Vijay Kumar Gaba

There are two types of investors in Indian stocks markets – (i) who own all Tata group stocks and all internet and related businesses like IRCTC, IEX, IndiaMart, InfoEdge etc.; and (ii) the others who own none of these. (It’s a Joke or Irony only time could tell.)

A survey of Indian investors indicates that presently the investor positioning and opinions are deeply and widely divided. The survey in the form of a free unstructured discussion with some professional, household and institutional investors was conducted over past two weeks.

Indian investors – A divided house

Based on the discussions, the investors in Indian equities could be divided into the following ten broad categories –

(i)    Fearful - Investors who are fully invested and are overweight in equities and/or cryptocurrencies but are uncomfortable with the current price levels and volatility. This category mostly involves High Networth households who have significantly increased their active involvement in the financial markets over past couple of years. Most of these investors have earned good return on their capital. They are moderately leveraged. Most of them have yet not defined any strategy to moderate their exposure to risk assets, though they are afraid of severe market correction and erosion in the value of their portfolios. Some of them are exploring investment in real estate by taking some money out from financial investments. They have been consistently reducing exposure to debt instruments and increasing allocation to equities and other risk assets.

(ii)   Fearless - Investors who are exclusively trading in risk assets like equities and cryptocurrencies, and are not bothered at all about the current price levels or volatility. These are mostly household investors (not necessarily high Networth) who have taken to trading in financial markets as their full time occupation in recent past. They enjoy the high volatility and are least bothered about the things like valuations, business models, sustainability etc. They have moderate to high leverage; and mostly have negligible allocation to debt securities.

(iii)  Optimistic - Investors who are deeply convinced about the “India Story”. They believe that the valuation premium for Indian equities is justified given the high growth potential, changing global supply chain landscape, increasing level of organized businesses and larger role of Indian businesses in the new economy. These are mostly professional and institutional investors. Many of these have recently increased their allocation to equities given the pressure on bond yields. Only a few of these would advise leveraged positions in equities at present level.

(iv)   Cautiously optimistic - investors, who are convinced about the long-term ‘India Story”, but find the present price levels unsustainable in the short term. These investors are a mix of professional investors, institutional investors and high networth households. They have been reducing their equity allocation for past couple of months. Paradoxically, some of these have increased the allocation to high yielding (credit risk) debt.

(v)    Hopeful - Investors, who misjudged the markets in the past 20 odd months. They either reduced their equity allocation significantly after pandemic breakout; or during the market rise in the past 6-9 months. These are mostly professional and household investors. They are overweight on debt, gold and alternatives like arbitrage funds that have yielded very poor returns over the past 20 months. These investors are sincerely hoping for a major correction in the equity prices so that they can correct their mistake by increasing their equity allocations. Ironically, many of these investors have increased their allocation to foreign equities in past one year to compensate for lower allocation to the best performing Indian equities. Their arguments for investing in Asian (mostly Chinese) and US equities are varied and mostly unconvincing. For example, a veteran investor allocated 10% of his portfolio to US Tech stocks, while vehemently arguing against the valuation of Indian IT and internet sector. Similarly, a professional investors, who listed meltdown in China as one of the key risks for the market, is invested in a global fund focused on Asian Tech sector (mainly Chinese semi conductor and internet stocks).

(vi)   Happy - Investors, who stayed composed and disciplined during the market volatility and religiously adhered to pre-determined asset allocation. These are mostly professional investors and high networth households. Many of them have changed their strategic asset allocation to increase the weight of equities in past one year; while maintaining a conservative debt profile. These investors are closely observing the markets for any lucrative opportunity, but are not perturbed by the present volatility.

(vii)  Dismissive - Investors, who have materially cut their allocation to risk assets like equities in the past 20 odd months and are regretting their decision badly. They are mostly household investors. They are regularly convincing themselves that the entire rally from March 2020 lows is farcical and the prices will correct to those levels in next one year. Though, many of these are actively looking at real estate to make up for the opportunity loss of equities. Interestingly, some of these are actively trading in commodities.

(viii) Hypocrite – Investors who are cautious and fearful in their personal capacity, but are advising others to increase the weightage of risk assets in their portfolios. These are mostly professional and institutional investors. A couple of fund manager who sounded extremely cautious in their comments, were actually seen aggressively marketing their small cap funds a few hours later.

(ix)   Explorers – investors who are consistently looking for profit making opportunities in the market, regardless of the benchmark index numbers, pockets of over exuberance and popular trends. These are mostly professional and institutional investors, who are either running ahead of the market in identifying new trends and rotating their portfolios to position for the likely emerging trends; or discovering the pockets of under valuations and positioning their portfolios with the assumptions that these pockets will soon converge with the broader market trends.

(x)    Observers – these are mostly passive or inactive investors, who observe the markets from a distance and have little position of their own. They are financially unaffected by the market movements; however many of them are very aggressive and emotionally charged about their opinions about markets. They love to express their views and offer advice to fellow investors.

While you discover what category you fall in; it might be worthwhile to also figure out- do you truly belong where you are, or you just drifted to this category unintentionally/unconsciously.

…and how they view the market

The investors in different categories analyze the present market conditions and trends from their own vista points. Obviously, they have divergent views, opinions and outlook for the markets. The following are some of the market views that are interesting to note.

Perception versus realty

While it is fashionable to talk about the stocks from some business groups (e.g., Tata, Adani etc.), the top gainers since first lockdown (23 March 2020) and second wave (01 April 2021) amongst the NSE500 group show no clear pattern or trend.

The top 25 gainer since first lock down do have significant participation of Adani group stocks and midcap IT Services, but otherwise the stocks and sectors are diversified. An overwhelming majority of stocks are small cap and there is no large cap stock in top performers. These stocks belong to a variety of sectors like IT Services, Energy, Telecom, Textile, Specialty Chemicals, capital goods, and pharma etc.

Contrary to popular perception, specialty chemical, pharma, and metals have scant representation in this group. Internet and retail are totally absent from this group. There is only one Tata Group stock (Tata Elxsi) in top 25 list, and no metal stock, except Jindal Stainless.

The list of top 25 underperformers is also quite random and lacks any clear trend or pattern. Apparently, Banks and Microfinance Institution appear to be top under performers. But most names included in the list have company specific reasons for their underperformance and do not necessarily represent any trend.

If we look at the market trends since second wave, a similar randomness is observed. There is no clear pattern or trend visible from the top outperformers and underperformers during April-September 2021 period. No Tata, Adani, Internet, Retail, IT services, PSU dominance is visible. Auto, Consumers and Hospitality stocks are also absent from the lists.

If we observe the sector-wise trend over the two time frames April 2020 to September 2021 and April 2021 to September 2021, we do get some interesting trends. For example,

Trends and patterns since first lockdown till September 2021

(a)   More sectors have underperformed the Nifty50, then the number of sectors that have outperformed; implying that the rally since lows of March 2020 has actually been much narrower than it is perceived; even though the broader markets have outperformed the benchmark indices by wide margin.

(b)   The global trends (IT and Metals) have dominated the markets since first wave. Contrary to popular perceptions, Pharma has been an underperformer.

(c)    Financials have underperformed materially, despite significant improvement in the operating performance and asset quality.

(d)   Realty sector has outperformed though not significantly.

(e)    Small cap (123%) and Midcap (76%) have significantly outperformed the benchmark Nifty (32%).

(f)    FMCG (and hence MNCs) have been the worst performers in this period. It would need lot of explaining to rationalize the outperformance of commodities when the consumption demand and capacity utilizations are at poor level.

(a)   In post second wave period, more sectors have outperformed the benchmark Nifty than the number of sectors that underperformed. The gap between the performance of smallcap/midcap and benchmark Nifty also widened further.

(b)   The domestic sectors like Realty, Infra, PSUs, Media and power joined the list of outperformers alongwith the global sectors like IT Services and Metals.

(c)    Surprisingly, Automobile has been the worst performing sector in this phase, despite some superlative performance from auto major Tata Motors.

(d)   Financials continued to underperform, despite popular perception of PSU Banks doing very well.

(e)    Pharma and Consumers also remained notable underperformers.

(f)    Given the rise in inflation (building material), rise in bond yields and expectations of monetary tightening; the bullishness in Realty while the lenders continue to underperform and the household participation in equity market is rising sharply is also a subject for deeper analysis.

Given the total randomness of the market performance, it is difficult to draw any meaningful conclusion from the performance during April 2020 and September 2021.

So far there is little sign of any sector’s overwhelming dominance on the market. Nonetheless, there are some small pockets of over exuberance and unsustainable valuations, where the investors need to tread with extreme caution.

In particular, the themes like renewable energy, ecommerce and hyperinflation have driven prices of some stocks to levels which may be unsustainable even if we extrapolate current business trends to 20yr forward.

Indubitably, renewable energy is a paradigm shift in global economics and may be a great business opportunity; but the assumption that all renewable energy producers and their ancillary units will make enough money to justify current valuations appears mostly off the mark.

The assumptions that current commodity prices will sustain the slowing growth, tightening money, declining consumption and normalizing supply chains even for a year appear absurd.

It is therefore likely that we might see a major sectoral rotation in next 6months, while the present broad trend (broader markets outperforming the benchmark) continues.

 The Ministry of Power, Government of India, recently issued Draft Electricity (Rights of Consumers) Amendment Rules, 2021 for public comments.

The amendment seeks to stipulate the following three rules to the existing rules:

“1.   “In view of the increasing pollution level particularly in the metros and the large cities, Distribution Licensee shall ensure 24x7 uninterrupted power supply to all the consumers, so that there is no requirement of running the Diesel Generating sets.

2.    Consumers, who are using the Diesel Generating sets as essential back up power, shall endeavor to shift to cleaner technology such as RE with battery storage etc in five years from the date of the publication of this amendment or as per the timelines given by the State Commission for such replacement based on the reliability of supply by the distribution company in that city.

3.    The process of giving temporary connections to the consumers for construction activities or any temporary usage etc. shall be simplified by the distribution licensee and given on an urgent basis and not later than 48 hours. This will avoid any use of DG sets for temporary activities in the area of the distribution licensee. The temporary connection shall be through a prepayment meter only.”

The proposed amendments appear to be governed by the desire to minimize the air pollution levels in India through all means. Prima facie, this is a well-intended thought and should be welcomed. However, a careful analysis of the context and proposed measure would suggest that these rules take the zeal for ESG a little too far.

Insurance value of DG backup ignored

These rules simply ignore the “insurance” value of the power back-up provided by the power generating sets (DG Sets).

These rules also seems to be denying the modern world where there are significant number of mission critical and life-saving functions that cannot afford power outage even for few seconds. Hospitals for example cannot afford to risk power outage in ICUs and lifts. Large apartment buildings cannot afford power outage in lifts. Data centers and banks’ servers cannot afford power outages even for few seconds.

DG Sets provide insurance against power outages to these functions. The power back up that relies on nature (solar and wind) may not provide adequate insurance cover in cases of natural calamities like cyclones, prolonged sun outages due to persistent rain etc.

This is the insurance value of DG Sets that prompts use of DG Sets in cities like Mumbai, where the distribution companies are obligated to ensure 24X7 power supply for past many decades.

The rules assume that most large buildings will have enough roof top and other open space to install solar panels that would generate adequate electricity to keep the battery bank charged to support the emergency and mission critical functions. This assumption may be mostly erroneous.

Whereas the rules put onus of supplying the uninterrupted power on the distribution licenses, it does not speak about grid failures, in which case distribution companies will be helpless.

The proposed rules also seem to be disregarding the available data on sources of air pollution in large metro cities. Numerous studies have indicated that the share of DG Sets in overall air pollution in large cities may be miniscule (2%). This level will fall further significantly after implementation of CPCB-IV norms in DG Sets. It is therefore important to focus on industrial clusters and farms for pollution control (through DG Sets) rather than large cities, IT Services clusters and residential complexes.

It is pertinent to note that in past 3 years, there have been some instances of implementing ban on use of DG sets during months when pollution levels usually spike. For example, in 2018, the Supreme Court-appointed Environment Pollution (Prevention and Control) Authority (EPCA) had banned diesel generator sets only in Delhi during the Graded Response Action Plan (GRAP). The Delhi Pollution Control Committee (DPCC) had issued a large list of exemptions where DG Sets were allowed. These included DG Sets used for essential services such as medical purposed (hospitals or nursing homes or healthcare facilities) elevators or escalators, railway services or railway station, Delhi Metro Rail Corporation services including its trains and stations, airports and interstate bus terminus, lifts of housing societies, etc.

Technological evolution of DG Sets denied

While the draft amendment rules emphasis on adoption of cleaner technology, they fail to acknowledge that DG Sets are also evolving fast in cleaner technology terms. The present genre of DG Sets emits significantly lower smoke and noise as compared to the legacy DG Sets. Moreover, the technology evolution of DG Sets and diesel (as a fuel) continues as we read this. Ethanol based generating sets are already being tested and gas based generating sets are in use at some places. But given the uncertainties of supply chain of ethanol and gas, diesel continues to be the most preferred fuel for power backup systems, for now.

ESG may be crossing some redlines

These rules are not isolated instance of the whole ESG paradigm crossing the red line of pragmatism & purpose; and venturing into the realm of over zeal and activism.

There is absolutely no denying the need and importance of the consciousness about good environment, sustainability and governance practices. But these practices must be pragmatic and not suffer from dogmas.

For example, we have seen a lot of ESG conscious investors shunning companies like ITC Limited, which has been amongst the few companies with positive water and carbon emission footprint for long, and embracing largest refineries and plastic producers as fully ESG compliant.

Setting tougher emission norms for DG Sets, like BS VI for vehicles, would be far more effective than replacing these with solar powered backup. DG Sets meeting the enhanced emission norms will be used in across the country and in all sectors. Therefore, the impact on environment will be much more impressive.

The government agencies and businesses which tried to transgress the territory of the Niyamgiri Devta (an epitome of environment and sustainability) may not be taken seriously if they talk about ESG. It has to be imbibed as a way of life not a goal to be scored.

Fear, paranoia and resilience prevails in 1HFY22

The financial year FY22 started with the country reeling under the impact of an intense second wave of Covid-19 pandemic. The images of citizens struggling for life saving drugs and Oxygen, overcrowded cremation grounds and corpses of the victims of pandemic floating in the Ganges were imprinted on peoples’ consciousness. For once, disease, death, and desperation dominated the popular narrative.

The life seemed still with everyone becoming fearful and paranoid. It felt that spirituality and austerity would dominate the behavior of common man for many months to come. The government went into overdrive to build health infrastructure, provide assistance to helpless citizens and planned, what would eventually become, the biggest public vaccination drive ever in history of mankind. The austerity and fiscal discipline did not appear to be anywhere in the list of top priorities.

The macro economic data for 1QFY22 however presented a slightly different picture. Private consumption was the largest contributor to the growth and government had refrained from spending much.

The 1QFY22 growth came in better than most had anticipated as the sporadic lockdowns did not affect the economic activity. The recovery in 2QFY22 appears to be much better than estimates, with many indicators reaching pre pandemic levels. The growth estimates for FY22 have been accordingly revised upwards by most agencies.

…did not impact financial markets

The financial markets also did not reflect the sentiments peddled in the popular narrative. Despite, the government incentives to promote local manufacturing; acceleration in award of contracts for large infrastructure projects; the government support and incentives for MSME credit; significant expansion in digital banking ecosystem; revival in real estate market, etc. the credit demand growth is persisting at multi decade low levels.

The stock market has witnessed heightened activity, with benchmark indices gaining close to 20% in 1HFY22 on the back of much higher participation from the household investors. Mid and small cap stocks dominated the activity, indicating the strong dominance of the sentiment of greed over the sentiment of fear.

The market rally has been rather intriguing, given that environment for equities has not been very supportive from conventional wisdom viewpoint.

The following factors, which have bothered the equity markets historically, have been conspicuous by their exalted presence.

·         The energy prices (Achilles heel of the Indian economy) have climbed sharply higher. The second round impact of the energy inflation have also become visible in higher costs of production and freight.

·         Food inflation has persisted at elevated levels. In fact, headline inflation has persisted above the RBI comfort zone for many months, terminating any chance of further monetary easing by RBI. The debate now circles around the tightening schedule of RBI.

·         The vulnerabilities of the Chinese financial system have been exposed with one of the largest real estate developer defaulting on its debt obligations.

·         The central bankers of developed countries gave clear signals that the monetary easing has peaked and their next step would most likely be the monetary tightening.

·         RBI has shown tolerance for higher yields and slightly weaker INR.

·         Institutional investors have remained on the fringes for most part of the 1HFY22.

·         The cold war like condition between US and China has intensified further. Polarization of global trade majors is also increasing

·         Geopolitical situation at northern borders remains alarming, with no resolution in sight for Sino-Indian standoff at LAC and increasing influence of China and Pakistan in Afghanistan.

·         The strong leader of Germany lost elections to the left alliance, reinforcing the trend of the left leaning socialists gaining power in most of the large countries, the environment for free trade and globalization continues to worsen.

·         The weather has been extremely erratic world over. Unusual weather pattern were seen across continents. Unusual snow fall and drought in Latin America; Drought, extreme heat and wild fires in North America; floods in Europe, China and Indian sub-continent caused extensive damage to crops and supply chain disruptions. The prices of industrial raw materials and food increased materially world over.

·         The corporate earnings have been stronger than the estimates in 1QFY22, but the valuations in many pockets are seen prohibitively high. The valuations in commodity sectors like metals and chemicals etc. seem to discounting the current inflationary trends to the eternity.

Money in pocket may not reconcile with profits shown in SM timelines

Regardless of the presence of the supposedly adverse factors, the equity markets have remained quite resilient so far.

However, in past couple of weeks the volatility in markets has increased significantly. While various commentators and observers have attributed the rise in volatility to one or more of the above listed factors; it is pertinent to note that these factors have been present, and widely acknowledged for past many months. It would therefore not be justifiable to attribute the market volatility and jitteriness to these factors alone.

The anecdotal evidence indicates that in view of the above listed factors, the participation in equity markets in past six months has been rather tentative and lacking in strong conviction.

Most investors appear to be actively trading, frequently booking small gains/losses. Thus, even though the benchmark indices have shown strong gains in 1HFY22, not many personal portfolios may be showing the matching gains.

Now, as the market commentary turns to “cautious optimism”, “fairly priced”, “Long term Story in tact” from “abundant opportunities”, “recovery trade”, “TINA for India” etc., the unconvinced investors/traders lacking in conviction are turning even more nervous.

Of course greed is still the dominating factor and not many market participants are taking money off the table; they are even quicker in booking profit and losses.

Sector shopping in search of quick gains is also gaining higher momentum leading to faster sector rotations, giving an illusion of abundant trading opportunities. Obviously, the money in pocket is not reconciling with the money being made on social media timelines.

Money made on Twitter wall is exponentially higher than what broker’s statement is depicting and that is making the investors/traders both nervous and greedier for now. So expect, the current state of volatility and low returns to continue for few more months at least.

Economy fast recovering to pre pandemic levels

As per the consensus estimates, Indian economy shall recover to pre pandemic level latest by the middle of FY23; in what is popularly called a “V” shape recovery.

The growth thereafter is expected to be more moderate. The normalized long term growth trajectory may however not reach 6%+ level (seen in pre pandemic period) till FY27 at least.

Corporate earnings - 2QFY22e growth to be moderate as base effect withers

Nifty 4QFY21 and 1QFY22 EPS growth was the strongest in more than two decades. Poor base effect and strong pent up demand were the primary causes attributed to such sterling corporate performance.

However, these factors are seen tapering from 2QFY22 onwards, and the cost pressures are rising. We may see revenue growth as well as margins moderating this quarter.

…though the long term earnings trajectory earning to remains robust

Regardless of the moderate 2QFY22 earnings growth, the long term earnings growth (Rolling 5yr CAGR) trajectory is expected to remain strong for FY23 and later years.

Markets – Greed dominates the Fear

During 1HFY22 the market performance was dominated by the cyclical sectors like Real Estate, Metals, Energy and Infra. IT Services was the only non-cyclical sector that continued with its good performance from 2HFY21. Financials and Auto were the major underperformers.

Given their underperformance for much of the past 3-4years, sectors like Realty and Metals were significantly under-owned, it is therefore likely that most investment portfolios might have underperformed the benchmark indices.

 

FII remained net seller while DII were small net buyers in 1HFY22

During 1HFY22 over Rs59716cr were raised through 26 IPOs. This compares with Rs54576cr raised through 33 IPOs in the entire FY21. However, an analysis by the brokerage firm MOFSL highlighted that almost 52 per cent of IPO investors sold shares on the listing day. This clearly indicates towards lack of conviction amongst investors, including institutional investors, in the new businesses. Most IPO investors appear taking this as a trading opportunity to make some additional money from the funds lying in the savings account earning a pittance.

India outperformed the peers by wide margin

During 1HFY22 the Indian equities outperformed the major global market by wide margins. Nifty gained close to 20%, whereas the second best Index S&P500 of USA gained 10%. Amongst peers Brazil was the worst performing market with a loss of 7%.

Market outlook and strategy

As of this morning, there is great deal of uncertainty as to the shape of the global order that would emerge in next couple of years. It is highly unlikely that we would get much clarity over next 6-12months. To the contrary, it is more likely that the conditions become even more uncertain and unclear.

Insofar as India is concerned, I continue to feel that 2HFY22 may just be a continuation of 1HFY22, with some added complexities and challenges. The country may continue to witness protests and unrest. The consolidation of businesses may continue to progress, with most small and medium sized businesses facing existential challenge. Disintermediation and digitization may also continue to gather more pace.

The normal curve for the economy may continue to shift slightly lower, as we recover from the shock of pandemic. A large part of the population may continue to struggle with stagflationary conditions, with nil to negative change in real wages and consistent rise in cost of living. Geopolitical rhetoric may also remain at elevated levels.

Market Outlook – 2HFY22

The outlook for markets in the near term is mostly negative.

Macroeconomic environment - Neutral

Global markets and flows - Negative

Technical positioning – Negative

Corporate earnings and valuations - Negative

Return profile and prospects for alternative assets like gold, real estate, fixed income etc. - Negative

Greed and fear equilibrium - Negative

Perception about the policy environment - Positive

Outlook for Indian markets

In view of the positioning of the above seven key factors, my outlook for the Indian equity market in 2HFY22 is as follows:

(a)   Nifty 50 may form a short term peak in next couple of months. The process of forming the top has already started. In case the market follows the trajectory of 2HFY08, we may see the top around 18700-18900 level, followed by a sharp correction. However, if Nifty follows the pattern of 1HFY07, we may see top around 18200-18300 followed by a sharp 20% correction and a sustained rally thereafter.

(b)   The outlook is positive for IT, Insurance, large Realty, healthcare, agri input, and consumer staples, negative for commodities, and neutral for other sectors.

(c)    Benchmark bond yields may average below 6.5% for 2HFY22. INR may average close to 74 in 2HFY22.

(f)    Residential real estate prices may show a divergent trend in various geographies, but may generally remain strong. Commercial and retail real estate may also continue to see recovery.

Key risks to be monitored for the market in 2HFY22

1.    Relapse of pandemic leading to a fresh round of mobility restrictions. (Less likely)

2.    Significant worsening of Sino-US trade relations.

3.    Material tightening in trade, technology, and/or climate regulations in India and globally.

4.    Hike in effective taxation rate to augment revenue.

5.    Material escalation on northern borders.

6.    Prolonged civil unrest.

7.    Stagflation engulfing the entire economy, as inflation stays elevated and growth fails to meet the expectations.

8.    Premature monetary tightening.

Investment - Strategy

Asset allocation

2HFY22 may be a difficult period for investors, in terms of high volatility, poor expected returns from diversified portfolios and poor return from long bond portfolios as yield firm up. In view of this, I shall continue to maintain higher flexibility of my portfolio; keeping 30% of my portfolio as floating, while maintaining a broader UW stance of equity and debt.

Large floating allocation implies that I shall continue to trade actively in equity. 30% of portfolio would be used for active trading in equities and debt instruments.

My target return for overall financial asset portfolio for 2021 continues to be ~7.5%.

Equity Strategy

I would continue to focus on a mix of large and midcap stocks. The core criteria will be old economy cyclicals which are cheaper from historical and contemporary perspective, have decent market share, are changing business model to suit the new conditions, and would benefit from economic recovery.

I would target 6-7% annualized price appreciation from my equity portfolio.

Miscellaneous

I have assumed a relatively stable INR (Average around INR74/USD) and slightly higher short term rates in investment decisions. Any change in these assumptions may lead to change in strategy midway.

I would have preferred to invest in Bitcoin, but I am not considering it in my investment strategy due to inconvenience and unease of investing.

Factor that may require urgent change in strategy

·         Material rise in inflation

·         Material change in lending rates

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

“The crisis of today is the joke of tomorrow” — H. G. Wells (English Author, 1866-1946)

As of this morning, a number of regional economies appear struggling with some sort of crisis. The factors causing these crises are varied; and in many cases even trivial. Collectively, these regional crises appear to be clouding the global economic recovery; and threatening a protracted phase of stagflation (negative or very poor real growth).

In particular, the sharp rise in global energy prices is a matter of serious concern for all. The prices of natural gas and coal are now at decade high. Crude oil prices are also at 5yr high and forecasted to move further in view of expected harsh winter. Consequently, the electricity prices and transportation (shipping and freight) costs have also risen sharply. The sharp inflation in energy prices is becoming a global crisis and being seen as a major threat to the global economy recovery.

From a plain reading of the events across the globe, inter alia, the following factors appear to be catalysing some sort of crisis, impacting the global economic recovery from the Covid-19 pandemic.

1.    Supply chain disruptions caused by labour displacement due to the pandemic; underinvestment in capacity building in past one year; uneven recovery across sectors and geographies; etc.

2.    High tide of pandemic stimulus ebbing.

3.    Erratic weather patterns across the world adversely impacting the crops.

4.    Hard geopolitical and trade related positioning between groups led by China and the USA.

5.    Precipitous shift in the business models towards ESG and digital, leading to significant change in demand and supply patterns for carbon and decarbonized products; material shift towards renewable energy and electric mobility, etc.

6.    Rising fragility of global financial system, with burgeoning debt both at the sovereign as well as household levels.

7.    Hardening nationalist positioning constricting free movement of labour and capital (e.g., Brexit).

The following are some of the instances that reflect the changing business conditions, demand supply patterns and the crises emanating from these.

US – Business consolidation and uncertainties hurting the supply chain

"Sorry. No French Fries with any order. We have no potatoes", a board at the Burger King in Florida read this week.

The shortage of trucks and driver is choking the supply chain across US. As per the industry sources, “Truck drivers that would transport cargo on flatbed trucks are being recruited away by Walmart and Amazon to exclusively pull box trailers or shipping containers. Large items like steel piles and premade concrete pieces either can't fit or can't be loaded into containers or box trailers. Vendors tell me demand is as high as 40:1, meaning for every available flatbed truck there are up to 40 waiting customers. The roads around the NYC metro area are as clogged with truck traffic as ever, but we're facing longer waits and higher prices to haul non-containerized cargo.”

One of the largest shipping ports in USA (San Pedro, LA) reported that some 60 container cargo ships idling at the entrance of the port complex last week. With an increase of 30.3% in cargo volume as compared to the same period in 2020, the congestion at ports is showing no signs of easing.

As per WSJ reports - The armada of cargo ships is due to surging volumes and unpredictability in global supply chains caused by the Covid-19 pandemic, and exacerbated by shippers pulling holiday-season imports forward to avoid delays later. The congestion at ports is one of a number of global bottlenecks as ports juggle strong consumer demand and shortages of workers and equipment caused by pandemic-related health and safety measures. These challenges have been  leading to significant delays and additional logistics costs.

UK gasoline crisis – Brexit may have a role to play

As the country heads into what could be a harsh winter, the US energy prices are soaring. In past nine months, the prices of natural gas in UK have risen over 250%. Though multiple factors could be attributed to the precipitous rise in energy prices and consequent second round inflation, logistic issues are cited as one of the principle reasons.

The complexity of the situation forced Paul Scully, the U.K.'s minister for small businesses to comment, “We know this is going to be a challenge and that's why we don't underestimate the situation that we all find ourselves in.”

The government officials and the prime minister himself have maintained that there is no shortage of the fuel in the country. It is the shortage of the drivers that is causing supply chain disruptions for fuel and food. The government is even contemplating to call the army to help bridging the supply chain gaps.

While there is no official word on labour shortages, it is estimated that labour supply may have got choked due to Brexit; travel restrictions due to Covid19; and less number of labour participating due to Covid19. The chief economist of KPMG speaking to media estimated that labour shortages may take 6 more months to fully resolve.

Andrew Goodwin, chief U.K. economist at Oxford Economics, told CNBC – “Households have got this big stockpile of savings to spend, but that will be starting to ebb away a bit simply because the bad news we're having on things like inflation. I suspect, we're going to end up in a situation where the reality is a little bit disappointing to what we were expecting say three months ago. And that's simply because of these issues with supply shortages, both in terms of sort of constraining output and also just eating into consumers' purchasing power."

Though the US economy is expected to reach pre Covid level by 3Q2021, demand pull is not something that is being cited frequently as one of the primary reasons for inflation spike. It is mostly the supply chain disruption.

Another popular view is that “It’s outrageous to suggest the current UK energy situation is the result of a rapid transition away from fossil fuels. It is primarily a gas crisis, fuelled by the nation’s slow transition to lower carbon sources. The origins of the crisis are complex, and date back many years.”

“Gas prices in Europe are at record highs, but the European Union’s internal energy market – of which the UK is no longer part – allows member states to trade with each other in a way that balances prices out.

This means EU countries can’t always take full advantage of very low energy prices, but at the same time means they’re protected from very high prices.

The UK, as an independent country outside the internal EU market, can take better advantage of low energy prices. But at times like these, when energy prices are very high, it left highly exposed to price shocks.” (Prof Aimee Ambrose, Sheffield Hallam University)

China’s decarbonization plan – Beijing Winter Olympics in play?

In the last week of September, the production line of a solder company in Kunshan was silent. In previous years, the factory was busy, stocking up for the National Day holiday. However, due to strict local power restrictions, they have temporarily had to suspended production. “All companies are going to stop production,” one manager explained, “When the policy first came out, it was thought that it wouldn’t affect processing companies. But since September 27, it requires all companies to stop production.”

Steel, non-ferrous metals, chemicals, textiles, and other energy-consuming industries are all affected. Unlike the previous round of flexible measures, which aimed to reduce energy consumption by 10%-30%, the current power control policy is more stringent. Now, local authorities are implementing an “open 2, stop 5” measure; companies will only be allowed to operate for two days a week. Most will have to reduce their production by 90% or shut down completely.

China aims to keep power consumption under control with carbon neutrality targets in mind. In August, the central government issued the “Barometer of 2021 Half-Year Regional Energy Consumption Intensity & Total Amount” – also known as the energy consumption “double control” plan. Under this plan, provinces must manage “total energy consumption” as well as “energy use intensity” while meeting their five-year targets.  (International Tin Association)

Some observers suspect that this plan is primarily aimed at ensuring blue skies during winter Olympics in Beijing; while other believe that it is part of the long term plan to decarbonize the Chinese economy.

The impact of “double action plan” is that Global consumers are already facing shortages of smartphones and other goods ahead of Christmas. The Global Times reported that “Multiple semiconductor suppliers for Tesla, Apple and Intel including ESON, Unimicron and ASE groups, which have manufactured plants in the Chinese mainland, recently announced they will suspend their factories’ operations to follow local electricity use policies.”

Brazil agriculture – snow and drought cause havoc

Brazil faced an unusual cold weather with froth killing the crop, followed by one of the severest drought in many decades. Brazil is also one of the worst affected countries due to Covid-19 pandemic in terms of the fatalities.

The New York Times reported, “Crops have shriveled up under searing heat. Immense water reservoirs, which generate the bulk of Brazil’s electricity, are growing alarmingly shallow. And the world’s largest waterfall system, Iguaçu Falls, has been reduced from a torrent to a trickle.”

Several states in the country are facing the worst drought in at least 90 years. The crisis has led to higher electricity prices, the threat of water rationing and a disruption of crop growing cycles. Agriculture, an economic engine of the nation — which relies heavily on hydropower — is now at risk.

Experts said the arid landscape, which coincided with a rise in illegal deforestation over the past months in the Amazon rainforest, could lead to a devastating fire season. Enforcement of environmental regulations is weak in the rainforest, and fire season traditionally begins in July.”

Before the worst drought in a century, Brazilians were surprised by unusual snow fall in July. At least 40 cities in the Rio Grande do Sul reported thick ice, while 33 others witnessed heavy snowfall reaching up to a meter high in some places, according to several reports. For most of the Brazilian population it was their first snow experience. The snow materially damaged sugar, citrus, and coffee farms.

“We’re left with a perfect storm,” said Liana Anderson, a biologist who studies fire management at Brazil’s National Center for Monitoring and Early Warning of Natural Disasters. “The scenario we’re in will make it very hard to keep fires under control.”

Brazil, is the world’s biggest exporter of coffee, sugar and orange juice. Poor Brazilian crop means that the global coffee and sugar prices have shot up sharply.

Conclusion

These are only some of the instances of regional crisis that are having global impact. The prices of food and energy are rising across countries. The productions lines are working at sub optimal capacities due to input shortages. The policy makers are hoping that these crises are all transitory and would ease in next few months (mostly on their own) as the pandemic related curbs are eased and bottlenecks are removed. However, in the interim severe damage could be caused to many small and medium sized business and households.

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

Future market price target is usually the least important and most subjective component of an equity research report. The household investors must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.

In a T20 cricket match, a statistical algorithm predicted that chances of Team “A” winning are 79%. The result was flashed on TV screens and a viewer promptly bet a dinner for two on Team “A” victory, with his friend. 

Two overs later, a rookie Team “B” bowler claimed a hat trick and the statistical predictor was now showing chances of Team “B” winning as 83% (from 21% earlier).

The general elections concluded just 3 hours ago. The TV screens were flashing results of exit polls showing Party “A” sweeping the elections with 65% of seats. The ticker on TV however did not show the disclaimer, which said that a 1.2% swing could change the results in favor of Party “B”.

A viewer who had a bet with his wife (a supporter of Party “B”) one year of dishing if the Party “B” wins majority, rued his reliance on TV breaking news for the full one year,

A prominent global brokerage house (XYZ) released a research report for ABC Ltd, giving a 12month price target of Rs400 (against the current market price of Rs210). The TV channels, social media timelines and newspaper headlines flashed “XYZ forecasts 90% gain for ABC Ltd”. Hundreds of investors rushed to buy the stock of ABC Ltd, without caring to read the research report. The report actually built multiple scenarios and highlighted multiple risks. Rs400 target, i2 months hence, was based on a completely blue sky scenario, with no risk playing out. It also assumed that the collective wisdom of market will get influenced by the analyst’s unconventional pricing method for the company.

As it happened – the sky came out to be clouded; some risk factors mentioned in the report also played out and market did not care to agree with the unconventional pricing method of the analyst. The stock price plunged to Rs75 a year later. Most investors booked losses; cursed the analyst and alleged him to be in cahoots with the unscrupulous market operators and corrupt company management.

Indifference to details may be one of the most unfortunate parts of the entire investment process of household investors (commonly referred to as the retail investors). In their eagerness and greed to make money faster than others, these investors usually act on headlines without actually caring to go into the details. It is also seen that the reliance on “Research Reports” by the household investors is mostly misplaced. Most of them only care to read the “price target”, without going into the analysts’ rationale for such target; or caring about detailed analysis of the business of the company. For household investors, it is critical to understand the types of equity research reports and their components.

Types of equity research reports

Equity research reports are prepared for a variety of purpose. The constitution of the report usually differs according to its purpose. For example -

The most common equity research reports are the Sell Side Initiation and Maintenance reports. These are reports prepared by research analysts employed by various brokerages for the purposes of marketing their investment ideas to the clients. The initiation report is the first report on a company by a particular analyst. This report usually contains a detailed quantitative and qualitative analysis of the company. After the initiation report is released, the analyst then releases periodic maintenance reports to update the original data for the new developments like quarterly results; corporate actions, and policy changes etc.

Second popular types of reports are “deal reports”. These reports are prepared by the investment banking research analysts to market the proposed equity issue of the underlying company to the institutional investors. These reports usually have an inherent bias in favor of the underlying company.

Third type of popular reports is “buy side equity research” reports. These reports are usually prepared by the research analysts of the investing entities (e.g., mutual funds, private equity funds etc.) for their internal use purposes. These reports usually are influenced by the guiding principles and investment strategy of the investing entity; and hence may not be relevant to all classes of investors.

The focus, content and emphasis of various types of reports are different based on their objective. Household investors cannot exclusively rely on these reports, made available to them on social media, blogs or friends in right places, for their investment decisions.

Components of a Research Report

The components of an equity research report would depend on its objective and target audience. The basic components of the most popular a “Sell Side Equity Initiation Research Report” would usually consist of following-

·         Description of the Company – Historical background, business, facilities, capacities, promoters, key management, etc.

·         Analysis of the business – Products, applications of products, competitive landscape, demand-supply dynamics, emerging trends, technological advantages, etc.

·         Analysis of finances – Historical trends in capital structure, cost of capital, capital allocation efficiency, leverage sustainability, solvency, advantages (or otherwise) relative to competition etc.

·         Analysis of profitability – Historical trends in margins, growth, return on equity, sustainability of margins etc.

·         Future Projections – Profitability, Growth, Solvency, Sustainability Competition etc. over next 2-4years.

·         Risk factors – Risks to the business, finances, profitability and forecasts

·         Actionable – Buy, Sell, Hold, Accumulate, Reduce etc.

·         Price target – Expected market price of the stock on a given future date.

There are many sources for the details provided in the research reports, e.g., – (i) Factual data available from historical records; (ii) Published research by professional research organizations and Institutions like CRISIL, CMIE, NSSO, RBI, IMF, etc.; (iii) Management presentations and company reports; (iv) Market research by the analyst himself; and ((iv) Analysts’ estimates., etc.

The suggested action (buy, sell etc.) is based on the estimated relative performance; implying that the stock of that particular company is likely to do better (or worse or in line) than competition and/or benchmark indices. In many cases, the actionable is actually not based on the estimated absolute performance of the stock price.

Future market price target is usually the least important and most subjective component of an equity research report. This piece of data in a report is heavily influenced by the analysts’ subjective perception of the business, growth, profitability, and the method of valuation used to derive such target. It is therefore common to have vastly different price targets given by different analysts at the same time, for the same stock

It is akin to a TV commentator forecasting a team’s score in a 50 over match at the beginning of the inning based on the weather conditions, grass on the pitch, and performance of key batsmen & bowlers in previous five innings, etc. Even though their analysis and forecast are based on their experience and available information, their forecasts about the total score seldom come true.

The household investors therefore must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.