In a more narrow range-bound market, stock-specific issues will once again come to the fore.
The last two-and-a-half years have been a crazy roller coaster ride in the Indian equity markets. 2007 marked the culmination of a strong five-year upmove and ended in a meltup, with markets exploding to the upside from September to end-December. The quality of the companies you were buying mattered very little in this phase. Real estate, infrastructure developers and capital goods companies were all the rage and as long as you owned companies in these sectors you out-performed the markets. If you did not own this stuff, you could deliver strong returns on an absolute basis, but it was tough to beat the market indices. Momentum investing was in full cry, and as is typical of bull market tops, growth (of both top line and earnings) was given overwhelming importance at the cost of capital efficiency. No one really cared about ROE or ROIC metrics, ‘show me top line growth and I will give you a valuation’ was the mantra. Concept stocks were also in fashion, and investors were willing to give high upfront valuations for long gestation business models like retail or insurance.
The macro calls,viz which sectors to be in, whether you want to have more beta in your portfolio etc were far more important than stock selection. If you understood the markets’ obsession with growth at any cost, you were fine.
In 2008, the picture changed in the sense that almost everything came down, and what was more important was judging the extent of FII ownership of a particular company. The more widely owned the company, the more the selling and hence the deeper the fall. Again stock selection was less important than getting the macro call of being defensive right. The momentum sectors of real estate and infrastructure kept their beta, but this time it was on the way down. Once again no one really cared about ROE etc; only FII ownership and debt levels mattered. If you understood the extent of fear and over-ownership globally you were fine.
Now in 2009, we have had periods of both of the above. Indiscriminate selling irrespective of company fundamentals, and now desperate buying trying to keep pace with the markets. The move-up in the last ten weeks has very closely resembled the market environment of Sep-Dec 2007. Market participants are beginning to question whether once again momentum investing is back in fashion.
This is not a new normal in my view. Markets do not go up or down 60 per cent in a single year on a continuous basis. Macro investing is not always overpowering, it does not always swamp everything else.
Investors, having got used to the wild swings of the past 30 months, are questioning the relevance of stock-picking in India these days. Their legitimite point is, what great value has fundamental research brought to the table? One has only needed to get the macro beta call right, nothing else has mattered. Whatever level of company-specific analysis one may have done, it has provided little edge.
My own point of view is that the environment is going to change and very soon. We will soon enter a consolidation phase in India, where for a period of time markets will have reduced volatility and trade in a reasonable range. The markets have to become a little boring for a time and we need to get away from the wild swings of the last 30 months.
In more narrow range-bound type of markets, stock-picking will once again come to the fore. Stock-specific issues will matter, and companies will deliver significantly different return profiles dependent on their own long-term growth prospects and capital efficiency. Investors will once gain focus on ROE, free cash flows, valuation multiples and quality of management. Which company you are invested in will once again matter.
During the mid-1990s, all the way upto 2006, India was always known as a stock-pickers’ market, investors would always point to an Infosys or a Bharti as examples of companies you could discover, buy and hold and make serious money independent of market conditions. India’s strength was its ability to continually throw up new companies and entrepreneurs who could scale and build world-class companies. The breadth of sectoral representation was always seen as a strong positive for the markets.
I think such an environment will return. Stock-picking will once again deliver alpha.
An interesting collorary to this possible move to stock-picking is about how all the infrastructure will get funded. The momentum markets of 2007 allowed all sorts of long-gestation infrastructure projects to get funded. As the market environment changes, so will appetite for this type of paper. Stock-pickers tend to prefer high ROE, strong free cash flow type of companies. They normally do not favour companies which need to raise equity at regular intervals, like our real estate and infrastructure plays. Also, by definition, for infrastructure projects at least, equity returns will be capped, if not for the first few projects, definitely over time. Infrastructure projects will also normally be very long-gestation in nature, with returns coming over time. Public market investors do not normally pay much upfront for a project whose cash flows will only begin in three-five years.
How will these companies raise the billions they need in a new, more sober market environment? The failure of many QIPs is already a pointer to this trend. Can a more sober, less growth-obsessed capital market fund the equity needs of all the infrastructure and real estate developers? If not, what does that mean for India’s huge infrastructure build-out?
It is also a commonly known fact that the stars of previous bull markets rarely tend to lead in a new market upcycle. Thus we have a dilemma as to how will all these new infrastructure and real estate projects get equity funding. Either a new growth-obsessed equity market environment has to emerge or new specialist infrastructure investors come to the fore whose tenure of capital and expected return profile are different. You will see the emergence of many more specialist infrastructure equity funds (many at the project level) of the type IDFC has already begun. Without these specialist funds I don’t see how the private sector can raise the equity it needs to build out India’s infrastructure.
