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Relative Choice

Oct 24, 2016


This month we review relative valuations on midcaps versus large caps, attractiveness of equities versus bonds, impacts of foreign flows versus domestic, first thoughts on quarterly earnings, bond markets strategies and upcoming global events.

Lessons from Bamboo Shoots

When a Chinese bamboo is planted, watered, and nurtured for the whole growing season, it does not outwardly develop even an inch during the first year. It does not show outward movement during any of the next three years either. While outward growth is n ot visible, the foundations are being built and strengthened. Then in the fifth year, something amazing and incredible happens. The Chinese bamboo tree seed at last grows, and proceeds to shoot up more than 80 feet in just one growing season. Like the bamboo tree, investing requires patience, resolve and perseverance, and the real rewards are back-end loaded. Eventually, meaningful dividends start to kick in. Investing is an exercise in patience & persistence.

The NSE Midcap Index Has Witnessed a Surge in Upward Revisions to Earnings Estimates

The NSE Midcap Index Has Witnessed a Surge in Upward Revisions to Earnings Estimates

Our Asset Allocation Model is Signalling Equities Relatively Attractively Valued Vs Bonds

Our Asset Allocation Model is Signalling Equities Relatively Attractively Valued Vs Bonds

Midcaps and large caps

There has been passionate debate around midcaps and large caps in investing circles. A number of voices have been heard stating it is time to buy large caps. Here in lies the rub. EPS revisions on the NSE Midcap have shown a marked improvement – revisions are up 10.5% yoy – while they are only flat for the Nifty 50 at 0.5%. Further, the chart above demonstrates that Midcap earnings estimates bottomed in May 2016 and have started accelerating to the upside. It is early days but it is the kind of news investors have been clamouring to see, particularly at an index level. Welcome news indeed.

Bonds or Equities?

The other debate that has been raging is between bonds and equities. With rate cuts back in play, bond investors have been sitting pretty. Our asset allocation model compares the attractiveness of bonds relative to equities, and it is indicating that equities look to be a more attractive bet on a relative basis. The yield differential has widened primarily as a result of the drop in yields. Equities are the more attractively valued asset class today on a relative basis. Our asset allocation models reflect our positive bias towards equities and bonds, away from Gold, with a slight overweight in Equities and a slight overweight in Bonds, balanced by an underweight in Gold.

The Last Time We Had a Sustained Decline in Rates Was 2002-2003

The Last Time We Had a Sustained Decline in Rates Was 2002-2003

We would further note that we have enjoyed a sustained drop in yields to a seven year low, and a benign rate environment since May 2013. The only other period in recent memory that witnessed a similar rapid and sustained decline was 2002-2003, and that presaged the launch of a major bull market. Given the valuation differential, it is unlikely we will see a similar outcome; however, the decline in yields bodes well for keeping valuations in check and improving discount rate calculations.

Domestic Vs. Foreign Flows

We have repeatedly made the case that Indian equities are less vulnerable to foreign flows than is widely believed and provide additional data to support our view.

In the chart below, we have tabulated the change in net cumulative flows from FIIs, DIIs and Mutual Funds. Some interesting points emerge from the analysis.

Mutual Fund Flows are the Foundation Stone Underpinning the Equity Market Since 2015

The Last Time We Had a Sustained Decline in Rates Was 2002-2003

FIIs were net sellers in 2015, all the way through March 2016 and it is only in the past three months that they have turned net buyers of equities. While looking at the indices, you would be accurate in stating that FIIs appear to have been the smart money. However, bottom up investors and fund managers delivered stellar returns during 2015 and 2016.

More importantly, mutual funds are the foundation that have sustained and driven equity markets in India over the past couple of years. While FIIs were net sellers, DIIs and Mutual Funds were strong buyers of equity in 2015. Further, mutual funds have been the most consistent contributors to equity markets over the past 2-3 years.

Earnings – First Look CY Q3

Autos – The Unicorn Effect – Amazon, Snapdeal, Flipkart, Ola and Uber are direct contributors to the strong numbers we are witnessing in four wheeler, two wheeler and now three wheeler sales. Ola has tied up with Mahindra and Nissan while Uber tied up with Tata and Maruti to contribute an incremental purchase number on vehicles that looks to be at least 240,000 vehicles, in addition to the thousands of cars already on the roads. Further, the gain in employment would appear to be net accretive to the economy.

IT – Wipro purchase of Appirio a Step in the Right Direction – Earnings for the IT sector have been dismal and questions are being raised about the viability of the business model. Within that context, the best news we have seen is Wipro’s decision to purchase Appirio, which includes This is precisely the positioning and expertise that the IT majors need to bring in house to shore up their competitive capabilities.

TCS and Infosys reported muted revenue growth and while both had reassuring tones, we suspect that the next quarter is likely to be challenging as well. HCLTech had reported good Q2FY17 on top and bottom lines. We remain underweight IT for now, while acknowledging the overwhelming negative sentiment towards the sector. The key question that remains unclear is whether it’ is a falling knife or a bouncing ball.

Financials – The initial indications are that the private banks, the housing finance and NBFCs are likely to replicate their performance from CYQ2. With rates declining, consumer interest in loans is likely to rise further, and widening spreads suggest better profitability ahead. IndusInd and DHFL reported slightly better gross NPAs compared to both Q1FY17 and Q2FY16. To date, Financials have reported the best numbers.

Fixed Income – New Realities

With rates headed lower, every fixed income investor is running through the options of the new reality headed our way next year, an environment of lower rates and consequent lower yields. While accrual bonds should form the core of the portfolio, we continue to believe trends favour a continuation of the declining rates scenario given the RBI’s dovish stance, benign inflation data, and global flows. Witness Blackrock’s recent announcement that it has been increasing its India debt holdings.

Within this context, a dynamic bond portfolio with short to medium exposure – something we recommended earlier this summer – would also be a wise choice. Finally, we would rate a diversified portfolio of corporate bonds an attractive opportunity as well, with the improving outlook for the domestic economy, and declining interest payment obligations for corporates.

IIP declined -0.7% in Aug, driven by a sustained fall in Capital Goods, while Consumer, Basic and Intermediate Goods improved. CPI eased further in Sep, at a welcome 4.31% as against 5.05% in Aug as favourable monsoons helped raise supply and keep food prices down.

The data points to further potential easing by the already seemingly highly accommodative stance of the MPC.

The 3rd Presidential debate in the U.S. made clear that Donald Trump is pro free trade. One of the fears that the markets had was protectionist policies should the Republican candidate win. Secondly, Clinton laid out plans for a massive jobs program, which we would translate that to a stimulus program, while Trump laid out plans for massive tax cuts, most likely for businesses. Trump’s rhetoric appeared to be toned down and markets appear to have already assimilated the impacts of the election outcome, with a likely Hillary win being the expected outcome.

The ECB hinted at extending its asset repurchase program in late October, brushing off earlier snippets of quantitative tapering. Meanwhile, China’s GDP growth for Q3CY16 came in at 6.7% in-line with Bloomberg estimates.

The U.S. T-Bond T-Bill Spread Suggests Economic Conditions Remain Mostly Benign

The U.S. T-Bond T-Bill Spread Suggests Economic Conditions Remain Mostly Benign


The Nifty tested the 8500 level last week and has seen a bounce back of more than 200 points to close at 8693. On the daily chart, the Nifty appears to be forming a bearish head and shoulders pattern. But confirmation of the pattern will come once the index breaks below the 8500 level on the downside and trades below it. Then the index can decline down towards 8100-8050 levels. This bearish pattern will be negated should the index trade above 8800 level.

On the derivative front, we have seen Nifty future open interest down by almost 40% from September highs. Also FIIs net long positions in index futures are down to less than one third of September highs. This suggests that long positions have been unwound in the market. Also, there has not been any significant build-up of short positions which is probably the reason the market is holding above the 8500 levels. Nifty options put call ratio is at one, which is a neutral level; suggesting the Index could remain sideways. Thus, market is cautious and the upside appears to be limited for the market. In the near term the index is likely to trade between 8750 and 8550 levels.

Market Appears to be Forming a Head and Shoulders Pattern

Market Appears to be Forming a Head and Shoulders Pattern


Earnings season is underway and the uptick in midcap earnings is a decidedly welcome early signal. A pickup in earnings estimates alongside a declining rate environment would bring valuations back into more reasonably priced territories.

The government remains focused on putting additional investment to work in spurring economic growth ahead of U.P. elections. The rate environment remains benign and Indian markets – bond and equity – remain an attractive destination for global investors.

While global flows may remain fickle, what’ has not been fickle is the domestic mutual fund investor, who has now become the foundation from which the index is once again in striking distance of new highs. Finally, with one week left in October, we are now entering a historical season sweet spot for equities, the November to May period.