Finding Refuge in Arbitrage

Indian market: Is there a way to ride this reckless phase without taking too much risk?

In normal times, bargains come in broader markets, not in blue chips. Broader small and midcaps quote at a meaningful discount to larger blue chips given their low scale and poor liquidity. But when mercury rises and when market moves up manically into a frothy zone, this equation turns upside down to drive valuation multiples into a bizarre zone. Currently we are going thro’ one such phase where small caps are sizzling at a significant premium to large caps. In an intriguing equation, smaller the size, spicier has the valuation become in this new bull-run. Below chart brilliantly captures this valuation conundrum by plotting the multiple across the market-caps. Micro caps have become the new masters when comes to multiples. On one year forward basis, BSE small cap index is at a scary multiple (of over 40+) while their bigger cousins are peevishly behind at 20+ level. As to be expected, the tiny ones (SME platform) are trading at the top of the table.

BizNotes_July17_Rev1

hese vagaries in valuations are not without any reasons. Changing composition of flows has contributed to this new found charm for the lower and middle rung of the markets. Earlier, flows were dominated by FIIs and hence the skew towards large caps as FIIs usually fancy larger market cap companies. With domestic flows taking the centre stage now, small and midcaps have started shining in a spectacular fashion. Given the long-term drivers for a structural shift in household savings from physical assets to financial assets, dazzle in domestic flows is unlikely to diminish, esp. when the other avenues for savings (fixed income) are much less attractive.

In such a situation, when excess domestic liquidity is expected to keep the valuation elevated for small and midcaps, how does one navigate this reckless run without taking too much risks (till eventual correction sets in).

Here goes the most interesting way one can handle investments in an overvalued market such as the current one:

Go tactical with asset allocation thro’ Arbitrage:

As any value investor would understand, building long term positions in a rapidly rising market, while would make the portfolio shine in the short-run, will dent its long-term performance without exception. As is often said, long-term outperformance comes from short-term underperformance. But there are ways by which one can make the short-term performance little more palatable. The trick is to tout for tactical short-term opportunities, but without taking the market risks. Event based arbitrage is one such tactical model that can help to add glitter to the portfolio without carrying the MTM (mark-to-market) risks. They are primarily short-to-medium term opportunities driven by event based corporate actions like buyback, open-offer and other special situations including mergers, demergers and delisting. The most interesting aspect of this tactical allocation model based on arbitrage is that, while it enhances the portfolio returns in the short-term by serving as a superior substitute for cash parking, it releases the cash at the most opportune time (during corrections) for enabling long-term portfolio building.

Besides arbitrage, there are two other critical ways one can deal with expensive markets. Bull market provides a brilliant opportunity to exit from positions that may not hold huge promise at reasonable prices, so to say to cleanup the past mistakes. Similarly, it also provides a huge window to prune profitable positions by booking profits. Both these actions help raising cash levels which can come handy during the market correction that eventually follows any one-way bull run.

Happy Value Investing!

 

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