Indian Markets: Is it all about carry trade?

It is fascinating to fathom that the set of stories that surface in every cycle in India is strikingly similar. In the upcycle, it is all about the structural India story in terms of growth potential, demographic dividend, financialization and formalization (un-organized to organized) etc. In the down-cycle, risks like twin-deficits (current and fiscal), falling currency and rising inflation etc. return to dominate the narrative. It is about shining macro in the upcycle and all about daunting macro risks in the down-cycle. It is not that this pattern has popped up only in this particular cycle. In every cycle in the past, without exception, one would find this striking script shaping the story.

What do investors infer from this? It is the simple fact that India macro is neither daunting (as feared in down-cycle), nor shining as scripted in the upcycle. Understanding what causes the underlying cycles that steer up the stories is far more stimulating for investors. These cycles, esp. in emerging markets, are caused more by the carry trade flows than anything else. These carry trade flows that triggers the big up-move or a sharp fall when they reverse, are dictated more by direction of Fed rates than any country specific chronicles. But what happens on the ground is grossly different. When the carry trade flows change the direction, narrative on the ground changes to suit the local script, thus amplifying the trend.

What we are currently going through’ is one such amplified trend of downturn in the broader markets (though indices are at all time high because of skewed surge in few stocks).  Though what has triggered this fall is a simple cyclical issue of EM (Emerging Market) carry trade reversal, the deficit and currency issues that normally accompany such reversal have come back to make the macro look murky and thus aggravating the fall. Local challenges like political uncertainties, SEBI’s surveillance adventures and untimely mutual fund scheme rationalization etc. couldn’t have come at a worse time to make this otherwise cyclical fall into deeper downturn. What is more important to understand is, this fall has nothing to with India-specific issues and is more triggered by carry trade reversal. All negatives (which are always present) come to the surface as normally happens in any down-cycle. More interestingly, when the carry trade flows come back, it will be time for positives to come to the surface to script the sensuous bounce. Early signs of such a reversal are already visible if one goes by the slow and gradual improvement in FII flows in this month i.e. about $250mn net inflows into equities so far in July. Investors who don’t get lost in the narrative (like murky macro, political risks etc.), but focuses on the underlying cycles, will more likely to use the current fall as a great opportunity for stock picking and portfolio construction for long-term rewards.

Happy Value Investing!!

 

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Smallcaps : goldmine or landmine?

Narrative has changed for small-caps, from one of gold mines to minefield of grenades in a short span of time. How should investors deal with this change in narrative?

From hidden gems to hidden worms, small cap investing has come a full circle now. In 2017, if you were not investing in small caps, you were missing out. Now if you are in small caps, you stand scrutinized and slammed. With tide changing from recklessness to risk-averse, it is quite astonishing how small caps have slipped from sacred to untouchables in a span of just six months.

Is it something unusual that investors should worry about? Or, is it rather a reoccurring theme that throws up opportunity for value investors? Let us go back to past such corrections in small & midcaps and examine how they played out eventually. Vicious corrections within a structural bull market is not something new. Let us take the previous bull cycle of 2004-08. In that period, small cap index corrected by over 10% at least 3 times and in two of them, the small cap index slumped by over 20%+ in 2005 and by over 40%+ in 2006. Of course, for individual stocks, there was no hiding place. Much of the stocks in the small cap space were slaughtered by over 50 to 60%+ in this period. Not much different in the current bull cycle which started late 2013. Savage fall in small caps occurred in two of the three declines we saw in this cycle i.e one in Feb 2016 on fear of hardening interest rates in US and in Nov’16 on DeMon impact.

As can be inferred from the below chart, what is interesting is that the recovery was quick within few months and more importantly, the bounce was far greater than the bump. In each of these fall, predictably, the narrative turned negative on small caps, only to return back with vengeance on subsequent bounce. It is important to understand that the price-action dictates narrative, not the other way around. Seasoned investors know what to follow and focus on. What is to be followed and focused is the cycles (price action), not the narrative. Unfortunately, noise that comes from amplified narrative numbs the investors into inaction.  This is not one or two year phenomenon. Over a 14 year period, this has happened consistently over and over again without exception, as can be seen in the chart. Yet, most investors do panic and fall into the narrative trap instead of taking actions based on cycles.  Few who learn from history make the most from these reoccurring cycles.

BizNotes_July18

There is a reason why every fall has been followed by a quick and sharper bounce. It comes from India’s strong structural growth story. If anything, this story has only become stronger this year with economy getting closer to the pay-off time from structural changes like GST, Subsidy reforms  thro’ DBT, RERA (real estate reform), Formalization/Financialisation initiatives thro’ increased tax compliance  etc. With long waited recovery in investment demand showing signs of revival, growth in broader economy is coming back with vengeance giving fillip to corporate earning cycle. It is funny that market with its eyes fixated on global cues, is ignoring the local positive developments on the ground. It is no surprise.That’s what bear cycle does. It makes the investors to ignore the good news and makes them to focus on the amplified negatives.

It is interesting that opportunities always come knocking just before the dawn. This is one such time where a sharp correction in small and midcaps couldn’t have come at a more prescient time, just when economy is likely to take off. With huge price crack, small and midcaps offer the best opportunity to capitalize on this upswing. Though it is tempting to move away from the small and midcaps because of ongoing narrative, one needs to take an objective approach taking evidence from past cycles. Having said that, unlike 2017 which was a one-way reckless rally, 2018 will be more a year of consolidation with heightened volatility. Given this, investors need to pursue a bottom-up stock-picking strategy, that too in a phased (nibbling) manner to get the best out of the crack in small and midcaps.

Happy Value Investing!!

May stands for Mayhem?

Rewind back to May’2013. One would find a striking similarity to what we witness now – ferocious fall in small and midcaps triggered by vicious fall in currency, sharp rise in ten year yield, incessant FII selling, rising fears on twin deficits (current account deficit and fiscal deficit). Underlying cause for the mayhem in both May(s) can’t be more similar. Back then, it was taper tantrum i.e. the term used for unwinding of bond buying program from Fed (withdrawal from quantitative easing). Fast forward to now, it is the expected acceleration in Fed rate hikes coupled with some unexpected jitters from crude that have caused the slump in small and midcaps.

But the interesting aspect of 2013 was, within few months, that is, well into taper tantrum, markets recovered with Rupee recouping much of its losses on return of FII buying. It was not so much of “taper” (unwinding) that caused the trouble, but the sheer prospect of such “taper” coming did more damage. In hindsight, going by the sharp rebound in the markets in six to eight months, taper tantrum was a terrific opportunity for anyone who cared to ignore the macro noise and focused on stock picking and portfolio building. Needless to say, current Fed induced fear, is a fantastic opportunity for seasoned stock pickers who have the wisdom not to time the bottom and have the stomach & nerve to digest the notional mark-to-market losses in the interim.

“It is time to invest, not to time the bottom. When it is raining gold (in the context of small and midcaps), it is time to reach for the buckets”

But unfortunately, few learn from history. Even those few who learn, most take comfort in the breathless commentary in business channels that focuses on the short-term gyrations than to switch-off from those endless chatter and take the most important action, that is, portfolio building on the ground. Those exceptional few who brave the volatility to build portfolio, needless to say, will reap rich dividends not too far in the future.

Happy Value Investing!!

 

 

Fasten your seat belts?

Economy turning corner, acceleration seen…

The good news is, the best is yet to come…

If things are going well, you don’t hear it. That probably captures what is going on in the economy. Rural recovery can hardly match rural distress when it comes to television rating points. No one can blame you if you haven’t heard rural recovery as much as rural distress. Teething problems in GST made splashy headlines, but recovery in GST collections and stabilizing e-way bill hardly make even whispers, let alone being fodder for breaking news. So is the case with the visible signs of turnaround in capex cycle, IIP numbers and so on. After long time, one gets to feel that all cylinders at last may be coming together to fire up the economic engine.

Pickup in investment demand:

For the economy, it has been a story of chocked capex cycle for last few years. It has been running only on few cylinders (esp. consumption), while its critical capex (private investment demand) cylinder was too clogged and sputtered to lend any material support. As for the reasons, it wasn’t that difficult to decipher what was at the root of so called investment inertia during that time. Over capacity and gross under-utilization in many sectors led to sharp slow-down in the need for capacity expansion and thus causing serious slump in the investment demand. Back then, the hope was that the sustained consumption demand will eventually lead to higher utilization which in turn will lead to recovery in private investments in early 2017, if not little later. But the two successive disruptions in the form of DeMon and GST, dashed this hope with consumption and the broader economy coming under severe strain under these disruptions for the past 12 months.

Disruption to Delivery:

It is now time for payoff from these disruptions. With the imprints of DeMon fading and with GST gradually gaining traction, consumption is back with vigor, leading to recovery in gross utilization numbers across sectors. Surge in order books reported by companies in the capital goods sector and the acceleration in IIP numbers in the last 3 months are the cases in point and provide evidence to early signs of recovery in investment cycle. Add to this, the optimism on monsoon, agri growth and rural recovery. All these add up as a huge ammunition for the economy to aspire for 8%+ growth sooner, may be as early as FY20, than expected earlier.

One doesn’t need to go too far to find supporting evidence for the afore-said economic narrative than to have quick look at the latest monetary policy commentary from RBI. To quote RBI,

“Turning to the growth outlook, several factors are expected to accelerate the pace of economic activity in 2018-19. First, there are now clearer signs of revival in investment activity as reflected in the sustained expansion in capital goods production and still rising imports, albeit at a slower pace than in January. Second, global demand has been improving, which should encourage exports and boost fresh investment. On the whole, GDP growth is projected to strengthen from 6.6 per cent in 2017-18 to 7.4 per cent in 2018-19 – in the range of 7.3-7.4 per cent in H1 and 7.3-7.6 per cent in H2 – with risks evenly balanced”

Of course, there are macro risks like rising crude and hardening domestic yield including negative global cues such as rising bond yield in US and potential acceleration in fed rate hikes etc that could cause temporary uncertainties. That said, if luck favors a little, we are looking at a huge economic tailwinds and consequently robust corporate earning cycle in the coming months for India.

Markets: Macro to drift, Micro to shine?

Coming to market, in its obsession to price the political/election risk, it has barely noticed the underlying acceleration in the corporate earning cycle. Weakening macro could be another reason why markets are yet to fully price-in the growth acceleration. India had the best of macro during last three years. Falling crude, contained twin deficits (current account and fiscal), strengthening currency, moderate or falling yield etc dominated the economic narrative in these years. That luck seems to have run out now as we begin the next fiscal. Cracks have started creeping in the macro with much of above factors showing signs of reversal.

But the good news is, this macro drift is unlikely to derail the carefully crafted recovery that is underway in the micro (corporate earnings growth). While macro may be losing some of its mojo, growth in the broader economy is coming back with vengeance, giving fillip to corporate earnings growth. Early signs of recovery in the investment demand (capex cycle) couldn’t have come at a better time. Having said that, broader trend for the markets at the index level will continue to be muted given the macro challenges, while improvement in micro in terms of sharp recovery in corporate earnings will drive stock-specific movements in the market. Unlike 2017, which was a year of magical macro, 2018 will be a year of micro with stock specific sizzle steered by progressive revival in the so-far elusive earnings growth. Investors should continue to focus on stock picking and portfolio construction during this dull phase of range bound market to benefit from the eventual breakout that is likely to happen as the acceleration in the economy gathers steam.

Behavioral Edge

To err is human. Except, in investments, errors end up lot more expensive. In most cases, esp. in listed space, such errors are more often caused by emotional short-circuitry than any intellectual shortcomings. Emotional handicaps often occur because of mind’s inherent nature to magnify events that are current and immediate while short circuiting other material events that may not be current. To understand this better, we can try modeling this in a algorithmic fashion. Imagine, we have a computing algorithm that magnifies micro inputs using self-feeding feedback loop and throws magnified outputs based only on “recent”, but minor events, bypassing other rational “past” material inputs. This model would effectively mimic the emotional brain with a behavioral bias.

Investment decisions are supposed to be rational and logical. But in reality, they are anything but that. If investors are rational, then, markets which are nothing but collection of investors, by definition have to be rational. Since we know markets are irrational, we can deduce that investors suffer from significant number of delusional defects that deter them from making sound logical decisions. Though there is a separate stream of finance, called behavioral finance, covers extensively on the various types of cognitive biases, we would like to look at closely one bias that has an outsized impact on investment results.

To understand this special one more, let us look at two investment options in the below illustration and check how investors respond to this situation.

BizNotes_April18

The choice is straightforward, if investors are logical. They should go with option-1 and accumulate/add on every fall. But in practice, what many studies have found is, much of the times, investors chose option-2. What is going on here? It is interesting to note that the emotional circuitry (blind-spots) edges out the logical circuitry in all those cases. Let us examine these blind-spots little more, by looking at the list of behavioral biases that are at play in this decision making:

• Loss aversion bias, even though loss is notional.

• Fear of more downside.
• Recency bias where mind gives more weights to short-term events.
• Tendency to over-estimate one’s ability to time the trend change.

As someone wise said, how one behaves near the top and near the bottom makes all the difference between success and failure in investing. If one has the ability not to freeze into inaction at the edges, then it brings real competitive edge in this business. This means, one has to constantly hone the emotional skills to deal with the greed of making more near the top and to deal with the fear of losing more near the bottom.

Logically speaking, both should be easy because both upside and downside are notional near the edges. But emotional short-circuitry magnifies the greed and fear so as to blind the logical circuitry. Large part of success in investing comes from how one deals with these inner demons that distort the decision cycle thro’ behavioral bias. Edge in investment business comes from simple emotional skills (EQ), not from any intellectual ability to solve three dimensional complex algorithms.

“Moat in investment business comes, not so much from thinking skill, but from silencing the emotional circuitry i.e. honing emotional skills”

Current market weakness is throwing multitude of option-1 type opportunities for investors to grab. It is time to still the mind by silencing the inner demons to capitalize on the market capitulation, not to lose bearings on probable paper losses.

Happy Value Investing!!

Year of Accumulation?

Shine is off from stocks. That is good and should be a welcome relief from the one-way reckless rally that has been ruling the roost for many months in a row. In a rare coincidence, multiple cues came together in a miraculous fashion to conspire a deadly blow to the bloated stocks. Global bond sell-off and tantrums on trade war couldn’t have come at a worse time. Just when the FM was lighting fire with his ill-thought LTCG tax (Long-term capital gains tax), global cues turned negative triggering a slump in Indian stocks. Macro fiscal worries from lavish MSP proposal and other rural largesse added to the ammunition with ten year yield Gsec yield spiking to levels not seen for many months.

All these are not completely unexpected except the eerie coincidence of all coming together. Market is hugely edgy and weighed down by uneasy calm. Weakness in the broader space should be a welcome development for seasoned stock pickers. If 2017 was an unstoppable one-way rally for much of the broader market, with volatility returning this year, 2018 should be viewed by serious investors as an opportune year for accumulation / portfolio building for an eventual breakout in 2019 when the economy starts reaping the rewards of series of structural reforms of past few years which will catapult the GDP growth rates to beyond 8%+.

“Structural reforms such as Bankruptcy code, RERA, Subsidy reforms thro DBT, Indirect tax reforms (GST), Financialization of savings, Inflation control etc. will drive the break-out for the economy from its badly stuck 7-7.5% range from FY20 onwards”

Investors should focus on portfolio construction and stock picking during
this period of volatility (because of weakening macro) by moving more additional investments into equities for benefiting from the eventual breakout that will play out from FY20 onwards. It is time to increase one’s equity exposure in a gradual fashion, not to lose bearings on paper losses.

Happy Value Investing!!

 

Time to invest, not to time the bottom…

Crack in the market always comes with cacophony. Investors should be wise enough not to wait for cacophony to clear and instead focus on picking undervalued stocks with high margin-of-safety without yielding to the temptation to time the bottom. As someone wise said, if you wait for robins, spring will be over.

Instead of timing, the focus should be on Margin-of-Safety (MOS). Let us turn to the anecdote of coin flipping to understand more on the concept of MOS. As we know, flipping the coin is a risky bet. Is there a way to improve odds in that? What if, heads you win and tails you do not lose? Though odds of winning do not improve, odds of not losing improve to 100%. This is exactly what Margin Of Safety does in investing. Strangely, in investing, when you are focused on downside, upside takes care of itself. Value investing is all about downside protection and MOS is the magnificent tool to mitigate the downside risk. It is the magical concept that magnifies the portfolio returns by denting the drags from losers and by earning exceptional rewards from winners. To quote Ben Graham, “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety”

How does one get MOS in stock picking? If MOS is defined as the discount from the intrinsic value of the underlying business, primarily, it comes from the mis-pricing in the markets. Mispricing can happen on two counts. One from the broader market trend and the other from stock specific scenarios(when underlying business comes across short-term bumps). In general, mispricing is on the upside when the mercury is up and it is on the downside when there is meltdown. It applies both to stock-specific swings and to overall market moves.

The challenge is not so much about getting MOS opportunities. Vicious corrections even in a virtuous bull market are not very unusual. Similarly, stock specific slumps are not scarce in a secular uptrend. The harder part is more about having the nerve to invest when such MOS opportunities arise, as in most cases, the accompanying high decibel narrative numbs the investors into inaction. Take for example the ongoing correction. Last week, small and midcaps were mauled mercilessly (continuing as we write this). For most of the stock prices, the clock was back by one year. Yet, the same people who were waiting on the fence for a sharp correction, turned frozen because of the changed narrative. As they say, money is made not in following narrative, but in following valuations. Narrative will take care of itself as time goes.  MOS grows in manic pessimism. Time to start nibbling is when narrative turns negative. If you wait for cloud to clear, MOS too will mysteriously disappear.

“Current market weakness is nothing but market’s way of adjusting to                                      the weakening macro. Market never adjusts in an orderly fashion. To                                    that extent, as market adjusts to the new macro challenges, expect lot                                    more bumps and humps in the coming months”

But time to bet is when these bumps and humps bombard, not when it becomes seamlessly smooth. While macro may not be at its best, underlying recovery in micro (recovery in corporate earnings) may provide the required support in the medium to long-term.

Happy Value Investing!!