Turning The Wheels Of Business Cycle Investing

Sanjeev Singh
Founder, Omniwealth LLP

Given that the stock markets in India have headed for higher levels anticipating a post-pandemic revival in earnings and economic prospects, commentators are sharply divided on the shape of the recovery. There’s the ‘glass half full’ camp which predicts a V-shaped revival. There’s a ‘glass half empty’ camp which thinks that the recovery will be partial – conforming to a U or even L-shape. Lately, there’s also a third camp in favour of a K-shaped revival, with some sectors losing steam and some gathering speed, thanks to the watershed changes in consumer behaviour ushered in by the pandemic.

These divergent views on economic outlook have led to a dilemma for most Indian fund and portfolio managers, who are quite uncomfortable with taking macro calls on their investments and profess to be purely bottom-up investors. With the overall trajectory of the economy difficult to predict, many of them have taken comfort in what has come to be termed as the ‘quality’ style of investing. The style, reduced to its basics, is about owning companies that score high on fundamental parameters such as high profit growth, healthy operating margins, low or zero leverage, steady free cash flows, high return on equity and stable or rising dividends over the last five or ten years.

With many multi-baggers over the past decade belonging to this camp, adherents of the quality style are convinced that no other style is appropriate for Indian markets and that stock-picking is simply a matter of doing a deep dive into a company’s historical profitability, balance-sheet and cash flows while screening for management quality. While screening companies for shareholder returns and management quality is an essential ingredient to good fundamental investing, focussing only on these metrics suffers from a key shortcoming. It nudges the manager to focus far too much on the rear-view mirror and too little on the windshield mirror which can alert him to the speed bumps and detours ahead on the company’s earnings prospects, sector fortunes and growth plans.

History points to the fact that both economic fortunes and the performances of individual businesses are cyclical. This makes past performance an unreliable guide to the future. In the last two decades, India has seen multiple inflexion points in the macro events shaping its economic prospects that have triggered a stark change in the sectors and stocks leading the market. In 2003-04, we were at record low interest rates (with the g-sec yield at 5 per cent), a current account surplus of 2.3 per cent and muted corporate and household leverage. These macro conditions laid the foundations for a sharp take-off in the capex Financial Planning MF Page - 09 Turning The Wheels Of Business Cycle Investingcycle between 2003 and 2008 that saw infrastructure, real estate and bank stocks deliver multi-bagger returns.

Between 2011 and 2013 came the next turning point – a high fiscal deficit, runaway inflation and unsustainable corporate leverage leading to an economic downturn. This precipitated a crash in infrastructure, real estate and financials and gave birth to the outperformance of the defensive pharmaceutical and IT sectors. In 2018, demonetization provided the cue for the next trend reversal that saw NBFCs and banks take over. Such inflexion points are hard to spot while one is living through them. But a top-down investor has a greater shot at this than a purely bottom-up investor.

The conditions today are ripe for another macro shift. Record balance-sheet expansion by global central banks has driven money supply to unseen highs and interest rates to record lows. India’s repo rate is at its lowest level in over two decades. Ample liquidity and low rates have presented very favourable conditions for equities to rally with low volatility. But if economic conditions improve and the stimulus is withdrawn, there can be a significant shift in the outperforming assets and sectors. The corona virus curve is flattening out and the availability of a vaccine may also alter the shape of the business cycle. Therefore the days of easy money from equities are over.

If the easy money policies of central banks and low rates were positive for equities and long duration debt in the last decade, the next decade may be very different, with elevated equity valuations and rate increases. This could result in far higher volatility and unpredictability in stock prices and the sectors outperforming in the next 10 years. For managers of equity portfolios, these changing macros would call for a drastic shift in investment approach from bottom-up to top-down and a high degree of nimbleness in identifying sector and business shifts as the themes and sectors leading the market may change rapidly.

The time appears to be right for business cycle investing. Business cycle investing is typically based on macros and has four distinct characteristics – a top-down approach which is ahead of the curve in identifying theme shifts, being market cap-agnostic to capitalise on opportunities across the universe, going overweight on select themes where conviction is high and concentrated weights in themes and sectors where one is convinced of potential. Your driving skills for navigating a village track full of bumps, after all, need to be very different from those required for speeding along on a six-lane expressway!

The writer is a Founder, Omniwealth LLP
Email: sanjeev@omniwealth.in
Website: www.omniwealth.in