As observed in my previous two posts (see here and here), I am inclined towards the view that the derating of Indian equities, compared to its historical averages, is partially structural.
The cyclical factors like El Nino, geopolitical uncertainties, inflation & rising bond yields in developed economies, lack of domestic investment opportunities in currently popular themes like artificial intelligence, semiconductors, etc. may be responsible for the poor performance of Indian equities to some extent. Statistically speaking, reversion to the long-term averages may also be a factor in correction in the equity prices from September 2024 high.
However, a part of the derating could be structural and we may not see the benchmark indices trading at 20-22x PE ratio in the short to midterm. Sub-optimal execution; lack of growth accelerators; a weakening perception about democratic institutions; policy unpredictability; stagnant real wages clouding demand acceleration; waning demographic dividend; and poor risk appetite of private enterprise does not augur well for any material rerating of Indian equities in the short to midterm.
Let me be clear about what this does not say. It is not a call that markets will fall. It only means that I should not count on rising multiples to do the work for me. If the PE ratio stays where it is, returns will have to come from earnings growth and dividends. And if the cyclical part turns out to be bigger than I think, I will have been too cautious. I am ready to pay that price.
Investment strategy adjustments
Over the next three years, I am considering the following changes to my own investment strategy.
· Cyclical equity as a separate asset class. Besides strategic equity, I will add cyclical equity to my standard asset allocation. To begin with, both will get equal weight. Strategic equity is the long-term core. Cyclical equity is the money I put to work only when the cycle in a sector turns in favor. Since this part will often sit in cash waiting for a trend, my actual equity exposure will frequently be lower than the headline number.
· Lower growth, higher cost of capital. For most companies, I will moderate my terminal growth and raise my cost of capital assumptions. This brings down my fair value benchmarks. Fewer stocks will look cheap, and that is how it should be if I do not expect multiples to expand.
· No buy and hold for direct equity. I will keep this strategy only for diversified mutual funds. With a single stock, holding through a full cycle without a view on the multiple can give back all the gains. For direct equity, I will need a clear exit point, either when the thesis plays out or when the price crosses my fair value.
· More patience with cyclicals. This applies especially to materials, industrials and financials. Instead of staying invested all the time, I will prefer to hold cash until a definite cyclical trend emerges in a sector. Then I will take concentrated, sizeable positions. I will miss the first part of the move, and I accept that. The bigger risk is concentration, so I must size each position in a way that a wrong call is survivable.
· Avoid consumer staples. I will stay away unless a compelling opportunity emerges, like gross undervaluation or a special situation. Staples volumes depend on the average household, whose real income has not grown much, and the stocks rarely come cheap. I will focus on aspirational consumption only, where the spending comes largely from upper-income households.
· Avoid companies that earn most of their revenue from government contracts. When one customer is the government, the company has little say on pricing, payment timelines or policy changes. This fits poorly with my concern about policy unpredictability. It also means that my industrial exposure will be limited to companies driven by private demand.
· Avoid public sector monopolies and oligopolies. In these companies, the interests of minority shareholders are not the first priority. Pricing, dividends and capital allocation tend to follow what the government needs at that point in time. The risk of competition emerging from the private sector is also very high in these companies.
· Avoid services and consumption companies with unusually high gross margins that are open to policy restrictions like price controls. Very high margins invite the regulator sooner or later. Private hospitals are one example that comes to mind.
What could change my mind
I do not see these adjustments as permanent. If real wages start rising, private capex picks up, earnings growth accelerates for several quarters in a row, and policy becomes more predictable, I will have to admit that more of the de-rating was cyclical than I assumed. I will review the framework once a year, and sooner if the evidence changes. But for now, I will stay with my current assumptions.
Summary
· A part of the de-rating is structural. Do not depend on PE expansion for returns.
· Lower fair values mean being fussier about price. Holding cash is a decision, not a failure.
· Hold diversified funds for the long haul. Hold direct stocks only with a clear exit plan.
· In cyclicals, wait for the trend to show up, then size up, but keep position sizes survivable.
· Be careful with businesses where the government is the main customer, the owner or the regulator.