What investors should know about the Indian Stock markets?

India is currently among the most watched Emerging Market nations. To top that, the Indian Equity Markets have witnessed unprecedented growth in the recent months. The YTD returns for Sensex alone has been 26% (data from BSE India). The euphoria and high confidence on the Indian Equities has continued to remain, especially from the institutional investors both foreign and domestic.

This is also leading to make many individual investors question whether they should invest in equities or sit on the sidelines. While individual risk appetite and time horizon would be some of the basic factors to understand before investing, there are many other fundamental factors to track. While the debate has been raging on as to which indicators should be looked at or ignored to make sense of the valuations of the Indian equity markets, the following factors can help bring some sense of clarity to the overall picture. Factors such as:

Current Price to Earnings Ratio (P/E Numbers): One of the most traditional tools used globally at gauging the valuations of an equity market of a country. In the last one year alone (based on data from Oct 16 to Oct 17), the P/E Ratio for S&P BSE Sensex has averaged close to 22 times in comparison to its historical average of approximately 17 on a trailing basis. For the BSE Mid Cap and Small Cap of the same period, the P/E valuations are at an average of 33.8 and 81.13 times.

Corporate Earnings: P/E Ratios are directly linked to the corporate earnings of the country. As per Kotak Institutional Equities Estimates, the Expected Earnings for companies representing the Nifty 50 Index are approximately 2% in FY 2018. A variety of reasons are attributed to these low earnings expectations, most famously discussed are the implementations and effects of Demonetization and Goods and Service Tax (GST).

Crude Oil Prices: Nearly 80% of India’s energy needs are import dependent. A direct consequence of this is the risk to the country’s inflation rate if the prices of crude oil are to rise. A rise in oil prices results in lower cashflows/profits for companies and higher prices for consumers. Brent crude oil prices are currently firming up at prices upwards of 60$ per barrel. This is a definite concern from an Indian economy perspective.

Exchange Rates: The Rupee is currently considered overvalued basis its 10 year average (Source: Kotak Research). This has a dual impact on the economy i.e. (A) it increases attractiveness of imported products, resulting in increased competition for domestic companies and lower profits; (B) it decreases the value of exported products and therefore hurts the margins of export based industries such as the IT sector. Both have resulted in muted growth prospects for these respective industries.

Bond Yields: In an growing economy like India, both equities and bonds compete for capital. In a equity bull rally, money is taken out from bond markets and pumped into equities, forgoing risk to capital for riskier investments. Currently bond yields are inching up to the mid 2017 high of 6.987% yield for the 10yr G-Sec. However there has only been net inflows into fixed income. Foreign Portfolio Investments into Government Securities have already reached 83.94% of their allotted limit (data dated as per 6^th Nov NSDL)

Inflation Rate: Inflation brings about it own risks to the stock markets. In the last Monetary Policy Committee meeting, the RBI revised the inflation projections for the rest of FY 2018 upwards to 4% – 4.5%. This may indicate a stop to future rate cuts, freezing any possibilities of reduction in lending rates. Medium term consequences for companies could possibly mean dearer than expected debt to  service, resulting in subdued profits and revenue.

Role of FIIs: The way that Foreign Institutional Investors park monies in the market can give an indication to the current picture of that market. While FIIs were very bullish on Indian Equities for most part of the calendar year, starting June they slowly but surely tapered inflows in equity, finally resulting in net outflows in the month of September and October. (Source: moneycontrol)

Global Scenario: On a global scale, economies are starting to look up, with further growth expected. According to IMF Economic Outlook, average expected GDP growth for FY 2017 is 2.5%. Globally, equity markets have participated in this growth including India. What probably may need to be put in perspective is that the rally in Indian Equities may be partly due to the global rallies taking place. Therefore the Indian equities are associated with risks in terms of foreign external factors like outbreak of war in the Korean Peninsula. Such events are likely to have negative impacts on the domestic markets.

Keeping in mind the above mentioned factors, Plan Ahead Wealth Advisors has a definite view that current equity markets are over valued and investors should exercise caution. The not so positive indicators from these mentioned factors should mean a significant correction cannot be discounted, keeping us wary of diving too much into equities without first educating investors of the potential risks in the short to medium term horizon.

 

 

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Why You need a Long Term Investment horizon?

In today’s volatile environment which largely stems from economic uncertainties from global markets, be it the Yuan devaluation some time back or Brazil being downgraded to junk or the September Fed meet on which everyone had an eye which resulted in no rate hike at the moment. The thing which most investors lose focus on is something that is called as long term investment perspective. By investing for the long term one will not try to time the market. Nobody can. We all know the simple rule of investment – buy at low and sell at high but invariably we tend to do it the other way round.

While focusing on short term we tend to buy stocks which have all the positive news around it and little do we realize the half of the time that news has already been priced in. If we focus on the short term our investments are bound to react to events in the short term both positive and negative. Whereas if we focus on the long term the returns will be impacted less by volatility and more by the performance of the investment instrument.

As per tax laws holding stocks beyond one year is categorized as long term but when it comes to investment an investment horizon of 3 – 4 years or more can be considered as long term. On the other hand when it comes to real estate it is far beyond that. Gold is another asset class but again it depends in which form it is held, whether in physical form as ornaments or in the form of ETFs.

Historical data also shows SENSEX had jumped 250% from April 1991 to March 1992 on the back of Harshad Mehta scam. He took crores of rupees from the banking system and pumped it in the market. The scam came to light when the State Bank of India reported a shortfall in government securities. That led to an investigation which later showed that Mehta had manipulated around Rs 3,500 crore in the system. On August 6, 1992, after the scam was exposed, the markets crashed by 72 percent leading to one of the biggest fall and a bearish phase that lasted for two years.

Similarly, from April 1999 to March 2000 SENSEX rallied 35% on the back of improving macroeconomic scenario – improved GDP numbers from growth in manufacturing, infrastructure and construction sector, falling inflation, healthy forex reserves and good industrial production numbers as against the year before and also the technology bubble was engulfing the rest of the world.

Again SENSEX fell 27% in March 2001 when the Ketan Parekh scam took place. A chartered accountant by training, Parekh came from a family of brokers, which helped him create a trading ring of his own. Be it investment firms, mostly controlled by promoters of listed companies, overseas corporate bodies or cooperative banks, all were ready to hand the money to Parekh, which he used to rig up stock prices by making his interest apparent.

Again in Feb 2008 SENSEX corrected by 8% approx on the day Reliance power Ltd. got listed. It closed 17% below its cost. Sensex witnessed a fall of approx 36% from 2008 to 2009 on the back of US Subprime crisis.

Following that there was a sharp pull back in equities between March 2009 to November 2010 led by global (Quantitative Easing announcement by US) and domestic (general elections) news flow. Putting all the pieces together the message to take away is that events will keep on happening but if one keeps a long term investment horizon it will be a safer bet.

The two main factors to consider before taking an investment decision for one self are ability and willingness. It is very important to know the difference between the two. Willingness is more about the attitude towards risk irrespective of the financial ability to do so. Ability on the other hand is financial capacity to bear the risk. It depends on income of the individual, his savings and expense pattern. It depends on the amount of money which one can keep aside purely for investment and not dip into it time and again for personal needs and can hold on to it even if they are not doing good at a particular point in time.

But again the point to note here is that if a particular investment is consistently a poor performer, one should plan an exit from the same and reinvest it in another suitable option. If one is not very good at deciding which stock to invest in and what the best time to do so is, then there are professionally managed mutual funds with different investment objectives from which one can choose.

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To buy or not to buy – Asset allocation holds the key…

With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with which mutual fund or stock to buy might be the wrong approach. Instead, you should start by deciding what mix of assets in your portfolio you want to hold – this is referred to as your asset allocation. You should consider an asset allocation strategy based on your

• Time horizon: Asset allocation will depend on how long can you hold on to that particular asset and whether you need it for a particular goal. If you need any of your assets for let’s say a down payment for your house which is due next year, then probably holding debt/fixed income oriented instruments is an option you should consider. Examples of debt include Bank or Corporate Fixed Deposits, short term bond funds, short term bonds and ultra short term or liquid Funds. On the other hand if you have a long term goal like retirement, you can allocate a large portion to equity oriented instruments and lesser towards fixed income oriented instruments. As you move closer to the goal, you can keep reducing the equity portion while increasing the debt component.

• Risk tolerance: This is different for each one of us. An individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Risk tolerance will depend on age of an individual – middle aged individuals generally tend to be more risk tolerant, as they may have more capital available for investing and have longer term goals.

 

In a volatile market scenario like the one we are witnessing now, and have also witnessed in the past, asset allocation becomes all the more important. The table below shows Sensex High and low on various dates. It also shows percentage fall from high. As you can see , the 1 year returns are as high as 105.9% from April 2003, but are also accompanied by a negative 1 year return to the tune of -31% from January 2008 during the US subprime crisis. Thus, had someone invested all of their money in equity prior to 2008 without a proper asset allocation in place, he would have incurred high losses in 2008. If someone would have invested keeping their goals, time to goals, risk tolerance, savings and expense pattern in mind, they could have held on to their existing investments while strategically rebalancing their portfolio as against panic selling and booking losses. The situation that we are facing now in 2015 around the Greece bankruptcy crisis and Chinese slow down have also resulted in Indian markets correcting significantly. The fall might look attractive to a lot of investors, and they might start buying irrespective of the asset allocation they might have charted for themselves. In our opinion, such events will come and go, and it will always be a challenge for investors to know how much further they could fall. Therefore instead of trying to time the market or haphazardly investing in what looks attractive,e one should go by ones pre defined asset allocation, because what looks attractive today may lose its sheen tomorrow.

Table 1 : SENSEX fall history

Source: Bloomberg, Reliance Mutual Fund

Historically, broad asset classes move in relation to each other are fairly consistently (for eg., when stocks are up, bonds tend to be down and vice versa). In diversifying the allocation across asset classes, you can potentially create a portfolio with investments that do not all move in the same direction when the market changes. However, if you only spread investments only by industry (eg. automobiles vs. pharmaceuticals), they are all in the same asset class (i.e., all in equities) and respond similarly to market changes. You are therefore open to much greater market risk. Asset allocation helps keep volatility in check.

Ultimately, there is no one standardized solution for allocating your assets. Individual investors require individual solutions. Asset allocation is not a one-time event , it’s a life-long process of progression and fine-tuning. Empirical data shows that it pays to be diversified across asset classes.

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Market Mantra May 2014

With most opinion polls and exit polls predicting a scenario for the BJP led National Democratic Alliance (NDA) wherein they would fall short of a majority by themselves or just about be able to cobble together a majority, the final numbers that came in were definitely a surprise, with the BJP winning an absolute majority all by itself, the NDA getting a significant number over the numbers required for a majority, and the Congress being reduced to the equivalent of a regional party.

The large margin of the victory means that the balancing act that most coalition governments have had to manage in the past to keep multiple constituents of the coalition happy, is not going to be a challenge for the new government. The other heartening fact was that the election was won on a development and growth plan which is an endorsement of the fact that the young India voted on issues that are very different from the past. In fact, this voting pattern on the plank of development is a continuation of similar behavior in multiple state elections in the last few years, and is certainly a trend to watch out for, creating more accountability on the political class and is potentially something which could be a game changer as governments, both at a central and state level, focus on economic issues far more than they did in the past.

The financial markets also seemed to be excited by the fact of India getting ‘Modi’fied as it is commonly termed.

On the day of the election result, the SENSEX temporarily crossed the 25000 level. Thus over the last month, the SENSEX and midcap indices have risen 7% and 11.2% respectively.

 

In spite of the fact that indices are at an all time high, the forward valuations are reasonable, with both Price Earnings ratios and Price to Book Ratios being below averages.

Cyclicals also continue to be at significant discounts (Price to book). Refer Graph.

 

Small cap and midcap are also significantly at discount to the fair value vis a vis the 10 year average (refer to the graphs below):

The low level of equity ownership of domestic investors is also a positive for mid and small caps as there had been a tendency
historically for retail investors to build exposure to equities through mid and smaller sized companies.

With the expected impetus of the new government to focus on the revival of the investment cycle and infrastructure creation, the challenge for the new government will be to set realistic expectations on when the turnaround can actually materialize, and not get drawn into the dangerous game of sacrificing what is good for the economy longer term at the altar of short term gains.

The choice of the Finance Minister and the role of the RBI governor in balancing the growth vs inflation dynamics is likely to be crucial moving forward, especially with the possibility of a weaker monsoon and worries of inflationary expectations in the economy starting to build up once again.

With fiscal challenges continuing in the economy, one can expect that the budget slated in early July will provide a better perspective on how the new government looks to focus its limited resources and direct them for maximum effect. Structural reforms like the roll out of the Goods and Services Tax( GST), direct tax code changes and reduction in red tape need to get immediate attention.

The weight of managing expectations on the new government is likely to be a challenge in itself, and whilst there will possibly be a 12 to 18 month honeymoon period for the new government, one needs to remember that global factors including liquidity flows, will continue to be needed to be watched out for very closely Confucius once famously said “ The expectations of life depend upon diligence; the mechanic that would perfect his work must first sharpen his tools.”

Investors will need to focus on their strategic asset allocation so that they do not get carried away by the euphoria that tends to come with unexpected outcomes that are viewed as positive. In case portfolios are underweight equities, they will need to be added to, whilst portfolios that are already overweight equities, may need to see some rebalancing towards fixed income.

Investors will also need to avoid the temptation of giving up the process of diversifying their portfolios overseas, as that continues to be a crucial risk mitigation tool on portfolios and the appreciating equity or currency markets in India should not come in the way of continuing that process that has only just begun for most investors.

Fixed Income: Even though the Equity markets are rejoicing the NDA win, debt markets still appear skeptical. The 10 year GSec yield still ranges between 8.75% and 9%, as the debt market tries to get a better sense on government finances, and RBIs view on interest rate direction . Repo rate is also more and more dependent on Consumer Price Inflation (CPI) numbers. Therefore, if the CPI does not come down the Repo rate is unlikely to be revised downwards.

Investors in fixed income can look at enhancing exposure to longer term fixed income products like duration funds gradually, as a focussed fiscal consolidation effort by the government is likely to be looked upon by the RBI as a positive for inflation, and could be supported through monetary policy decisions that are not as aggressive as they have been in the past.

Currency: The fair value of rupee is believed to lie in the range of 58-62. RBI has been buying dollars to avoid appreciation of rupee. Inflow of foreign currency over the positive growth expectations of Indian economy could contribute to appreciation of rupee. However, one needs to keep in mind that these inflows are significantly a function of risk appetite amongst global investors and thus the Indian currency appreciation in 2014 thus far, has not been an isolated event, as you will notice in the graph showing the INR vis a vis other emerging market and Asian currencies. As long as inflation differentials of India vis a vis the US continue to be high, the currency will need to depreciate to keep the economy and exports competitive.

Gold: The outlook on Gold still remains negative and the attractive valuation of asset class like equity makes it a less attractive investment vehicle. In addition, import duty cuts and currency appreciation could continue to be challenges for gold in the shorter term.

 

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