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Imponderable Risk

Jun 24, 2019

“Headlines, in a way, are what mislead you, because bad news is a headline, and gradual improvement is not.” – Bill Gates

Imponderable Risk

Pushing a country to the edge can lead to unpredictable and unexpected outcomes, and unnecessary risks for the global economy. Post the Iranian take down of the U.S. drone, Tehran has signalled it seeks one of two outcomes: reversal of sanctions, or war. Iran will target oil supplies through the Straits of Hormuz, oil production facilities in the Middle East, and Israel. With the norther border of the Persian Gulf lined with anti-ship missiles, Iran’s ballistic missiles are capable of hitting carriers with pinpoint precision. Tehran’s objective will be to cease oil exports from the Middle East to the rest of the world.

The repercussions, should this come to pass, are staggering, starting with oil shooting above $100 at minimum. There are implications for derivatives markets and the global financial assets. A saving grace is that the U.S. President recently announced his re-election campaign, and it would seem that the U.S. would not have an appetite for Iraq 2.0 or escalation.

The One Strategy that No Portfolio Manager Will Admit To

Back to equity markets, this week we review the relative attractiveness of large, mid and small caps. We’re fairly certain there are no portfolio managers out there today that present their strategy to clients as one that consists of “buying the most expensive stocks, and adding to them as they rise in price and valuation”. Almost every investment manager will hem and haw, stating they look for stocks that are cheap or reasonably priced, or value. Ironically, the list of outperforming stocks in the NSE 500 over the past couple of years is filled with exceptionally expensive stocks.

Expensive Stocks Continue to Deliver the Highest Returns in the NSE 500…

Expensive Stocks Continue to Deliver the Highest Returns in the NSE 500…

Some of these names are perennially over-valued, and egregiously so. Trent (PE 106), United Breweries (PE 64), Godrej Properties (PE 86), Titan Co (PE 81), Astral Poly (PE 78.8), Shree Cement (PE 67), Bata India (PE 54), Honeywell Automation (PE 60) sport heady valuations.

U.S. FANG Stocks Tell a Similar Story

We could call this the Modi premium, but that would miss the larger point. This analogy extends to the U.S., where it’s unlikely one can find a quintet of stocks that has done better than Google, Netflix, Amazon, Apple, FB, over the past decade.

So Where Are the Value Stocks, Value Managers, And What’s Driving This?

This completely contradicts a dictum from the holy grail of value investing: No one ever got wealthy paying top dollar. Legendary value manager’s returns have been less than legendary these past two decades. One can say, “This is the world we live in.” But there’s more going on than meets the eye…

The Unintended Consequences of Disruptive Capital on Investor Perceptions

Disruptive capital is sweeping across businesses, industries and countries. Billionaire funded entrepreneur steps forward and says, “I am going to disrupt XYZ”. XYZ could be books, retail, B2B marketplaces, content, transportation, hotels, travel, hospitality, or pretty much anything. Startup is subsidized and services offered cheaper than cost, fragmented ecosystems replaced by integrated platforms, and massive wealth creation and concentration.

Brand, Size, Positioning and Management Demand Premiums

The five largest companies in the world are technology companies. Capital is winning against labor. Capital – via machines, automation, robotics – is replacing labor at accelerating rates. In the battle for capital, brands, intangibles, and networks are winning, as is size, innovation, resources and positioning. Companies with these attributes are generally immune to disruptive capital, demand a premium, and generally tend to be large, and growing, and therefore deserve premium valuations. Let’s take a look at other factors across cap categories.

Large Caps Are Consistent Growers, and Rising in Dominance the Past Couple of Years…
…While Mid Caps Are Struggling of Late, and Small Caps Showing Signs of Recovery

Large Caps Are Consistent Growers, and Rising in Dominance the Past Couple of Years

Large Caps Have Superior Sales & PAT Growth Metrics Relative to Mid Caps

Large Caps Are Consistent Growers, and Rising in Dominance the Past Couple of Years

Large Caps as a Group Are Only 16.9% From Their 52 Week Highs

Sales and Profit Growth – Large Caps Offer Consistent Predictable Growth

Large caps have delivered consistent growth most of this decade, while mid and small caps are volatile. The separation between large and mid/small has widened in FY19, though small caps seem to be on an uptrend the past couple of years. Large caps accelerated their PAT growth in FY19, and expectations for large caps growth remain in line with mid caps through FY21.

Valuations – Large Caps and Small Caps

Mid caps had a clear boom period during FY15-18 and corrected in FY19, with no signs of a recovery yet. Mid caps still sport a premium to large caps. Small caps have been particularly beaten down in FY19, and appear attractive at a substantial discount to mid and large caps. Valuations for large caps have been generally consistent and reasonable.

Price Performance – Large Cap Domination

While almost one in two large caps are skirting new highs, only one in five mid caps and only one in ten small caps are doing the same. Large caps as a group are off 16.9% from their 52 week highs, mid caps are down 22.7% and small caps are still down a surprising 34%.

Volatility – Large Caps

Yet again, large caps have demonstrated declining volatility since 2011, while mid cap volatility remains high.

Large Caps Remain in a High Valuation Band that Has Sustained Since FY17…
… While Mid and Small Cap Valuation Bands Have Swung Like a Pendulum…

Large Caps Remain in a High Valuation Band that Has Sustained Since FY17

Large Cap Volatility Has Declined Since 2011…

Large Cap Volatility Has Declined Since 2011…

Small, Mid or Large?

Across a variety of measures, large caps demonstrate superior performance to mid and small caps.

We cannot make a case for mid caps, but a case for small caps can be considered. We continue to recommend portfolio structures with a two thirds large cap weight, and within the mid and small cap mix, our preference would be to skew towards small over mid cap.

Rounding Out the Discussion on High Valuations

Investment wisdom suggests that high PE stocks will eventually falter and suffer painful declines. Page Industries, Maruti, MRF are examples. We concur, with caveats. There is a lot happening in the world today. The successful portfolio manager will be the one that is able to discern market opportunity, business fundamentals, trends, cross currents, and market action, and unlikely to be the manager that blindly follows single factor based investment decision-making. Google, Amazon, Microsoft and a number of Indian equities have sported extreme valuations for much of their investment lifetimes.

Investment Outlook


Iran’s ability to shut down the Straits of Hormuz has consequences for world financial markets. The consequences for the global derivatives market in crude – and equities – would be akin to a pack of bricks hitting a house of cards. We doubt the U.S. has the appetite to escalate the conflict and expect world leaders at the G-20 to broker a détente.

A Refreshing View Offered by the RBI MPC

“Recourse to such asymmetric options – heads I win, tails the regulator dispenses – is akin to the use of steroids. They get addictive and have long term adverse effects in the form of frequent relapse even though their use may be justified to relieve occasional intense pain. Hence, it would be better for the banking system to build its own immunity and strength.” – Dr. Viral Acharya, RBI MPC.

We applaud Dr. Acharya’s comments and positioning in this regard. Dr. Acharya’s resignation does not come as a surprise in light of his strong views on RBI excess reserves as he stated in October of last year, and other contentious issues. Stressed entities appear to be actively working to reduce excessive leverage and cover obligations. Willing buyers appear to be stepping forward and the process of debt reduction appears to be meaningfully underway. Such is the manner in which capital markets are supposed to operate.

Caveat Emptor and the Role of Advice

It is increasingly and abundantly clear that there are a multitude of risks in capital markets. Fiduciary responsibility has been abandoned at multiple check points. Caveat emptor is the rule of the day. Buyers need to acknowledge they had better put in the time and energy to read the fine print of financial documents or have specialists do so for them.

The Critical Role of a Trusted Advisor

When we consider client portfolios, the diversity of holdings, complexity of requirements, it remains clear that the advisor, supported by a team of product specialists, positively contributes to long term portfolio returns, acts as coach, talks clients out of meaningful mistakes, represents the client’s best interests, remains a critical resource in the investment process.


Six Year Breakout

Gold has finally broken out of its trading range and hit a six year high above $1400. Clearly, someone believes that the Iran – U.S., China U.S., central bank situations could worsen, or is buying protection. Governments around the world have been purchasing Gold. Gold is clearly an inflation hedge, so the most likely source of the breakout is driven by inflation risks related to crude.

We maintain a 10% weight in each of our three wealth profiles, and believe all investors should hold a small exposure to Gold – either physical or financial – in their portfolios.


Sovereign Funds and Private Equity Off to a Healthy Start in 2019

Foreign institutional investor flows into Indian equities are $11 billion year-to-date, surpassing the total annual tally over the four previous years and setting 2019 on course for the highest annual inflows since 2012. This bodes well for the currency, fiscal situation. Sovereign wealth funds are also piling into India, buying stakes in infrastructure, energy, real estate, attracted by political stability, a growing middle class and upcoming reforms. Private equity isn’t far behind. SoftBank is in the final stages of due diligence for investing $1 billion in Piramal Enterprises.

Monetary Policy Uncertainty

Middle East tensions have shifted attention from the July budget to global geo-politics and crude. Should crude oil continue to reflect rising tensions, the budget math will get increasingly tricky, as will the ability to deliver rate cuts.

Indian 10-year bond yields fell to the lowest in 20 months last week at 6.79%, tracking U.S. Treasuries lower after the Federal Reserve hinted at easing rates in coming months. However, bonds came off highs as crude oil prices rose sharply, and concerns around inflation, war and financial markets resurfaced. The Indian rupee remains range bound at 69.50~ levels.

Should crude prices accelerate higher, yields are likely to rise. Currency volatility will need to be managed by the RBI. Fears of inflation will exert pressure on yields as well.

Interest Rates Have Bottomed in the Short Term, with Upside Risks

While we do not think the U.S. is willing to expose the stability of the global financial system, interest rates are likely to have bottomed last week and the bias on rates now looks to be heading higher, with risks skewed to the upside. As the situation unfolds, clarity on the nature of action will come forward. Until that time, ongoing review of portfolio holdings, risk, liquidity, mark to market, and stressed entity updates remain appropriate areas of focus.

Technical Strategy

A volatile week for the market with partial recovery of losses in later part of the week after negative start. For the week Nifty declined 0.84% to close at 11,724. Broader market indices BSE Midcap and Smallcap lost 0.65% and 1.96%, respectively for the week. The Nifty traded in a range of 11,850 and 11,620 odd levels last week. Thus, a breakout from the range will provide direction to the market. On the downside market has support in the region of 11,620 and 11,590 which is the top of rising gap. Breaking below this decline can lead to 11,425, filling the gap area and next support will be 11,275. On the upside index needs to cross 11,850 on sustainable basis in order to bounce back to 12,000-12,100 levels. In Nifty options maximum open interest for Put is seen at strike price of 11,700 followed by 11,500; while for Call maximum open interest is seen at 12,000 followed by 11,800. Significant amount of Call writing was seen in strike prices of 11,800 to 12,000 suggesting in the near term upside is likely to be capped at 12,000 levels. For the week India VIX has increased by 5.1% to 14.61. After touching sub 14 levels, VIX is also seeing some recovery. For markets to stabilize, VIX needs to normalize at current levels but breaching the mark of 15 could lead to further profit booking in the market.

Technical Strategy

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