A tough time for portfolio managers

Markets are going through a major shift in style and leadership, akin to the 2003-08 bull run

While markets are near new highs, it is not an easy time to be running an equity portfolio. The markets seem to be clearly in the midst of sector rotation or leadership change, and the winners of the past 15 years do not seem to be working.

If one looks at price action over the last two years, since Covid came to an end, the markets have been led by a very different set of winners. Given the duration of this market leadership transition, it seems more than just a blip. Leadership changes of this type typify a bull phase and do not reverse until the bull market ends.

As the share of consumption in the economy has stalled and the investment share of gross domestic product has risen, stocks and sectors exposed to the infrastructure buildout and capex cycle have fared very well. Similarly, there has been a huge surge in the valuations of the public sector undertaking (PSU) stocks. Once considered to be almost pariahs, PSUs are now in fashion. Investors are convinced that the Modi government will unlock the full potential of these companies, which have been experiencing years of underperformance and hence are trading at very cheap multiples. PSU banks, in particular, have made up their entire underperformance compared to private banks, and have been the place to be in financial services.

There is also a strong thematic play in electricity/power ecosystem stocks, as well as anything related to manufacturing and defence. Investors are convinced that through a combination of supply chain diversification and smart use of industrial policy, India has never had a better opportunity than today to gain manufacturing market share. The total addressable market here is huge, and companies can quickly scale 2-3 times given the scale of supply that has to move. In the power ecosystem, whether it be renewables or thermal, India needs a massive power capacity ramp-up and equivalent investment in the grid. Investors can sense the large profit pools in the ecosystem, given the scale of investment needed. Defence presents a structural opportunity to gain exports share and indigenisation.

The market is clearly signalling from its price action and sectoral leadership that we are back towards a scenario reminiscent of 2003-08. In that bull phase, the market was led by capex-heavy sectors, infrastructure and real estate, and investment-driven sectors. The market was more focused on revenue growth than returns on capital and free cash flow. The so-called quality universe of long-term compounders lagged the markets. This period was the last time quality compounders were actually cheap in India. Investors were chasing growth at any price, and capital investment was greeted with cheers from the markets. Post-global financial crisis, with the Indian capital investment bust and surge in non-performing assets (NPAs), the market’s drivers of performance again reversed.

From 2009 onwards until very recently, we saw the era of the quality compounder. Quality stocks, typically consumer-facing with high returns on capital, stable and predictable growth in both revenue and earnings and with a good industry structure performed incredibly well. This was the era of consumer stocks and plays on formalisation. While these stocks delivered reasonable earnings in the 15-20 per cent range, they also had strong multiple expansion, which supercharged their performance. This multiple expansion phase seems to have now ended and we appear to be in the midst of a period of multiple normalisation for the quality universe. As their multiples compress, these stocks have been mostly treading water with limited price appreciation over the past 18 months. Given how expensive they were trading, it may take some more time for the multiples normalisation process to complete. Given their current growth outlook, multiples are still too high for many of the quality compounders and will tend to undershoot as the cycle reverses.

Similarly, we saw value migration from PSU stocks to their private sector competitors. This was most visible in the PSU/private bank trade, but was also seen in telecom, insurance, and aviation. This trade is also now reversing. PSU stocks are now trading at multiples above their private peers in some sectors and have delivered a huge return alpha over the past 18-24 months. It is unlikely that the PSUs will keep losing share indefinitely. Markets seem to believe that the PSUs can now keep their current market share and have better productivity and profitability. They continue to have scope for operational improvements.

The basic message is that the portfolio construct that made one successful over the last 15 years has been underperforming for some time and is likely to continue to do so until there is full reset of multiples within the quality universe. Portfolio managers who have cut their teeth in the last 15 years have, by and large, only seen the quality trade work. If you were not there in 2003-08, you have not seen the opposite or antithesis of quality driving markets. The market action is quite clear. Leadership has changed. We are unlikely to go back to the old dynamic anytime soon.

Similarly, the trend of mid-cap outperformance is driven by the increasing power of domestic flows, which shows no signs of reversing. Again if one goes back a few years, when foreign portfolio investors  were the more dominant source of equity flows, mid-caps would routinely underperform for years on end. Unimaginable in today’s context.

Anyone investing over the last 15 years has largely made their money backing quality at almost any price and avoiding PSU stocks and asset-intensive businesses like the plague. This strategy is unlikely to work in the current bull market setup, with mid-caps, PSUs and stocks benefiting from the investment cycle leading the charge.

So what should an investor do? Forget their investment philosophy and latch onto what is working? Jettison their quality names and buy the manufacturing and investment theme? Or should you move in the opposite direction? Use the parabolic price moves in some of the more cyclical stocks and sectors to exit and recycle the capital back into the lagging quality names at cheaper prices, knowing full well that this recycling of capital will hurt short-term performance?

The answer to this really depends on whether you are playing the absolute performance game or relative. Also, whether you are targeting long-term risk-adjusted performance or need to keep up with the benchmarks on a quarterly basis? It also depends on your investor base and their willingness to give you the rope to underperform on a short-term basis in return for better long-term numbers.

The market is going through a major shift in style and market leadership. These shifts happen every few years and are also cyclical. This is why it is hard for any single fund to continue to outperform every single year. Many funds outperform in the long term, but almost no one does it consistently every single year. How to traverse these leadership changes and whether to react depends on the fund objective, patience of the investor base, and ability to sit through periods of underperformance. Whichever way you cut it, portfolio managers have a tough job ahead of them.

The writer is with Amansa Capital