priced. Getting the purchase price right ensures that the investment enjoys adequate margin of safety.

“It amazes me how people are often more willing to act based on little or no data than to use data that is a challenge to assemble” – Robert J. Shiller 

The Demon Remains

The one thing where market consensus is growing is that domestic inflows into equity aren’t going to slow down anytime soon. This growing consensus is emboldening the sell side and the mutual funds industry.

The persistent FII selling isn’t doing much to unnerve domestic players. They seem supremely confident. But, such confidence is always a function of altitude. The higher the market is placed, the more confidence in equity. Indian market participants have almost always demonstrated more faith in equity at higher levels. This time is no different.

What are the risks to the present overconfidence? When this question is raised, thought leaders say that there is presently no alternative to equity. The risks seem to be getting sidestepped.

Let us take the risk head on. The risk to equity will rise if the economy decelerates post GST instead of gaining momentum. The slowdown in the economy should end up being temporary rather than structural. Economic thinking in India is still deeply divided on the impact of demonetization. This leaves the jury divided.

“All persons ought to endeavor to follow what is right, and not what is established ” – Aristotle

Valuation drivers always prevail

What should be a good time horizon to judge your investment performance? Should this time horizon be the same irrespective of where we stand in the market cycle? These are questions that are rarely raised or addressed.

We almost always conclude without reason that one year is a good time to judge investment performance. We judge performance linearly just the same way we assess fixed deposits. But, equity as an asset class is incapable of generating linear returns.

Marketing literature that show high five-year returns always hide the fact that there could have been two or three years when performance was worrisome. Returns could have been lower than inflation or even negative. Recency bias is largely to blame for mistaking equity returns to be linear. If performance was good for one or two years, we forget the times before, when performance was bad. We treat this as inconsequential.

We start believing in new normals. But new normals in equity investing can never be linear. If returns are higher for a while, we would inevitably see time corrections follow. Valuations can alter time horizons and always play a big part in deciding the “how long” and “how much” questions in investment performance.

When the valuations are rich, we may need to wait for a while before we get richer.

 

“The individual investor should act consistently as an investor and not as a speculator.”

– Ben Graham