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Last Updated : Mar 27, 2017 09:40 PM IST | Source:

Indian markets at crossroads: 'Focus on Return of Capital, not Return on Capital'

Today, India’s global position is very similar to that mid-cap company which is trading at rich valuations however undergoing some structural changes having potential to change its very orbit.

Jatin Khemani

Founder & CEO, Stalwart Advisors

Imagine a conversation between two investors about a hot mid-cap which has recently done pretty well. The optimist might justify buying or holding on to it saying, "Look at this new CEO who seems like an intelligent fanatic, has fire in the belly to make it a global giant. Look at his execution quality over last three years and the earnings potential of this business given humongous size of the market opportunity."

The cautious investor, however, would differ by pointing out to current valuations being close to life-time high and the potential irrational moves by competitors in the short-term.


Today, India’s global position is very similar to that midcap company which is trading at rich valuations, however, undergoing some structural changes having potential to change its very orbit.

The interesting part is that arguments from both sides are so strong and sensible, that you get swayed in that direction depending on whether you are talking more to bears or bulls.

It is now widely acknowledged that India’s current leadership is strongest we have ever had. We are witnessing some landmark reforms like GST, promoting initiatives like Make in India to give impetus to manufacturing and boost employment generation, financial inclusion, Direct Benefit Transfer and crop insurance to remove leakages and empower rural India, Real Estate Regulator Bill.

Also, there is a significant focus on improving ease of doing business with lots of small incremental improvements leveraging technology, meaningful efforts to curb black economy, focus on building infrastructure across the board be it roads, railways, power, etc.

In short there have been many right moves and we seem to be heading in the right direction.

We are today the fastest growing major economy in the world. Weakness in commodities over last two years, has been a major boon for us helping manage our current account deficit, making our currency one of the strongest among emerging markets; helping control inflation and making room for interest rate cuts.

The eminent question- Is it all priced in? Maybe, may be not!

This bull market started towards the end of 2013, months before the new central government was elected. If one goes by the index returns it is nothing much to talk about – Nifty has moved up barely 54% in these three and half years (Oct 13-Feb 17) and we’re calling it a bull market? Tell it to someone who witnessed 1991 bull market and he might think you are kidding! That’s because this time the action has been entirely in the broader markets: Here’s a snapshot of how stocks have fared in this period:


However, a significant part of this return has come by way of re-rating i.e. multiple expansion. Today, investors are willing to pay much more for every rupee earned by a company versus what they were willing to pay in 2013. A lot of companies which were trading in 10-20 P/E band have been re-rated to 40-50-60 P/E bands. For a lot of companies, especially constituents of key indices, the earnings growth has significantly lagged expectations and is yet to catch up, resulting in Nifty’s P/E spiking to 21.


This is even worse for small and mid cap indices, where P/E multiples are even higher than Nifty50’s. We all understand what happens when we pay too much for even something that is good-we end up either loosing capital or suffer opportunity cost due to time correction; for earnings to catch-up. Here’s a snapshot of 3, 5 and 7 year returns of Nifty based on entry P/E of Nifty:


If you invest in markets when P/E is lower than 14, the returns over next few years are phenomenal. However, that needs a lot of patience and ability to sit on cash. There have been only 415 trading days in last 4,435 days, when Nifty traded at a P/E below 14 i.e. just one out of ten days. However, if you are entering on the other extreme, the only saving grace could be a long-term investment horizon.

But this time it’s different! (Yes we know that’s the most abused phrase in markets)

In 2007 not only the P/E reached its peak at 28, but the profit margins, average capacity utilisation, market capitalisation to GDP ratio etc. were all very high. However, based on FY16 data, the situation is much different than previous bull market; there is significant room for earnings to catch up given the low capacity utilisation and potential margin expansion, which are much below long term average. We are already seeing some early signs of domestic capex revival. A good monsoon after two consecutive droughts is further expected to revive rural economy which should have a ripple effect on lot of sectors.

Our take on Indian Markets

• We feel markets have become challenging for value investors and incrementally getting difficult to find attractive opportunities.

• We are not implying sell everything and run away, however risk-reward isn’t that favorable. Markets can double even from these levels too, who knows? But these are times when more importance should be given to Return ‘of’ Capital against Return ‘on’ Capital.

Are you holding Bubble-portfolio?

Another important consideration is the composition of portfolio during such heated markets. If somebody had majority of the portfolio in TMT (Technology, Media and Telecom) stocks during the 2000 bubble, the portfolio would have not only crashed 80-90% but majority stocks never recovered leading to permanent loss of capital. Similarly, during 2007-08, if the portfolio held majority stocks from infrastructure and capital goods same story would have repeated. This time around, there is no specific sector that is leading the bull market. However, one can clearly see bubble valuation in select pockets.

Some Interesting & Funny Observations

1. There is a new breed of investors who are probably experiencing their first bull market and can be seen on social media and WhatsApp groups. There is a lot of exuberance and investing is starting to look like easy money.

2. Quality of ideas discussed in forums are deteriorating – holding companies, asset plays, chore bane more are the emerging themes.

3. Google Trends show ‘multibagger’ search making new highs, as much as 3x from 2007 peak.

4. Getting calls from friends and family, however, funny part is that calls are either of these two extremes:
a. Some are those who invested at previous peak (2007) in ULIPs, they have finally broken even and seeking suggestion if they should exit.

b. Others are first time investors and want to know next multi-bagger stock idea or best ‘small & mid cap’ fund.

5. New experts are emerging on social media platforms like Twitter. These ‘Gurus’ regularly tweet about their stocks (after they buy) but these are merely tips as they don’t carry investment thesis and risks involved-

‘I am looking at ‘Suckers Limited’, seems interesting. After a long consolidation the stock seems to be at an inflection point’ is all you can say when you are allowed maximum of 140 characters. Remember the words of wisdom by Rakesh Jhunjhunwala ‘Tips are hazardous to wealth’.

We also share some of our preferred picks, however every idea which we have shared in public domain over last two years have been accompanied with research reports carrying detailed investment thesis and major risk factors involved, which is followed up by regular updates along with current rating to all our guest users too.

Are you a new investor? Here’s our advice for you

• Avoid investing it all at once — this may not be the best time to commit big money. Invest some portion in few good businesses, for rest wait for a better opportunity; they always come — remember Feb-Mar 16 or Nov-Dec’16.

• Worst time to go down the quality curve- stick to well run businesses and managements with unquestionable integrity. Since quality businesses are trading at 40-50 P/e, others at 20 P/e might look relatively cheap but what if latter deserves a 5 P/e given the track record of its promoters?

• Avoid tips at all cost and stay away from noise- if you don’t have time to do in-depth research, outsource it to fund managers via SIP or trusted advisories, but don’t risk your capital for tiny gains.

• Have minimum horizon of five years, longer the better.

• Control greed and have a reasonable expectation- attempting to make quick buck would make you prone to commit grave mistakes.

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First Published on Mar 27, 2017 09:40 pm
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