Dec 10, 2018
We live in the best era in history to be an investor, but that doesn’t mean it will be easy. It’ll never be easy.
Outlook
An Election Cloud Descends Over the Markets Heading into 2019
First the good news. The Fed finally appears to be on hold, having hiked the U.S. and global economy into a slowdown. The RBI has also switched to accommodative mode, signalling a willingness to promote growth and support credit markets as necessary. Inflation is low, and economic growth is reasonably healthy, with pockets of weakness.
The bad news…the trade war is still on, and the domestic economy has just had a cloud of uncertainty thrown over it, with the election exit poll results signalling a dismal showing by the BJP.
Electoral Outcomes Fade in Impact Over the Medium Term
The fact that its even close suggests that the voting public has sent a clear message to the BJP. The discontent possibly relates to the disconnect the voter feels between the state of his/her wallet, the quality of life and media propaganda on the major progress that the country is making. We’ve regularly lauded the benefits of structural reform by the government; however, the BJP appears to have largely ignored the working middle class, heaped reforms and inconvenienced the small business owner, disrupted normal functioning of industry, and possibly not succeeded in improving the quality of life of the farmer and rural worker meaningfully. Meanwhile, large corporates have grown increasingly powerful. The voter feels disenfranchised and ready for a change. That two well regarded Congress leaders led the charge in Rajasthan and Madhya Pradesh likely played a part.
However, it’s not dire straits for investors. Consider that the average CAGR return for equities during the BJP tenure under P.M. Modi is 8.4%, while the market CAGR return under P.M. Manmohan Singh is 17.4%. The BJP has actually under-performed the average long-term return on equities. (see table)
Clearly, myriad factors are at play and that’s precisely the point. That Congress presided over the greatest bull run in Indian equities from 2004 to 2014, during which markets rose 400%, does not suggest causation. Should the unexpected unfold, it will create short term angst, but longer term, markets will march to the beat of one factor – earnings.
The research on the subject, and our own experience with political regime change is clear. Elections matter more in the short term, less in the medium term and diminish in importance over the longer term.
The Political Outcome Matters in the Short Term, Less in the Medium Term
…and Fades Away in the Longer Term…
The Sensex CAGR is 17.4% Under Congress Versus 8.4% Under Modi
Markets Have Sold Off on Tech Bubbles, Real Estate Bubbles, Investor Euphoria…
…But Rarely Does a Change in Political Regime – Should One Occur – Lead to Longer Term Impact
A Turning Point in Central Bank Policy Is Good News…
After months of rate hikes and hawkish inflationary rhetoric, the Fed and the RBI are both talking about a turn in policy and accommodative policy heading into next year. This is undeniably great news and a turning point in central bank monetary policy.
Inverting an Unexpected Outcome
Should the Congress, or third front, win the election, investors still need to deal with the fact that there remain very few alternatives that offer reliable long-term high returns. As portfolio managers, we’re confident that genuine growth stories will continue to unfold in the stock markets, which are markets of individual stocks. With regards the election, it’s premature to determine how things are likely to pan out, and clarity will emerge over the coming weeks.
Asset Allocation Principles
Staying true to asset allocation principles in the context of individual goals and risk appetites remains as important as ever. Equally important will be playing the long game; in other words, extending investment horizons to years, staying the course, and employing tactical strategies to benefit on the margin from volatility. In other words, a sound portfolio structure, a small number of tactical decisions and otherwise staying the course should remain the operating mantra for investors in 2019.
The last week of December is a time to ponder big picture trends, so we won’t be publishing the last week of December. We’d like to take this opportunity to Wish you a Wonderful, Prosperous, Happy, Healthy and Peaceful 2019!
Technical Strategy
The Nifty hovered around 10900 levels at the start of week and eventually declined on back of global cues. Rally in late trade on Friday saw the Nifty recouping some of the losses. The Nifty settled at 10694 levels down by 1.68% for the week. Index has formed bearish dark cloud candlestick pattern, while on daily forming inside bar pattern providing some hopes for bulls. Thus, on upside Nifty needs to cross 10750 levels for market towards 10900-10940 levels. On the downside declining below 10585 levels expect market to test 10420 levels which is now critical support. In Nifty options, maximum open interest for Puts is seen at strike price 10000 followed by 10200; while in Calls it stands at 11000 followed by 11500. As mentioned earlier, India VIX remains at elevated levels and consolidating in a range of 16 to 22 levels for last couple of months. Further rise will be a cause of concern and it will lead to pressure in the markets; whereas declining below 16 will be supportive for sustainable up move.
Portfolio Performance Review
We start our portfolio strategy review by posing the following question. At the end of 2016, drowning in the throes of demonetisation, had an investor been offered a 33.9% return in 2017, and a 4.3% return in 2018, would they have accepted? What about a 51% return in 2017 and -10% return in 2018? Our sense is most would have accepted either scenario, with returns averaging out to a 20% CAGR over the 2 years. Those happen to be the returns that our PMS strategies have delivered over 2017 and 2018 YTD, and highlight the lumpy, but fairly attractive, nature of equity market returns.
Portfolio Objective
We manage our portfolios with a dual objective, capital appreciation and capital preservation, based on the consideration that investors want to fully participate during bull markets, while minimizing losses during bear markets. The pendulum swings from capital appreciation to capital preservation, as markets move from bull to bear.
Performance – Olympians
We review performance on an absolute basis, relative to the benchmark, and relative to our mutual fund peers and PMS peers. Underlying data on the analysis is available upon request
.Since the cycle trough in Dec ’16 (demonetisation), Olympians has delivered a 20.8% CAGR. After a strong showing of 33.9% in CY 2017, Olympians has delivered a positive YTD return of 4.3% in a challenging year for equities. During the two years we have managed Olympians as a discretionary PMS portfolio, Olympians has outperformed the benchmark NSE 100 handily.
As most investors that track the market closely know, this year has been a tough year for large cap mutual funds. Olympians ranks 2nd against mutual fund peer group of 16 funds on a YTD, 1 Year basis, 3rd over 2 Years and top quartile over 5 Years.
Olympians Has Delivered a +20.8% CAGR Since the Cycle Trough in Dec ’16…
…Outperforming the Nifty YTD and in CY17
Olympians Has Outperformed the Nifty by 28.7% Absolute Percentage Points Over 5 Years …
Olympians Ranks #2 YTD Versus the Large Cap Mutual Fund Universe YTD (16 Funds)
…and in the Top 2 Funds Over 1 Year, Top Quartile Over 2, 3 and 5 Years
Versus PMS Managers, Olympians Ranks #1 (7 Funds) Over the Past 1 Year…
Similarly, versus a peer group of 7 Large and Large & Mid PMS funds, Olympians is ranked 1st over the past 1 year, on data as of October 31st, 2018. This outperformance likely improved in November.
Sectoral Attribution
We trimmed our sectoral weight in Financials as the sell-off accelerated earlier this year, and rates were rising. We over-weighted Information Technology as the Rupee weakened. We raised our under-weight in Health Care on signs that the industry was stabilizing. We maintained our underweight in Communication Services, Real Estate and Materials as industries with structural disadvantages, lack of demand, and cyclicality respectively, which generally has been a deterrent to long term wealth creation.
Trimming Financials Earlier in the Year, Adding to Consumer Staples and Adding to IT Were Key Sectoral Calls
Olympians Top 10 Holdings Have an Average CAGR of 29.9%
Stock Selection Attribution
Our outperformance was driven by stock selection, and concentration. Unlike mutual funds which hold 40-60 names, Olympians owns only 12-16 stocks. We list above the Top 10 Holdings in Olympians. The average CAGR of our top 5 holdings is 31.0%. The average CAGR of our top 10 holdings is 29.9%. Notably, many of these holdings have been added in the past 2 to 3 years as we reshuffled Olympians prior to launching our PMS offering. We added Bharat Forge last year in the wake of a slowing global economy and Bharat Electronics on expected surge in defence spending. Neither story panned out and we were fortunate to exit those names and minimize portfolio impact.
Valuation & Growth Factors
Olympians Sales and PAT growth over the past three years is 12.5% and 15.2% respectively. We expect sales to accelerate to 16.6% over the next 3 years, and PAT to 18.5%. YoY PAT growth is negatively impacted by two names, both of which have a turnaround quality to them, one a corporate bank and the other a leading pharma company. ROE remains solid at 19% FY 2019. Valuation, however, remains somewhat expensive at 29.8 times FY19, and that remains the key issue with most large caps. Valuation is skewed higher due to our ownership of two leading consumer names, and a dominant adhesive and chemicals manufacturer. However, rich valuations are balanced by the predictability, growth and stability large caps provide in a volatile world.
Valuation Remains Expensive for Large Caps…
…But Large Caps Provide Predictability & Stability
Go Forward Strategy
2018 has been a painful year for small and mid-cap investors, while quality large caps largely escaped the carnage. Alongside the investment stability and predictability of earnings, large caps are enjoying advantages driven by move to organized, access to low cost capital and economies of scale advantages.
The largest companies enjoy unfair advantages of scale, reputation, power and distribution. Take the case of Reliance Industries. There are a very limited number of companies that could have unleashed an audacious strategy to become a dominant player in an entrenched mature industry such as Telecom in the span of 2-3 years.
Winners keep on Winning. Whether it be Hindustan Unilever, Reliance, HDFC Bank, today’s market environment gives large, profitable and dominant franchises an edge to launch new products, forays into new industries and strategies for growth. The opportunity set for large caps still remains large. Reliance is a 100 billion dollar company with operations in one country. Apple is ten times larger, and global, and a trillion dollar company. There is no ceiling for size, and a lot of growth still left to come.
We remain focused on low turnover strategies, quality, dominant, large cap leaders with visible and predictable growth prospects, and concentrated well diversified holdings over a long tail strategy.
Performance – Titans
We review performance on an absolute basis, relative to the benchmark, and relative to our mutual fund peers and PMS peers. Underlying data on the analysis is available upon request.
Since the cycle trough in Dec ’16, Titans has delivered a 19.8% CAGR, outperforming the NSE 200 by 2.3%. Titans delivered 51.0% in CY 2017, outperforming the majority of PMS and mutual funds, with returns driven by a healthy exposure to mid and small cap stocks. YTD, Titans is down -10.0% while the NSE 200 is down -1.4%, in a challenging year for mid and small caps. During the two years we have managed Titans via our PMS as a discretionary portfolio, Titans is outperforming its benchmark NSE 200 by 1.4%. Year to date, Titans has under-performed the NSE 200 by 8.6%, due to thehigher beta and higher weightage in mid and small caps relative to the benchmark.
Titans Has Delivered +19.8% CAGR Since the Cycle Trough in Dec ’16 Vs 17.5% for the NSE 200…
…Outperforming the NSE 200 Over 2 Year, 3 Year and 5 Year Periods
Titans Has Outperformed the Nifty 50 by 28.6% on an Absolute Basis Over 5 Years
Titans Ranks #3 Versus the Multi-Cap Mutual Fund Universe Over 2 Years…
…and Top Quartile Over 3 Years and 5 Years
Titans Also Ranks in the Top Quartile of PMS Multi Cap Funds Over 2 Years and 3 Years…
Performance Vs Peers
2018 was a tough year for most funds with exposure to small and mid-caps. The fund ranks in the top quartile over 2 years, the duration that the fund has been managed as a discretionary PMS. Over 2 and 3 years, Titans compares favourably versus fund and PMS peers, ranking in the top quartile. One year returns have been below average, as the large weightage to mid-caps and small caps hurt portfolio performance.
The NSE 200 Has a Weightage of 87.5% in Large Caps, 11.6% in Mid-Caps & 0.3% in Small Caps…
…While Titans is a Pure Multi Cap Strategy with a 49%/18%/20% Split
Trimming Financials Earlier in the Year, Adding to Consumer Staples and Adding to IT Were Key Sectoral Calls
Titan Top 10 Holdings Have an Average CAGR of 29.9%
Sectoral Attribution
We added to mid-cap Information Technology as the Rupee weakened earlier this year. We raised our under-weight in Health Care on signs that the industry was stabilizing. We have maintained an underweight in Communication Services, Real Estate, Utilities and Materials as industries that are either in a structurally weak phase or cyclical with limited forward visibility. Our over-weight in the NBFC sector and private banks held up well in large part despite the sell-off in NBFCs.
Stock Selection Attribution
Like Olympians, the core of the portfolio of large cap names has delivered solid returns. The average CAGR of our top 5 holdings is 33.3%. The average CAGR of our top 10 holdings is 30.0%. Most of these names were added in 2016, when Titans underwent a significant reshuffle, and the core of the portfolio remains solidly positioned.
Quality names were hammered due to ASM monitoring and the SEBI reclassification mid-year last year. With respect to losses, a dominant player in the financial services industry that looked to have strong retail positioning, ran into a slew of issues and lost positioning. A holding in an OMC stock took a significant knock on government decision to merge two entities, which destroyed shareholder value, alongside rising crude prices.
Titans FY 18:20 Expected Sales and PAT Growth is 20.7% and 23.1% Respectively…
While Valuation is 24.8 Times FY20, In Line with Growth
Valuation & Growth Factors
We expect Titans to deliver 23.1% FY18-20 earnings growth, alongside 20.7% sales growth. Secondly, PAT during the recent quarter was solid, at 22.4%. Valuation remains expensive but is skewed by a couple of large cap quality consumer growth stocks.
Hedging & Tactical
We did not get a signal in 2017, but 2018 generated four signals, each one accurate. The signal in January worked and delivered positive returns. The signal in May was disrupted by the SEBI reclassification mandate which unleashed havoc on mid and small caps. Recent signals have continued to be accurate. In hindsight, the signals should have generated alpha, but that is retrospective prescience, and does not factor the myriad external challenges that come part and parcel with taking tactical timing calls. We derive comfort in the knowledge that our hedging did not hurt portfolio performance, while our cash calls meaningfully contributed, and both added to peace of mind during high risk periods such as February, October and November.
We took a cash call in October, on October 3rd to be precise, moving to 22% cash. We re-deployed 5% on October 26th, the bottom of the market. The put position in October gave us the cover to raise our equity exposure. This call contributed in a meaningful way to our portfolio return in November.
Going forward, we remain committed to loss avoidance should our models dictate the need to do so. Should you prefer to remain unhedged, just inform your wealth manager and we will remove the hedging option for your account.
Go Forward Strategy
Our benchmark, the NSE 200, with an 87.5% weight in large caps is in essence, a large cap index, with a barely meaningful exposure of 11.6% weight in mid-caps and 0.3% weight in small caps. Titans will underperform the index in corrective markets and outperform in bull markets.
Our bottom up analysis of the CNX 500 suggests that the valuation premium of midcaps has been wiped out. Large and mid-caps sell at about similar valuations, 23.5 times FY20 and 29 to 30 times FY19. Earnings growth expectations are better for mid-caps at 31.6% but 23.6% growth in large caps is attractive as well. However, large caps offer stability and predictability.
Our portfolio selections will be driven by preferences on geography, growth visibility, predictability, and stability. We will tilt the portfolio towards predictable, visible growth with domestic focus and larger cap preference. The uncertainty will lift sometime in the first half of 2019, once election uncertainty is resolved. Our cash position is 13-14%, which gives us a reasonable amount of cash to deploy.
