Naveen Chandramohan, Founder & Fund Manager of ITUS Capital talks about market volatility
The equity market seems to be quite volatile due to the second wave of coronavirus. How do you see its impact on the returns from the equity in the next year?
Equity markets, being an auction-driven market, never like uncertainty, and this is the exact reason which gives interesting opportunities to investors. Investors need to accept volatility as part of the course around the investments they make rather than monitoring the value on a daily basis as it results in sub-optimal decision-making.
There are two kinds of risks in the market – ‘known unknowns’ and ‘unknown unknowns. The first wave of the virus back in March 2020 was an unknown unknown – where the event took everyone by shock, as we had to learn how to react. Not just businesses, but not knowing what this meant at an individual level further fuelled the panic situation.
Today, while we are going through an infrastructure breakdown, we are better prepared to handle this individually and also, as businesses. I still continue to be optimistic that we have seen the worst, and my base case is that the lockdowns and better vaccine drives will help us come out of this over the next 2-3 months (case in point being for other states to learn from Mumbai). This is what I call a ‘known unknown’.
Equity markets do not react too negatively to known unknowns. While we are facing headwinds in the near term, I continue to see businesses witnessing growth in select sectors, which will translate into healthy equity returns (of 15 per cent) over the next 3 years. I do believe that the next 1 year returns will be dependent on one’s discipline around allocating capital rather than COVID-related.
How do you see the current result season and the sectors that surprised & disappointed you?
As an investor, we look for businesses that have the ability to grow their free cash flow from operations, which is directly related to the health of the business. While we are bottom-up investors, we believe select sectors like manufacturing (from a domestic API perspective), IT/technology, non-lending financials have structural tailwinds behind them and have continued to show strong growth in the excess of 15 per cent.
Currently, the disappointments have been at individual businesses rather than sectors.
Considering that we are coming off a low base in terms of corporate India profitability, the results season has been fairly robust. However, one needs to realise that the expectations are high for the earnings from here and not all businesses are going to match these expectations.
What is your take on the overall equity market valuation?
It’s important to take a step back and understand the market cycle we are in today, in India, and globally. The environment of easy liquidity has ensured that the value of money is coming down, which has resulted in asset price inflation across the board. In a market, like we have today, the focus for investors must be to avoid mistakes rather than maximise returns; meaning to say that it’s essential to own businesses, which have growth potential rather than chase prices. The valuations are not cheap, and they are also not meant to be in a market where liquidity is abundant. Having said that, I still believe a well-constructed growth-oriented portfolio with a focus on valuation has the potential to generate a 16 per cent-18 per cent internal rate of return (IRR) for investors, which would be extremely healthy, where the cost of capital is at 5 per cent-6 per cent.
Which sectors look attractive now? Also, discuss which ones should be avoided?
Again, for us at ITUS Capital, we approach investing from the viewpoint of a business rather than a sector. We spoke about the sectors that we view as having tailwinds today in India. We continue to believe that investors should have an allocation or exposure to these. We continue to stay away from sectors, which have a poor return on capital, and are predominantly capital intensive, and funded through debt. These include capital goods, hotels, multiplexes, etc. We do not believe that these businesses can be a core part of investors' portfolios as they require more of a trading approach towards capital allocation, which does not suit our thought process.
Should you prune your exposure to small and mid-cap stocks now?
I believe SEBI has classified companies to give a framework for investors to think about it. If I look at our portfolio, we have companies in the small-cap stocks, which are monopolistic businesses that are growing in the excess of 30 per cent from a cash flow perspective. I do not believe they are expensive either. I would certainly not want to look at exiting them. Classifying companies via market caps is how we, as investors, have bucketed businesses; it’s imperative to dig deeper and understand the business model. It’s important to understand that you have value-destroying companies in large-caps too, which does not mean that they need to be a part of one’s portfolio.
We would not cut our exposure in this bucket as our portfolio companies have cash flow growth in excess of 18 per cent and are generating a return on capital of approximately 25 per cent. If the valuation is within reason, which we believe they are, it does not merit pruning in our view.
How should retail investors approach the current equity market?
Investors have to think beyond COVID today; though it’s hard, I do not believe that volatility is going to be determined purely because of this. We are in an environment of easy liquidity and I believe this is here to stay. Structurally, this bodes well for certain businesses, but investors should maintain discipline and have a process to their investing. We are at an inflection point in the country if investors have the ability to think from a 3+ year horizon. If investors want to think of 1 year and view below, one needs to think about equities from an asset allocation perspective to ensure that they do not take sub-optimal selling decisions during volatility.
What is an appropriate asset allocation for an investor now?
I have never liked the concept of asset allocation by age. I know many people in their 40s do not handle volatility well but have come across equally calm investors in their 60s, who embrace volatility in equities. A good question for investors to handle would be to ask themselves to ‘what per cent of my financial exposure can suffer a 40 per cent fall and I can continue without panicking’. If that allocation is 60 per cent, then that’s your allocation to equities. It is the question of how you react at a psychological level, rather than your age.