Even the best of blue chips can let you down badly in the stock market. Very few people would doubt the potential of the India growth story and the fact that banks are the best proxy to play that theme. Yet the country’s biggest bank, State Bank of India, has been one of the worst performers in the basket of blue chips, read Sensex, over the past one, two, three and five years, dragged mainly by the burden of bad loans — a pitfall of the economic downturn.
You can add more names to the list — BHEL, L&T, JSPL, NTPC, Coal India, Sesa-Sterlite, Tata Power. Even Infosys proved to be a wealth destroyer till sometime back before the cross-currency headwinds helped it bounce back. It’s so bad that one is almost beginning to question the wisdom that these stocks offer relative safety.
Beyond the blue chips, there is maddening talk on the Street about how cheaply-valued midcaps are going abegging. Not to be outdone, smallcaps too are seeing a rush, with a few mutual fund houses launching special schemes to ‘capture the opportunities’ in this space.
From a business cycle perspective, a downturn in the stock market is often followed by talk of value hunt, even as purists keep looking for growth stocks, or businesses that show great earnings potential because of good earnings history and competitiveness in the industry. Value stocks are the ones that have become under-priced in spite of great fundamental strength.
There are many more themes, if you care to look around. For instance, the currency headwinds and a weak outlook for the rupee may tempt you to go for a few overseas-focussed businesses, while the public sector undertakings — many of them known for big dividends, huge cash reserves and large market shares — have a class of loyal investors who swear by them in times good or bad.
And then, there is the traditional division of cyclical — ones that peak and trough with the economic cycle — and defensive stocks – ones that are relatively immune to such hazards.
Each set of stocks presents an opportunity, and challenges too. But it’s not really about picking just one theme or the other. For, one key learning from the prolonged market downturn is that one should not stay concentrated in one basket of stocks. Instead, the idea should be to go for the right mix of all good things.
In terms of business size, the largecaps are considered steady businesses while the midcaps are high-risk, high-reward bets. Nonetheless, the midcaps have historically delivered stronger returns compared with their largecap and smallcap peers. They are in a sweet spot of a growth cycle offering great scalability of business, and are often in the thick of things in mergers and acquisitions, thus creating potential for windfall gains. They also offer direct exposure to select market trends or future growth opportunities, unlike largecap firms that have more diversified businesses and are controlled by several growth drivers in a variety of business segments.
While the average investor is generally underexposed to this segment of the market, studies show adding midcap equities can not only improve the performance of a largecap portfolio but reduce risk too.
The smallcaps, on the other hand, are the riskiest among them all; often the so-called vanishing companies are from among them. Yet over the long term, say 10 years, smallcap stocks have often emerged big winners, followed by midcap and largecap stocks. Theoretically, the lower the market capitalisation of a stock, the higher is its volatility. Yet, adding riskier assets to a portfolio can actually lessen the overall risk and/or increase the overall return.
Says Chandresh Nigam, MD & CEO of Axis Mutual Fund, which recently launched a smallcap fund: “Selective smallcaps have historically outperformed the largecaps over a long period. We believe the lower correlation of smallcap stocks with the bellwether index brings the desired diversification in an investor’s equity portfolio. The valuation gap between smallcaps and mid/largecaps has widened over the last few years and this presents us with an opportunity to pick quality businesses operating in niche markets with healthy balance sheets at lower prices.”
The three baskets tend to perform very differently in different phases of an economic cycle and it’s not possible to know when the market will favour which segment. Also, there are times when a certain marketcap category may look particularly attractive.
Marketcap diversification in a portfolio has its own virtues, allowing you to capture the strong performance of one category to offset the decline in another, and thus, achieve a certain steadiness in performance in times good or bad. Yet, there is no set pattern to achieve the right mix of them all. It would largely depend on one’s risk tolerance, goals and circumstances.
A traditional asset allocation model would suggest higher share to the largecaps and smaller shares to midcap and smallcap stocks, but more aggressive investors – ones who can withstand volatility, afford to take a higher risk for higher return and, more importantly, wait a little longer — may change the mix and make larger allocations to midcaps and smallcaps. Investors with a shorter time horizon and those looking for less volatile stock returns will do well to have larger allocations to the largecaps.
Says Prashant Sharma, chief investment officer of Max Life Insurance: “Having the right mix is a function of the investor’s/fund manager’s risk appetite and investment objective. One could take a broadbased benchmark as the base and add stocks as per one’s outlook and analysis.”
Playing on the business cycle has its pitfalls. While cyclical stocks gyrate with the ups and downs of an economic cycle, the defensives may lose their power to defend when the downturn gets prolonged, as evidenced in the Indian market in recent times. The dilemma is best reflected in two separate reports released by brokerages Kotak Securities and Nomura recently.
“Most of the defensive stocks are richly valued now, whereas the ones with low valuations do not have adequate growth visibility,” said Kotak. “Within the beaten-down ‘domestically-oriented’ and ‘investment-led’ sectors, one can look at stocks having attractive valuations, strong balance sheets and ethical management. Further, core sector reforms will lead to an improvement in the fundamentals of these sectors,” it said.
Nomura’s Prabhat Awashti, Nipun Prem and Sanjay Kadam said they remained cautious on the domestic growth cyclicals, which are geared to the industrial cycle (driven by capex) rather than to the agricultural cycle. “For growth to be meaningful and sustainable, it has to be driven by investment demand. A near-term uptick because of the higher farm output this year is positive for growth, but it is for the consumption variety with limited multiplier effects,” they said.
There is no alternative to understanding the business cycle and the current headwinds of the economy to achieve the right balance. An understanding of the macro-economic forces at play is also crucial in choosing between export-oriented businesses and domestic players. What makes the task tougher are the currency hedges that companies use to guard themselves against such fluctuations, thus nullifying the impact on either side.
Says Prashant Sharma of Max Life, “If one is positive on infrastructure pickup and investor sentiments, one can pick up more cyclical stocks. However, if one is more guarded, give a higher weightage to defensive stocks. Currently, the way valuations stand, we feel a higher weightage to the cyclical stocks could earn better returns.”
As for export-oriented sectors, one can pick them if the bet is that the rupee would depreciate further, he says, pointing out that there are export-oriented themes other than the traditional pharma and IT sectors.
Value stocks hunters try to play on valuation dispersions within the same sector or market-cap segment, which can happen due to earnings upsides through incrementally higher capacity utilisation, growth process hitting a cyclical low, a temporary factor like currency volatility or simply because some stocks are not getting adequately noticed by investors. In contrast, growth stocks are said to have above-average earnings potential and strong competitiveness in their industries. In both cases, the fundamentals of the economy play a key role.
“Value investing, one of the most popular investment themes globally, is a far bigger theme than any other opportunity in India in the prevailing market situation,” says Nimesh Shah, MD & CEO of ICICI Prudential Asset Management, which has launched two value funds in the recent weeks. Shah says using the value strategy in the current scenario makes a compelling sense, because the domestic challenges, the most compelling one of which is continuation of the reforms process, will crystalise after the 2014 Union elections.
Some analysts say a mix of both growth and value stocks makes good sense, as each type tends to lead the stock market in different market cycles.
The PSU vs private sector comparison is generally titled in favour of the latter because of their management efficiencies. Yet, some investors find relative safety in PSUs, as they are less prone to structural problems. The government’s policies for certain sectors and its rush to sell stakes in many PSUs in adverse times resulted in sharp erosion in valuations of select PSU firms in recent times and, thus, investor interest in them.
According to Max Life's Sharma, some PSU companies have huge inherent strengths. “It’s not possible to make generalisations, but private enterprises generally tend to be more efficient. Having said that, on a company-to-company basis, some PSUs could be superior to private firms in the same space due to their first-mover advantage, monoplies and comparable efficiencies.”
Raamdeo Agrawal, joint managing director of Motilal Oswal Financial Services, says this is the best time to restructure a portfolio, as the market is not overvalued. “There is some comfort that many investors are drawn to midcaps rather than largecaps, but the absence of local participants is disappointing.”
Motilal Oswal likes ING Vysya Bank, Aurobindo Pharma, UPL, PI Industries and KSB Pumps in the midcap basket. Its top largecap picks are ITC, Infosys, HDFC Bank, NTPC, Wipro, L&T, Hindustan Zinc, NMDC, Maruti Suzuki, Hero Motocorp, Dr Reddy's Labs, Adani Port &
SEZ and Glenmark.
Hemant Kanawala, chief investment officer of Kotak Old Mutual Life Insurance, doesn’t favour the midcap stocks at this stage. “These stocks have strong correlation with GDP growth and interest rates and currently both the factors are acting against investing in these stocks. Although there are many interesting opportunities in this space, the time horizon will have to be slightly longer to get desired returns from these investments," he feels. He advises retail investors to focus on companies that are leaders in their sectors and have strong cash flows to support their growth.
Source : mydigitalfc.com