The quote attributed variously to Charles Darwin as well as to American lawyer Clarence Darrow would probably stand investors in good stead today: “It is not the strongest of the species that survives, nor the most intelligent, but rather the one most adaptable to change.”
In the last six months, investors have seen an extreme roller coaster ride, first on the downside and now, on the upside. Many records were broken on the downside, when we saw the sharpest fall of the last decade in a month’s time and the unusual sight of oil trading in the negative, and the like.
These six months have turned out to be a nightmare for even veteran investors when it came to predicting market movement. As markets in the west have already achieved their highs and ours are close to doing so, what can we learn from the fall and rise so that we can try to apply this learning to future crises and to better our returns?
No one knows where the market is headed in the short term. As the famous saying goes, the market is a voting machine in the short term and a weighing machine in the long term. We, as investors, acted late when it came to the gravity of the problem and conveniently ignored both the pandemic and the economic slowdown.
Suddenly, the market realised the severity of the issue leading to panic selling in every segment — large, mid, and small caps. The fall was severe when the Nifty plunged from 12,000 to about 8,000. At that point, the perception of risk was higher than the actual risk. Even though news flow was extremely negative, there was an opportunity waiting to be taken, had we paid attention to the valuation multiple.
On March 23, when the market reached the recent bottom, the valuation of 30 out of 50 Nifty stocks were 30% lower than their five-year historical average versus 15 stocks before the fall started. Even on the basis of market cap to GDP ratio, it had hit about 56%, which was considered to be the lower bound for the broader market valuation in the last 10 years.
It was one great opportunity to buy good businesses as if at a sale. The perception of risk was already priced into the stock. As investors, we should avoid double counting the risk.
Perils of past winners
The current underperformer (banking) had the largest exposure in the investor portfolio and current outperformer (pharma) had the least exposure. For example, weightage for banks in the Nifty Fifty has risen from 25% in FY10 to 30% in FY15 to 36% FY20. At the same time, pharma weight has fallen from 7.35% in FY15 to 2.71% in March 2020.
An investor has the natural tendency to choose sectors that have done well in recent years due to the recency effect and familiarity with the sectors. Post the market correction, huge interest was seen in the banking/NBFC sector as they had done well in the last five years.
But the investor might fail to appreciate that this pandemic has placed severe stress on the already stressed banking segment. As per RBI, our banking sector GNPA (gross non-performing assets) was already as high as 8.5% at the end of FY20 and is expected to reach 12.5% on a base case scenario for FY21 and 14.7% under a severely-stressed scenario.
For any lending business, moratorium on loans should ring alarm bells as it signals increased business risk. An investor who wants to take exposure to the banking sector should take cognisance of the new reality. In the last five months, even though the market saw a strong rallybanking has been an underperformer. On the contrary, the best performing sector pharmaceuticals did not elicit high investor interest. To reduce sector risk, an investor should balance the portfolio with multiple sectors and invest in firms with future prospects and at right valuations.
Bad news about economy
The bad news on economic front is no secret and is available to all. So, it is generally priced into the market. During the last six months, most investors got it right about the economic projection but not the market movement.
During the pandemic, the consequences of economic depression became amply reflected in lower prices. Acting on the bad news and not allocating capital when valuation was attractive on a sustainable business basis turned out to be a costly mistake for investors.
From the recent bottom, more than 104 companies had generated more than 100% returns and 199 companies delivered 50% plus returns. Only five companies have delivered a negative return from March 23.
It was the opportunity that we were waiting for and when it arrived, most of us missed it by looking at only the bad news and not seeing what the market had priced in. A calibrated approach of investing during lower market levels should aid the investor in capturing the forward, higher returns.
As the fear of risk was high during the pandemic, the largest amount of capital was withdrawn from equity assets and allocated in liquid and overnight funds with expected forward return of 4-5%. As the pandemic was evolving, the risk for fixed income was getting higher due to lower future return while the risk for equity was coming down due to lower valuation risk.
On an average, in the last five months, BSE 500 companies had delivered about 69% return which, in fixed income, would take at least 10-plus years. It is not about one versus the other but about having the right asset allocation, and allocating capital based on long-term risk appetite of the investor and forward returns of the asset.
The current market mood should not determine the incremental capital allocation.
To conclude, we initially overreacted to the crisis and pushed valuations lower but now we might be under-reacting to the problem as we are yet to find a vaccine or a sure cure for he virus, and there is no economic growth in sight. Taking a balanced approach to markets and investing regularly in frontline companies should help the investor attain satisfactory and sustainable returns.
Source: ACE Equity, RBI Financial Stability Report and Motilal Oswal Valuation Report
(The author is head of research and co-fund manager at ithought Financial Consulting)
