Chuck Prince, ex-CEO of Citibank, had famously said in 2007: “As long as the music is playing, you have to get up and dance”. He did not realise the music had stopped playing by then. For in a few months, the mortgage crisis threatened the survival of his own bank. For many small and mid-cap stocks that have collapsed last week, the question is, ‘Has the music stopped playing?’
Small and mid-cap companies have seen a tremendous expansion in their valuations since the beginning of 2014. An invisible hand was supporting their valuations also known as the Modi PE. It drove a rapid re-rating which became a self-fulfilling trend as mutual funds and PMS schemes attracted money at an unseen speed. However, earnings lagged forecasts and yet the market remained optimistic. The micro, after the twin impact of demonetisation and Goods and Services Tax (GST), is beginning to improve as seen by auto numbers and results of a few companies.
But new worries have cropped up and a few grey clouds have enveloped the sky. Says Utpal Sheth, senior partner and CEO of Rare Enterprises, “Mid-cap valuations have come off from the peak, but still has scope to correct further”. With various macro factors in play, he reckons that “the remaining of the current fiscal year will be one of consolidation”.
Expansion in price earnings ratio is the sweet spot in the phase of any stock. But it has one nemesis: Uncertainty. Indian equities are suddenly faced with five of them:
1) Going by recent by-poll results, Prime Minister Narendra Modi’s win in 2019 although likely is not a certainty for the market. Politics and coalition governments have little impact in the returns over medium-term, yet it does affect near-term sentiment if markets are expensive.
2) The bond market is nervous. Axis Mutual Fund in a recent note titled ‘A Dislocated Bond Market’, says that the Reserve Bank of India's (RBI) conflicting positions are leading to difficulties for participants to judge the stance of monetary policy. Also, the second half of the financial year will see government competing with corporates on borrowing during the busy season.
3) Crude oil is a beast that bulls don’t enjoy meeting on the ring. With it nudging $80, there could be pressure on the fisc if oil-related excise duties are reduced.
4) The Rupee has become a weak link in the chain. With the heavy selling of bonds and equities by the Foreign Institutional Investors' (FII), its vulnerability to a rising crude is well known. Its already on retreat mode with weak exports and a strong dollar.
5) Auditors growing discomfort with accounts of some companies. Independent directors could also turn cautious.
The market internals are reflecting the change. New 52-week lows far outnumber the highs, 64 percent of the stocks in BSE 500 are below their 200 dma and way of their highs showing that the broad market is hurting. IT and consumer names are pulling in the money; both are least vulnerable to the uncertainties described above.
A portfolio of stocks that can withstand the above headwinds should outperform for rest of the financial year. Obvious choices are technology and consumer sectors, something that is playing out since the beginning of this year. Stellar companies with a track record of good governance should also benefit. A combination of quality, size and growth will be the standouts.
Stocks which are down 50 percent or more from their recent peaks are going to have a hard time coming back to their peaks. There may be, however, an opportunity in the carnage. Those growing consistently will surely attract value investors as the India opportunity has in no way diminished. With GST and insolvency reforms, the future is likely to be rich and rewarding to companies that adapt and are honest to its stakeholders.
Of course, some of the clouds could just as easily disappear as they arrived. And a good monsoon will be just what the doctor ordered. Yet, the next nine months could be turbulent and make many cautious. A spike in domestic interest rates could make debt more attractive. Says emerging markets fund manager, Amit Bhartia of GMO, “US 10-year treasury rates have crossed 3 percent for the first time since 2013 making emerging economies like India vulnerable to outflows. A sharp fall in the rupee could add to the uncertainty”.
Not being certain on key variables that affects the economy and sentiment leads foreign investors to reduce their bets. Legendary screen and comic book writer Joss Whedon had said, “I don’t like uncertainty. I don’t play poker. I don’t like bluffing”. His cast of The Avengers would agree.
(The writer is a partner at Goldcrest Advisors LLP and attempts to decode what the action of the market is telling us. He tweets @dev_rivervalley; and has a blog: https://tradercrest.wordpress.com)
Updated Date: Jun 04, 2018 09:36 AM