Thursday, February 7, 2019

Benchmark diverging from broader market - No change in strategy



Some food for thought
"In all my years of baseball, I have always expected to be traded. I never liked the idea."
—Jackie Robinson (American Athlete, 1919-1972)
Word for the day
Hoggery (n)
Greedy behavior.
 
First thought this morning
In a federal democracy, the disputes between the federal and provincial governments are neither unusual nor unexpected. It is perfectly alright for the provincial governments to use all means available within the perimeter of the constitution, to secure maximum federal resources and concessions for the people of the province. It is also the duty of provincial leadership to protect the interests of the provincial employees and officers.
The events that took place in Kolkata in past few days may look bizarre, but these were certainly not unprecedented.
In January 2014, we had seen very similar scenes in the national capital when the then CM Arvind Kejriwal sat on a dharna demanding action against two policemen, and actually resigning from his post on that pretext. Last summer, he again staged a dharna in the office of Delhi's Lt Governor, apparently over a rift between the IAS officers and the Delhi government over an alleged assault on Delhi Chief Secretary in CM's house.
The difference however was stark in the reaction of other political parties; especially the Congress party (INC). INC had badly castigated Delhi CM's protests as anarchist, while it is now supporting West Bengal CM whole heartedly.
Before that, MGR (1982) against center's refusal to allocate more rice to the state of Tamil Nadu; Jayalalitha (1993) against Karnataka state refusing to release agreed quantum of Cauvery water; Shivraj Singh Chauhan (2014) protesting against inadequate relief from center for farmers; and Chandrababu Naidu (2018) demanding special category status for the divided state of Andhra Pradesh - protested by sitting on dharna.
In past there have been many instances of state governments calling statewide bandh to protest against center's policies or pressing their demands.
I am not taking any sides in the latest dispute. Just highlighting that this is nothing new, and people should not be worried about the future of democracy in the country.
Chart of the day
Benchmark diverging from broader market - No change in strategy
In past few weeks, the divergence in performance of benchmark indices and broader markets in past six months, has been a matter of intense discussion amongst market participants. Post August 2018 highs, BSE Sensex has fallen about 6%, whereas BSE Midcap has corrected ~14% and BSE Small Cap has corrected ~20% (till 05 February 2019).
This divergence has divided the market into various camps. For example—
1.    The fearful are capitulating, and looking to completely exit the mid and small cap portfolios. Some of them are even considering changing the asset allocation to underweight equity exposure altogether.
2.    The greedy are looking for bargains in the stocks that have fallen dramatically in past few weeks in particular.
3.    The rationalist are arguing for maintaining the asset allocation in equity and keeping the portfolio well diversified, regardless of the recent underperformance in broader markets.
4.    The opportunists are looking to increase exposure to mid and small cap stocks that have fallen unduly, purely due to poor market sentiments.
In my view, the recent skew in performance of stocks calls for no change in investment strategy. It is important to note that for the market cycle (End February 2016 to current) the performance of the benchmark and broader markets is almost the same. Since February 2016 lows, BSE Sensex has gained ~59%, whereas BSE Midcap is up by ~51% and BSE Small Cap Index is higher by ~43%. Therefore, the recent sharp correction in mid and small cap is nothing but the mean reversion to normalize the outperformance during 2017-18.

 
Another pertinent point to examine is whether the performance of benchmark and broader markets can diverge further.
In my view, the answer to this question would depend upon a number of factors, for example—
(i)    Whether the contagion in debt market could be contained to a few names or it will spread further to engulf more companies.
(ii)   Whether the political conditions post May 2019 are good enough to sustain the confidence of investors, or fear of instability will precipitate a fresh round of panic selling.
(iii)  Whether the global economic conditions deteriorate due to Brexit and trade conflicts causing widespread "risk off" trade.
While these are all unknowns as this point in time, nonetheless the market performance during January 2008 to March 2009, when somewhat similar situation prevailed, could be a good basis to make forecast about next 6-12months.
This 15month period saw BSE Sensex returning (-)54%, while BSE Midcap (-)67% and BSE Small Cap (-)73% did much worse.
I have made one more observation. Most market participants are comparing the stock price performance in isolation to judge the performance of stocks in various categories.
In my view, this could be seriously misleading exercise. The stock price changes could be result of equity dilution, changes in balance sheet leverage, some corporate action etc.,
I believe, to find opportunities in distress, it would be better to evaluate the stock price correction, in conjunction with changes in enterprise value (changes in debt, cash and market capitalization), changes in profitability etc.
For example, other things remaining the same, if the stock price of a company has fallen by 80%, but the enterprise value has fallen by just 25%, that means that the debt of company has risen materially in this period and therefore the stock may not be that attractive as the fallen stock price may show in isolation.
The following tables show some indicative data for the top 20 losers and gainers out of the most liquid NSE listed stocks (stocks traded in F&O segment). Investors may ask their respective advisors to research further details.

 
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