Economic recovery and revival of corporate earnings bodes well for equity as an asset class
What is your outlook on the current equity market in India? Do you see a correction in the market looking at the elevated valuation?
The markets continue to be strong. Nifty 50 Index is up to 2.3x since March 2020 lows whereas Mid/Small Cap Indices are up 2.7x/3.1x. Nearly 10 per cent of Nifty 500 Index constituents were up over 5x during this period.
High-frequency data indicate a continued economic recovery. Fertilizer sales, exports, railway freight, power demand, PMI, Government gross receipts, daily e-way bill generation and steady growth in retail investors all point towards a reasonably strong recovery.
The Indian economy expanded at a record 20.1 per cent YoY in 1QFY22, but two-year annualized growth was -4.7 per cent (decline). Corporate earnings growth is continuing its strong show with consensus estimates pegging the current financial year’s earnings growth at over 25 per cent YoY. The corporate earnings to GDP ratio rose to a 10-year high of 2.6 per cent in FY21.
Over 50 per cent of the Indian adult population has got at least one dose. Active cases are down 89 per cent since the second wave peak is early May 2021, but have been inching up over the last fortnight.
While longer-term movements are guided by corporate earnings and economic growth, the near term can get influenced by a host of variables – one of the major ones being liquidity. With key central bankers of the world continuing with their asset purchase programs, the liquidity continues to remain strong, at least in the near term. In a record low rate and high liquidity environment, economic recovery along with the revival of corporate earnings growth bodes well for equity as an asset class.
There is reasonable consensus that rates are at significant lows with virtually no room for further cuts. Fed is expected to start tapering the asset-buying program from the year-end. This could put pressure on global equity valuations.
As per Bloomberg data, based on consensus estimates, Nifty is trading at one-year forward P/E 22.5x. This is 38 per cent higher than the 10-year median one-year forward valuation of 16.3x. In the last 16 years, only two per cent of the time, Nifty has traded at a higher valuation than the current one. To that extent, Nifty is trading at a significant premium to historical valuations and qualifies as expensive.
Although it’s a common practice to compare an absolute valuation with its history and then conclude whether it is expensive or not, we also look at current relative valuations and compare them with historical data.
One-year G-Secs are trading at 3.87 per cent. The inverse of yield is the P/E ratio. Hence 3.9 per cent yield translates into a P/E ratio of 25.8x. Hence, the same equity which is trading well above historical averages starts looking relatively cheaper than debt (or fixed income). If history is anything to go by, equity markets have offered reasonable risk-reward opportunities when their valuation has been lower than fixed income.
As a result, as long as we are in rising liquidity and low rate phase, the valuations can remain elevated and markets can remain buoyant for much longer than many think. One needs to closely follow the liquidity and rate turning points. Incrementally, investment positions would be better off with slightly reduced risk positions with allocations towards Large-cap and Hybrid funds.
According to you, should new investors enter the equity market or should they wait till the market corrects?
The legendary investor Peter Lynch had once said that “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.” It’s a timeless quote, years of wisdom put into few words. Even the Oracle of Omaha has said “It's all about time in the market and not timing the market”.
Interestingly, in the last 20 years, Nifty is up 16.8x (cagr 15.1 per cent). In others words, Rs 1 lakh invested 20 years ago would have become Rs 16.8 lakh now. Every year has about 250 trading days. Hypothetically, suppose, in anticipation of correction, someone missed out on just one biggest gaining day every year. Effectively, the investor would have been invested in 4980 out of 5000 trading days, across 20 years. A mere single best day miss every year would have resulted in the investor creating 61 per cent lesser wealth of Rs 6.5 lakh (cagr 9.8 per cent), instead of Rs 16.8 lakh. None of us can claim to predict those best days in advance. It makes sense to remain invested at all times unless the long term story is not intact, which is not the case here.
Having said that, given that markets have had a strong 17-month rally, it would be prudent to have a little more balanced asset allocation.
What are the positive and negative triggers you see for the equity market in the next few months?
The key positive trigger would be the continuation of high liquidity and low rate regime, combined with continued economic recovery and corporate earnings growth. The US has said that it will start tapering from the year-end. Still, liquidity will continue to rise, albeit at a slower pace. Any disorderly or sudden taper/rate hike announcement by major nations may have a negative reaction in the market.
Few parts of the world are witnessing a rise in Covid cases again. Any sharp acceleration in the cases can come as a negative surprise for the market.
Which are the sectors or categories that you are currently betting on and the sectors you are not confident on?
We look for growth at a reasonable price. And with it, we endeavour to look for structural growth areas. We like themes (and related sectors) like Digitization, Financialization and Healthcare.
Digitization: As per the Mckinsey Global report titled “Digital India” (April 2019), Digitization in India is a USD 435 billion opportunity by 2025. Multiple sectors beyond core digital are expected to witness the transformation. Estimated opportunity with Financial Services is at USD 170 billion, Agriculture USD 70 billion. Despite being one of the world’s largest internet markets, less than 10 per cent of India’s population transacts online (vs 40 per cent plus in China). Strong growth in the last 5 years in wireless broadband subscribers and data usage will likely help multiple categories such as e-commerce, grocery, travel, etc. The sectors that are key beneficiaries of the Digital future are Software, Telecom, E-Commerce and Industrial Automation. Even the recent trends in the IT industry have been quite encouraging especially with increasing hiring.
Financialization: Digitization is aiding financial inclusion, in turn promoting the financialization of savings. 80 per cent of Indians had a bank account at the end of 2017 up from 53 per cent in 2014. This is aiding shift to financial assets, evident in the growth of MF assets (up 4x in 8 years) and rise in Demat accounts (up ~3x in 8 years). India’s Credit to GDP ratio at 56 per cent is one of the lowest amongst the top economies of the world. Households have the capacity of taking greater credit from financial institutions. Even in Insurance, India’s premium to GDP ratio is significantly lower than comparable developing economies.
Healthcare: We see a multi-decade opportunity in healthcare owing to rising affluence and ageing population. The key focus areas under healthcare include Domestic Formulations, US Generics, Active Pharmaceutical Ingredient (API), Contract Research Organization (CRO), Contract Development And Manufacturing Organization (CDMO), ROW formulation. Domestic Formulation: India is one of the fastest-growing markets with rising per capita expenditure on pharmaceuticals with a rising share of Chronic. US Generics: Active drug shortages in the US is on the rise, improvement in Indian Pharma’s USFDA regulatory compliance, Rate of generic price erosion also moderating, USFDA monthly ANDA approvals have been improving. API / CDMO / CRO: These are sticky businesses with high entry barriers and a huge growth runway; Indian companies have the highest dossier filings in US APIs and have an opportunity to increase global API share. Global CRO market estimated at USD 45 billion in 2017; expected to reach USD 73 billion in 2022.
In the near to medium term, we also see opportunities in Industrials and Materials led by the government Capex on one hand and global economic recovery on the other.
We are underweight on Auto Sector. They first got impacted by the pandemic which had a big impact on volumes. Just when there were hopes of some demand revival, their already not so high margins got challenged by rising commodity prices. As if this was not enough, the sector is witnessing a shortage of key chips/semiconductors. Companies have come out with profit warnings and a few of them had to reduce production days as well. On top of it all, the traditional ICE engine companies are facing stiff competition from new-age EV makers, forcing them to do Capex on EV too.
All the above factors combined have dented the earnings growth visibility of the sector, driving our underweight stance.
What is your take on new-age companies?
The common threads across a number of new-age companies in India (and globally) are :
a. Using technology to bring efficiency and bridge any existing gap.
b. Being fiercely client-focused.
c. Disruption of existing delivery model is often collateral damage rather than outright objective.
With the rise and penetration of the internet and e-commerce, the delivery through technology is getting better by the day. Surplus liquidity and near-zero rates have ensured that funding is also not a challenge. A lot of these new-age companies have brilliant business models. Most of them (not all) have a sharp focus on market share gains, but not much on operating cash flows (as constant funding takes care of any deficit). However, cash flows would be eventually required for these companies to become long term compounders.
We focus on companies with positive operating cash flows in at least 7 out of the last 10 years (70 per cent in case of history being less than 10 years)
PGIM India Hybrid Equity Fund has a lower annualized 3 and 5-year return as compared to its category average, is there any specific reason for the same?
On a 3-year basis, the fund is almost in line with the category average. On a 5-year basis, the annualized is lower than the category average. This fund was a 100 per cent equity fund prior to February 2016. From early March 2016, it became a hybrid equity fund, but we were allowed a maximum of 60 per cent net equity, while most of the funds in the category were at 75-80 per cent zone. The divergence got resolved only when scheme categorization was introduced and from mid-2018, all schemes in the category have 65-80 per cent equity. Unfortunately, from early March 2016 till mid-2018, BSE 200 index was up nearly 60 per cent and our lower equity vs category was bound to have its effect.
The fund now invests 65-70 per cent in domestic equity (across market caps), 10-15 per cent in International equity and remaining in fixed income.
Do you see it as the right time for retail investors to rebalance their portfolios and book profit from their equity holdings?
Multiple studies did globally reveal that over 90 per cent of the overall portfolio’s return, in the long run, is explained by asset allocation. Hence, it is more important to stick to the asset allocation planned by an investor’s financial advisor than taking a near term view on the market.
Sticking to the asset allocation will automatically require profit booking when equity exposure goes beyond the limit of the planned allocation. In case, an investor’s equity allocation has breached the planned range, it would be prudent to book profits and come back to planned asset allocation.
Looking at the valuation of the equity market and interest rate cycle, what should be the ideal asset allocation for a moderate risk-taking investor?
An ideal and efficient portfolio would be structured in a way that is capable of capturing the upside and manage the downside. The allocation has to be based on the risk profile of the client, his/her age and time horizon, among other factors. An investor may consult their investment advisor for the asset allocation that is right for them.
Equities have shown historically that they are the best asset class to beat inflation over long periods. India’s median age is 28 years compared to 40+ for most major nations, India’s dependency ratio has been falling (which is key to high growth) and per capita income has reached the inflection point. With a long runway of growth, Indian equities should have a lion’s share in the client’s portfolio, subject to the risk profiling fitness discussed above. It is usually said that allocation to equity should be 100 - Investor’s age. However, conventional wisdom has to be customized as per the risk-taking ability and willingness of the investor.
About 10-20 per cent of equity exposure should be earmarked for global investing. India accounts for only 3 per cent of the world market cap. There are multiple growth themes available outside India, which are not really available in India – we all are active consumers of many such themes.
Exposure to debt or fixed income needs to be higher for people in a higher age bracket.
Conventional wisdom suggests that 5 per cent of net worth should be in gold, purely for diversification purposes.