Myopic Mis-pricing !!!

It is the season for Aam Aadmi . Sniffing a whiff out of changing political landscape , markets are scripting its own Aam Aadmi version by rewarding the segment handsomely where common man ( retail investor) is most active  i.e. small and midcaps  . With new found optimism  in small and midcaps  , the valuation discount in this space  have narrowed relative to larger peers . In the last 3 months , small and mid caps have rallied quite smartly by over 20%+ viz-a-viz 10%+ in the large caps. This is the first sign of turnaround in the overall trend of the market.  

There is no denying that such an astounding rally in small and mid caps is a welcome news for many value investors   . But it poses a new challenge  . The challenge is a classical dissonance  value investors face in any sharp market rallies , which is , where to find the next “value themes” for new investments when valuation discount is fast disappearing by swift rallies .

Fortunately , the current market is in no such hurry to bridge the valuation gaps , leaving whopping mispricing in certain pockets providing a sigh of relief to value investors   . One such sector to which the market has turned a blind eye  is “auto components” where mispricing is rather myopic and manic  to say the least . The sector offers deep value opportunities for anyone who wish to look beyond few quarters. Here are few glimpses of why the sector could surprise on the upside over the next few years.     

  • With low single digit growth for last two years , Auto is one of the worst performing sectors in this down cycle  . With earnings at low point relative to normalized potential , valuations for auto components as a sector , are at deep discount to its intrinsic worth (barring few high profile ones) giving scope for huge upside when the cycle turns .
  •  Auto being the discretionary category , it is the first one that recovers when the economy turns ,  going by the  experience in the earlier economic cycles  . This mitigates the risk of prolonged delay as could be the case in other beaten down sectors like capital goods and infra which suffers from risk of longer gestation in addition to balance sheet issues in those sectors .
  • Emerging trend  of India being developed as a  potential  production base for Asia and Middle East by larger Auto MNCs could propel business for domestic auto components in the coming years . Suzuki’s recent plan to hike stake in its arm in India (Maruti Suzuki) seen in this context reveals its larger game plan .
  • Falling Rupee has brought a sense of urgency for such plans which were hitherto languishing at drawing boards . Further , weak Rupee  is making  auto components exports more promising in general.

Notwithstanding the rally in small and mid caps , sentiment in this sector is so negative that it has thrown valuations out of gear . With stocks at multi year lows , investors can ill afford to ignore the deep value opportunities in this space . It is worthwhile to recollect the similar deep cut opportunities in IT small and mid cap space , not too long back . Investors who heeded the call of value investing in that space at that time have been rewarded handsomely in this rally with punters and institutions lapping up such stocks at hefty valuations now . Auto component is a story to watch out for in 2014 and beyond.

On Overall Market :

For all the fierce fears expressed by market pundits  , “Taper” turned out to be not just empty tantrums , but a damp squib  .  Taper announcement has come and gone ( Fed has begun reducing bond purchases by about 10 Bn starting this Dec ), yet Rupee or 10 year govt yield barely budged  .  In fact , Rupee has been one of the best performing emerging market currencies in the last 3 months on the now famous “Rajan Effect” since the taper fears tarnished the currency in the month of Aug . Between September and now, the Brazilian real has declined 6.38 per cent, the Turkish lira by 4.29 per cent and the Indonesian rupiah by 5.74 per cent. Countries with ‘fragile’ high deficits have remained under pressure, as the fear of capital flows reversing remains strong. In contrast, the rupee has not only stabilized while the swap windows were open but has held on even after oil firms have returned to the spot market. It is up 2.26 per cent in December. That much for the predictions pumped by pundits .

Good news does not end there . FII equity flows have made a stunning reversal in the last 3 months , though debt market continued to see marginal outflows . With $ 2.4Bn+ inflows in Dec alone ( still ticking) , equity flows couldn’t stronger . With not much money left for outflows from debt market ( about $ 15 Bn has already exited out of the total 22Bn odd investments in debt) coupled with significant cushion created thro’ FCNR deposits ( about $ 34 Bn) and the falling CAD (current account deficit) , one can breathe easy on the currency .       

Add to this , the growing confidence on political stability and the changing political discourse in the country towards clean governance . With such political re-rating , it is not unreasonable to build a case for more optimistic 2014 and beyond .  Low base effect , robust prospects in agri growth and expected recovery in macro metrix ( muted though) couldn’t have come at a better time. Market is looking forward to 2014 with lot less cynicism and with much more optimism  , as reflected by the sharp rallies in the broader markets ( small and mid caps) . However , disappointments if any from negative political fall out ,  can wreck this confidence and lead to delay in rerating , though probability for such an outcome is on a gradual decline going by growing voter enthusiasm for positive  change as mirrored  by  huge voter turnout  ( amongst youngsters in particular) . In summary , it is not far fetched to assume  that the risk of not being in Indian  equities  far out-weighs the risk of any untoward events including negative political fallouts .No better times to increase allocation to India story than now , though it has to be done in calibrated and phased manner as the market is expected to present better opportunities ahead of elections . Watch out for interesting times in the New Year !!!. 

Wish you a Great  New Year and Happy Value Investing !!!