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!!

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Follow the Cycles, not the Narrative!

“Herd follows the narrative whereas Contrarian follows the Cycles”

Let us start with some interesting facts and then turn to intriguing questions…

Last few weeks have witnessed some dramatic changes in prices in certain asset classes. Oil prices are up by 25 to 30%, IT stocks in India came out of slumber and produced stunning returns, Indian Gsec ten year bonds crashed and globally dollar index is down by over 10%+ etc. Behind these seemingly disconnected events, is there a common thread that is running across?

To explore this, let us turn to the questions.

Why does a 1 to 2% change in forecast for oil demand results in 30%+ change in crude oil price? How does a marginal change in forecast for IT spending galvanizes IT stock prices into frenzy? It doesn’t stop here. Mere 3% change in Govt. borrowing has busted the bond prices by over 15% or marginal change in relative monetary policy stance had an outsized impact on the global currency markets with dollar index diving by over 10%.

What is going on here?

“Market is a huge magnifying machine. Direction, not the magnitude sets up the asset prices in this asymmetric world where frothy financial flows distort everything deviously”

It is the nature of markets to mis-price assets for marginal changes in fundamentals. Changes in fundamentals are not anything rare, constantly occurring, driven by dynamics of business cycles. Much of the times, in such changes in business cycles, mis-pricing gets magnified because of the distortion of flows that gets dictated by amplified narratives that accompanies such cyclical, but marginal changes in magnitude.

One will be able to appreciate this phenomenon more thro’ an illustration. Closer look at the dynamics of IT stocks in various downturns over last several years will offer clues to the phenomenon we are talking about.

As someone wise said, Tech spending that drives stocks prices in IT sector is after-all cyclical and it moves in line with global GDP growth prospects in general and with US growth prospects in particular. That said, it is not that simple. What adds complexity is the variable lag time between GDP growth and IT spending. Lag time has been different in each of the past downturns in IT spending. Where it turns interesting is, every time when tech spending hits cyclical low in the past, narrative turned manically negative amplifying some of the ongoing challenges the Industry faces from time to time.

“In 2002, end of y2k was blown out of proportion as end of IT spending. In 2009, global financial crisis was cited as end of BFSI spending. In 2012, it was the turn of “Euro crisis” ruining IT sector. In 2017, it was digital, automation and AI that will bring end to traditional IT business model”

Below chart captured this brilliantly. It shows, how narrative amplifies the otherwise cyclical downturns into a colossal catastrophe to create great contra investment opportunities for someone who keeps an eye on cycles, not on narratives that follow. This is not to, of course, claim that there are no structural challenges for the sector. As the sector matures and becomes sizable, structural headwinds do come and can’t be wished away. Current structural challenges and the matured size have brought down the sector’s sustainable long-term growth to single digits. The point here is to illustrate how, within the trend-line growth, opportunities are created because of over blown narratives that depresses the stock prices whenever cyclical low happens within the trend-line growth.

BizNotesCycles_Narrative_Jan'18
Investing is at its best when narrative goes negative.

“Time to invest is when drums are beating, not when trumpets are blaring”

Follow the cycles (mis-pricing), not the narrative for the superior results in investing.

Happy Value Investing!!

Liquidity glut: Best is Behind!

Opportunities ahead for potential mis-pricing in bond and debt market.

Liquidity

First anniversary has come and gone, yet animated arguments still continue on its original motive. You guessed it right, we are talking about DeMon. While opinions are still deeply divided on its broader impact, one area where even its detractors do not seem to disagree is on its benign impact on bank deposits. The sensational midnight move scripted the story of savings-glut that unfolded subsequently. Banks were flooded with deluge of deposits at a time when credit demand was weak, leading to huge surplus in liquidity in the system. Deposit rates fell as a result and led to one of the biggest block-buster year for domestic flows into equities. That is not all. With support coming in from moderating inflation and stable currency (on robust FII flows), RBI rate action was on the dovish side leading to virtuous cycle of ever increasing liquidity in the system.

Surge in MF assets

If there is one business where the currency move left a biggest footprint, it must have been mutual fund industry. As a direct fallout of mid-night move, assets managed by mutual funds across the spectrum soared to historic highs. The industry is staring at a eye-popping surge of 40% in its assets this calendar year. It is no coincidence that the monthly SIP book has nearly tripled to Rs 6000+ Cr from its earlier 2000Cr level. This has brought tremendous stability to the Indian markets which otherwise used to dance to FII’s unpredictable tunes.

Odds stacked against now?

2018 may not be as lucky. Footprint of DeMon is fading. Much of it has been used up in capital markets. One can see the first signs of tightening liquidity in the whole sale deposit rates. Rates in this segment have hardened by over 40 to 50bps in the last couple of months. Unlike the year gone by, there will be a competitive chase for attracting deposits by banks in the coming year. More so, with a likely pickup in credit growth. With much less fiscal elbow room on the fallout of faltering GST revenues, liquidity position is likely to get worse in the short-term, as Govt. won’t be able to come to the rescue by boosting expenditure. Add to this the hardening hawkish undertone of RBI on firming inflation and rising risk of fiscal laxity on growing rural distress, it is difficult to build a case for neither softer rates nor for benign liquidity in the coming year. If this week’s spike in ten year Gsec yield is any indication to go by, bond markets seem to be factoring in a worsening fiscal as well as liquidity scenario for the coming months. Ten year yield surged to 17 months high of 7.3% this week. Even if the RBI keeps the status quo on the repo thro’ the year, rates on the ground will start inching up on tighter liquidity and on higher borrowing costs (higher deposit rates).

Year of Volatility?

If one goes back to early period of the current political administration and looks at some of the predictions for 2018, it was foreseen that this Govt. will gain more control in the upper house by 2018 and hence will steer some significant structural reforms in this year. But in an ironical twist, the current administration is losing some of its political capital in the rural segment precisely when it is gaining more control in the upper house, as reflected in the recently concluded state polls. Unlike the state in which polls got concluded recently, the states where series of polls have been lined up in 2018 have much larger share of rural population. Given this and the incumbency risks, it is not difficult to fathom a volatile period on account of noisy political narrative in the coming year. The economic backdrop is unlikely to be benign either. Rising interest rates, tightening liquidity, continued delay in earnings recovery, volatile crude amid normalization of rates in US etc are likely to keep 2018 much more volatile than the smooth ride we have seen in the current year.

Come back time for Debt

For debt investors, opportune time may be on cards. Short-term rates are likely to firm up and that should entice the savers back to debt markets. Investors who wants to add a kicker to the coupon thro’ duration play (like the Gsec/gilt funds), good times may come soon as we expect ten year yield to spike in the early part of 2018 on tightening liquidity amid rising risks of fiscal laxity in the upcoming budget on pressures from the rural constituency to splurge on populist measures. Opportune time is not limited only to debt investors. The rub-off will be there on equities as well. Given the heightened valuations at which equities are trading, rocky narrative both on political and fiscal side will make the coming year more volatile times compared to the one-way run in the year gone by.

Happy New Year!

 

When negatives get ignored…

In a sign of growing, but dangerous complacence among investors, markets scaled all time high on a day when the ten year Gsec yield spiked to 17 months high of 7.3%. That is not all. Market in its manic rush to breach the next barrier (on the upside of course), it seems to be ignoring all round negative news-flow. Take a look at this. Crude is at a multi-year high. Interest rates are hardening on tightening liquidity and on rising inflation risks. GST collections are on steady decline month after month. Equity FIIs are on sell mode in December. Primary market supplies (IPOs, QIPs and Offer for Sale) are on all time high. On pipeline of supply of papers from Govt.(divestment), there is no sign of slowdown. IIP numbers continue to be patchy and do not inspire confidence on the ever elusive earnings recovery.

It does not stop there. Fiscal worries have come back to haunt the bond markets. If Govt.’s latest demand for additional borrowings of 50,000 Cr is any indication, fiscal slippage could be over 30bps in the current year (fiscal deficit target of 3.2% will be breached and the actual number will be around 3.5%+). Bond markets seem to have expected this shock and factored part of this surprise with the ten year yield spiking to level not seen in the last many months.

Yet, stock market has not given up on making new highs. Where is the dis-connect?

It is not that all these negatives have sprung overnight. They have been in the making for a while. But so far, strong and surging domestic liquidity offered the counter narrative. Domestic flows were so strong that weak fundamentals did not matter much to the markets that were in a hurry to make the next highs. It may not be so any longer with early signs of trouble for liquidity as reflected by hardening rates in the short-end of the yield spectrum and rising whole sale deposit rates.

Then why markets are ignoring all warnings? Probably, this is what happens when market goes thro’ a one way run without any major blip for 12 consecutive months. To borrow from Buffett, nothing sedates rationality like the large doses of effort-less money. Market participants seem to be under serious intoxication by easy money. This is not to say that one should sell and scoot from the markets. That is not what we intend to say here. Though the long-term positive outlook is still intact, in the short-term, given the elevated valuations and emerging short-term risks, pruning positions selectively (stock specific) to build cash levels is critical to navigate the volatile times that may be in store.

Wish you a very Happy New Year!!

 

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!!

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Bank Recap: Now Performing Asset?

NPA1NPA

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.