The investors’ dilemma

Investors are facing a genuine dilemma at the moment. Rarely has the big picture for India looked better. On almost any macro parameter, India stands out as an oasis of growth and stability in an otherwise lacklustre emerging market (EM) environment. Whether it is the top-down macro numbers, the current account deficit, fiscal policy, the rupee, or more granular corporate data, the reasons for enthusiasm and confidence are apparent.

The numbers are good and getting better. No other large EM country can grow real gross domestic product (GDP) at 6 per cent plus for an extended period irrespective of the economic environment in the West. No other large EM has spent the last five years rebuilding corporate and bank balance sheets. Corporate confidence and the private capex cycle are visibly improving. From a relative perspective, there are limited alternative choices in the EM world where you can deploy capital in size. Geopolitics has never been more favourable, and India finally seems to have a chance to build a credible manufacturing story. The country is far more relevant today, a top 10 market for virtually every product, among the fastest-growing, and a clear alternative to China for sourcing everything except the very basic assembly operations.

First of all, we have to be careful to not get overpowered by the hype. India still has significant challenges and no country has an inherent right to grow at 6-7 per cent for a decade. Our GDP per capita is still 127th in the world. It requires hard work and continued heavy lifting on the policy front. Both climate change and competitive populism could derail our prospects. We have been here before only to disappoint.

Regardless of whether one believes in the long-term growth story, the reality is that one has never seen a bigger divergence between enthusiasm for the top-down view of the country and the ability to deploy capital on a stock-specific micro perspective. Almost every investor I talk to is finding it difficult to find new ideas. Markets are expensive, and the well-known quality stocks even more so.

There are always certain stock-specific ideas at any time that are interesting, and there are always undiscovered companies, but the broad markets are not presenting any obvious mispricing. You have to know India well and have the confidence to go against the tide and look at neglected sectors/stocks, with no institutional coverage. To buy anything, you are being forced to extend your time horizon, and to justify prices, the execution and scale-up must be flawless.

So, what should an investor do in such a time? Should you just raise cash, try to time the markets, and wait for better entry points? Given the momentum and enthusiasm for India, what if the correction does not come anytime soon? We have already experienced $40 billion of foreign selling over the past couple of years, yet the markets in local currency terms hardly declined at all. Given the robust domestic flows, which I believe is secular, maybe the correction, when it does occur, is sharp and swift or from a much higher level. Will you be smart enough and nimble enough to grab the opportunity? If you sell now, will you have the emotional resilience to buy back stocks at a higher price than where you sold them? Do we really want to become market timers? One can understand being patient and waiting to deploy new capital, but do you really want to raise cash in anticipation of a market sell-off? There is a wall of money waiting for the correction, and has been on the sidelines for months now. When everyone wants a correction, it very rarely comes. Should one just take the long-term view and sit through some short-term excess valuation? Maybe markets will just grow into the valuations as earnings catch up? We may have a period of consolidation, but the markets may not decline by much, or for an extended period. Too many questions, no answers.

Is it possible that we are totally missing the big picture? A stealth bull market has restarted? Price action is broad and healthy. The market rise is not hyper concentrated or unbalanced. The valuations make sense and are justified if we believe that India is entering another extended upcycle, (2003-08), when earnings compounded by 20-25 per cent over a five-year period. No one saw that quantum of an earnings upcycle coming, and maybe we are blindsided again.

Corporate India has spent the last few years cutting costs, and there is significant operating leverage. We are in the sweet spot of capacity utilisation wherein a large percentage of incremental revenues drop to the bottom line. The market is telling us that we are on the cusp of a strong earnings upcycle. Jaded as most of us are by the poor earnings delivery of the past decade, we can’t model it. We will believe it when it happens. Markets are discounting mechanisms, if you wait for proof of an earnings upcycle, it will be too late.

Another theory may be that we now have a committed $40 billion entering the equity markets from domestic investors every year (retail, insurance, pensions and provident funds). This money cannot leave India, and equities have been firmly established as the asset class of choice. This number will also keep rising as the absolute levels of household savings rise. This equity hothouse effect, due to capital controls, will cause valuations to expand on a sustained basis. We have seen this in other EM markets in the past. Until and unless domestic equity issuance ramps up significantly, we are in an excess demand situation. Markets may not correct and multiples adjust till the IPO pipeline ramps up significantly or fresh supply of quality equity hits the market.

This is a confusing time and most investors are just happy to hold on to what they have, which further pushes up valuations for high quality companies.

One mistake that investors should avoid in my opinion is going down the quality curve in search of cheaper valuations. This is a mistake that all of us make in times of high multiples. Buy the cheaper and weaker business. This normally does not end well and the investor is left with positions they have limited conviction in and which were cheap for a reason.

What one can do is look for areas and sectors of the market that have been neglected and have performed poorly over the past one or two years, but are good businesses. Ignore short-term negative perceptions or momentum. One can also move away from mid caps and small caps where the valuations have expanded dramatically and look for larger cap laggards, of which there are many.

Many of the new initial public offers (IPOs) also present opportunities as they are good businesses with a strong pedigree, in many cases priced at a reasonable level, and one can get sizeable allocations. You need to be very discriminating here as most IPO’s do not create value.

Most investors, both domestic and global, have never been more convinced of the long-term India story. They all complain about where and how to deploy capital in a valuation sensible way.

Focused on the best businesses, they are maintaining their holdings in their core, high-conviction companies, and selling businesses where they have less conviction, or which are more cyclical in nature. They are narrowing down to the best businesses where even if markets correct, they will just add more. Many are using the mid-cap euphoria to exit past mistakes, where they have been given a second life.

The writer is with Amansa Capital