Vijay Kumar Gaba

The debate over whether “equity investing” is an art or science is never ending. There are arguments on both sides, but none of these appear strong enough to settle the debate. Almost all episodes of this debate usually end with the compromising statement - “Equity investment is both an art and a science.”

The application of quantitative research and financial models does give it a scientific color. But use of quantitative methods and financial models is highly influenced by the personal preferences, experience, estimates and prejudices of the user. Invariably, the forecasts of fundamental analysts vary based on what parameters they have used in forming their respective opinions. For example, a 50bps difference in weighted average cost of capital (WACC) used by two analysts could give dramatically different assessments for the fair value of a stock. As someone pointed out, fundamental analysis of equity stocks is like navigating a car. While all the cars are designed scientifically, the drivers have distinct styles of driving and the results – time to travel a defined distance, safety of the passengers and vehicle, fuel mileage obtained from the vehicle etc. – largely depend on the style and experience of the driver.

The “art” side of equity investing is even more complicated. Most investors view a particular stock from the vista point they are standing at that particular point in time. Their decision to buy or sell stock depends on their financial, psychological, and social condition at that particular point in time. The decision (and therefore view on a stock) can change dramatically if they move to a different vista point, i.e., their financial, psychological and/or social change.

For example, an investor who invested in a portfolio of stocks 10yrs ago for children's college fees, he/she will sell the portfolio as soon as the children get admission in college, irrespective of the future outlook of these stocks.

Parallel to the debate of ‘science” vs ‘arts”, a lot of mythical investment strategies are also commonly discussed and marketed. The investors, analysts and money managers use terms like “value vs growth”; “cyclical vs defensive”; “large cap vs midcap”; “financials vs technology”, which are mostly mythical and have no scientific basis.

·         Most large IT Services companies count BFSI as their primary customer segment. Most large financial firms are reporting spend on technology as their primary capex. How could possibly the investment in these two sectors be alternative.

·         Auto, Energy, and Banks sector equities have given positive returns over the past 3yr, 1yr and YTD2022 horizon. This period saw one of the most pervasive socio-economic disruption globally and triggered a global recession. Whereas, media, pharma and IT services are the sector that are down on 1yr and YTD2022 basis, though IT and Pharma sectors have given strong returns over the past 3yrs. The question is how would define what is cyclical and what is secular or defensive in this scenario.

·         Midcaps have outperformed Nifty over past 1yr and 3yr timeframe. So what is the relevance of largecap vs midcap debate?

The point I am trying to make is that the investors must avoid these mostly redundant and mythological distinctions and debates and focus on their investment objectives and strategy to achieve those objectives.

Whereas the investors have enough good opportunities to invest in markets, the traders are facing many challenges. The biggest challenge is that most trading opportunities are available in the cyclical businesses like commodities and automobile. The price movements in these stocks are sharp and quick on both sides.

Since most of these stocks (metals, sugar, paper, cement, textile, power, auto etc.) have already gained significantly from their recent lows and are no longer available at cheap valuations, the margin of safety in trading these stocks is obviously low. In past couple of decades, the commodity cycles have been short and deep. If this cycle also turns out to be a usual cycle, against a super cycle as widely assumed, the corrections could be quick and deep.

In these circumstances, most of the traders, especially the smaller ones, are forced to trade with small quantities. The holding period is much smaller, mostly less than a week. Profits/losses are booked at much smaller amount. The number of stocks traded is much larger and the quality of stocks being traded is deteriorating with every rise in the prices.

Some readers and trader friends have asked for my views on trading opportunities in the market. I must say, trading in stocks is certainly not my domain of expertise. This requires completely different skills and training. Nonetheless, since a question has been put to me, I must try to answer with whatever knowledge and experience I have. In my view—

·         In past one month the benchmark indices have been mostly directionless. However, we have witnessed heightened volatility in this period. Usually, this phenomenon is witnessed close to the top or bottom of the market cycle. We may not be close to the peak of the market, but certainly we are not close to the bottom either.

·         The risk reward for the traders is negative. The market upside may be limited to 5-7%, whereas the downside could be in the range of 18-20%, even if the indices retrace 35-40% of the up move from lows of March 2020.

·         The traditional signals for correction – Market to GDP, yield differential, EBIDTA Margins peaking, distance from 200EDMA – are clearly visible but being ignored by the market.

·         The rally in commodities is totally counterintuitive and may be driven more by hopes of continuing supply constraints. The inventory buildup may in fact hurt both the hoarder and the financier in mid-term.

·         Most of the IPOs to be launched in 2021 are new economy businesses. The structure of the market is clearly shifting away from the conventional cyclical businesses, in line with the global trends. Tech enables financial services (Fintech), E-Commerce platforms, ITeS, AI etc are likely to get maximum allocation of new money. Intuitively, the market activity shall be dominated by the non-cyclical technology driven businesses. Healthcare and financials may also continue to remain in the trading arena. But commodities and utilities should logically be waiting on the sidelines for another decade at least.

Famous Spanish-American philosopher George Santayana famously said, “Those who do not remember the past are condemned to repeat it”. One of his less famous saying however was, “And those who do study the past are just as likely to make the same stupid mistake as those who do not”. The latter thought applies to the stock market participants more than the first;

Even though the standard guidance to the market participants is that historical performance is no guarantee to the future performance; most of the analysis and behavior is usually based on extrapolation of the past trends.

Analyzing the present consensus view of the analysts, strategists, investment managers and traders about the likely performance of Indian equities in short term (mostly next twelve months), I find that there is an unusually overwhelming consensus on the following trends:

(a)   The small and midcap stocks may do significantly better than their large cap peers largely due to sharper earnings upgrade.

(b)   Cyclicals businesses (commodities, auto, industrials and financials etc.) may do better than the secular businesses (FMCG, Pharma, Technology etc.) as the economic recovery gathers steam.

(c)    Growth stocks (businesses which have direct correlation with the economic growth like cement, steel, capital goods, oil & gas, financials, transport etc.) shall do better than the value stocks (stocks mainly bought for dividend yield, wealth preservation and secular growth, e.g., large FMCG, MNC Pharma, etc.) on relative cheap valuation.

However, a deeper peep into their analysis, gives an impression that most of them are relying heavily on the past underperformance of value, cyclical, mid and small cap etc.

In past 3 years (2018, 2019, 2020) The benchmark Nifty has gained ~34%. Only IT, financial services and services sectors have done better than the benchmark Nifty over this period. PSU Bank (-52%); Media (-52%); Auto (-23%) and Metals (-23%) have been major laggards. Small cap (-22%) and Midcap (-1%) have also lagged significantly.

This underperformance might to be the key driving force behind the present consensus view. I have absolutely no view on the correctness or otherwise of the consensus view, as it has no influence on my personal investment strategy. Nonetheless, I would like to share the following observations with the readers:

·         The small and midcap basket usually includes the following five categories of stocks:

(i)    Companies which are relatively new in the business. These companies may be growing fast and have the potential to become large; or they may not have potential to grow materially.

(ii)   Companies which were much larger in past but lost the advantage or made strategic mistakes on leverage, expansion, products etc.

(iii)  Companies which are older, stronger but their businesses are not scalable.

(iv)   Companies which have no meaningful business, but are listed on stock exchange for a variety of reasons.

(v)    Companies which have highly cyclical business. These companies do very well when their business cycle is good, but usually lose the entire gains in down cycles.

·         New companies with high growth potential and strong older companies with sustainable high dividend yields are the categories that create tremendous wealth for the shareholders.

·         Highly Cyclical businesses give massive returns to the investors who understand the business cycle and are able to buy the stocks at cusp of the upcycle and sell before the party ends.

·         Rest all categories usually inflict losses on investors; which in many cases result in erosion of entire capital invested.

·         Another noteworthy observation is that many small and midcap companies that appear to have given stupendous return in one market cycle, just disappear from market clandestinely. All hopes of recovering the losses made from investing in such companies, in future market cycles, are usually belied.

From the above observations, it could be deduced that to make meaningful money from small and midcap companies, one has to either have strong knowledge of the business cycles or have materially higher risk taking ability.

Smaller investors like me therefore should resist the allurement of quick gains. If they must, they should prefer to invest in a small and midcap fund managed by the professional fund managers, who have good knowledge of the business cycles and are usually emotionally unattached with any particular stock.

 I remind myself of this narration almost every market cycle. I think, it is the time to reiterate once again.

Have you ever been to vegetable market after 9:30PM? The market at 9:30PM is very different from the market at 5:30PM.

At 5:30PM, the market is less crowded. The produce being sold is good and fresh. The customer has larger variety to choose from. The customer is also at a liberty to choose the best from the available stock. The vendors are patient and polite, and willing to negotiate the prices. As the day progresses, the crowd increases. The best of the stuff is already sold. Prices begin to come down slowly. The vendors now become little impatient and less polite and mostly in "take it or leave it" mode.

By 9:30PM, most of the stuff is already sold, and only inferior quality residue is left. The vendors are in a hurry to wind up the shops and go back home. The prices are slashed. There is big discount on buying large quantities. Vendors are aggressive and very persuasive. Customers now are mostly bargain hunters, usually the small & mid-sized restaurant, caterers and food stall owners. They buy the residue at bargain price, cook it using enticing spices and oils, and serve it to the people who prefer to eat out instead of cooking themselves, charging much higher prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

A very similar cycle is repeated in the stock markets.

In early cycle, good companies are under-owned and available at reasonable prices. Market is less volatile. No one is in a hurry. Smart investors go out shopping and accumulate all the good stuff.

Mid cycle, with all top class stuff already cornered by smart investors, traders and investors compete with each other to buy the average stuff at non-negotiable prices. Tempers and volatility run high.

End cycle, the smartest operators go for bargain hunting; strike deals with the vendors (mostly promoters and large owners) to buy the sub-standard stuff at bargain prices. Build a mouth-watering spicy story around it. Package it in attractive colours and sell it to the late comers and lethargic, at fancy prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

If my message box is reflecting the market trend near correctly, we are in the end cycle phase of the current market cycle. I daily get very persuasively written research reports and messages projecting great returns from stocks which no one would have touched six months ago, even at one third of the present price.

The stories are so persuasive and the packaging so attractive that I am tempted to feel "it's different this time." But in my heart I know for sure, it is not!

In past one month, the set of businesses commonly referred to as “cyclical” in stock market jargon has outperformed remarkably. This one month outperformance has resulted in this set of stocks outperforming the benchmark Nifty on past 12 month performance basis also. Though, on three performance basis these stocks continue to lag substantially.

If I go by the media reports and the messages and report in my inbox, there is still “huge” value left to be realized in these set of stocks. The arguments are varied and quite persuasive.

·         A former CIO of a fund recently tweeted that “Deeply negative rates with excess liquidity getting cleared at zero rates is like cocaine to asset markets. We are in midst of a blow off top rally and if RBI does not mop this liquidity then stock prices in India could rise beyond imagination.

·         Another prominent fund manager, reputed for his stock picking skills, argues that so far the liquidity has gone into financial assets. From here on liquidity may move to real economy and fuel demand for infrastructure building and capacity creation. Components of cost like power, labor and interest rates are favorable for Indian businesses hence profitability should improve. There is strong case for investing in cyclicals which will benefit from capacity building in infrastructure and manufacturing.

·         The global brokerage firm Goldman Sachs (GS), in a recent report, highlighted that global Copper prices are now at highest level in past seven years. GS forecasts that “the world’s most important industrial metal was in the first leg of a bull market that could carry prices to record highs.” The report further emphasizes that-

“Against a backdrop of low inventories and net zero carbon pledges from countries including China, Japan and South Korea, Mr Snowdon believes significantly higher copper prices will be needed to incentivise new supply and balance the market.

We believe it highly probable that by the second half of 2022, copper will test the existing record highs set in 2011 [$10,162],” he said. “Higher prices should ultimately help defer peak supply and ease market tightness, but this first requires a sustained rally through 2021-22.”

·         A report by Motilal Oswal Securities highlights that Indian steel spreads have risen ~25% in 3QFY21 and are at a three-year high. Brokerage expects the spreads to stay strong on the back of a domestic demand recovery and higher regional prices.

It is further noted that Despite domestic iron ore prices rising to a five-year high, spot steel spreads are at a multi-year high due to higher steel prices and subdued coking coal prices. While iron ore prices from NMDC have increased by 30% YTD in FY21, imported coking coal prices have declined by ~35% YTD, keeping total raw material cost in check. As a result, domestic steel spreads are strong at INR33,000/t for flats (HRC) and INR30,000/t for longs (rebar).

·         Nirmal Bang Institutional Equities notes that Automobile sales continued its growth momentum in November’20 amid rise in preference for personal mobility on the back of good festive demand, upcoming wedding season, soft base due to overlapping of Diwali in November this year and continued positive sentiments in rural & semi urban markets. Barring 3Ws, all the segments reported YoY volume growth.

·         Emkay Global highlighted in a recent report that Chemical prices are firming up. The report mentions that In Nov’20, prices for key products such as Phenol, Benzene, Acrylonitrile, Butadiene, Toluene and Styrene jumped over 20% MoM in international markets. Rising container freight costs (~2x) on dedicated Asian routes due to a capacity crunch have pushed prices higher for certain chemicals. Freight costs within Asia are also likely to see an uptick in Dec’20 as carriers are prioritizing long-haul routes over shorter ones as a result of better economics. PVC prices have increased 10% MoM and are likely to swell further next month.

On the other side of the spectrum are people like Peter Chiappinelli of GMO, who are convinced that this liquidity fueled rally is about to end anytime now. In the latest GMO Asset Allocation letter, Peter emphatically advised his clients as follows:

“Currently, we are advising all our clients to invest as differently as they can from the conventional 60% stock/40% bond mix, just as we were advising them in 1999. Back then, we were forecasting a decade-long negative return for U.S. large cap equities. And that is exactly what happened. Today, the warning is actually more dire. U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession, and CAPE levels are well above 2007 levels, within shouting distance of the foreboding highs reached in October 1929. But it gets worse. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon. We believe the chances of a lost decade for a traditional asset mix are dangerously high.”

My personal view is that it’s 9:30PM in the stock markets. I believe that in post pandemic era, many of the traditional businesses may even not survive. Besides, in Indian context, the present capacity utilization levels may not warrant any significant capacity addition in next couple of years at least. The so called “Atam Nirbhar” capacity building trade may mostly be limited to soft commodities (like chemicals); electronics and defense production. Unlike 2003-10 infra capacity additions, it may not trigger any life changing opportunity for many engineering and capital goods companies.

The logistic constraints and paranoid inventory building by some economies may cease in next six months as vaccine is made available to more and more people. The Central Banks, especially RBI, may look at containing liquidity in 2021, before it can actually cause an inflationary havoc. The hyperinflation which many analysts, economists and fund managers are secretly praying for since QE1 in 2009 may actually not happen at all. I am also convinced from my own research that stress in unsecured credit segment has increased materially in past few months and banks will have to bear the brunt of this. I shall therefore let this trading opportunity in financials, commodities and cyclicals passé.