Indian stocks: Paradise for value investors

August 30, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The BSE Sensex romance with the 16,000 level seems to have been rekindled, with the Sensex closing below it on August 26, after a gap of more than 18 months during which it touched a high of 21,109 (missing the all-time high of 21,207 by a whisker).

As is the case, when a key sentimental support level is broken, most experts on business TV channels (a strong contrarian indicator) started giving short calls on the market the moment 16,000 was broken. Why is the level so important? What does it mean for the near-term outlook for markets? What should the investors do now? These are some of the questions that must be roiling the mind of every equity investor in India.

For starters, the Sensex closing at 15,848 on Friday is the lowest weekly close after nearly two years. This means investors who had invested in index funds made only 1.66 pct p.a. on an average in the last two years (as on Aug 26). Those in diversified equity funds fared somewhat better getting 5.4 pct p.a. in large cap funds, 9.9 pct p.a. in mid-cap funds and 9.2 pct p.a. in flexi cap funds.

Though positive, these returns are dismal as compared to what is normally expected from equities. In real (inflation adjusted) terms, equities have hardly yielded anything as WPI inflation (and I am not even talking about CPI inflation) has averaged around 9 pct p.a. over this period.

Compare this with 31 pct p.a. from gold, more than 6 pct p.a. from money market and short-term debt funds, 6.75 pct from medium-term debt funds and 6-7 pct from long-term debt funds and one can see that equities have underperformed the other asset classes significantly. Isn’t it then time for stocks to start catching up with their long-term averages (theory of mean reversion)? After all, haven’t stocks proven over time they are the best when it comes to beating inflation and creating long-term wealth? Is it then time equities start outperforming other asset classes?

While the answer to the above questions is in the affirmative, this does not mean that stocks will start rising from tomorrow, as headwinds from global and domestic fronts continue to remain strong. A confluence of global and domestic concerns had led to this sharp fall in the first place and they are yet far from over.

Threats of a double dip recession in the U.S., sovereign debt crisis in Europe spreading to much larger countries such as Italy and Spain, rating downgrade fears for France, rating downgrade of Japan (to Aa3 by Moody’s), together form a potent weapon causing uncertainty and risk aversion in financial markets. Believers in the efficient market theory would argue that this was all priced in, then why such swift retribution in equities. The fall has been even sharper in Indian equities, despite the strong domestic consumption-led India growth story.

For starters, the financial markets had priced in very slow growth in the developed world and not a recession. The reluctance of the U.S. Fed to commit itself to a third round of quantitative easing (QE3) has worsened investor sentiments even though there are strong doubts on the efficacy of such programs as is evident from the results of QE1 and QE2.

Emerging markets such as India, China and Brazil, which were earlier expected to be the engines of global growth, have their own share of problems in the form of high inflation, higher interest rates and hence slower growth. Now questions are being raised as to whether the global economy can chug along at a pace of 3-4 pct p.a. in the current environment. Empirical evidence shows that equities seldom do well in an environment when growth is decelerating or is expected to decelerate. At best they move in a range and at worst, there can be a sharp correction such as the one that we have already seen over the last month or so. Risk aversion continues to be high, but surprisingly, this time the flight to safety does not seem to be towards U.S. Treasuries. U.S. dollar is not rising as used to be the case earlier whenever the volatility indices went high. The CBOE volatility index is upwards of 30 pct, but the dollar index is still languishing at around 74 levels. Do we have a new so called ‘safe haven’? A look at the price movement in gold, Swiss franc and Japanese yen suggests so. All three of these have risen sharply ever since global equities began their most recent march down, towards the end of July.

The recent fall in Indian stocks has thus been a part of the global trend. And it is almost impossible for stocks not to get affected by the global trend in today’s globalised world where money and news move freely across borders at the click of a button. Even though the Indian economy might be largely insulated to events in U.S. and Europe, the financial markets are not, a fact that has been proved time and again.

Still we start talking about the India growth story and why and how Indian equities should buck the trend at the slightest hint of trouble abroad. And this time, India has its fair share of domestic problems too. High inflation, lack of reforms (much was expected from the monsoon session of parliament), slowing investment growth, high interest rates, slowing manufacturing and service sector growth (IIP growth has averaged slightly above 5 pct in the first quarter of 2011-12 while service sector PMI shows signs of deceleration), fears of a large fiscal deficit, deteriorating trade deficit numbers and a slowdown in overseas flows, have all contributed to a decline in investor confidence.

Having said that, do we fear a recession in India? Unlikely to the extent that you can almost rule it out. However, recession fears in the developed world can continue to haunt India in the manner they have done of late, as equities get de-rated, exports turn sluggish, overseas flows just about manage to finance our current account deficit, thereby putting pressure on the currency, and so on and so forth. For India, the most conducive global environment at this juncture would be a muddle through global economy with developed world growth between 2-3 pct, low commodity prices and low real interest rates in the developed world. It is however tough to see all these happening together in the near term. Even if the developed countries such as U.S. and Europe were to try and revive their economies by doses of quantitative easing, the same will raise commodity prices too, which is again bad for India as its inflation will get out of control (as seen during QE2).

We have already seen high inflation forcing down the level of financial savings in Indian households to less than 10 pct of GDP, in 2010-11. Hence, even though we can boast of a savings rate of more than 30 pct, this can very soon decline if inflation were not controlled immediately. RBI might thus be quite right in adopting a hawkish stance even when growth is slowing down.

Summing up the outlook for Indian equities, the macro picture and sentiments remain very weak in the near term, the latter more so after the Sensex closed below 16,000 levels on Aug 26. Solace can be drawn from the fact that perceived risk continues to remain very high whereas actual risk (the risk of equity prices falling by a large quantum from here on) remains relatively low because of attractive valuations in some pockets. A ray of hope has also emerged from the withdrawal of Anna Hazare’s fast. This should enable parliament to take up some of the critical reform bills that were supposed to be taken up during the ongoing monsoon session. Aggressive policy action and a strong boost to infrastructure investments can provide the much needed kicker to growth, which should then be taken as a positive by markets. RBI policy also remains an overhang for the markets and a dovish tone or a pause in rate hikes on September 16, 2011 should help soothe sentiments — though I have seldom seen equity markets in a bull run when rates are being cut (as rate cuts are a decisive admission of slowing growth).

Looking at the micro environment, it seems that a lot of the negatives are already priced in in certain pockets such as midcap stocks in the infrastructure and banking space, though the same cannot necessarily be said about the large cap names in these sectors. Midcap stocks in sectors such as cement, road, port and power infrastructure, construction, banking, etc. are trading at throwaway prices. Of course, there are corporate governance issues with some of these companies, but for a bulk of them the main concern is policy inaction and higher interest rates. As interest rates peak (they might already have) and some strong policy action is seen in the near term (a distinct possibility) these stocks might present a very attractive investment opportunity.

These markets are a value investors’ paradise. For the first time in the last two years, the average one year forward PE level for the Sensex has come down to the attractive zone (13-14 times). In some sectors such as infrastructure, metals, oil & gas, materials and mid cap IT, it is even lower. As and when the situation stabilises and growth seems to have bottomed out (it cannot decelerate forever and we know stock markets have a knack of anticipating turnarounds before others), these stocks and sectors should get re-rated significantly.

The ideal allocation for equity investors should hence be as follows —

1.       Neutral weight on large cap funds

2.       Neutral weight on flexi cap funds

3.       Overweight on mid-cap funds

4.       Overweight on value style funds

5.       Overweight on infrastructure funds


Whereas, the investment strategy should be –

1.       Get a six month STP in equities and then hold it with a minimum 2-3 year investment horizon

2.       Invest lump sum amounts on dips below 16,000 on the Sensex, strictly with an investment horizon of 2-3 years

Technically, frontline indices such as Sensex and Nifty seem to have broken crucial support levels as they closed below 16,000 and 4,800 levels respectively. This is likely to result in most of the long positions being wound up and fresh short positions being built, signifying intense fear and to some extent a panic.

TIME TO BUY and HOLD with a 2-3 year investment horizon.

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