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The Untouchables

Feb 18, 2019

“The contrary investor is every human when he resigns momentarily from the herd and thinks for himself” – Archibald MacLeish

Chile’s Acclaimed F.M. Visits India – His Comments on Fiscal Austerity vs Profligacy

Before we get to our commentary, a quick note. Last week, Andres Velasco, former finance minister of Chile, was in town. Andres is Latin America’s acclaimed finance minister, having pulled Chile back from the brink of a massive economic crisis. Mr. Velasco detailed how he used classic Keynesian policy to pull Chile through the 2008 crisis by saving money during good times, taking the fiscal surplus to 8% of GDP, and then spending aggressively during the 2008 economic crisis, bringing the surplus down to a deficit of 5% of GDP. That’s thirteen GDP percentage points of stimulus. Notably, the nature of stimulus was critical, as the U.S. Europe and Japan have amply demonstrated. Mr. Velasco used the stimulus for subsidies and tax cuts, rather than bank bailouts, resuscitated the Chilean economy and created massive positive social impact.

The Whatsapp Chat Rooms Are Quieting Down…

Investor chat rooms on whatsapp have quieted down. Domestic flows into equity funds are stumbling. There’s a new set of losers every decade – 1987, 1998, 2001, 2008 and 2018. Young urban India were recent entrants in equities, lured by tantalizing returns, particularly in mid and small caps, and persistent industry marketing.

Maybe an equity wealth effect exists in urban India, as consumers have pulled back their purse strings on financial investments and big ticket purchases, in the face of governance scandals, funds siphoning, manipulation, greed, and corruption. The market has taken the role of judge and jury, firing first and asking questions later. Promoter and investor wealth has been destroyed in hours. It has been a minefield, and even the savviest investors in India have taken hits to their portfolios, and over the course of the past year, small and mid have now become the new untouchables.

Globally, U.S. is in a Growth Slowdown…
…But the Data Remains Mixed and a Recession Does Not Appear Imminent…
…Europe on the Other Hand, Seems Ready to Dip into Contraction

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The Fed Has Engineered a Global Slowdown with a Rise of 200 bps in the Fed Funds Rate

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The Fed Engineered Global Slowdown

While we’ve heard mention of slowing U.S. growth, the data suggests economic activity in the U.S. has slowed but a recession does not appear to be imminent. Rather, things look worse in Europe which seems on the verge of contracting, while the U.S. is experiencing a slowdown in parts. With an anemic recovery, one would expect an anemic slowdown. That, arguably, has already occurred and is priced in by markets. More importantly, the Fed put appears to be back and we’re likely done with rate hikes and balance sheet contraction is expected to moderate.

Earnings, Adjusted for PSU and Telecom, Despite Media Reports, Look Good

We adjust the Nifty 50 for Indian Oil earnings, which reported a huge loss. The Nifty 50 ex IOC, is up 21% top line, 14.9% on PAT. Financials, Industrials, IT, and Energy (Reliance Industries) have led the charge on top line, and Financials are leading on bottom line. Let’s also put the earnings performance in context: these numbers come in a quarter when IL&FS defaulted, we had an NBFC crisis, the RBI Governor resigned, there was a surprise election verdict, a credit freeze and a sharp sell-off in the markets.

Strong Top Line Growth, Mid Cap Earnings Shine

For the broader universe, we’ve adjusted earnings for Bharti Airtel and PSU banks (Allahabad Bank, Andhra Bank, Bank of India, Central Bank of India, IDBI Bank, Indian Overseas Bank and Uco Bank). The numbers are similarly impressive, up 19.2% on PAT and 18.5% on top line.

Strong Top Line Growth (18.5%) and Strong Profit Growth (19.2%)…
…Adjusted for a Handful of PSUs and Bharti Airtel

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Mid Caps Top Line is Up 17.4% and Profits Up 39.0%…
…While Large Caps Have Delivered Predictable 15.3% Growth

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Analysts are Forecasting Strong EPS Growth, Yet Again…
…Particularly for Mid Caps

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Mid caps are the primary reason for the strong show, demonstrating impressive growth of 17.4% and 39.0% top and bottom line respectively.

Valuations – Progress for Mid Caps

Valuations – the bane of the equity investor in recent times – have corrected substantially for mid caps and we’d attribute it to both earnings growth and price correction. Mid cap valuations are now cheaper than the Nifty 50; granted, we are looking at forward earnings data, which should be taken with a healthy dose of skepticism. We note also that mid caps have not been this cheap since Dec 2016. With low inflation and low interest rates, a continued correction lower does not have to be a pre-requisite for a bottom if we’re in a cyclical correction.

We also computed run-rate P/E on current quarter earnings for the various caps. Large caps are valued at 20.7 times, mid caps at 21.5 times and small caps at 18.5 times. Essentially in line with current growth rates and marginally at fair value but not cheap.

But Equities Remain Expensive at the Index Level

As usual, the skewed capitalization, weightage, and structure of the Nifty 50 is an impediment for investors to draw meaningful observations at an index level. The trailing bottom up P/E for the market, adjusting for PSUs and Telecom, is 21.7 times. That’s out of the band of extreme over valuation. Forward earnings are approximately 18.5 times which would be considered reasonable and inching closer to trough valuations of roughly 16 times. The MSCI India trades at a 55% premium to emerging markets, but again, index level valuations are limitingly flawed, particularly in light of strong company level earnings.

Forward Valuations on Mid Caps are Now Lower than Large Caps…
…And At Levels Last Witnessed in Dec 2016

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Equities Outlook

It Feels Like 2003 and 2013… Half the Market is Down 40% from the Highs, But…

804 of 1180 stocks or 67% of stocks are down 30% or more from their 52 week high. 559 stocks, or 47% of the market, are down 40% or more from highs.

In conversations, we get the sense that the end of the world – or at least the Indian capital market – appears to be at hand. It felt the same in 1998 when LTCG brought systemic risk to the fore and feels the same as summer 2013, but felt worse during Lehman 2008 and Nasdaq 2002.

Mid and Small Caps are the New Untouchables…

Mid and small caps are the new untouchables. There is limited clarity on what the short term holds, and it’s possible we have volatility ahead and further negative surprises. One cannot underestimate the ability of the unscrupulous few to pull the rug out from under the unsuspecting many. Such is the nature of financial markets, at home and abroad. But the level of negativity, pessimism and aversion suggests that we’re somewhere nearer the trough. Earnings are growing for the majority of the market (see chart) and this, alongside central bank accommodation will provide markets relevant support.

The RBI Will Likely Deliver Further Rate Cuts and the Macro Environment Remains Favorable

There is every likelihood that the RBI will deliver one, if not more, rate cuts. There is likely to be a stimulus heading to rural India soon. The Fed will most likely be lowering interest rates later this year. Inflation continues to beat on the downside. Interest rates remain low and show signs of heading lower.

Most Companies Are Delivering Strong Top and PAT Growth in the CNX 500

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The Macro Economy Remains Healthy and Earnings Should Continue to Come Through

The macro economy remains healthy. Composite PMI is in growth. Credit growth remains robust, up 14.5%, particularly for services. News flow on Make in India continues to be robust. We continue to believe the most logical path is for earnings to continue to deliver, which will eventually start a new leg higher. Corporate banks could lead the recovery, or it could be Info Tech if the U.S. holds up.


For lack of a proxy for quality growth, we use our in-house Sanctum large and multi cap funds, which are down 2.8% collectively in CY 2018, while registering a 42.4% gain collectively in CY 2017.

There is no longer an edge in information, and it’s becoming fairly clear there is limited consistent edge in analytical ability. The only edge then becomes a longer-term investment horizon, and an ability to take advantage of behavioral opportunities. Tactical asset allocation remains the largest potential source of alpha.

Diversification and thoughtful asset allocation remain the key pillars of strategy. We’d deploy capital on moves lower between now and the election, with additional allocation post the election should markets deliver a surprise verdict. We prefer quality growth, diversified portfolios at reasonable valuations. We also think the deep aversion to mid and small caps spells contrarian opportunity for the smart investor that has the ability to be patient, average down in coming weeks, and hold for a three-year horizon.

Fixed Income

An Abandonment of Fiduciary Responsibility in Debt Funds…and Investors Take the Hit

Debt fund managers with fiduciary responsibility have sacrificed security of principal in the reach for incremental yield. Is it really alpha that these funds were delivering, or just beta? Looks a lot like beta. The market is going through a price discovery process, and INR 60,000 crores has exited certain MFs according to Bloomberg. As usual, caveat emptor is the clear takeaway for advisors and investors that entrusted capital with fund managers.

Short Rates and Long Rates Have Trended Surprisingly Lower

Short term and long term rates had headed higher leading to the IL&FS default. We find no such action today. The market does not appear concerned about rural relief stimulus either, as the 10 year g-sec now sits near recent lows. Rather, the action suggests that the market is stabilizing. With IL&FS, one would expect most banks and NBFCs have gone through their counterparty exposures with a fine tooth comb. However, fear remains palpable amongst investors, and worries about financial contagion abound.

The RBI and the government stand ready to backstop the system and the larger consumption economy remains healthy. The consumer balance sheet remains healthy, save those poor investors stuck in long term real estate investments with developers.

Strategy – Safety of Principal in the Shorter Term

Nevertheless, uncertainties in the short term need to play out, and worsening credit conditions remain a risk. In such a scenario, we favour the short end of the curve, higher rated, clean credit, short duration and/or liquid, until risk is clearly clarified. We also prefer exposure via principal protected structured strategies with upside participation.

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Technical Outlook

The Nifty declined 2% for the week to close at 10724 levels. After witnessing breakout above 11000 levels, Nifty retraced back and has tested lower end of the range. Long lower shadow on Friday indicates buying coming in lower levels. Thus index continues to trade in broad range of 11000 and 10500 levels.

Now needs to cross 10800 levels on upside bounce back to be seen towards 10900 and 10980 levels. But clear visibility will be once Nifty start to trade above 11100 levels on upside. On downside if Nifty starts trade below 10670 levels then expect decline towards 10550-10530 levels. But breakdown will be seen once starts trade below 10500 levels. In Nifty options, maximum open interest for Puts is seen at strike price 10700 followed by 10400; while for Calls it is seen at strike price 11000 followed by 10900 and 11200. With the Nifty moving lower Put unwinding was seen in 10900, 10800 and 10600; while Call writing was seen at 10700 and 10800. India VIX increased by 4.38% to close at 16.46 levels on Friday. Further rise in VIX will keep market under. It needs to move below 15 levels for markets to move higher.

The Untouchables

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