Indian Stocks: Back to the Future!

With much of future gains frontloaded, returns to moderate from hereon even if markets remain elevated.

Bull Market.png

Risk is a dirty word now. As the Economist’s recent lead story quipped, there is bull market in everything. The only asset class that has crashed recently is “volatility”. By implication, it means that risk has crashed to new low if one takes volatility as a measure of risk. In other words, high returns that markets are delivering are coming amid vanishing risk. It is tantamount to saying markets are rewarding double digit “risk free” returns. That should challenge even the novice proponent of basic financial model, leave alone the masters of finance. Such aberrations are possible for a brief period on temporary disruptions like liquidity spike etc, but projecting that into sustainable future returns would be suicidal. In such a situation, one of them has to give in. Either the risk (volatility) has to come back into play or returns have to regress meaningfully.

Lot is priced-in!

Indian markets have priced in all possible positives, leaving nothing to chance. Be it stable political formation far in 2019 or quick recovery in investment cycle and thereof in earnings in FY20 or projecting macro sweet spot of moderating inflation amid low interest rates far into future etc, markets are in no mood to see any slip-ups on any of these. Look at all the exits (promoters and VCs) around in IPOs, QIPs etc, it is not difficult to infer that the markets are priced to perfection. As per one of the statistics, almost 80% of the money raised in the primary markets has gone, not into new capital raising, but for the exits of the VCs and promoters. It is more of a primary trade than the real fund raising. It points to India Inc’s low level of confidence to invest ahead for the recovery.
The other place to look for cues on how frothy the market has become, is to study closely how goal posts start shifting in valuation metrics. Take the case of cyclicals where the shift has been surreal. From valuing cyclicals on normalized earnings, market has moved myopic to value them at high-teen multiple on the peak cycle earnings. The case in point is the valuation in cyclical stocks like HEG and Graphite. Across the spectrum, valuation metrics are shifting to manic levels. History tells us what happened to such salubrious stock prices when sanity returned later.

Madness doesn’t stop there. Look at how collection (portfolio) of otherwise freely traded stocks gets seductive oversubscription just because they are elegantly packaged as ETF. If that is not crazy enough, a leading wealth management companies got away with raising tens of thousand crores under its Alternate Investment Fund to tap into the much fancied pre-IPO space, just when the Big Bull of Indian market fears bubble in the IPO segment. Flows into such fancied structures have become frothy so as to distort valuations to dangerous levels across spectrum.

When stocks are priced to perfection, what next?

If anything the above prognosis points to, it is the manic mis-pricing on the upside for much of stocks. When markets are priced to such (im)perfection, two things can happen. One, if some of those sanguine macro assumptions (listed above) slip, volatility could come back with vigor to haunt the hallucinated markets. Second, even if the slip-ups don’t surface, future returns would be fragile as lot of it is already front-loaded in the current price. If so, sitting on the sidelines is a safe and smarter option for the sane investor (if you are not already invested) as it gives at least 50% chance for an entry opportunity if the markets slip, or in the worst case, no great loss of returns given the limited upside from here on in the medium term. If one is fully invested, selective and phased pruning to build cash levels is a prudent option.

Where do you hide?

Is there a way to ride this reckless phase without taking too much market risks? How do you get the money to work in such a sticky situation? This is where Warren Buffett’s “Workout” wonder comes into play. It is Advantage Arbitrage. 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.

Economy to look up, markets to meander?

There is a growing view that the economy is on the mend. It is well debated and settled that the worst is behind for the economy. It can only look up from here on, though the pace of acceleration can still be debated. More so, if one goes by the endorsement the Govt.’s policies have received from the global credit rating agencies including Standard & poor. It is more or less clear that the short-term impacts of both GST and DeMo will fade away and growth will return quickly, though breakout from 7%+ range will take a while. What is not settled and still being debated is what markets would do. Fund managers across the spectrum admit in private, that markets have run far ahead of fundamentals discounting everything but the kitchen sink. Markets and economy has been out of sync for long. So far, it has been the case of languishing economy and mesmerizing markets. Going ahead, roles may get reversed with meandering markets on one side and energized economy on the other side. As has been argued in the cover story of this column, future returns are expected to regress in the medium term even as the economy starts progressing, though in the longer run they will synchronize again.

Fund managers of mutual funds worry in closed rooms that the continued deployment in this elevated markets is sure to attract law of diminishing returns for the investors in future. But they continue to play to the tune given the risk of otherwise under-performance in the short-term if they don’t dance to the music. Surging domestic liquidity has led to complete vanishing of volatility this year as reflected by one-way run in the benchmarks. This is the first time in many years the markets have returned positive returns month-on-month for a row barring few months in this calendar year. While some of the pundits have rushed in to claim this as new normal, other seasoned ones are more cautious claiming this as an aberration which will get normalized by either price action or by time correction. Increasing supply of papers from IPOs/QIPs or from govt.’s divestment could trigger such an adjustment though markets have so far evaded such a spillover effect in spite of surge in supplies.

This does not mean that the meandering markets will not give meaningful stock-specific opportunities, though they will be far and few as the party gets more pompous. Needless to say, this is time for caution and prudence, as has been emphasized many times in this column. Pruning frothy positions to raise cash levels is one of the ways one can exercise such prudence in this ebullient market.

Happy Value Investing!!



Bank Recap: Now Performing Asset?


Bonds to the Rescue. In a (modi)fied move, Govt. chose to galvanize the sputtered economic engine, not by any ordinary direct stimulus, but by a smart indirect, that too a leveraged one that has the potential to have a dramatic multiplier effect on the economy. Capital bazooka is not just about Rs 2.1tn, but multiple times of that if the lending picks up on the ground as the Govt. hopes. If Govt. had taken the path of any direct stimulus, not only it would have invited criticism from fiscal hawks, its impact would have been mere transitory. Smart thing about this is, it is a stimulus disguised in much needed reform measures for NPA resolution. But the story goes beyond that. On the face of it, this massive recapitalization move comes across like a marvelous engineering where there appears to be no losers, only winners. Or is it just another round-trip trick? Let us look at some of the hard facts to understand this.

First, the Financial Engineering:

How about infusing massive funds into bad-debt laden public sector banks without actually moving any real cash? Apparently, it looks like banks are going to fund their own bail-outs. One may call it a financial jugglery or sophisticated financial engineering. But that is what is at the heart of this bank recapitalization plan. It is a cash neutral plan. But still, it raises capital of the banks in the liability side. Instead of cash, what get stuffed in the asset side are the recap bonds that will be issued by the Govt. or any other intermediary on behalf of the Govt. If they are perpetual bonds (details are being still worked out), what will hit the fiscal numbers will only be the annual interest cost, which is unlikely to be more than 7-8K cr. It is another matter that Govt. can save even that by going in for zero coupon bonds. The new capital that has come into the bank can be used to take the haircuts on the stressed assets and what is left can be used to spur the lending. That is the grand plan. It is interesting to note that Govt. resorted to such recap bonds in the 90s. These bonds were neither tradable nor qualified for SLR (Statutory Liquidity Ratio as mandated by RBI), but later converted into equity or perpetual bonds. This historic perspective is critical to foresee what sort of details is likely to come out in the coming days. It is unlikely that the Govt. will make the recap bonds tradable as they may crowd out private investment.

Cost to the Banks:

In this cash-neutral plan explained above, everyone looks like a winner with no one incurring sizable costs. It will be naïve to assume that such a massive exercise can be done without paying the pertinent dues. To understand the real costs, one has to scratch a little and dig deeper. There appears no free lunch for anyone in the chain. Let us take the case of banks. Cost to the banks come in two forms. First, the erosion in bank’s current bond portfolio because of expected rise in 10 year yields (early signs of which are already visible with ten year G-sec yield moving up by over 10 to 15 bps post the announcement) and second, more importantly, the rise in cost of funding (liabilities) and its impact on profitability (reduction in net interest margin) as markets start demanding higher yield from banks that are stuffed with sizable recap bonds.

Cost to the shareholders:

For shareholders, the biggest risk comes from potential dilution in their holding because of the massive infusion. One should be wary of smaller PSU banks with large stressed assets as the dilution can be as high as 50%+ in the book value, even assuming 20% premium to the current price at which the infusion happens. This would mean the upside potential is low even for banks that are trading at a significant discount to the adjusted book value. Driven by this massive dilution, we expect significant increase in Govt.’s ownership in PSB stack. GOI’s ownership in many of the small and mid-sized banks to shoot up to near 90% as the total capital infusion is estimated to be close to the current market cap for much of these banks (excluding the large banks such as SBI and BOB).

Still, Everyone Can Win:

Strange thing with this bank stimulus is that it can boost confidence which in turn can spur growth that can in turn fuel write-backs in the banking system (reduction of NPA) and so on in a upward spiral fashion. Who knows, like the TARP (Troubled Assets Relief Program) in 2008 in US, this spiral can even lead to Govt. eventually making money from the recap bonds. So much so for the financial engineering and that explains why the field of finance will continue to be fascinating for folks like us for long time to come.

Interesting time to watch out for!

Small-Midcaps: Stock-specific Sizzle?

Stock specific actions i.e. momentum in small and midcaps so to say, are nothing new. This is the phenomenon that has been shaping market movement over past months, primarily driven by deluge of flows into domestic mutual funds. What is new is the expected acceleration of this phenomenon because of continued delay in earnings recovery in the top end and increased disenchantment of FIIs with Indian markets. This has caused lackluster movements in the top end of the market (large caps), while broader markets exhibit continued stock specific actions because of heightened domestic flows. For the first time ever, domestic flows surpassed FII flows by multiple times. To be precise, it is over 3+ times FII flows in this year (because of aggressive FII selling amid huge domestic buying over last three months). This, coupled with the fact that India macro is losing part of its luster on hardening crude and on weakening prospects for twin deficits (fiscal and current account), will strengthen this trend of stock specific actions further in the coming months.

As has been argued by this column for a while, the GST and DeMo impacts are transitory and will fade away sooner than later. That does not mean that the economy will break out of the range (6 to 7% range) any time soon, though it will be off its first quarter low of 5.7% soon on GST restocking and on low base effect in Q3. The break out to the 8%+ level can happen only if the investment demand recovers (capex cycle), prospect of which has improved though on the recent bank recapitalization move, one has to watch out closely the metrics of utilization and surplus capacity to sense the early signs of such a recovery. Until then, both economy and the markets are unlikely to break out of the range, while stock specific action will sizzle the small and midcap space. This, in a way means extended phase of time correction (with intermittent volatility of course) for top end of the markets, if not for the entire markets.

The key downside risk to the above prognosis is likely to come from potential acceleration in Fed action on monetary tightening. So far under Yellen’s chairmanship, market has been pricing-in a gradual and moderate tightening from Fed. Market will be watching closely on the new Fed chairman’s appointment for cues on the direction and for the pace of monetary tightening which in turn will dictate the global market’s trend.

What is the real story on the Economy?

Narrative has changed since the time the GDP and current account data-points were released for the June quarter. Shocked by the sharp slowdown in growth numbers coupled with surging deficit in current account, business media and policy commentators have started to beam with breathless commentary on how India’s macro has suddenly lost its magic on fallout of demonetization and on poor implementation of GST. Feeling vindicated on their criticism on some of the policy measures of this administration, esp. on DeMon, the mainstream channels have joined the chorus to magnify this quarter muddle into a mega trend of sharper slump. Yes, the GDP growth which came at 5.7% for June quarter was shockingly low and the CAD (current account deficit) at 2.4% belied even the most pessimistic projections. That said, placing the complete onus on some of the transient factors like GST and DeMon, will be akin to missing the woods for the trees.

Closer look at the data points will tell us that the economy has been slipping steadily since March  2016,much before the DeMon struck on 8th Nov’16. As can be seen in the below exhibit, the core GVA (growth measured in Gross Value Added metric excluding agriculture and govt. expenditure) peaked in March’16 quarter at 10%+ and has been sliding since then to sub 5% in March’17 quarter, before marginally recovering to 5%+ level in June quarter. This, seen in the context of structurally falling numbers both in private investment growth and in GFCF i.e. Gross Fixed Capital Formation (as reflected in the charts below), will make one understand that the root of the malaise is not in the transient factors like GST etc, but  in the secular slowdown in investment demand. Of course, sharp appreciation in Rupee over past several months in real effective exchange rate basis (ref chart below) has added to the woes. With current account slipping, adjustment is on cards with Rupee beginning to lose its shine and thereby providing much needed relief for the exporters. That leaves us with the bigger challenge which is, how to stem the rot in capex cycle?. Without reviving private capex cycle, it is near impossible for the economy to cross the 7 to 8% hurdle, though it can recover to high 6% when the transient factors fade in couple of quarters. This is because, private capex constitutes over 30%+ of GDP (over $600 Bn) which if remains sluggish, can scuttle the much brandished India Story, leave alone the scary job prospects. Govt’s ill advised plan to splurge on public investment by relaxing fiscal norms (thro fiscal stimulus), can barely move the needle on growth, while could upset the portfolio flows (esp to debt) and hence Rupee, if bond investors start fleeing on the prospect of rising market borrowings (hence Gsec yield). Hope Govt. doesn’t compound its macro problems by yielding to the increased noise on fiscal stimulus.


But reviving investment demand is not going to be easy. Govt. has been struggling with this for last two years. What ails the private capex, is not so much to do with supply of credit than to the demand for credit. Given this, neither the rate-cuts nor the balance sheet cleanups in PSU banks can revive the investments meaningfully, though can help incrementally. Given the surplus liquidity that is sloshing in the global monetary system, capital or the cost of it is the last thing that worries corporate chieftains, though they continue to clamor for rate-cuts as part of their diversionary tactics. India Inc is not investing, not for lack of capital, but because of the gross under-utilization in much of the sectors. High capital intensive sectors such as Energy, Metals, Oil & Gas etc. suffer from serious surplus capacity globally too. Add to this, the surge in buy-out opportunities for the Indian corporates because of balance sheet stress in much of the capital intensive sectors. Why would any corporate invest in green-field projects if ready capacities are available at distressed levels. The solution lies in the consumption demand. Sustained rise in consumption can improve utilization and hence the need for additional capacity which will in turn revive the investments. Greenshoots across global economies of course will help in reducing spare global capacity while strengthening private consumption in India will over time compel chieftains to open their purse strings. Till then, it is going to be sub-7% reality, which the Govt. and investors have to make peace with. 


Money is made in waiting!

That said, the hard part is, it will be an agonizing wait…

Value investing is simple, yet isn’t easy. The wait for value to emerge and the subsequent wait for value to unlock, in most cases, is a protracted and a painful one. What makes it worse (emotionally of course) is when value emerges, the slide doesn’t stop just because it is undervalued, given market’s manic tendency to undershoot. After all the wait for markets to come off the overshoot, the notional portfolio erosion during the under-shoot after initiating value buying, makes even the staunch value investors shaky. To digest the erosion and still have the nerve to add during the undershoot, knowing well the long wait ahead for the value to rerate (unlock), is what makes the whole process gut-wrenching. Similarly, even the rerating ride (upward value unlocking journey) is equally rocky and bumpy with many false starts and vicious falls. If one adds client’s expectations/pressure into the equation, hardly can anyone envy the money manager who has taken the road-less-travelled path of value investing. If this is not hard enough, such money managers have to go thro’ this cycle multiple times to create value over long-term.

Add to these, the challenges that come frequently while deploying cash in a falling market. After holding cash for a reasonably long time while the market kept rising, when the market turns and cracks, it will be tempting to quickly deploy when valuation turns attractive. If the market undershoots further, as it normally does, depleting cash too quickly tempted by attractive valuation could hurt the portfolio. Alternatively, if the market bounces quickly without undershooting further, decision to deploy quickly could prove to be a genius one. Both are possible outcomes in any market (irrespective of the economic fundamentals at that point of time) depending on to what extent the fear cycle plays in the given point of time.

Let us illustrate this vide an example. Given below is the price-chart that captures this dynamics for a stock that has moved into the deep value zone recently. In the below chart, point A represents the point of overshoot, point B represents the time from which value starts emerging, point C represents the point of undershoot where it becomes a deep value and point D representing the beginning of rerating. As one would infer, the overall time for the entire cycle to play out, from overshoot to undershoot and then to rerating, goes even beyond three long years. In some cases, the wait could be even longer if the undershoot turns ugly or rerating gets retarded, depending on the extent of bearishness in the market.


The above chart is not an imaginary one. It is a real one (except for the dotted segment) for a stock that has turned deep value in the ongoing correction. It is a price chart of a company that is into renting high tonnage cranes for the wind sector.  With the wind sector suddenly losing shine on serious short-term setbacks, this stock is on a free fall, thereby providing a fat-pitch opportunity for value pickers.

Value opportunities are not limited only to few stocks. With bubble popping out in small and midcaps in the ongoing slump, many stocks have sunk to new lows, thereby providing entry opportunities. For anyone who is willing to invest on the emotional capital of “Waiting”, these are great time to load up one’s shopping carts.

Investing isn’t easy. Superior skill and extra-ordinary nerve are required to achieve above average results in investing. To quote from Howard Marks memo, “So, in the end, there is only one absolute truth about investing. Charlie is right : It isn’t easy”

Happy Value Investing!

Seller’s Strike…

With Nifty flirting around 10K milestone, it is busy time for business channels and financial portals. All of them compete with each other with screaming headlines on how so and so stock has multiplied so many times in such a short time. Number of such stocks that have skyrocketed keeps growing by leaps and bounds. It is no accident that much of these stellar stocks are from the infamous group of tiny or micro caps. The reasons are not difficult to fathom.

In many cases, the surge in prices is more to do with lack of sellers than to do with aggressive buying. Incessant rise in price has led to sellers going slow on fear of premature exit, leaving many counters with few buyers driving up the prices. As a result, stocks are soaring amid thin volumes. In such a scenario, even a small selling when it comes, could leave a deep crack in some of these celebrated multi-baggers.

Though this trend is more prevalent in tiny caps, the rub-off of this trend on wider small and midcaps is one of key reasons for elevated valuations in the broader markets. As anyone who had attempted to sell even marginal quantities would know, the prices are very unreal and portfolio value could see a big erosion even on small selling. Given such a fragile nature of valuation, one should be very careful not to take the sharp rise in portfolios at face value. Tide does turn and when it turns (no one knows when), it will be a turn for the buyers to strike. When that happens, the whole momentum game  could play in reverse, esp. for tiny and micro caps. It is time for caution for the overall market, esp. when it is driven by surge in liquidity rather than by ever-elusive earnings upgrades.

Pockets of Pessimism

banner-octIndian Pharma: Fat pitch in sight, get ready for a hard swing!

It may seem odd to talk about a fat pitch when Nifty is at a striking distance from a five digit mark (sorry, struck and gone well past that mark is another matter). It is no secret that Sensex has been soaring to stratospheric valuations on surging liquidity from both domestic and foreign investors. If anything, stocks are simmering at frothy levels for a while now. Yes, this is true for much of the sectors where it is a story of trumpets blaring amid ever-rising list of multi-baggers. But that hasn’t stopped the markets to punish prices in certain select pockets to seductive levels on growing uncertainties in the short-to-medium term. If one looks around for sectors where drums are beating amid plunging stock prices, it is unlikely that one would return empty-handed.

No prizes, of course, for guessing the sectors that have been the laggards in this bull run. It is widely known that the top stocks that have spectacularly soured the sentiments are from the infamous group of three sectors, namely IT, Telecom and Pharma. While all of them are going thro’ sectoral short-term setbacks, on measure of mis-pricing relative to long-term business fundamentals, Pharma seems to be more promising.

In a rare instance of unfortunate coincidence, confluence of factors have miraculously come together to conspire a deadly blow to the fortunes of pharma industry. The sector that helped India to build global prominence is suddenly facing huge set of headwinds on account of following developments:

  • Increased regulatory scrutiny (Increasing cases of warning letters and import warnings from US FDA).
  • Consolidation of distributors in US resulting in pricing pressures for generics
  • FDA’s increased focus on fast-tracking drug clearances leading to more competition in generics and hence putting pressure on prices.
  • NPPA (National Pharmaceutical Pricing Authority) bringing more drugs under price control in domestic market.
  • The risk of dictum from Indian govt. on generics prescription in the local market.
  • To top it all, GST hiccups couldn’t have come at a worse time i.e. destocking and delay in restocking in domestic formulations.

Very rarely, such a series of setbacks suddenly surround a particular sector and cause stock prices to get mis-appraised in a disproportional degree. Pharma is going thro such a painful period in this so called perfect storm. Are these setbacks structural or cyclical? If anything, FDA’s vigorous vigil will play a vital role in streamlining the quality process which is positive in the long-term to achieve bigger business scale in generics. Similarly, accelerated drug clearances by FDA, while putting pricing pressures, will also help small and medium players to gain faster access to US generics. In our recent meeting, CEO of one of the promising mid-tier pharma companies, echoed this long-term view. Moreover, much of the domestic challenges listed above should not dent the long-term prospects for the sector, except the dictum of generic prescription, which many industry insiders don’t see it coming given the practical challenges in implementation. With govt. going slow on this, the noise around it has subsided significantly.

As someone wise said, great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be mis-priced manically. Pharma seems to be offering that classical value opportunities to those who have lots of patient capital. More so with small and mid-cap pharma (stock specific, of course) where relative undervaluation can give additional kicker.

Happy Value Investing!