The essence of value investing is to invest when valuations are cheap and in favour. It is a fairly straight forward to buy cheap and hold for long years as valuations gradually trend up. But what must investors do when markets become expensive? An investor must know how to exercise discipline during both over-valued and under-valued phases. While ‘buy and hold’ is the only proven way to creating long-term wealth, investment choices matter. This is true especially when too much money chases performance in bull markets and performing stocks are in scarcity.
The current state of our equity market brings back memories of the years 2000 and 2008, where the bull run suddenly took a tailspin. In both the years, like it appears now, there was widespread consensus among investors on valuations. Herd mentality among investors led to scarcity in stocks. This drove up valuations swiftly, further fuelling herd mentality. This virtuous cycle finally went bust.
Back in 2000, investors were liberal in valuing companies belonging to select themes like information technology (IT). We had a situation where the IT blue chips traded at 3-digit price-to-earning (PE). Investors wanted to own ‘tech’ and chased the price upward. This created a scarcity of shares. People sold blue chips in other sectors like Hindustan Unilever Ltd, Britannia Industries Ltd and GSK Consumer Healthcare Ltd to buy stocks such as Satyam Computer Services Ltd. The scarcity drove up tech stock valuations and in 2000, the blue chip tech stocks traded at multiples of up to four times those of other sectors.
The year 2008 saw a repeat of 2000. This time, the excesses happened in infra and power. Companies with limited track record took on business risks way beyond their capabilities. They borrowed huge sums of money. The accounting wasn’t great and the market valuation went too high. Companies needed huge sums of capital to execute their projects and needed to raise equity. Most companies ended up borrowing and then missing out on raising equity. Companies could not execute their big plans and ran up losses. Investors ended up losing 90% of their money in mid-sized infra companies.
The post-election euphoria of 2014 was principally led by large-caps. Investments from foreign institutional investors (FIIs) were in exchange-traded funds (ETFs) and domestic mutual funds (MFs)—mostly large-cap funds. The index hit a new high in 2015 only to reach the lows of February 2016. Market expectations ran ahead of the economic recovery, resulting in sell-offs by savvy FIIs.
But the same can’t be said of the entire market. After the election results of 2014, mid-caps were favoured as they benefited from falling commodity prices during the 2014-16 period. Investors started to sell large-caps and focus on mid-caps. High net-worth individuals were already deeply entrenched in mid-caps. When MFs raised big money in this category during 2015, mid-cap valuations began to climb swiftly. By end of 2015, mid-caps had outperformed large-caps. Valuations raced ahead of earnings. A situation arose where large-cap valuations were much lower than the mid-cap valuations.
In 2016, the economic recovery remains slow, with talks of green shoots doing the rounds for quite a while. Large and the well-known names in industry are struggling to grow earnings at 15-20% per annum. Except a handful, most large companies have not been able to meet estimate forecasts. And, there is hardly any immediate scope for sustained earnings upgrades in the near to medium term, in front rung large-cap stocks.
Yet, investor appetite for equity is at full throttle with the belief that economic recovery is round the corner. Retail investors are chasing stocks and equity MFs’ assets under management are swelling. In this scenario of ordinary returns, capital is desperately chasing ideas. Fund managers and portfolio managers are under compulsion to deploy money. Given their compulsion, investors prefer to invest only in stocks with strong earnings visibility. The small- and mid-caps have captured the lion’s share of MF inflows, further fuelling a boom in them. Naturally, investors continue to hold on to overvalued stocks. They are unwilling to sell them.
Their logic is that the scarcity won’t go away anytime soon. This has made the herd mentality worse. Everybody either owns the same set of stocks or is buying them. These stocks are already consolidated in strong hands. As more people chase them, their valuations will rise further. Today, several mid-cap stocks are selling at PE multiples twice that of the Nifty. Scarcity, clearly, is to blame for the prevailing investor biases and this will definitely hurt long-term wealth creation. But, in every previous market cycle, nobody could predict the end of the scarcity. All we know is that when the herd mentality was at its peak, scarcity ended quickly. Why? Because scarcity is merely an outcome of consensus. And consensus is a fickle thing. When the consensus is shaken, the scarcity will vanish.
Scarcity in one category or theme has never sustained beyond 1 or 2 years. Yet, the herd mentality has made investors repeatedly pour capital into one sector over short periods of time. Only a few rare investors know the cost of being the part of a herd. The consensus in the market is scary and absolute. Finding contrarians is rare. The scene is set for a swift and sudden reset of valuations. The only way to keep our investing safe and sane is to adhere to the principles of value.
Value investing ensures disciplined, long-term wealth creation. While showing conviction to hold on to equity for very long years, an investor must also ensure that her investment book is structurally sound and aligned to valuations. When markets get overheated, an investors must reallocate capital from overvalued parts to undervalued parts. It is important to note that pharma and FMCG stocks traded at the decade’s lows in 2008, even as power and infra stocks traded at high valuations. Now, large-caps are more attractively valued than micro-caps, small-caps and mid-caps. A long-term investor must ensure that she allocates money sensibly. The conservative way is to re-balance investments. This will ensure that the buy-and-hold strategy works in the long term. Importantly, it is time to actively apply value-investing principles to ensure that the investment choices are right and our conviction delivers.