Current State of Markets – An Opportunity
Historic times
Indeed, we are witnessing historic and abnormal times with ‘Once in a generation’ events unfolding in the Western financial world. Western countries are facing a ‘structural’ problem, and not a ‘cyclical’ problem. Uncertainty, confusion and fear are rampant.
It’s an Advanced Economies problem, not Indian
At the root of the Western financial crisis, is the overstretched U.S consumer who has lived beyond his means. Added to it, was poor lending standards by banks and a heavily leveraged financial system. The entire edifice of trust and confidence in financial markets has now broken down. Lending standards will tighten and their banking system will have to deleverage as most banks are short on capital. This will surely lead to a slowdown in economic growth and maybe a recession in the U.S and Europe. In all this, it is important to note that it is a Western problem and not an Indian one.
But, collateral damage in the short term
In this age of global financial linkages and uncertainty of unparalled proportions, ‘collateral’ damage could not have been avoided. What Indian markets have seen is the impact of these financial linkages and a ‘ripple’ effect. Large FII outflows in India primarily reflect ‘Position Liquidation’ and not selling due to serious concerns on long term fundamentals of India. Position Liquidation has been mainly caused by (1) general factors such as fear, lowering exposure to equities as an asset class and (2) firm specific factors such as redemptions, closure, reducing leverage. It is important to note, however, that the fall in Indian markets is in line with the rest of the World.
India is structurally strong
Indian banking system is structurally sound. Indian banks are strong, well regulated and prudent in their lending standards. Indian banks are some of the best capitalised banks in the World with an average capital adequacy of 13% and leverage of 14 times. Compare this, with a capital adequacy of less than 10% and leverage of 20-30 times for Western banks. Further 25% of Indian banks deposit base is statutorily invested in SLR securities – i.e. government securities, unlike anywhere in the World. This is over and above a CRR of 6.5% with the RBI. Indian banks have no exposure to U.S Sub prime.
India is a high savings economy and Indian households are underleveraged. India is a domestic economy, unlike most other Emerging and Asian economies which are dependent on exports to the Western world for their growth. India’s demographics, with one of the youngest populations in the World, will allow high growth rates for a long time to come.
It is interesting to see that, so far, Indian economy and its markets have continued to function uninterrupted and without the requirement of any regulatory changes or governmental intervention. This is not the case with most markets in the World where we have seen bailouts, government intervention in the banking system in terms of guarantees, banning of short sales, halting of trading etc. India has effectively continued to function as a free market economy.
India’s fundamentals are improving
A global recession, as it is building up to be, will net-net be beneficial to India. Two of the biggest concerns on India have been high crude oil prices, which makes government’s finances vulnerable, and high inflation. Crude oil prices have already corrected 50% from the peak of US$145/bbl and other commodity prices have also crashed by 40-50%. A global recession can lead to a further correction in commodity prices. Being a net importing country, India is a big beneficiary of this.
No doubt a global slowdown will also slow our Growth rate. But what is important to note is that India still will continue to grow at around 7% p.a., a high growth rate in itself and will also continue to be the second fastest growing economy in the World. More importantly, our Growth Gap over the rest of the World will be maintained. Chart 1 & 2 below compare the actual and forecast GDP growth in 2007 and 2009 respectively as per the World Economic Outlook report issued by the IMF in October 2008.
Source : IMF
India has enough policy ammunition to support growth going forward, as the recent rapid action by the RBI in cutting CRR and Repo rate shows. With a global slowdown, inflation and interest rates can now start falling and in turn support growth.
Market at very attractive levels
Equity markets always, ultimately, reflect the fundamentals and growth of the economy and corporate profits. We expect that a 15-20% p.a. corporate profit growth over the next 3 years is easily achievable, especially given the possibility of lower inflation and lower interest rates going forward. Valuations have also now corrected steeply. Indian markets are at 10x P/E on one year forward earnings, compared with the last 15 years average of around 15x. Remember, India has been never been as strong in the last 15 years as it is now.
Expect more divergence
Unlike earlier, we have a different economy and market now, where within the overall growth there will be large differentials in growth between sectors and also between companies within the same sector. In a global slowdown backdrop, there will be gainers and losers. This will also get reflected in stock performances. Stock selection has now become that much more crucial.
Waiting for the FIIs?
Isn’t everyone waiting for FII inflows to start back in? True, FII inflows are crucial. But there are not going to be any warning bells before flow improve. The biggest surety for flows to come back in the market is strong fundamentals. Liquidity always, ultimately, flows towards an attractive asset class. It is fundamentals that drive liquidity and not the other way round.
In the past 25 years, whenever there was a crisis, money flowed away from emerging markets and back into the Western financial system due to ‘risk aversion’. But, this was always in the context of a structurally strong U.S and Western world. Things have changed now. Once the global financial crisis settles down, we think we can see renewed interest in the structural stories of Asia and India in particular. The entire concept of ‘Risk Aversion’ we think will get redefined over the coming few years.
Don’t time the markets
At Lotus India, we strongly recommend investors not to attempt market timing and engage in bottom fishing. The truth is that no one can time the markets. The ideal thing to do is to invest with a longer term horizon when the fundamentals and valuation are attractive. Whether markets correct further from here or not is not relevant. When you look back three years later, it will not matter whether one invested at 10,000 index or 8,500 index or 12,000 index.
Lotus India’s Philosophy and Strategy
At Lotus India, we have always emphasized on a balance between ‘risk’ and ‘return’, for delivering a consistent and dependable performance. Our investment process and team work are geared towards disciplined stock selection.
We continue to maintain the normal level of cash balances i.e. 5-10% in our portfolios. We believe that playing with cash levels is a risky strategy. Response to emerging situations has to come through suitable changes in stock selection and portfolio construction strategies in a fully invested portfolio.
During the past couple of months we have reviewed our portfolio and we are investing mainly in the following kinds of companies:
· companies which are already fully funded in terms of their growth plans
· companies which have pricing power
· companies where expectations are realistic and are there no exagerations
· companies where valuations have corrected significantly without a significant change in business fundamentals.
We are overweight the Banking, Oil Marketing, Telecom, Engineering, FMCG and Media sectors. We are underweight IT services, Metals, Real Estate and Pharma sectors. In the last 2 months we have increased allocation to our theme ‘Beneficiaries of Global slowdown’ in comparison with our other themes of ‘Consumerism’ and ‘Investment’.
Advice for investors
At Lotus India, we look upon the current state in the Indian equity markets as a serious opportunity for disciplined equity investors. This surely will turn out to be an exceptional opportunity for investing in Indian equities.
A few simple rules to follow
- Have confidence in the India growth story
- Look upon the current times as an opportunity
- Do not time the markets
- Invest for the long term – at least 2-3 years
regards,
Tridib Pathak
Chief Investment Officer - Equity
Lotus India Asset Management Co Pvt Ltd
(A JV between Fullerton Fund Management Group and Sabre Capital Worldwide)
