Value investing, I believe, is one of the best long-term ways to invest in any asset class -be it equities, fixed income or real estate. Seth Klarman, one of the most famous fund managers in the United States, who runs a Boston-based money management firm named `Baupost’, had once famously said: “Value investing is at its core is the marriage of a contrarian streak and a calculator.” The idea for this column arose from the aforementioned quote. Very often, layman investors think that contrarian investing means buying something cheap. But as Klarman says, the right way to be a contrarian investor is to carry your calculator all along with you.
The good thing is contrarian investing can be implemented across asset classes. At some point in time, it can be in equity, debt or real estate. In a rare situation, when all the asset classes are doing well, gold is considered the best bet (as in 2007) as the yellow metal becomes a contra asset of all other asset classes.
In order to zero in on a contrarian, one can use several parameters. When it comes to equity one can consider PE, PB, market-cap to GDP and comparison with 10-year yield. When it comes to real estate, the parameter to look at is the gap between mortgage interest rates and rental yield. Lower the gap, better it is as this suggests that real estate has become attractive. The case in point here is: From 2009 to 2014, the rental yield in America was much lower than the mortgage interest rate, suggesting that real estate had become a contrarian asset class. Now, in the current situation, among all the asset classes, the most contrarian asset class seems to be fixed income.
It is often thought that a hawkish RBI is bad for debt market and vice versa. However, history points to the fact that a hawkish RBI keeps the debt space lively given that the target is to lower inflation. On the other hand, a dovish RBI means near term easing, but with an inherent risk of spike in inflation thereby leading to a short rate cycle. Given that the RBI has been dovish in October and November 2016, which meant that there was always a fear that the fixed income cycle was in its final stages. But now, with a more hawkish RBI, the fixed income cycle looks to have extended. The current upmove in yields, along with change in investor sentiments, has taken us back to a mid-cycle point in fixed income cycle.
The other aspect which investors most often watch very closely is the fiscal position when it comes to making fixed-income investments. The point most of the investors miss is that a fiscal policy which is countercyclical is never bad for fixed-income markets and the government expenditure only and only substitutes low private sector activity. The Japanese economy is the best example where fiscal deficits have been high for a long time without affecting the bond yields. India is undergoing a corporate deleveraging cycle and we can afford a higher fiscal deficit at this point of time. The fact that the combined deficit of the Centre and the state government has not gone up only makes the case of fixed income stronger.
In the past, Richard Koo, the chief economist at the Nomura Research, has very eloquently presented that no nation can have a scenario whereby people, companies and the government, all save. In India, we are going through a phase where people and companies, too, are saving.
What this means is that fiscal deficit is not a very good indicator for what is going to happen in the fixed-income market. In a deleveraging cycle, fiscal deficit does not play a role of increasing 10-year yields. So, the link between fiscal deficit and 10-year yield is valid only in a scenario where private sector capex and people are aggressively investing in physical assets. However, we are not in any such situation currently , which is why we think we are in a very attractive phase for fixed income.
With RBI’s inflation target moving lower to 4%, the real yield offered to fixed income investors has gone up. If we compare the real yields as the difference between 10-year yield and the medium-term inflation target of the Reserve Bank, the current markets offer a real yield of almost 3%, which is one of the highest offered by the markets in this cycle. Even if we compare this real yields against the real yields offered in other parts of the world, barring Brazil and Russia (both are cyclical commodity economies) no other fixed income market offers a better real yield. Even the real yield on US 10 year is only 50 bps. If the US real rates were to go up further, it may not necessarily translate into higher real yields for India, as well.
From an equity fund manager’s view point, 91-day Treasury bill yield is equivalent to a large cap. As on date, the 91-day T-bill yield has come down to 5.90% which is much lower than the policy rate even in a month like March. On the other hand, a product like 10-year State Development Loan (SDL) trades at 7.8% which is much higher than the 91-day T bill.
In effect, we have all the factors which make debt a contrarian investment attractive valuation, negative sentiment and an investment scenario where private sector capex, credit growth are all low. This simply indicates that the time is now to invest in debt as the outlook looks attractive.