” As indices surge, investors must adopt a balanced approach and invest in frontline firms”
~ G.R. Balaji
American lawyer Clarence Darrow once said,
“It is not the strongest of the species that survives, nor the most intelligent, but rather the one most adaptable to change.”
For investors, the last six months have been one of an extreme roller coaster ride first on the downside and now, on the upside. Many records were broken on the downside, when we witnessed the sharpest fall of the last decade in a month’s time and the unusual sight of oil trading in the negative, and the like.
These six months have turned out to be an extreme nightmare for even veteran investors when it came to predicting the near-term market movement. As markets in the west have already achieved their highs and our market is close to doing so, what can we, as investors, learn from the fall and rise so that we can try to apply this learning to future crises and to better our returns?
No one knows where the market is headed in the short term. As the famous saying goes, the market is a voting machine in the short term and a weighing machine in the long term. First, we, as investors, acted late when it came to the gravity of the problem and conveniently ignored both the pandemic and the economic slowdown. Suddenly, the market realised the severity of the issue leading to panic selling in every segment — large, mid, and small caps.
The fall was very severe when the Nifty plunged from 12,000 to about 8,000. At that point, the perception of risk was higher than the actual risk. Even though news flow was extremely negative, there was an opportunity waiting to be taken, had we paid attention to the valuation multiple.
On March 23, when the market reached the recent bottom, the valuation of 30 out of 50 Nifty stocks were 30% lower than their five-year historical average versus 15 stocks before the fall started. Even on the basis of market cap to GDP ratio, it had hit about 56%, which was considered to be the lower bound for the broader market valuation in the last 10 years. It was one great opportunity to buy good businesses as if at a sale. The perception of risk was already priced into the stock. As investors, we should avoid double counting the risk.
Perils of Past Winners
The current underperformer (banking) had the largest exposure in the investor portfolio and current outperformer (pharma) had the least exposure.
An investor has the natural tendency to choose sectors that have done well in recent years due to the recency effect and familiarity with the sectors. Post the market correction, huge interest was seen in the banking/NBFC sector as they had done well in the last five years.
But the investor might fail to appreciate that this pandemic has placed severe stress on the already stressed banking segment. As per RBI, our banking sector GNPA (gross non-performing assets) was already as high as 8.5% at the end of FY20 and is expected to reach 12.5% on a base case scenario for FY21 and 14.7% under a severely-stressed scenario.
For any lending business, a moratorium on loans should ring alarm bells as it signals increased business risk and, an investor who wants to take exposure to the banking sector should take cognisance of the new reality. In the last five months, even though the market saw a strong rally(banking is the biggest sector of the index) banking has been an underperformer. On the contrary, the best performing sector pharmaceuticals did not elicit significant investor interest.
To reduce sector risk, an investor should balance the portfolio with multiple sectors and invest in companies with future prospects and at right valuations.
Bad News About Economy
The news that most of us are aware of and is available in the public domain has no special advantage to anyone and is generally priced into the market.
During the last six months, most investors got it right about the economic projection but not the market movement.
During the COVID-19 pandemic, the economic depression became known to everyone and that got amply reflected in the lower price. Acting on the bad news and not allocating capital when valuation was attractive on a sustainable business basis turned out to be a costly mistake for the investor.
From the recent bottom, more than 104 companies had generated more than 100% returns and 199 companies delivered 50% plus returns. Only five companies have delivered a negative return from March 23. It was the opportunity that most of us were waiting for and when it arrived, most of us missed by looking at only the bad news and not seeing what the market had priced in. A calibrated approach of investing during lower market level should aid the investor in capturing the forward, prosperous returns.
As the fear of risk was high during the pandemic, the largest amount of capital was withdrawn from equity assets and allocated in liquid and overnight funds with expected forward return of 4-5% and this decision was considered to be smart. As the pandemic was evolving, the risk for fixed income was getting higher due to lower future return while the risk for equity was coming down due to lower valuation risk. On an average, in the last five months – BSE 500 companies had delivered about 69% return which, in fixed income, would take at least 10-plus years. It is not about one versus the other. Having the right asset allocation and allocating capital based on long-term risk appetite of the investor and forward return of the asset is appropriate. The current market mood should not determine the incremental capital allocation.
To conclude, we initially overreacted to the crisis and pushed the valuation lower but now we might be under-reacting to the problem as we are yet to solve the health problem and growth is still fragile. Taking a balanced approach to market and investing regularly in frontline companies should help the investor attain satisfactory and sustainable returns.
Source: ACE Equity, RBI Financial Stability Report and Motilal Oswal Valuation Report