The benchmark Nifty 50 crossed the 16000 mark for the first time this week. Predictably, the moment was celebrated by media and “market influencers” with gaiety and fervor that is usually shown at Nifty50 crossing every subsequent thousand (K) mark. The fact that from 10k to 11k - it is a 10% rise; whereas from 15K to 16K it is just 6.67% rise, is usually disregarded in celebrations and recounting of the journey from one ‘K’ mark to the next “K’ mark.

It is also mostly ignored that Nifty, like any other statistical number, is meaningless in isolation. It must be juxtaposed with some “other” statistical number to derive any inference. The selection of this “other” number, however, usually depends upon what the data user wants to conclude. If the user wants to feel good about the current Nifty number, a comparison with an inferior set of statistics is preferred (e.g., Nifty has performed better than gold over past decade); whereas if the user wants to show the current Nifty number in a poor light, a superior set of statistics may be chosen to compare (e.g., Dhaka DSE30 has outperformed Nifty50 by 150% over past one month).

However, if the idea is just to celebrate, like drunk dancing in the wedding of a distant relative, a statistical number may be used in isolation.

Nifty: Drunk dancing in a wedding

In past 25years, Nifty return pattern has been quite erratic. From one ‘K’ to the next ‘K’ view point, there have been three instances of very fast journeys (2006-08; 2017-18 and 2020-2021); and there have been two long journeys (1993-2003; 2008-2015).

But this data may actually mean little for an individual investor, considering that-

·         The average vintage of investors in Indian market may be less than 15years;

·         There have been four massive draw down of over 25% each in these 25yrs, where many investors may have given up with little or even negative returns;

·         The point to point return in Nifty from any randomly selected date means little for individual investors. It is the actual return that matters;

·         Anecdotal evidence suggests that maximum investors take or increase their equity exposure in the rising market only. The largest inflows by household investors are usually seen during the last phase of an up move. Also, the exposure of household investors to Nifty ETFs is not significant, so change in Nifty value may not actually reflect the return earned by an average household investor; and

·         Most household investors prefer to invest in mid and small cap stocks with ‘multibagger’ return potential. The rate of failure in this segment is extremely high. There is decent chance that most household investors have underperformed the Nifty returns over this period.

For a majority of the household investors, therefore, celebrating a milestone in the 27yrs journey of Nifty is mostly like drunk dancing in the wedding of a distant relative. It gives a momentary high, dirty cloths and a painful hangover, the next morning.

Good, Bad and Ugly

The Good: Increased household participation in equity investing is a good sign for everyone – corporates; investors; market participants and the government. The channeling of household saving to productive sector, against negative real return yielding deposits or unproductive assets like gold is always welcome.

Another good thing to note about Indian equities is that Nifty has outperformed the global peers in INR as well as USD terms during past 12 months.

The Bad: However if we accept that (a) most of the household investors were already fully invested in March 2020; (b) the new investors have not made meaningful allocation to equity and are just testing waters; and (c) A large number of investors have withdrawn money from mutual funds and other professionally managed investment scheme and invested directly in equity (as indicated by the data of larger retail participation in daily trading activity and persistent outflow from mutual funds over past 15 months) .then we could easily assume that not many investors have made 100% return from the lows of March 2020, even though most of those who stayed invested through panic would have been saved from losses and made decent return on their investments. Also it would be reasonable to assume that the current portfolios of many investors are dominated by stocks with relatively poor quality of balance sheet, earnings profile and sustainability.

The Ugly: The ugly part is that the small and midcap stocks have massively outperformed the benchmark since Pandemic lows of March 2020. Not all small and midcap stocks are poor quality. But a large part of these stocks are either poor quality or represent highly cyclical businesses. This kind of divergent performance has usually ended disastrously for investors. As of now, there is no reason to believe it will be different this time.

Nifty returns vs Investment returns

We can put the Nifty returns in perspective by taking example of these two household investors ‘A’ and “B”.

Investor A is an ideal investor. He is 40yrs old; started investing in 2006 (Nifty 3966) when he joined his first job; has a portfolio that is mostly aligned to Nifty (mostly large cap funds and some direct equity); invests his surplus savings (Rs5,00,000/year) at the end of every year; and has not sold anything in 15years.

After 3 full market cycles, this investor would have earned a return of 11.55% CAGR as of today. The rate of change in Nifty in this period is 10.13% CAGR.

Investor B is also a household investor, 40yrs old, started investing in 2006 (Nifty 3966) when he joined his first job; has a portfolio that is mostly aligned to Nifty (mostly large cap funds and some direct equity); invests his surplus savings (Rs5,00,000/year) at the end of every year; but is not as disciplined and confident as the Investor ‘A’. He easily gets influenced by the forces of greed and fear – sells during panic and buys in euphoria.

He started in December 2006 and exited in December 2008 (post Lehman); redeployed the sale proceeds and new savings in December 2010 (Post QE) and exited in December 2016 (post Demonetization); again redeployed in December 2017, did not get panicked in March 2020, and is still invested. This investor would have earned 7.9% CAGR on his investment, though his net principal amount invested is same as Investor ‘A’. (For the sake of simplicity, dividends and cost of investments have been ignored in these calculations)

Nifty returns: A realistic expectation

The jargons like long term and short term are frequently used by the market participants, without providing any context to it. This jargon may have entirely different connotations for different set of investors. For taxation purposes, it refers to less than 12 months (Short term) and more than 12 months (long term). For risk capital investors (VC, PE etc.) this may relate to life cycle of a business; and for stock traders it may a technical swing lasting between few weeks to few months. Also, for a portfolio (diversified mutual fund etc.) investor this could be different than the investor holding a direct stock.

If for the sake of simplicity, we assume long term to mean 5 calendar years, Nifty returns (rolling 5yr CAGR) were very volatile for first 20years (1995-2015). Since then the volatility has reduced materially, with this number stabilizing close to +/- 12% range. This is despite poor economic growth and large drawdowns on demonetization, GST, Covid etc.

While equity markets do enjoy better attention of investors, it is the bond market that usually guides the direction of financial markets, including equity and currency markets.

The following recent signals from the bond market are worth noting:

US Junk Bond Yields fall below inflation

Investment demand for speculative-grade debt and high-yield bond exchange traded funds has been so high that yields on the riskiest U.S. companies are now below that of inflation. The rally in corporate debt rated below investment grade has also pushed yields down to record lows around 4.54%, compared to consumer prices that rose 5% in May year-over-year.

The head of equity research at Julius Bär, summarized the situation as “Inflation has risen to record-high levels in recent months, and the 10-year US bond yield has fallen to a fresh five-month low. What is the reason for the rally in US Treasuries? Obviously, investors believe that peak growth and peak expectations are already behind us. The US Federal Reserve’s (Fed) shift towards earlier-than-expected rate hikes has removed fears that inflation may run out of control, and falling purchasing managers’ indices from record-high levels support the case for decelerating economic growth. This is a normal mid-cyclical consolidation driven by base effects and most likely set to continue at least until Q1 2022.”

India: Credit risk category outperforming

In India also in past one year, the riskier corporate bonds have yielded best return as compared to the highly rated corporate and Sovereign bonds. The five year return on credit risk funds was less than half of highly rated corporate bonds and gilt.

These trends clearly indicate that bond market is not buying the theories of immediate full recovery to pre Covid level; sustainable higher growth, hyperinflation and imminent rise in borrowing cost.

 “The afternoon knows what the morning never suspected.”―Robert Frost

In past few years, cryptocurrencies (especially Bitcoin) have gained material importance in the global financial system. Though the character of Bitcoin (or cryptocurrencies for that matter) is still evolving and it is not certain if it will assume the character of a currency; end up just being a collectible asset like Art, wine, vintage vehicles, old coins, etc.; or just end like a bad dream. But as of now, the debate over its relevance, sustainability, desirability, etc., is intense and wide.

In my view, it is a debate that will continue for many more years and no one will remain unaffected by it. Almost everyone who transacts in money or is part of the global economic system will need to deal with at some point in time.

Majority of experts still skeptical

A large number of prominent personalities in the field of finance, technology and economics, like Warren Buffet, Jamie Dimon, Peter Schiff, Paul Krugman, Bill Gates, et.al., have publically criticized the popularity of Bitcoins. In their wisdom they have chosen the terms like “fraud”, “rat poison”, “scam” etc. to describe Bitcoin. In India, the legendary investor Rakesh Jhunjhunwala publically vowed never to own Bitcoin.

The following statements of the legendry investor Warren Buffet represent the sentiments of the people who are skeptical about the sustainability of cryptocurrencies as a viable currency or asset class”

"It's not a currency. It does not meet the test of a currency. I wouldn't be surprised if it's not around in 10 or 20 years. It is not a durable means of exchange, it's not a store of value. It's been a very speculative kind of Buck Rogers-type thing and people buy and sell them because they hope they go up or down just like they did with tulip bulbs a long time ago." (2014)

"In terms of cryptocurrencies generally, I can say almost with certainty that they will come to a bad ending. If I could buy a five-year put on every one of the cryptocurrencies, I'd be glad to do it, but I would never short a dime's worth." (2018)

It is “probably rat poison squared”. (2018)

“I think the whole damn development is disgusting and contrary to the interests of civilization. Of course, I hate the bitcoin success… I don’t welcome a currency that is so useful to kidnappers and extortionists”. (2020)

 "Cryptocurrencies basically have no value and they don't produce anything. They don't reproduce, they can't mail you a check, they can't do anything, and what you hope is that somebody else comes along and pays you more money for them later on, but then that person's got the problem. In terms of value: zero." (2020)

Later, however, JP Morgan, disregarding the earlier comments of CEO Jamie Dimon, “admitted its mistake” rejecting Bitcoin as a scam and has shown inclination to accept the cryptocurrency as an attractive asset.

Eric Peters, CIO of Hedge Fund One River Asset Management, proclaimed (about Bitcoin) that "There Is A Vague Sense That Something Powerful, Apolitical, Transnational, Is Emerging".

In the meantime, Rakesh Jhunjhunwala, the legendary Indian investors who is often referred as Warren Buffet of India, was heard saying in a TV interview, "I won't buy it for even $5. Only the sovereign has the right to create currency in the world. Tomorrow people will produce 5 lakh bitcoins, then which currency will go? Something which fluctuates 5-10% a day, can it be considered as currency?"

Regardless of the extremely negative expert commentary, Bitcoin has not been termed illegal in any of the major economies in the world; even though some countries like China have imposed severe restrictions on transacting in Bitcoins. El Salvador has become first country in the world to accept Bitcoin as the legal tender.

Despite being most volatile, Bitcoin has remained one of the best performing “assets” in past couple of years.

The historical context

The work on developing as crypto currency started in early 1980s. The idea was to create a medium of exchange that is independent of any central authority, is based on trust and is accepted by distributed consensus. The process was formally commercialized in 2009 with release of Bitcoin, the first decentralized cryptocurrency. May be uncertainty over future of fiat currencies post global financial crisis (which led to printing of unprecedented amount of new money) prompted adoption of an independent currency as medium of exchange. Since then, the cryptocurrencies based on block chain technology have been gaining popularity. Presently, besides Bitcoin, over 6000 variants of crypto currencies are in vogue globally. Many central bankers have also expressed in using digital technologies to supplement the paper currency.

The present value of all cryptocurrencies in circulation is over US$1.6trn; out of which bitcoin alone accounts for about US$750bn. This compares with US$5.8trn of monetary base (M0) of USA). The average daily trading value of bitcoins alone is over US$23bn. It is clear that Bitcoin is emerging as a serious challenger to Gold as an alternative currency or medium for exchange of value.

Two large global corporations Tesla (again!) and Amzon have expressed the intent to accept Bitcoin as valid payment for transactions. This has further intensified the debate and softened some of the critics.

The Indian context

In Indian context, the money market regulator (The Reserve Bank of India or RBI) has taken a guarded view of cryptocurrencies. It has refrained from terming it as illegal. However, some attempts have been made to discourage the use and ownership of cryptocurrencies. The Supreme Court of India has disagreed with some of these measures, and paved the way for legal ownership of cryptocurrencies. However, the regulatory and taxation regime is still evolving and may take some time to get established.

RBI vs Supreme Court

RBI issued a circular in 2018 directing all entities regulated by it (Banks and NBFCs) not to deal virtual currencies or provide services for facilitating any person or entity in dealing with or settling those; thus virtually banning use of crypto currencies in India. The Supreme Court quashed the said RBI circular in March 2020, on the appeal of the Internet and Mobile Association of India, representing various cryptocurrency exchanges. The SC accepted the argument of the appellant that in the absence of any specific law banning cryptocurrencies, dealing in these is a “legitimate” activity; hence RBI’s circular banning these is untenable.

In August 2020 various media reports suggested that a “note” had been forwarded to the concerned ministries for inter-ministerial consultation to promulgate a legislation banning the use of crypto currencies in India. Reportedly, the inter-ministerial committee headed by the former Finance and Department of Economic Affairs (DEA) secretary, Shri Subhash Chandra Garg (who has been in news recently for criticizing the government for backtracking on reforms) had drafted the Bill of the law to ban the cryptocurrencies. In the meantime, as per various media reports, since March 2020 SC order quashing the 2018 RBI circular, the local crypto exchanges have reported as much as 20x trading volume growth and a significant increase in the number of signups.

The aggressive marketing campaigns by these ventures however are focusing on promoting Bitcoin ownership for vanity purposes, palpably as a substitute for gold.

NITI Aayog initiative on Blockchain recognizing its importance

In January 2020, NITI Aayog (the think tank of the government of India on policy matters), had released part 1 of the discussion paper on “Blockchain: The India Strategy”. The well-researched and well-presented paper unambiguously stated that the government recognizes the opportunity, importance and need for blockchain based crypto currencies.

The paper recognized that “‘Blockchain’ has emerged to become a potentially transformative force in multiple aspects of government and private sector operations. Its potential has been recognized globally, with a variety of international organizations and technology companies highlighting the benefits of its application in reducing costs of operation and compliance, as well as in improving efficiencies.”

It is admitted that “Blockchain is a frontier technology that continues to evolve. In order to ensure that India remains ahead of the learning curve, it is important to understand the opportunities it presents, steps to leverage its full potential and such necessary steps that are required to help develop the requisite ecosystem.” And “Blockchain technology has the potential to revolutionize interactions between governments, businesses and citizens in a manner that was unfathomable just a decade ago.”

The paper candidly admits that “Blockchain is seen as a technology with the potential to transform almost all industries and economies. It is estimated that blockchain could generate USD3 trillion per year in business value by 2030.”

Obviously, the government of India recognizes the potential, opportunity, need and importance of cryptocurrencies. However, it wants to tread with extreme caution. The NITI Aayog’s discussion paper notes that —

“Blockchain has been positioned as a revolutionary new technology, the much needed ‘silver bullet’ that can address all business and governance processes. While the promise and potential of blockchain is undoubtedly transformative, what hasn’t helped this technology, that is still in nascence of its evolution, has been the massive hype and the irrational exuberance promulgated by a bevy of ‘Blockchain Evangelists’.”

“Any transformative technology, in its initial stages of development, as it moves out of research / development phase to first few applications to large scale deployment, faces several challenges. Part of the problem is that such technologies are initially intended to solve a specific set of problems. Bitcoin, which has led to the popularity of decentralized trust systems and has powered the blockchain revolution, was intended to develop a peer-to-peer electronic cash system which could solve for double spending problem without being dependent on trusted intermediaries viz. banks. As Bitcoin started gaining prominence, the potential of underlying blockchain technology started getting traction. However, some of the early design features that made Bitcoin popular, primarily limited supply and pseudonymity, have become potential challenges in wide scale implementation of blockchain.”

(The NITI Aayog discussion paper “Blockchain: The India Strategy” could be read here.)

Bitcoin ticks most boxes

Given the nascent stage of evolution of block chain technology and crypto currencies based on it, the cautious approach is understandable. However, the caution must be pragmatic and should not transgress to typical dogmatic paradigm.

In my view, the real debate is whether the world needs an independent reserve currency for cross border transactions; given that the unmindful printing of fiat currency by the respective large central banks in past two decades has perhaps diminished the credibility of the popular global currencies USD and EUR.

A broad evaluation of Bitcoin (or any other widely accepted cryptocurrency for that matter) highlights that Bitcoin may meet all prerequisites of a good currency – e.g., medium of exchange, store of value and unit of measurement. As evident from the following evaluation table, the advantages of Bitcoin, as an evolved independent digital currency, outscore gold on some parameters. It also outweighs any fiat currency that is not backed by real assets.

Gold vs Bitcoin

For many centuries, Gold was the most popular currency – store of value, medium of exchange and unit of measurement. However, with evolution of paper currencies and metric system, the usage of gold as a medium of exchange and unit of measurement declined significantly.

In past couple of centuries, Gold has served as reserve currency whenever the paper currencies have lost faith of people due to a variety of reason, particularly high inflation and fiscal profligacy. It has also been used as such during transition periods in global strategic power equilibrium. However since end of Breton Wood agreement in 1971, gold has not been used as reserve currency. Post fall of Berlin Wall in 1989 the strategic supremacy of USA, and consequently USD, has remained mostly unchallenged.

The demand of gold as store of value is a deeply complex matter. In past gold had been a preferred asset to store value both during economic (especially hyperinflation) as well as political (including geo-political) crises.

In 1970s the world faced serious stagflation as the demand generated by post WWII reconstruction activities faded and Iranian revolution created a worldwide energy crisis. Gold jumped 10x in real terms during the decade of 1970-1980), to give back most of the gains in the following two decades.

Again in the decade of 2000s, as the dotcom bubble hit the global economy, interest rates crashed leading to sub-prime crisis that culminated in a major global financial crisis. The gold jumped 5x in real terms during this decade (2001-2011).

Presently, the gold prices are only marginally higher than the highs recorded in 2011. Whereas Bitcoin has risen almost 1000% since 2011. Like gold in 2001-2011, Bitcoin has risen 5x since outbreak of Covid19 pandemic, whereas gold is higher by about 5% in this period. The question is whether unconsciously markets are replacing Gold with Bitcoin.

Is Bitcoin replacing Gold

When economics fails in providing solution to a problem of livelihood and sustainability, philosophy always provides the answer.It is a natural instinct of human being to look up to the skies for guidance when all our efforts fail. (Some even do so without making any effort at all!) Religion has therefore been an inextricable part of human life since beginning of the civilization.

Most ancient cultures, China, Egypt, Mesopotamia, Indus Valley etc. have believed in continuation of life after death. Gold being an indestructible (and therefore sacred) object had always been an important part of their religion, culture, traditions and beliefs. It naturally evolved as symbol of power and prestige over time. The church & temples, kings & feudal lords hoarded and displayed gold to asset their power and status.

In past one century, especially past three decades, the factors like popularity and spread of technology in common man's life; rising fascist and communist tendencies due to worsening socio-economic disparities; rise in electronic transactions (personal, social and commercial) thus lower risk (less travel, less physical transactions & deliveries); emergence of new articles of luxury to serve the vanity needs of the affluent; stronger and deeper social security programs; demise of monarchy and feudalism; popularity of spiritualism over rituals; dissipation of church & temples, etc., have all led to sustainable decline in traditional demand and pre-eminence of gold.

In the modern context, technologically challenging things, e.g., Bitcoins, certainly find greater favour with investors as compared to gold.

Conclusion

To conclude, I would say that the ultra-loose monetary policy prevalent in most developed countries shall have to end at some point in time in foreseeable future. This suppression of savers and poor cannot continue into perpetuity. However, ending this tiger ride may not be easy and would require some innovative measures.

For example, the following is one of the scenarios that is potentially possible—

·         US Government and Fed decide to correct the fiscal and monetary indulgences of past couple of decades, by material devaluation of USD and letting USD retire as global reserve currency; settle trade and currency dispute with China agreeing to restore the global trade balance.

·         Global commodities are no longer priced predominantly in USD. The share of neutral currencies (cryptocurrencies) increases substantially in global trade.

·         Consumption pattern change materially. The consumption of fossil fuels, steel, chemicals etc. declines structurally.

·         Digital transformation leads to material rise in productivity, further adding to deflationary pressures created by aging demography of the developed world; thus alleviating the fears of hyperinflation and need to resort to gold as reserve currency.

This may sound fanciful but is not totally unlikely.

There could be many similar or different solutions to end this tiger ride of quantitative easing, negative rates, and suppression of poor (people, economies and regions). Out rightly, rejecting the need and importance an independent currency at this stage could prove to be fatal.

The question, whether Bitcoin would be emerge as the independent global currency would best be answered by time. I would though not reject the probability. Nonetheless, Bitcoin (cryptocurrencies in general) has assumed the status of a popular alternate asset and there is no reason to despise it, just because its price in USD terms is highly volatile presently.

(A couple of years ago, one central minister got confused between Isaac Newton and Albert Einstein and erroneously attributed theory of gravity to Einstein. The Enforcement Directorate of Social Media (EDSM) immediately took cognizance of the mistake and forced the minister to correct his mistake. The minister in reference also happened to be a Chartered Accountant by professional qualification, like me. It is reasonable to believe that the minister, like me, does not understand the nuances of the theory of relativity and laws of motion, and got confused. Nonetheless, learning a lesson from that episode, I want to upfront clarify that my knowledge and understanding of the theory of relativity and laws of motion is zilch. Any references to relativity and gravity herein is just plain English and should be read as that only.)

My investment advisor often motivates me to invest in stocks having “valuation cheaper than the industry average or significant valuation discount to the industry leader”.

One of the most common investment advices I get from investment gurus is “invest in quality only”.

I have observed that the most common portfolio evaluation tool used by the market participants is “returns relative to the benchmark”. This benchmark could be an index, returns made by some famous large investor, returns made by a friend or family member, etc.

“Relativity” is thus an important driving force of the investment strategy.

“Mean reversion” or the gravitational pull & push of averages is one of the strongest premises in the financial analysis, especially in the context of investment timing and forecasting prices. The entire spectrum of technical studies of trends in prices (technical analysis); future valuation forecasts (long term average of valuations; standard deviation of valuation parameters etc.); and even earnings forecasts use the “gravitational pull towards mean” as a key control point in their operation.

I think there is a need to reimagine the application of the concepts of “Quality”, “Relativity”, and “Gravity” to the businesses of equity research, investment advisory and portfolio management.

Quality is good as a noun

"Good is a noun...Good as a noun rather than as an adjective is all the Metaphysics of Quality is about. Of course, the ultimate Quality isn't a noun or an adjective or anything else definable, but if you had to reduce the whole Metaphysics of Quality to a single sentence, that would be it."- Robert Pirsig in Lila: An Inquiry into Morals

Honestly, how many of us could tell “who is Kevin Mayer?” without taking the help of St. Google. A mention of Usain Bolt though may ring many bells. If I mention both names together, most may deduce that Kevin Mayer is also a sportsperson.

Kevin Mayer is the world champion of Decathlon, a discipline involving ten track and field competitions. On the other hand Usain Bold is champion of short distance running (100m and 200m). If someone asks me “who is better athlete Kevin or Usain?”, my answer would be “it depends from which vista point I am looking at them!”.

If I am primarily looking for momentary thrill, excitement and/or extreme competitiveness in sports, I would say Usain Bolt is better, because his performance sharply raises my adrenalin level, brings me to the edge of my seat, gives me Goosebumps for 10 to 20 seconds, and then I can go back to my regular work. I would also enjoy seeing someone winning with extremely thin margin (fraction of a second) and may derive some motivation to be highly competitive in my life.

However, if I am looking for an example of stamina, endurance, consistency, multi-dimensional talent & skills, I would prefer Kevin. His performance guides me to adopt a balanced approach in life; as it shows that you do not have to win all the games to be a winner in life. He could still be a winner by a large margin, even if he performs well in 6 out of 10 events of the decathlon.

Now apply this analogy to some popular comparisons in stock market, e.g., Hindustan Unilever & ITC and HDFC Bank and Kotak Bank!

The stock of a company does not necessarily become “quality” if it is “relatively cheaper”; or it has given “relatively better returns” over past few years.

I may prefer to invest in a company that has a sustainable business model; its stock has given 10% CAGR over past 20years, with low volatility, simply because I can plan my finances with this investment much better.

Someone else may find quality in a cyclical business that has just entered an upcycle. The stock of this company may have given 12% CAGR over past 20years , but with much higher volatility and unpredictable dividends.

The point I am trying to make here is that “quality” in relation to investments, like anything else in life, should not be considered in relative terms. The quality of a portfolio of investments should be absolute and in congruence with the underlying investment goals.

If my investment goal requires my equity portfolio to grow by 10% CAGR over next 20years, the quality for me would mean the portfolio of stocks which have high probability of growing 10% CAGR over next 20years. Performance of Nifty/Sensex; performance of competitors; performance of other sectors and markets; performance of alternative assets over this period should be mostly irrelevant to me.

Relativity may not always apply to stock analysis

There are many models to evaluate the fair value of a business, e.g., discounted cash flow method, earnings multiplier; revenue multiplier; replacement value; liquidation value etc. In practice it is seen that each business has some peculiarity and applying a standard text book valuation method may not be most appropriate way to find its fair value. Analysts accordingly modify the standard methods as per their understanding of the business.

Comparing the relative valuation of two businesses therefore may not be appropriate in most cases. Nonetheless it is common to evaluate businesses on relative valuation basis. The worst part is that analysts use different methods to find the fair value of a business, in accordance with the size, capital structure, off balance sheet items (eg., hidden assets or contingent liabilities) etc.; but often a common parameter is used to assess the relative valuation of two or more such businesses.

Imagine three pharma companies – one is a large diversified drug producer with presence in 40 countries; manufacturing branded generics and formulation; has a decent portfolio of specialty drugs and has a strong research capability for new molecules; second is a midsized CRAM service provider to foreign companies and third is a small domestic branded generic manufacturer with no export revenue. Would it be appropriate to compare these three businesses on the basis of PE Ratio; EV/EBIDTA; book value or dividend yield basis?

The businesses like depository services, stock brokerages, and asset management mostly collect the revenue upfront. The working capital requirement for these businesses may be negative or negligible. Comparing these businesses with NBFCs, which have a significantly different business model, risk profile and cash flows, may be highly inappropriate.

Notably, the global valuation guru Aswath Damodaran, calculated the fair value of the recently listed food delivery business Zomato to be Rs40.79 against the IPO price of Rs76 and listing price of Rs116. More than half the shares issued in IPO exchanged hands on the day of listing; implying that a large number of discerning investors were willing to pay 2.5x to 3x of fair value assessed by the guru. The quality and fair valuation obviously has different connotation for the guru and the market participants.

 Gravity does not work in many cases

The mean reversion or gravitation pull & push for stock prices and valuations has not worked in a large number of cases. In past one decade, the prices of stocks like Asian paint, Pidilite, Dabur, etc., have consistently defied the gravitational pull to mean. Similarly, there is of dearth of stocks that have defied gravitational push to mean despite much desire of the market participants. Most notable examples of such stocks include ADAG stocks, JP Group stocks, Suzlon (all part of Nifty in 2008-09). In some cases however, gravitation force has worked just fine, e.g., PSU Banks.

To conclude, in my view, individual investors must focus on “quality” of their portfolio in absolute terms not in relative proportion; set investment goals as per their social, personal and financial conditions; and evaluate performance of their portfolio in terms of congruence to their investment goals. This shall make their job much simpler.

 The yields curve in India has been moving higher for past few months, despite the efforts made by the Reserve bank of India to anchor the benchmark yields at lower levels. In past one year, the RBI has used most of the arrows in its quiver to manage the bond yields, apparently with the three targets in view – (a) to help the government fund its fiscal expansion at reasonable rate; (b) to keep the financial markets calm in the times of adversity; and (c) to keep the rate environment supportive of growth.

However, last week the RBI appears to have changed the trajectory of its policy by accepting higher coupon (6.10%) for the new benchmark security (6.10GS2031). This move is widely expected to result in India’s yield curve inching little higher, and perhaps flattening a bit.

The debt market traders have largely seen the latest move of RBI as the rise in its tolerance for higher yields. Though the governor has maintained that RBI is committed to keep the borrowing cost for the government under control, and focusing on the benchmark 10 year yields for yield directions alone may not be appropriate.

The minutes of the last meeting of Monetary Policy Committee of RBI clearly stated that “all members of the MPC unanimously voted to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward”. The governor specifically stated that “At this juncture, providing a policy environment supportive of sustained economic recovery from the second shock of the pandemic is necessary.” It would be reasonable to infer that there is no certainty about the next move of the MPC on policy rates. If required it could be a cut also.

The global trends in bond yield have been providing mixed signals. Despite, the concerns expressed by the top central bankers about the rising inflationary pressures, the bond market have remained generally buoyant. People’s Bank of China has in fact went ahead and cut the key reserve ratio, committing to the growth disregarding the inflationary pressures.

In the year 2021, so far seven major central banks have effected change in their policy rate; out of which six (Brazil, Czech, Hungry, Mexico, Russia and Turkey) have hiked the rates and only one (Denmark) has cut the rates.

The US Federal Open Markets Committee (FOMC) has indicated that its next move could be a hike; though it not happen in next twelve months at least. The European Central Bank (ECB) signals are though mixed.

What does a tolerant RBI mean to markets?

In recent months, the inflation in India has mostly remained above the RBI’s tolerance range. The MPC committee has repeatedly reiterated that for now the growth remains a priority. Nonetheless the rising price pressures do find a strong mention in MPC commentary. Inflation has persisted above RBI’s base target of 4% for more than a year now. For FY21 as a whole, it has remained above the tolerance range of 4%+/- 2%.

The fiscal expansion in the wake of economic crises that emerged due to the pandemic is yet another cause of worry for the monetary managers. S&P Global has estimated that for FY22 the fiscal deficit of India may remain elevated at 11.7% of GDP. This is much beyond the limits envisaged under the Fiscal Responsibility and Budget Management Act (FRBMA). It is pertinent to note that for FY21, the general government fiscal deficit of Indian government amounted to 13.3% of GDP (S&P expects it to be 14.2%). Obviously, the fiscal pressures may also be weighing on the RBI mind.

In recent months there have been many occasions when the RBI auction of government securities has devolved on the primary dealers.

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(a)   RBI is not getting enough demand for the benchmark 10yr securities at 6% or lower coupon.

(b)   RBI is finding itself behind the curve, since it effectively enhanced its tolerance to inflation, without making corresponding adjustment to the bond yields.

(c)    RBI is preparing the markets for the likely global monetary tightening. Even though the large global central bankers may not cut the policy rates in next twelve months, there are decent chances that they taper their bond buying program, leading to unwinding of some of the USD and EUR carry trade. A higher yield could be a good incentive for global investors to stay put in Indian gilts.

(d)   After accepting higher yield for benchmark 10yr securities, RBI may also desire a little flatter yield curve, which means rising yields at the middle of the curve. This may be desirable considering that the steeper yield curve may be acting as a disincentive to raise long term funds.

What could be the trade?

One of the obvious trades would be to increase the duration in debt portfolio to protect it from flattening of yield curve.

The other trade would be to invest in dynamic bond funds (debt counterpart of the Flexicap equity funds).

Insofar as the equity market is concerned, theoretically equity valuations ought to respond negatively to the rising yields. But in practice the correlation is not seen to have worked in many instances.

Theoretically, the higher bond yields should result in higher opportunity cost for owning equity. The probability of lower future return would make the trade relatively less profitable resulting in investors moving more allocation to the bonds. However, this may not work in the present circumstances due to a variety of factors. For example—

·         The yield curve is too steep presently to have any meaningful impact on the equity traders’ opportunity cost.

·         Even at the 5-6yr maturity, the real yields continue to be negative, whereas the equity returns are projected to be decent for next couple of years at least.

·         Higher benchmark yields are not likely to transmit to the lending rates in a hurry, given the poor credit demand and massive accumulation of reserve money with the banks.

·         The leverage in the equity markets is significantly lower as compared to previous rate cycles. Any large unwinding is therefore unlikely in the short term.

·         Despite the acceptance of higher benchmark yield, RBI remains committed to support the growth. Since the growth is not likely to reach the desired levels anytime soon, any meaningful tightening by RBI is highly unlikely, notwithstanding the pricing pressures.

The market has read this very well and refused to react negatively to higher yield. It is reasonable to expect that this status quo may prevail.

Is RBI running behind the curve?

The more pertinent question however is “whether RBI is running behind the curve and the economy will have to pay for this lag later in the day?”

In my view, the historical evidence indicates that most central banks usually like to remain behind the curve rather than jumping the gun. There are very few instances in the history of RBI when it has preempted the inflation and hiked beforehand. I will therefore not be unduly worried about RBI running little behind. Besides, RBI would not like to relive the experience of 2011 when the rates were hiked prematurely and the required a hasty retreat.

It is true that RBI will need lot of luck with inflation in next couple of years. The premise that “inflation is transitory” and pressures will ease as the global economy opens up more in next 6-9 months, must come true to make RBI’s task easier. Else, we shall be ready for an undeniable “Stagflationary” phase in the economy. Remember, the Indian economy is already facing a sort of stagflation, but it has been mostly denied.

What the Global trends say

Last weekend, Peoples Bank of China (PBOC) surprised the market by cutting the reserve requirement ratio (RRR) for all banks by 50 bps, releasing around 1 trillion yuan ($154 billion) in long-term liquidity. The analysts widely view the move as an attempt to sustain the post pandemic growth momentum which had shown some sign of fatigue in recent data.

As per the UBS EM strategist, "China was first in, first out (with COVID policy support) - it effectively started tightening (monetary policy) in Q3 last year - so now it is possible that the message is, if you are thinking about global significance, that the PBOC is showing that economies are still somewhat fragile and inflation is not likely to be too damaging over the medium term."

The Researach Analysts at Ashmore Group, London feels “The 50-bps cut in reserve requirement ratio came slightly earlier than most expected. China is likely to ease monetary policy via RRR cuts and OMO operations in order to allow for more local government bond issuance. This will support strategic infrastructure investment such as railways and 5G rollout. We expect fiscal policy to remain focused on specific sectors most affected by the pandemic like small companies. We also expect macro prudential tightening on the property market to remain in place.”

US yields are now at 2% or below across maturities and appear falling towards lows seen 6 months ago. Obviously the market does not believe that Fed would actually care to hike rates earlier than 2023. The market consensus also seems to be concurring with the Fed’s view that inflation is transitory and passé by end of 2021.

The Minutes of the recent FOMC meet suggest that while tapering of QE is on the table, but few Fed members are in a rush to actually do it. The statement read “The overall mindset was tilted towards patiently watching the progress of the economy and labor market, and providing ample adjustment time to the markets. Given the current condition of the labor market and the inflationary pressures, we reiterate our view that tapering could start early next year with the announcement coming in August-September 2021.”

Many analysts are sensing an economic signal from the plunging yields in US, with the simultaneous surge in the dollar. The evidence is rising that the reflation trade may be getting unwound.

There are some dissenting voices, like an analyst at Bridgewater Associates’, who believes that “Bond markets are sending a clear message that inflation is transitory but investors should prepare for the possibility that they're wrong”.

Bill Blain (morningPorridge.com) was even more candid. He writes, “The brutal reality is the Central Bankers, who are all honourable men and women, understand the levers they pull no longer function as they once did. Why? Well, these honourable men and women have broken the system as a consequence of their actions. Oops. Now they have no choice but to follow.. which means trouble ahead until the global financial system can be resolved.”

“Most of the market is fixated on what the S&P does this afternoon, what new high the NASDAQ will make this month, or where Amazon is going to top this quarter. They have the vision of a blind man when it comes to anything much beyond the end of their one-year time horizon. Even the bond market seems blind.”

In the meantime, fissures have emerged in the ECB’s unity over inflation target. As per media reports, “European Central Bank unity on its inflation target could dissolve into division as early as next week when policymakers meet to discuss changing its guidance on raising interest rates.”

“In its recent policy review, ECB has set 2% as the inflation target and will allow overshoot of this target as necessary. This marks a change in long established stance –since 2003, ECB has kept an inflation policy stance of “below, but close to 2%”. The recent surge in cases across Europe, if uncontrolled, could throw off Eurozone from recovery path and continuation of QE will be key.”