Year-end dilemma: Hold or fold?

It will depend on an investor's view of the long-term potential of the economy

As we come to the end of the year, all investors need to re-examine their portfolio and asset allocation. Do they have too much in equities? Is tech too large a weightage? Is this the year to make the shift from US assets to emerging markets (EMs)? Will investors in India be raising cash for the stream of upcoming initial public offerings? All are valid questions, and all need debate and discussion.

A similar question that is on the mind of global investors is what to do with India? The markets have done surprisingly well over the last two years, rising over 45 per cent from January 2020 compared to a 35 per cent rise for the US and less than 20 per cent for EM equities as a whole. In this year itself, MSCI India is up 26.5 per cent, compared to (-) 1.25 per cent for MSCI EM (till September 30). The Indian markets are expensive, trading at over 22 times forward earnings and are at a steep 90 per cent premium to the broader EM universe. Most valuation ratios in India are higher than long-term averages. This outperformance is despite India still not having recovered fully, with year-end 2021 gross domestic product (GDP) still about 5 per cent below the pre-Covid trajectory, unlike the US and other large EM countries where the recovery will be either complete or marginally below pre-Covid levels by year end.

For global allocators, the question then is: Should they fold and take their profits or stick it out for the long haul? Will India’s outperformance continue? The market has a reputation for volatility and severe swings in performance and most are sitting on large profits. The answer depends on your narrative on how India will grow after this year’s acceleration. There are two very contrasting narratives out there.

Most academics, especially those sitting overseas are convinced that the Indian economy has some serious structural issues. We were slowing before 2020 itself, and the structural challenges imply that we are destined to fall back to a 5 per cent growth trajectory after the current surge. Insufficient second generation reforms, limited productivity growth, a lack of investments and poor industrial policy design, which prioritise self-sufficiency over exports, all doom us to this fate. This group basically does not buy the argument that India has paid the price for cleaning up corporate and financial system balance sheets. The country has gone through a balance sheet recession, coupled with extreme risk aversion, which invariably hits growth. We are coming out of this finally. They do not seem to feel that any of the changes made— be it the goods and services tax, bankruptcy code or the production-linked incentive schemes, accelerated digitalisation or genuine privatisation will accelerate growth and productivity. The hit to the informal sector, in their view, is so severe that we cannot recover, and that Covid has only made the disparity between the rich and the poor wider. They opine that consumption cannot recover with such severe damage to informal employment, and neither can investment with low levels of capacity utilisation. Further, weak economic growth implies poor corporate earnings and thus given current valuations, market returns will be muted, and India will disappoint once again. This narrative has many followers and if you do truly believe that India can now only grow at 5 per cent, you must take your profits and exit. The risks of a drawdown outweigh any potential upside.

Illustration: Binay Sinha

The bulls obviously see things very differently. Most feel that we are on the cusp of a multi-year economic upcycle, similar to 2003-08. They see the glass half full. We are coming out of a balance sheet recession, many structural changes have been made, the price for which has been paid up front. Corporate India has rarely been more positive on its future prospects. The real estate and private capex cycles are both turning. IT hiring has never been more robust and the start-up ecosystem is on fire. It has never been easier to raise capital in India or buy an apartment. The wealth creation has been unprecedented. Exports are booming and employment will pick up strongly. Formalisation has improved prospects for listed companies and capacity utilisation across industry leaders is not 65 per cent but over 80 per cent. The bulls point out how depressed profit margins are even today, with profit share/GDP still significantly below long-term averages. Profits have now begun to inflect, and the last three quarter earnings have beaten expectations. 

They are pencilling in a multi-year cycle of high teens to mid-20 per cent. The return on equity has already crossed 15 per cent and will continue to trend higher. Despite all the disappointment with India over the last decade, Indian markets have outperformed the EM universe delivering net returns of 9.19 per cent compared to 6.09 per cent for the MSCI EM index (10-year returns till September 30). India has, in fact, outperformed the broader EM universe on a 1/3/5/10 and 20-year basis delivering an alpha of between 300 and 800 basis points annualised. It is also a stock-pickers market, with greater churn in the index and a higher annualised standard deviation of returns. Over the coming years, we are going to see a flood of really exciting new companies list, broadening and deepening the market. India is also underrepresented in all indices, which will get corrected, structurally improving capital flows in both debt and equity.

If the markets can deliver a multi-year growth cycle with earnings compounding at mid-teens, it may not make sense to get off this train just yet. In a world of generally low growth, this type of an earnings trajectory will stand out and get bid up. The markets will gradually grow into the valuation, with the scope for good returns even with multiple compression.

The markets may consolidate in the short-term, given the surge in oil prices and India’s outperformance, but the fundamental debate remains where you stand on the long-term growth question. That is what every investor must monitor and come to their own conclusions. Whether you hold on for the long term or fold today largely depends on your answer to this question.

We remain in the more positive camp, but respectful of the negative narrative and on high alert for contradictory data points to our view.

The writer is with Amansa Capital