The Five Lessons of 2018

Markets closed out 2018 in a burst of volatility, capping a year of several yo-yos. Equity and debt markets had a tumultuous 2018, which served to drive home certain basics. Here they are.

 

1. Midcaps and smallcaps are risky

2018 showcased a fact that had been brushed under the carpet for years – that midcap and smallcaps are risky and are not meant for those who cannot handle steep falls. The year reinforced the norm that when markets are in a correction mode smaller stocks tend fall more than their larger counterparts.

In the 2014-2017 period, midcap and smallcap stocks seemed infallible. Consider 2016 – markets across the globe corrected from the second half of 2015. Within the first two months of 2016, the Nifty Midcap 100 lost 15% and the Nifty Smallcap 100 dropped 24%. Midcap and smallcap funds lost 17% on an average. But while sharp, the fall was short-lived. March to October 2016 saw the two indices gain 35% and 44% respectively. Funds in this space rose 35% on an average. This behaviour repeated in 2017. The real pain of a correction was not felt.

But in 2018, the midcap and smallcap segment fell and stayed down. January was the peak and the two representative indices corrected steadily right through the year. There was no bounce back, even as the Nifty 50 and Sensex alternately rallied and corrected throughout 2018. The Nifty Midcap 100 is down 18% from its January peak while the Nifty Smallcap 100 lost 33%. On a weekly rolling basis, both indices have clocked more weekly losses than they have weekly gains in 2018. This has not been the case in the 2013-2017 period. The fall saw the high 2017 returns completely wiped out.

                               

But here’s the good news: while midcap and smallcap funds fell, most have managed better than the indices. On an average, midcap and smallcap funds lost about 3 and 10 percentage points less than the benchmark in 2018. Funds such as Franklin India Prima, Invesco India Midcap, HDFC Midcap Opportunities, Axis Midcap, HDFC Smallcap, Reliance Smallcap, and Franklin India Smaller Companies all showed good ability to limit downsides in the correction.

2. Equity is not for the short term

Volatility made a comeback in 2018; deviation in 1-month rolling returns of the Nifty 50 this year are over 1.5 times more than in 2017. Measured by this metric, volatility in 2018 was higher than years such as 2014 and 2016 as well. The Nifty 50 and the Sensex were strong in January, corrected for the next two months, rose until September, crashed spectacularly over the next two months and were volatile for the rest of the year.

Equity market behaviour was also unpredictable. A recent example is the market reaction to the December resignation of the RBI governor, which coincided with shock state election results. Markets spent one day correcting and bounced back almost immediately, contrary to all expectations. Similarly, factors such as oil prices and the rupee fluctuated right through the year, influencing equity markets in their wake. Finally, global markets were also unpredictable and volatile.

Volatility apart, 2018 showed that short-term is not good for equity especially after a year like 2017. Of the BSE 500 index, 75% of the stocks have ended the year on a loss. Equity funds faltered in 2018 in consequence across all categories. A 1-year or even a 2-year period is not enough for equity investing. Investors who got into the market in 2017 would have seen their gains reversed by the end of 2018. Getting into short-term predictions on where markets will be headed, whether markets are at a low or a high, whether this is a good time to invest or not, would all have been an exercise in futility.

Keeping a 5-year and above horizon for equity is always preferable, and tagging important near-term goals to equity is a strict no.

3. Hybrid aggressive funds are not infallible

Not just pure equity – 2018 reminded markets that hybrid aggressive funds can also fall. These funds are still equity oriented and a steep market wide correction will pull down returns in the short term. Remember that these funds do move across market capitalisations on the equity side and a midcap fall would hurt returns even as these funds shifted to the largecap segment.

While the debt component provides a balance, it would not have been enough to compensate entirely for an equity fall. Funds also tend towards longer-term accrual on their debt side and yield fluctuations hurt too. Therefore, while hybrid aggressive funds are far less volatile than equity and contain downsides much better, they are still liable to fall in a 1-year period if there is a sustained equity market correction. These funds require a 3-year holding period to deliver.

                                   

Those depending on regular dividends from these funds would also have learnt a lesson in 2018. In correcting markets, surpluses are hard to come by. Funds may have also been using the dips to accumulate stocks at cheaper prices. Some funds which were paying monthly dividends skipped a couple of months. Other funds may have kept up their quarterly/monthly dividend payments, but the amount was much reduced.

Should markets continue to correct, dividends could further be affected. Therefore, depending on equity-oriented funds for regular cashflows would not be wise.

4. Higher debt returns don’t come without risk

In other words, do not chase higher debt fund returns without understanding the risk. The failure of an institution such as IL&FS and a credit downgrade from the top rating to default in a matter of days is a one-off event. Downgrades do not always result in default. What the episode did show is the effect of credit risk and rating downgrades on debt fund returns. A drop in a paper’s credit rating results in a revaluation of the market value of the paper, consequently influencing fund returns.

Two, it shows that higher portfolio yields and returns can come about only in the face of higher risk. Where fund yields or fund returns seem higher than peers or the average, this is usually because some level of credit risk has been taken in the portfolio. For example, consider Indiabulls Short Term, which has among the best 1-year returns of 7.4% and a November portfolio yield of 11.7%. About 56% of its November portfolio is in papers rated below AA+, which defines higher credit risk. In contrast, Kotak Short Term Bond, whose 1-year returns are 6.3% and YTM is at 8.7% holds no paper below AA+. Therefore, while one fund may look like it is lagging on returns, it could be because it is less risky. This holds for hybrid conservative funds too.

Three, it spotlighted concentration risks in debt funds. Adverse rating actions have a bigger impact on concentrated portfolios than more diffused ones. Invesco India Credit Risk, for example, suffered a good deal more from the IL&FS fallout than a fund like Aditya Birla Sun Life Credit Risk fund. The Invesco fund had a much higher exposure to the IL&FS group papers than the ABSL fund, and therefore saw a steeper NAV fall post the downgrades. The 1-day fall in NAV after the first downgrade was 0.03% for the ABSL fund and 0.39% for the Invesco fund. NAV drops after the second downgrade were similarly much higher.

A larger fund size also helps, especially in the liquid and ultra short duration categories. A pull out by institutional investors can leave the fund vulnerable while additionally making it harder to meet redemption requirements.

Therefore, where there is no ability to see a drop no matter what the holding period, it is always best to stick to funds that do not take risks.

5. Debt can be volatile too

Debt funds follow either an accrual strategy or combine it with a duration strategy (like dynamic bond funds) when the interest rate cycle throws up opportunities. However, 2018 (in conjunction with 2017) showed that the interest rate cycle can get unpredictable and yield movements can be volatile.

Going into 2018, markets had been building in rate hikes. The Reserve Bank followed through with two hikes. Gilt yields were falling, dropping to 7.12% by around April. Then crude oil prices spiralled, rate hikes in the US continued, the rupee depreciated, and inflation remained. Gilt yields were rising. Then there was a liquidity crunch in the wake of IL&FS. Gilt yields hit the 8% mark and moved lower later on. The end of 2018 was a reversal of the start, with rate cut expectations now being built in with inflation staying low. The graph below shows the movement of the Nifty 10-year Gilt index over 2018, which is influenced by gilt yield changes.

Volatility in debt cannot be ruled out. Betting on rate cycle directions and a duration strategy can backfire. Sticking to an accrual strategy is a better option, especially for the risk averse.

What should you do?

The lessons are not new. 2018 just reinforced them. The steps you need to take are not new, either:

1. Stick to an asset-allocated and category-allocated strategy. This will ensure that you are in line with the level of risk you can and you need to take, based on your goals. It will also ensure that you haven’t gone overboard on some funds – like midcaps, for example.
2. Maintain a long-term view when it comes to equity. Each year, markets find different reasons to move. There will always be bad news and good news. Over time, though, short-term moves get ironed out. Keep return expectations realistic. A 12% CAGR over a 20-year period in equity is the same as buying a piece of land for Rs 20 lakh and selling it for Rs 2 crore.
3. Stick to your SIPs. Don’t lose faith. SIPs cannot give you high returns if the market corrects. What SIPs do is to ensure you are not influenced by short-term movements and invest across market cycles. This will allow you to catch market downs as well as ups and keeps your savings on track.
4. Don’t be afraid of debt funds. credit events like the ones in 2018 are extremely unlikely to repeat. Debt funds always hold the potential to beat FDs and are more tax-efficient. Be aware of the risks in the fund you hold, and stick to the safer options. If you cannot handle volatility of long-term debt funds, stay with short-term high-quality accrual funds.
5. Keep a mix of funds in your portfolio. Not just in terms of different asset classes or categories, but in fund strategies too. This will ensure that if one strategy takes time to deliver, another will prop up returns in the meantime.

It is rare that equity and debt markets both do poorly at the same time. 2018 was a good year to bring markets back to earth and help understand the risks in investing. So, don’t get discouraged by the 2018 market and think long term. Cut out the noise and stay invested!

MORE WILL UPDATE SOON!!

20 Nifty stocks fell 15-60% in 2018; Should you invest in beaten-down names?

Beaten-down stocks make for an interesting investment case, but the challenge is to figure out whether the underperformance is temporary or structural in nature.

Investors are always on a lookout for stocks that could give quick returns and are also available at fair valuations. The year 2018 was not a good one in that sense - while returns from benchmark indices were merely in single digits, many quality stocks corrected in double digits.

Nifty50 recorded gains of little over 3 percent in 2018, while nearly 60 percent of the index components gave negative returns.

So, are all the stocks that have seen a double-digit cut in 2018 attractively valued? Well, that might not be the case always, suggest experts. It does make a good investment case, especially if they are Nifty50 companies, but investors should also study the reason why the stocks fell in the first place, they say.

Beaten-down stocks make for an interesting investment case, but the challenge is to figure out whether the underperformance is temporary or structural in nature. Heavily beaten-down stocks have major structural challenges like Tata Motors which is seeing a major global slowdown.

However, if the challenges are internal and the management has the capability and ability to resolve the issues then the stock will make for an investment case. Sun Pharma is one such case and it presents with a good investment case.

Kulkarni further added that in 2019 some beaten-down stocks like Yes Bank and Sun Pharma could perform well if they are able to resolve the internal issues, but if the challenges are structural in nature like in case of Tata Motors and Tata Steel then the time is not ripe for these stocks.

Out of Nifty 50 stocks, 20 counters fell 20-60 percent in 2018, which includes Tata Motors, Yes Bank, Bharti Airtel, HPCL, Vedanta, and BPCL.

The S&P BSE Largecap index recorded gains of over 1 percent as compared to small & midcap indices which fell by 13 percent and 23 percent, respectively, in 2018.

The first rule of investing is to look at the earnings growth of the company. The divergence between good quality growth-orient companies and value stocks is still very high. Most experts advise investors to stay with quality names or largecaps as volatility could rise ahead of general elections.

Largecaps might not give multibagger returns, but they play a crucial part in protecting your capital in case momentum starts heading south.

We expect volatility to be high in the first half of CY19. Hence, it will be ideal to stay invested only in good names where one is confident of any earnings improvement or business cycle changing in FY20 (at least till election results come through).

We would not suggest an across-the-board investment in beaten-down stocks. We would recommend investing in only a few names like Tata Motors, oil & gas companies, and select names like Eicher Motors where valuations have become reasonable.

Oza further added that one should avoid getting into beaten-down companies which have issues beyond fundamentals, like corporate governance or bleak sector outlook. Post-election results, if we see either a BJP/Congress-led coalition government then one can get into select beaten-down largecaps.

MORE WILL UPDATE SOON!!

Bank of Baroda-Dena, Vijaya Bank merger: Brokerages say time to ‘buy’

The swap ratio appears fair in respect to Dena Bank owing to the multiple challenges faced by the bank, and most experts feel that Vijaya Bank shareholders have nothing to gain from this merger.

  

Most global as well as domestic brokerage firms such as Nomura, Motilal Oswal as well as Kotak Institutional Equities maintain their buy or add rating on Bank of Baroda after the share swap ratios were announced for a merger with Dena and Vijaya Bank.

Shareholders of Dena Bank will receive 110 equity shares of BoB for every 1,000 shares they hold. Vijaya Bank shareholders will get 402 equity shares of BoB for every 1,000 shares they hold. The swap ratio clearly seems to be in favor of BoB shareholders, suggest experts.

The next big questions is – should one buy Bank of Baroda now? Well, analysts at top brokerage firms maintain their positive stance on the stocks after the swap ratio announcement.

"BoB’s board has decided on the merger ratio for the amalgamation of Dena Bank and Vijaya Bank, implying a 6-27 percent discount to the current prices of Dena/Vijaya Bank and 18-43 percent lower than BOB’s Sep-18 valuation. We believe this is fair for BOB’s shareholders given BOB’s superior franchise and NPA coverage position.

The merger will be ~4% book-accretive (increase the book value) to BOB and ~4% earnings-dilutive. BOB trades at 0.65x Sep-20F book on an adjusted basis, which we believe is undemanding, hence maintain our Buy rating. We prefer corporate banks of the India financials, with Axis/ICICI, but remain positive on SBI/BOB.

The swap ratio appears fair in respect to Dena Bank owing to the multiple challenges faced by the bank, and most experts feel that Vijaya Bank shareholders have nothing to gain from this merger.

But, for Bank of Baroda, the merger will lead to the creation of the third largest lender in India, with an advances and deposits market share of 6.9 percent and 7.4 percent, respectively.

The retail book of the merged entity will increase to 20 percent of total loans (16% for BoB standalone) due to a higher retail book of Vijaya Bank. The combined entity will have a CASA mix of 33.6 percent, with a Credit-deposit ratio of 70.7 percent (71.4% for BOB standalone). Post-merger, the number of PSBs will reduce to 19 from 21 now, said a report.

While the process of merging multiple entities will present its own set of challenges in the near term, BOB stands to benefit over the long term, in our view.

We will look to revise our estimates on attaining more clarity on the growth and earnings trajectory. We maintain our Buy rating with an unchanged target price of INR140 (1x Sep-20E ABV).

Kotak Institutional Equities in a note said that the focus now shifts to actual integration from financials. It maintains an ‘ADD’ rating with fair value unchanged at Rs 130 for Bank of Baroda.

The challenges of integration of IT systems, employee satisfaction, branch rationalization, client experiences at the time of merger are issues that are hard to model.

Even though most brokerage firms see the merger as a positive step for Bank of Baroda, two global brokerage firms namely -- Morgan Stanley and JPMorgan maintain their Underweight or Neutral rating on the stock.

Morgan Stanley maintained its underweight rating on Bank of Baroda with a target price of Rs 95. The global investment bank expects 30 percent dilution for BoB and trailing BVPS accretion or book value of equity per share of around 15 percent. It expects BoB to see material moderation in credit costs.

JPMorgan maintained its Neutral rating on Bank of Baroda with a target price of Rs 100. The global investment bank is of the view that the merger swap ratio alleviates pricing concerns.

Merger synergies will take a long time to play out, and it is of the view that the next round of PSB mergers is likely to follow only post-elections.

MORE WILL UPDATE SOON!!

Positive on corporate banks, cement and consumption themes in 2019:

Investors should continue to focus on stock selection and overlook the clamour that we would hear over the next 6 months, as we approach the general election.

India is in the midst of a structurally high growth phase and remains the fastest growing economy in the world with IMF projecting 7.3 percent and 7.5 percent GDP growth rates for FY19 and FY20, respectively.

However, 2019 will be earmarked with uncertainties pertaining global as well as domestic factors. There would be two different and powerful developments that are expected to influence the world markets, viz. a)return to pre-crisis normalcy in the global monetary system and b) an uncomfortable new normal in international politics and global relations.

The withdrawal of monetary stimulus coupled with a rate rise in the US conspicuously left the markets more vulnerable to the political shock of escalating international trade war, in particular.

We expect the global expansion to continue in 2019 despite risks emanating from politics and international relationships, as the economic expansion outside the US would provide the necessary fillip to world economic growth.

The market performance in 2018 was a contrast to 2017 with most of the equity markets falling hitherto, while on the flip side, 2017 had seen a steep rise.

Although volatility will rule the roost, we do expect 2019 to be a good year of performance for equities. The pace of monetary policy normalisation in the US is slated to slow down, as the positive impact of fiscal stimulus on economic growth starts waning away.

This should culminate in dollar weakness in 2019, which will, in turn, bode well for emerging markets (EMs). The trend of ~15 percent divergence between the performance of developed and emerging markets since the inception of the year should perhaps reverse in 2019.

With respect to India, the benefits of implementation of several structural reforms such as introduction of Goods & Services Tax (GST), Insolvency & Bankruptcy code (IBC), RERA, JAM (Jan Dhan, Aadhar, Mobility) have started to manifest in the growth numbers and will aid in removing inefficiencies from the economy and formalising the same.

Corporate earnings have started picking up after a lag of 4-5 years. Albeit, the net profit (PAT) growth in Q2FY19 was at a mere 10 percent, the revenue growth was at a multi-quarter high.

The PAT growth was essentially impacted by higher input costs (crude linked, metals, etc.) which ideally should reverse going forward, as most of these prices have eased.

For FY20, we expect to see high teens earnings growth led by normalisation of the earnings for the banking stocks, a surge in infrastructure related CAPEX and consumption ahead of general elections.

On the valuations front, while the Nifty looks optically at an elevated level, it is only a handful of stocks that are holding the Nifty. Post the recent correction, the excessive valuations, especially in midcaps and smallcaps have also settled down.

The market has reverted to near long-term averages, which makes them attractive. While we are cognizant of the near-term events such as elections, which could inject a bout of volatility, we believe it will not have any material impact over the longer run, irrespective of the result.

We believe the volatility in the markets over the next few months will provide a good opportunity to build a quality portfolio from the long-term standpoint, as India is firmly entrenched on the growth path.

Sectors in focus:

We remain positive on the corporate banks. We believe that we are transitioning from the asset quality recognition phase to resolution phase as testified by the initial success seen in the NCLT cases, wherein the recovery rates have been either inline or better than estimates.

Besides, incremental stress formation has reduced significantly, as reflected in the Q2FY19 results of all corporate banks. Going forward, with the normalisation of credit costs, we expect a significant turnaround in profitability and return ratios of banks.

We also have a positive view for the cement sector, as we expect the capacity utilisation for the industry to go up, which will eventually bring back the pricing power in the sector.

Furthermore, the input costs have been truncating due to fall in crude oil prices and some appreciation of INR, which should aid profitability going forward.

We remain bullish on the discretionary consumption space as most of the impeding factors such as high crude, up fronting of insurance costs, and credit squeeze due to NBFC issues, which led to a muted festive season, have now reversed.

We expect to see the continuation of the premiumisation story play out in the discretionary consumption arena.

What should be the investment philosophy of investors?

Investors should continue to focus on stock selection and overlook the clamour that we will hear over the next 6 months, as we approach the general elections.

We are a firm believer in the long-term India story due to its very large consumer base, increasing affluence and strong demographic dividend. We would advise investors to deploy capital in a systematic manner and not time the market to take advantage of this large long-term opportunity.

Compounding of capital will be more important than timing the markets. The stock prices over longer-term always follow the earnings cycle and hence that is where the focal point should be for the investors.

Staying on the course is what makes one a successful investor. If you are investing for the next five to ten years, the focus should be on the opportunity and ways to harness it.

One should align their investments as per one’s goals and risk profile and use market corrections to their advantage to invest for the long term.

MORE WILL UPDATE SOON!!

India likely to grow faster than many nations, 2019 to be year of mid and smallcaps

Investors need to be more selective then usual with their decisions by sticking to quality of earnings & corporate governance, strong financials and growth prospects.

 

2018 turned out to be the most volatile and eventful year for Indian market and economy where the benchmark indices hit an all-time high before witnessing a sell-off mainly driven by rising crude oil prices, depreciating international currencies, increasing trade protectionism, geopolitical updates, outflow by FIIs, macroeconomic data and corporate events.

But moving towards 2019, India has witnessed a huge positive change and a major boost in the economy with a sharp correction in Brent crude prices that helped in appreciation of the Indian rupee. This will further result in narrowing current account deficit, lower subsidy payout, lower risk of inflation and increased room for RBI to cut interest rate.

Politics along with economic headwinds would be a major factor influencing equity market in 2019. All eyes are focused on the general election of 2019 but after the outcome of recent state elections, it is observed that there could be volatility but not much divergence in the market.

Moreover, new reforms by the upcoming government will be the launch-pad that the markets will be looking for.

Steps taken by the government and the Reserve Bank of India (RBI) to ease rules on foreign borrowings and bonds would stabilise the rupee and rein in the current account deficit (CAD). Rising Indian inflation would be one of the most keenly watched numbers and the RBI might impose corrective measures to curb it by controlling liquidity or by increasing the interest rates.

Further, the government and RBI are in consultations over the liquidity squeeze that has gripped non-banking finance companies (NBFC). The government feels RBI opening a special liquidity window for NBFCs apart from banks, honouring credit lines already sanctioned to them will help.

Globally, markets will watch bond yields and how the geopolitical tensions pan out. Turbulence for global markets may emerge from Italy, Turkey, Brexit and the Middle East. The steps of the Federal Reserve would be keenly observed.

Moreover, the incremental tariffs by the US on Chinese goods may dominate market moods in the coming year. Brent crude prices will float

around $60 a barrel and will halt the recent fall as the OPEC and non-OPEC members' new deal takes effect to reduce oil output.

Valuation parameters after the recent correction have become reasonable and the market looks attractive with visible growth earnings and strong fundamentals. 2019 will be the year of small-cap and mid-cap stocks along with positive participation from FIIs.

Significant fall in the commodity prices would also help markets to outperform other global markets. Indian rupee will remain strong and keep trading at around 70 and below against dollar.

The market scenario would be flat to mildly positive, at least until the general elections and Nifty will close the FY19 at around 10,500.

Going ahead with positive macro newsflows, there is a possibility of Nifty hitting 12,000. Nevertheless, in an unforeseen event, levels of 9,700 cannot be ruled out.

It's easy for emotions to overwhelm investing decisions, but now is the time to put the rule of 'buy low and sell high' into action.

Indian markets will maintain its upmove with a fair share of volatility. Investors need to be more selective than usual with their decisions by sticking to earnings quality and corporate governance, strong financials and growth prospects.

On the whole, we expect India to grow faster than many nations and long-term outlook for the domestic market continues to be strong.

We recommend buying the following stocks with an upside potential of around 15-20 percent from the current level with an investment horizon of 9-12 months:

Larsen & Toubro

L&T is well-placed to benefit from several big-ticket projects, as it satisfies all basic requirements, i.e., balance-sheet size, strong track record, technical expertise and adequate liquidity to bid for such projects.

Recovery in domestic business, order inflow and execution in domestic infra segment, focus on improving RoE and working capital, healthy execution of large order backlog and strong performance of key subsidiaries will strengthen the growth trajectory ahead.

Maruti Suzuki India

MSIL is working towards its commitment to bring electric vehicle in India by 2020. MSIL's largest distribution network across the country, strong performance, strong product pipeline, new launches, next level of excellence in product design with updated technology, better product mix and ramp-up of Gujarat plant would moderate margins in the long run.

Phillips Carbon Black

Government's 'Make in India' programme and anti-dumping duty on imports of CB from China has resulted in PCBL's high sales volume. Its increase in cash flow and improved working capital management has helped in reducing the leverage burden and overall reduction in debt.

PCBL with its technical superiority and cost efficient operating model is expanding its product portfolio which will help in reporting better numbers.

RBL Bank

RBL's robust and diversified loan growth trajectory, well-maintained asset quality coupled with healthy margins, leveraging technology to acquire-engage and service clients, enhancing distribution through a combination of owned branches, and business correspondents, partnerships and acquisitions and highly capable management give a positive outlook for the bank.

Tamil Nadu Newsprint and Papers

Tamil Nadu Newsprint and Papers (TNPL) has emerged as the third largest player in the Indian paper industry with a wide range of portfolio. Consistent economic growth and greater emphasis for education show there is a big market/scope for the company like TNPL to grow going forward.

Paper industry has to face continuous YoY increase in zero duty imports of paper and packaging board under Free Trade agreements along with shortage of raw materials but TNPL has managed the above challenges by matching its capability, increasing capacity, performance and continuous R&D towards recycling and reuse.

MORE WILL UPDATE SOON!!