With sentiments turning negative, investors should focus on capital preservation and liquidity.
One way to value a business is break-up value – net worth minus outstandings. This is very conservative; it ignores future profits. A second approach is discounted cash flows (DCF), assigning net present values (NPV) to future cash flows. A third approach is the soundest in practice and the preferred one, if available: Compare a business to its listed peers.
These methods are used by merger and acquisition specialists, by the venture capital industry and by I-bankers looking to take a company public. They can also be used by retail investors. They are scalable, in theory, at least. They can be used to price entire markets. In a globalised economy where investors and hedge funds easily move funds transnationally, entire markets are routinely compared to each other.
By those standards, India has always been richly-valued. It trades at higher average PEs compared to most of its developing economy (DE) peers. This is because it has delivered high growth with fair consistency and the future projections have also been consistently upgraded.
However, when global capital is scarce, FIIs cut back on DE exposures. At those times, valuations tend to fall across DEs (usually across first world markets as well) and Indian equity also sees downturns along with its country-peers. Investors place greater value on structural stability (sustainable debt, for example) and less weight on growth prospects.
The new year looks as though it could shape into one of those conservative, bearish periods. Equity prices have fallen everywhere through the first two weeks of 2011. Many country economies are grossly imbalanced, and the euro and dollar are both under pressure.
For all the glib FII talk about “bottom-up” investing, currency instability plays a major role in warning off the more risk-averse global investors. Investors tend to seek shelter in hard currency havens when they see major global risks. Although India's fiscal deficits and inflation issues are no worse than most countries and in fact, better than some developed nations, the rupee is not a hard currency.
So, on the front of comparative national valuations, one of India’s major problem is a soft currency and there's zero chance of the rupee floating in this situation. That's a bearish factor. DCF also indicates the Indian market should be priced down. Since domestic interest rates are rising, the discount rate must also rise, which means the NPV of the Indian stock market, and hence, its market capitalisation, should fall.
Another method of valuation is to assess what prices major institutional players consider reasonable. In the second half of calendar 2010, domestic institutional investors (DII) were net sellers above Nifty 5400-5500 levels. In 2010, the FIIs were net sellers only above 6100. But in January 2011, they've been heavy sellers down to 5650.
In a risk-averse environment, heavy institutional commitments are unlikely at higher levels. So there may not be a solid floor above Nifty 5400-5500 and it’s quite possible the market will move down much further than that. By conventional valuations, even 5500 is rich since the Nifty would trade at a PE of 21.
A much deeper correction is actually more likely by historical standards. Indian bear markets often bottom at PE 10-11. Bear markets can easily shave over 30 per cent off peak values and often, 50 per cent off, as occurred in the 2008-09 bear market By this logic, the retail investor should be wary of increasing overall equity commitments at this instant. No conventional investment strategy will deliver optimal results in such a gloomy scenario. The best chance is to find alternative investments, including selective shorts, or to just focus on ways of preserving capital and maintaining liquidity. Short-term fixed deposits may be one conservative method of operating in such a scenario. This would preserve capital until such time as there is a correction. You could rollover 14-day and 21-day deposits until say, June 2011.
If you don’t like this idea and you don't want to short, find counter-cyclicals, or at least, businesses less likely to be affected by negative sentiment. IT and Pharma are more exposed to global trends than local so, they could provide some protection. Sugar and other agri-commodities can also have trends not co-related to equities. The energy sector could also disconnect from other trends (though energy developments inevitably affect the macro-economy).
If a large part of 2011, maybe the whole year, is bearish, there will be no magic formula. All the options suggested above could be wrong. But an investor is more likely to come out unscathed if he faces the possibility of a big bear market head-on.
