At The Crossroads

Podcast Transcript:

When markets are overvalued, what should an investor do? Should we buy overvalued stocks which we really like? Or, should we stay in cash? Or, should we go where others don’t dare to go and invest? This was the dilemma of 2017-18.

This dilemma was not merely that of ordinary investors. Expert investors, professional fund managers, and portfolio managers have lived down this dilemma for the past year or so. During this phase, we have seen monies flowing fast into equities. This only made things worse for everybody. Logic demanded we should not do what we are not fully convinced about. But, if you were in the business of managing money, turning away money was simply not the done thing.

So, we saw the experts themselves enter the domain of identifying companies outside the proven stock universe.  This hunt for new blue chips became the hotbed of action. We saw more and more people coming out with ideas they believed were deserving blue chips. The race started to get even more racy as money continued to chase ideas. Private investors too began to start identifying themselves too closely with companies.

The business of investing turned more and more aggressive. Governance started to be given more license. The mutual funds started to join this party. Micro caps, Small-caps, and mid-caps became the only saleable flavours. A peculiar situation soon emerged where these new flavours sold at higher valuations than the index bellwethers.

Briefly, this situation seemed to be sustainable. As an investor, one could either learn to live with it or just stay away for a while. Or, go where others dared not to. This was hardly as simple as it sounds.

Advisors began to feel the very dilemma pinch their decision processes. The events of April and May 2018 have again triggered a search, rekindled anxieties, and opened up serious fears. For one thing, the trend has broken down. And, large caps have done better than emerging companies. There are clear indicators of changing trends in money flows, valuation perspectives, stock choices and performance expectations.

Clearly, the liquidity will not sustain for too long. In the absence of liquidity, the valuations look suspect. In such a scenario, only companies that do better than expectations and retain the respect of investors will be able to hold onto their valuations. The others may only break down.

This is the emerging scenario which advisors, fund managers, portfolio managers, HNIs, and retail investors are heading into.

What should one do?

Stay safe. Move to safety. Exit overvalued parts of the market. Focus on the more liquid parts of the equity universe. Don’t make the lack of liquidity your biggest portfolio risk.

This is my simple approach. To agree or disagree is a personal and professional choice.

But, there is no escaping this choice. It cant be put off anymore. One needs to stand up and be counted on any one side.

Staying outside this game and focusing on other asset classes may need to be done very carefully given the global interest rate risks and regulatory overhang on other asset classes.

So, equity remains a good bet. But not an easy one to make.

Think Ahead

While the markets were focused on equities, yields on the 10-Year gilt quietly rose to cross 8% again. With other asset classes like real estate not doing much, and returns from equities clearly slowing down, debt makes a clear comeback as an option for conservative investors.

Over the next few months, investors can build a compact portfolio with the right mix of equity and debt. In fact, this is a good time to re-look at asset allocation, carefully rejig the allocation to each asset class, and build both debt and equity portfolios for the medium term. Importantly, choosing investments must be done in a way that ensures long-term tax efficiency.

Debt investments must be chosen keeping in mind a longer time horizon. Locking into higher returns from debt investments must happen when interest rates trend higher. This requires a carefully crafted investment strategy. Equity investing must also ensure choices are aligned to medium portfolio out performance.

Past performance will now tend to confuse our choices. One must learn to think beyond past performance and focus on what lies ahead.

Anchoring Bias

Podcast Transcript:

My stance on mid-cap funds has been bearish in a while. After the dream run between 2013 and 2017, I started to feel very uneasy about them from September 2017. I had been advising clients to invest in the very funds when the valuations were softer and definitely attractive. But once these valuations went behind levels I consider reasonable, I turned cautious.

Firstly, I was advising clients to avoid investing aggressively into mid-cap funds. Then, I advised them to gradually move their monies into safer parts of the market. The decisions seemed out of sync with what industry was telling customers. Every dip was being bought and it appeared the best thing to do. The mid-caps simply kept going higher after every fall. This made investors believe that every dip must be bought. Implicit was the belief that the stocks will only go higher.

The current capitulation in mid-caps is also being bought into based on the same belief. The fact that stocks went higher after every previous occasion is why people are hurrying to buy this dip. But, this time could well be different. The reading of investors could well be wrong. Here is why.

We are thinking that the high valuations of 2017 are the new normal. But this belief has little or no basis. It is merely a demand-driven phenomenon. Now, supply promises to be abundant in quality equity paper. This only means we are going to see scarcity go away. Finally. So, sustaining valuation in a supply driven market will turn to be a challenge.

Investors seem to be ignoring the headwinds ahead. The reason is simple. Anchoring is biasing them. It so happened that everyone who bought previous dips made good money. That is biasing investors heavily inducing them to aggressively buy every dip.

But we are not necessarily going to be right going forward. There could be a long period of lull when performance could be ordinary. It is doubtful if investors will show the required patience in mid-cap funds for such a long time. Negative returns or non-performance may even get punished. Redemptions cannot be ruled out. If, and when they happen, they could be a major spoiler. We are going to see smarter investors selling into rallies. This would mean those buying the dip and not selling the rally may suffer in the end.

Rising oil prices and interest rates can dampen earnings. This may well lead to contracting valuations. As valuations fall, it can well lead to a reverse spiral in stock prices.

This turns anchoring biases into a grave risk. We need to be aware of what can happen if the situation creates furthers fears in investors’ minds. And what if the fears refuse to go away?

I believe we now need to avoid anchoring biases. The times are different. It is important to be in sync with the emerging market context. Anchoring biases may now prove to be very costly.

RBI Monetary Policy, June 2018

Monetary Policy:

As the macroeconomic outlook becomes less transparent the monetary policy committee has only become more steadfast in its neutral stance. This leaves room for all possible outcomes and actions. The neutral stance has often been equated to a status quo for policy rates. So, the rate hike of 0.25% may come as a surprise to some.

Inflation has always remained at the core of policy decisions. Oil prices have already increased by 12% since April. More clarity on global oil prices may emerge after OPEC’s meeting later this month. Till date, price hikes have been passed on to the end consumer. Raw material costs have also spiked as a result of this. The RBI anticipates an upward inflationary trend and is working to manage this.

On the other hand, India’s growth story continues to remain positive. A normal well-spread out monsoon bodes well for the agriculture sector. Urban and rural consumption look healthy. Capacity utilization in the manufacturing space has improved. The resolution of stressed assets is ongoing and better provisioning norms are ultimately working in favour of banks.

Investment Strategy:

Rising bond yields should be viewed as investment opportunities rather than pain points. The RBI’s neutral stance does not provide a clear view of where interest rates are heading. Risks are elevated when there is less clarity. Asset allocation will play an important role in mitigating risks.

Play It Safe

“Large caps look inexpensive compared to small and midcaps.” A value investing peer said this in a rather complaining tone. To investors who made most of their wealth buying small and midcaps, these are troubling times indeed. The situation has remained so for the past year. Investors have been struggling to cope with this. Stocks were expensive and people were buying them as if there was no tomorrow.

Nothing contrasts this frustration more starkly than the bold and aggressive SIP flows into the same space from retail investors. Investors have been pouring money into this space based on past returns. While experienced investors struggle to deploy money in the space, public investors were partying with the monies of the retail investor. But, the first signs of cracks are clearly there. For starters, stocks which were not owned by mutual funds have corrected sharply. This gives a false impression that fund owned stocks are safe. But, there is more to this than meets the eye. Fund owned stocks in the midcap space will correct when the funds are not in a position to support their prices. It is fairly safe to assume that day shall come.

Meanwhile, the market struggles to find defensive investments in equity. Portfolios will take an increasingly defensive stance and returns over the next 12-18 months will probably see better traction in defensives. Aggressive investment strategies will probably take a break. The time is ripe to stoutly defend portfolios.


The Winner Takes It All

Participation in equity markets is viewed as a secular trend. Being invested is not the same thing as being invested in the right place. Even within the equity market, where you are invested matters. For instance, one could still have been fully invested in equity markets without owning a single tech stock in 2000 and a single infra stock in 2008. Keeping a reduced ownership of financials and midcaps and yet being fully invested in 2017- 2018 may well be the contemporary equivalent of that behaviour. Outcomes could have been dramatically different for the consistent contrarian.

Domestic money has been a serious determinant of every bull run of recent times. This bull run is predicated upon how aggressive domestic flows are directed and where they are headed. The end of this bull run also arises from this direction, actually from its reversal. So what actually happens? After long periods of continuous inflows into a particular segment of the market, we started seeing the flows go the other way. The catalyst could be from anywhere. And once the reversal happens, more people will get caught by buying the dips.

Strangely, in both 2000 and 2008, there was ample scope to be a determined contrarian and succeed at it. The answer lies in relying on top down investing when the bottom up trade goes over the top. This is easier said than done. The current phase is also looking to become a top down dominant trade again. The sad thing is that nobody seems ready and willing to bet on it. The winner will clearly take it all.

Revisit Your Math

Rising oil is something nobody has factored into their investment calculus. So, there will be a need to rewrite the whole math. When the market is forced to suddenly revisit its math, it is more likely that the rework will be aggressive. So, the market reaction will tend to be kneejerk. For sure, there will be a sense of urgency.

The sharp bounce we saw in technology stocks at the prospect of a weakening rupee is a recent instance of this behaviour. Now, we are staring at costly oil. This should mean a weaker rupee, tighter forex reserves and higher inflation. India has one more decade of enduring the pain of oil. By then alternate energy will clearly grow and electric technologies will de-risk our economy significantly from oil. But, the intervening years will see the pain come and go.

Should we read too much into the oil price trend? Will it impact our macros severely? The government has a number of options before it. It certainly has to take decisions that will help soften the double blow from the spike in exchange rate and oil price. When it does, there will be other consequences. Striking the right balance is critical.

In the past, governments failed miserably at this. While oil is a risk, it is also likely to help the much-awaited earnings recovery for the index. We remain a commodity heavy index and there is definite scope for earnings of biggies to grow. But, that is contingent on the quality of governance. Populism will clearly spoil the party. One thing is certain. Those companies that saw earnings expansion purely due to cheap oil are going to see their party end abruptly. The stock market seems ill-prepared for that event.