Markets suffering from the Economic Mess with High Volatility and Lack of Confidence
Headlines in Financial papers:
India is in a mess. Government financials are in a mess. The attempt to control twin deficits has failed. Inflation remains stubbornly high. Rupee is in a free fall. Worse, the panic has taken hold at a time when the US is seriously thinking of winding back its policy stimulus, that is, quantitative easing. This fear alone is leading to dollar investments leaving the shores. Companies, bankers and experts have all given up hope of an early economic recovery. There appears to be a total breakdown of trust and co-operation in the system.
The business class has given up the hope that the country would ever get back to the high growth rates achieved in 2003-07. Most have made business plans assuming that growth will be five per cent at best over the next few years. Cost cutting and asset rationalization, not growth, are at the top of their agenda. Everyone is convinced that this growth slowdown is largely self-inflicted. We have lost the plot and cannot blame our travails on external factors.
In short, the mood is deeply pessimistic. Many now fear about the country’s future. And the same is reflected in Mr. Market which is at his manic-depressive best. Stock markets, gold prices, oil prices and rupee have each competed to grab headlines over the past few days and weeks. And if one looks at the volatility that we have seen in recent months, one must be asking these questions – “Should I just sell my stocks and run away from the stock markets?” Or, “Should I simply invest in fixed deposit and bonds?” Even rational and sensible people now seem to have given up.
Recently, Raghuram Rajan, RBI’s new governor beautifully described our bipolar behaviour. Indian cricket fans are manic-depressive in their treatment of their favorite teams. They elevate players to god-like status when their team performs well, ignoring obvious weaknesses; but when it loses, as any team must, the fall is equally steep and every weakness is dissected. In fact, the team is never as good as the fans make it out to be when it wins, nor as bad as it is made out to be when it loses. Its weaknesses existed in victory too, but were overlooked. Such bipolar behaviour seems to apply to assessments of India’s economy as well, with foreign analysts joining our analysts in swings between over-exuberance and self-flagellation. A few years ago, India could do no wrong. Today, India can do no right.
Aditya Puri of HDFC Bank expresses similar views when he says he does not think this 5 per cent GDP growth is the new normal. It may be somewhere between 7 – 7.5 per cent. It could take up to 12 to 18 months to reach there but we tend to go into a depression very fast. So if you look two months back, no one was smiling. Today, it’s a little more optimistic.
The Role of Confidence:
The confidence today is at its lowest ebb – in our economy, in our leaders and in our investors. Significant uncertainty, both domestic and global, is one of the outstanding characteristics of today’s investing environment. It discourages optimism regarding the future and limits investors’ certainty that the future is predictable and controllable. In other words, it saps confidence. This is a major difference from conditions in the pre-crisis years when we witnessed an extremely high level of confidence. No one thinks that way today.
A feel good environment characterized by strong confidence creates pleasant conditions, but encourages dangerous behaviors and an ascent (in the economy and the markets) from which a correction becomes inevitable. In that way, the less confident attitude of 2013 create a lackluster, less enjoyable environment, but also a preferable and more prudent base for the future.
The pendulum of confidence often swings to extremes: between optimism and pessimism, between greed and fear, between euphoria and depression, between credulousness and skepticism, between risk tolerance and risk aversion and thus, between reckless aggressiveness and excessive caution. At positive extremes, people believe only good outcomes are possible, and at the negative extremes, they conclude only bad outcomes are possible. As we have seen endless number of times, investors reach the overconfident state when things have been going well for a while, meaning prices have already soared. And, alternatively, the latter hopeless state is inevitably reached, after the news has turned unremittingly negative and prices have collapsed.
This is the pattern that makes herd wrong at the extremes and creates reward for contrarianism. When most investors are driven to drop their prudence by an excess of confidence, we should be terrified. In the same way, when most investors become devoid of confidence and flee the market, we should turn aggressive.
The three stages of a market turnaround from an extremely depressive mood as prevailing today:
– the first stage, when a few forward-looking people begin to believe things will get better,
– the second, when most investors realize improvement is actually underway, and
– the third, when everyone believes things will remain better forever.
What does it really mean? The essential raw material for a market to go up is cheapness, and that cheapness exists in stage one precisely because there are so few believers and so little confidence that favourable developments and good times lie ahead. We believe, this is the most wonderful investing time, particularly in the Small &Midcap segment, if one would like to invest with a time horizon of at least two years.
How Confidence factor can work in India?
What Indian economy and Indian stock market lacks today is the Confidence Factor. For a plethora of reasons – domestic factors like corruption, continuing infrastructure bottlenecks, policy ambiguity, lack of reforms, Supreme Court denying mining of iron ore or coal, high import of gold, bureaucratic interference, etc., etc., or external global factors like withdrawal of cheap money policy, high commodity prices, high oil prices etc., etc. India seems to have lost its confidence level completely, and that has resulted in an environment of despair all around. An improvement in the Confidence level can significantly change this environment. And this confidence factor can come from anywhere –the recent appointment of the new RBI Governor is a case in point. Both money and stock markets welcomed his speech with a high level of approval (though it is too early to pass any hasty judgment).
Similarly, it can also work if government starts taking tough measures in order to bring economy out of rut and avoid rating downgrade for the country. A change in government in May 14 election (read Narendra Modi) could be a major game-changer for the country.
For the most part, India’s current growth slowdown and its twin deficits are not structural problems. They can all be fixed by means of modest reforms. With excellent monsoon, the country is expected to witness strong growth in agriculture in the current year. Rural economy is likely to do quite well. The government is trying its best to contain the fuel subsidy on the one hand and to remove infrastructure bottlenecks on the other hand. If this is done, it can boost the overall economic growth in particular and confidence level in general.
Overall, when people start seeing promising long-term prospects, confidence in the economy returns faster than expected.
Rupee depreciation – boon or bane?
While the sharp depreciation of rupee has received a lot of negative publicity, not much has been written about its positive fallouts. Few have realized that with the drop in rupee, our products are now much cheaper than in China. Manufacturing has been one of the weakest links in recent times, but the rupee fall now makes a variety of products more exportable or import-substitutable. China, which had been the factory to the world for many years, has seen its currency actually appreciate slightly against the dollar during the past few months while the rupee fell sharply, making Indian products more attractive. We see quite a few manufacturing companies doing extremely well over next few quarters with a rise in their sales and profits.
In fact, with depreciating rupee, we have already witnessed India’s exports posting double digit growth in July-August, while imports declining, thereby narrowing the trade deficit.
The sharp fall in the rupee along with the fall in share price provides a good opportunity for foreign promoters, especially MNCs, to consolidate their stake at a reasonable price. The RBI has also recently made it easier for foreign and non-resident Indian promoters to increase their stake in domestic companies.
What can work for Indian Stock Market?
What favors India today is extremely low level of expectation from policy makers, and extremely low levels of valuations particularly for small and midcap company stocks. A few policy initiatives can set the ball rolling particularly when no one wants rating downgrade for the country. Indian small and midcap indices have gone down by more than 50 per cent over last 5 years despite a rise in sales turnover and profits of the constituent companies over the same period.
Our performance and expectations:
Table below gives QuestPMS performance since inception in October 2007 comparing it vis-à-vis various large cap, small cap and midcap indices. You will notice that since we mainly invest in small and midcap stocks, our performance has been lagging behind the large cap indices which have been holding on due to large scale investment by FIIs in large cap stocks.
Composite Performance of all clients as on September 30, 2013:
In terms of fundamentals, we strongly believe, we have invested in quality businesses and expect them to do extremely well in coming years. It is irony of the situation that despite good businesses being excellently managed, their share prices are falling due to continuous selling by domestic investors. We firmly believe, time is not far away when huge valuation divergence between large-cap and small & mid-cap stocks will force smart investors to have a re-look at their investment strategy.
Few of the companies in our portfolio are currently traded at attractive cash earnings multiple (less than 3 years of cash earnings). A few others give an annualized dividend yield of 4 to 5 per cent. And still others are traded at market capitalizations which are less than 10 -15 per cent of their annualized sales. More than 60 percent of total sales of composite portfolio come from global markets, thus benefiting from rupee depreciation.
In order to take advantage of irrational market situation, we have started rationalising our stock positions by consolidating individual portfolios, selling some shares and re-investing the sales proceeds into the fundamentally stronger but cheaper stocks.
Smart investors buy when there is fear in the air, and they sell when they smell greed. It is time to control fears and start investing.
While it is truly difficult to be positive at present, one should not forget that we are a democracy with checks and balances. We have a very young and hugely aspirational population. The political system will eventually have to adapt to the needs and wishes of this huge demographic. We will have to make the systemic changes to bring growth back. It is wrong to think that we have permanently lost our way.
The risk is that we could have some more pain ahead, maybe even a crisis before the required changes happen. However, most veterans feel that the worst is over for the country and pessimism is overdone, particularly for small & midcap segment of the market. While large cap liquid stocks have actually performed reasonably well despite all headwinds, most smallcap & midcap stocks are pretty much beaten down and there we see lot of opportunities
September 30, 2013
To know more about Quest and QuestPMS please visit our website: www.questinvest.com
DISCLAIMER: This communication does not constitute or form part of any offer or recommendation or solicitation to subscribe or to deal with QuestPMS. The views expressed by Ajay Sheth, Portfolio Manager QuestPMS are his personal views as on the date mentioned. These should not be construed as investment advice to anyone. This communication may include statements that may constitute forward looking statements. The statements included herein may include statements of future expectations and, are based on the author’s views, observations and assumptions and involve known and unknown risks and uncertainties that could cause the actual results, performance or events to differ substantially or materially from those expressed or implied in such statements. The author does not undertake to revise the forward looking statements from time to time. No representation, warranty, guarantee or undertaking, express or implied is or will be made. No reliance should be placed on the accuracy, completeness or fairness of the information, estimates, opinions contained in this communication. Before acting on any information contained herein, the readers should make their own assessment of the relevance, accuracy and adequacy of the information and seek appropriate professional advice and, shall be fully responsible for the decisions taken by them.