Sandip Sabharwal - Uncategorized - AN INCREDIBLE MONTH – STOCK MARKETS

The month of August, I must confess went completely contrary to my expectations where I had expected the markets to cool off given the high valuations and growing speculative excesses along with the huge money drain out from sub par IPO’s priced very aggressively. However the markets this month completely moved to the other side and we ended up having the best month of the year 2021 with the Nifty moving up by 8.5%. However the Midcap rally stalled with Midcaps underperforming and the index moving up by just 2%. So what lies ahead is something we need to evaluate and strategize on.

Views on the markets are based on several factors which include global linkages, performance of other emerging markets, macro economic dynamics, valuations as well as sentiments. It is tough under most circumstances and for the view to play out many things need to move the way one thought. In my 25 year experience I have not seen so much divergence between the Indian Markets and the Emerging Markets basket as a whole where the correlation seems to have completely broken down, atleast in the near term. While the correlation was perfect till February 2021 it has completely broken down as seen in the following chart. Such events are very rare.

India’s premium on valuations over the Emerging Markets basket has also gone upto 90% now which is the highest in history. Historically given the high valuations of consumer and technology stocks in India this premium has always existed but at 20-45%. Overall Indian Market valuations are also much higher than average. At 17000 Nifty valuations are as follows

Expected Nifty EPS Consensus P/E
2021-22 690 24.6
2022-23 800 21.2
2023-24 920 18.5

These valuations are very aggressive and build in a 40% earning growth for this year which might be actually tough to achieve.

The results season was a mixed one with many Automobile and Consumer companies reflecting a squeeze in margins and underperforming expectations while metals and mining and technology companies were the outperformers. The market also has become very divergent in its performance where the valuations of stocks in certain sectors like Consumer Stocks like Titan, Jubilant Foodworks etc, Retail like Avenue Supermarts, Financials like Bajaj Finance, Diagnostics, Chemicals etc now trading at valuations that are as high as 100-150X PE for the current year and 80-90X for next year. People always believe that “This time is different” however markets have proven many times in the past that stock prices ultimately are a function of earnings and the earning picture has to be very very strong for such valuations to sustain.

The FOMO factor in the markets is also reflected in the kind of collections IPOs and Mutual Fund NFO’s are seeing. In the last two months itself we have seen two mutual fund schemes collect Rs 10000 Crores and Rs 14500 Crores respectively. These are huge numbers in the Indian context and flowing in after a huge move in the markets. Sentiment analysis wise its not a good indicator for the absolute near term.

But it is not that things are not happening in India. There are many companies and sectors that have been doing well. Technology sector stocks are benefiting from the significant wave of digital investments and a new cycle is on, metal and commodity stocks are benefiting from a huge surge in prices which are helping them deleverage the balance sheet, textile exporters are benefiting from restocking and good retail demand, capital goods and infrastructure companies are benefiting from low interest rates and a growing order booking cycle as both the government and private sector start a new investment cycle. Besides this the Make In India drive driven by incentives and a growing demand cycle is finally looking to play out after a long wait. New investment themes are getting introduced to investors through IPO’s which might be aggressively valued at this point of time but will see value at some stage and will be good investment bets. The private unlisted space is seeing huge Private Equity flows which is helping them grow and also creating employment opportunities. The challenge is that valuations and euphoria have overtaken the markets in the near term.

Stocks can never be buy at any price. In actuality risk is a very misunderstood concept. Most believe that investing at the time of panic and despair is risky. Actually the perception is that of risk at this stage and the actual risk is very low as established high quality businesses are available much below intrinsic value. As an example, a year back Bajaj Finance crashed to Rs 1800 levels. Most saw concerns in the company at that time. Today it trades at Rs 7200, four times growth over 12-13 months with no growth, a deterioration in the balance sheet and possibility of lower margins going forward. At Rs 1800 it was at a Price to Book of 3X and today it is at 10X which is very high in the context of valuing financial sector stocks and unsustainable. A good company needs to be distinguished from a good price for the stock of that company. No company is a buy at every price.

Lets see this via an example of HDFC Bank. The stock was at Rs 1250 levels in Mid 2019 when its Price to Book at that time crossed 5X. In Mid 2021 the stock was at Rs 1400, a return of just around 12% over a 2 year period. It did crack in between as all stocks in the March 2020 crash, however we are not taking the despair period in the analysis. In my view many people who are buying stocks irrespective of valuations will face this challenge over the next two years where many excessively fancied stocks might not even given single digit returns over the next two years.

The long term growth prospects of India are good driven by an evolving economy and growing productivity across segments. As equity investors we need to buy stocks below instrinsic value so that we make above market returns over the long run. Last one years returns are not a baromter of long term returns. For example many fund strategies including mine have given returns of 50-100% over the last one year. However a longer term analysis of Midcap and Largecap portfolio returns from the Mutual Fund universe shows that over 5 years the top performing largecap and midcap funds both have given a return of 18-20% on a CAGR basis. These are the top funds. Average returns are more near 15%. As such long term return expecatations have to be more near those levels.

Profitability cycles vary across periods with periods of compression and expansion in margins of companies in the economy. As such one of the other parameters that is widely used is Market Captialization to GDP. This ratio has varied widely across periods reflecting value when in the 40-70% range and overvaluation in the 120-150% range. The Market Cap/GDP at some major points over the last many years has been as below

  Market Cap/GDP
March 2003 45%
December 2007 150%
March 2009 50%
December 2019 110%
March 2020 50%
August 2021 125%

The challenge for economic growth could come from various areas. A persistent high inflation, impact on demand due to below par monsoons, inability of the government to provide fiscal stimulus, removal of global liquidity and higher rates, persistent prevalence of covid, semi conductor shortages and container shortages which are impacting production as well as trade etc. The positive side is the possibility that interest rates will remain lower for some more time, easy availability of equity capital and high FDI flows, greater productivity in the corporate sector subsequent to Covid etc.

In conclusion I would be even more concerned on the stock markets in the near term. Remember every bull market sees deep corrections whenever froth builds up to unsustainable levels. We are at that point or very near to that. Except for reopening stocks, select capital goods and infrastructure stocks and specific stories within some industries the valuations are very high. There is a clear consensus today that markets cannot fall and many on the sidelines have now started to jump in as they have got frustrated waiting for a correction. Keeping some cash is the best strategy today, whether this strategy is right or wrong will be known over the next two months.