In India, like in most markets, over the long term value strategies tend to outperform growth. Indeed over the past decade, as research done by Ambit Capital shows, value – defined as companies with a low price/book (P/B) multiple but high return on equity (RoE) – has been the single best performing category of stocks, with a 26 per cent compound annual growth rate (CAGR). This is closely followed by another value grouping (stocks with low P/B, but also low RoE) which has delivered 25 per cent. The value stocks have handily outperformed the growth categories of high P/B and high RoE (21 per cent CAGR), and high P/B, low RoE (16 per cent CAGR).
While value has beaten growth on a 10-year snapshot, the picture is very different over the last three years. Here growth, specifically the high-P/B, high-RoE sub-segment, has massively outperformed. The out-performance of these stocks versus low-P/B, high-RoE stocks has been nine per cent in 2009-10, 18 per cent in 2010-11, and 14 per cent in 2011-12 (source: Ambit Capital). There are staggering numbers and very much against the long-term trend. What’s happening? Is this sustainable?
First of all, the high-RoE, high-P/B category is really a proxy for defensive quality, which is largely composed of consumer-facing business, both Indian and multinational, as well as a smattering of great franchises like the HDFC twins. These stocks (especially those selling into rural India or playing into the consumption theme) are now trading at all-time high absolute and relative valuations. Many of them, like Hindustan Unilever and ITC, are at lifetime highs. The relative P/B multiples of defensive versus cyclicals is also at an all-time high. In simple English, this means that defensive categories of stocks (like fast moving consumer goods and pharma) have never been more expensive when compared to their more economically sensitive brethren. This type of extreme price divergence is more apparent when looked at from a sectoral perspective. Over the last two years (till end August), consumer stocks are up over 45 per cent, pharma stocks are up low double digits and IT companies are up low single digits; every other sector has delivered negative returns.
It is perfectly understandable why this type of extreme sectoral divergence has happened. Over the last two years, we have gone through a cycle of continuous and unabated negative revisions to both economic growth and earnings estimates. Where once, most investors thought India would never grow below eight per cent, and that was the new Hindu rate of growth, everyone has now pencilled in five to six per cent GDP growth for this year, and many think these low rates of growth are the new normal. Even on earnings growth, corporate India has disappointed, and we have not seen growth go beyond single digits over the last couple of years. In an environment where growth is spiralling down and we have heightened earnings uncertainty, investors seek out growth and earnings stability wherever it can be found, and bid it up. This is what has happened to the defensives over the last two years. In a slowing Indian economy, rural consumption has been the one bastion of strength, and companies playing into this theme have been able to deliver 20 per cent-plus earnings growth without skipping a beat. Starved of growth, investors have flocked in droves into these stocks and sectors, almost regardless of price. The wave of money flowing here has driven valuations to all-time highs. As these stocks have been the only one’s delivering positive price performance, they have also attracted momentum traders and others playing price performance. Funds heavily exposed to these stocks and sectors have done very well, significantly outperforming, thus attracting more inflows — which are once again ploughed into the same stocks, creating a bit of a self-fulfilling prophecy. We have now reached the stage where these stocks are heavily over-owned, with most funds very overweight and a huge chunk of money hiding here.
What investors have to consider is how much longer can this trade, and the huge divergence continue?
I would argue that we are now coming to an end in the cycle of negative earnings and GDP growth revisions. I think the economy is stabilising, and there is a reasonable chance that economic growth will accelerate to at least seven per cent in 2013-14. Even for corporate earnings, if global growth remains weak but stable, commodity prices continue drifting down, the rupee remains between 52 and 55 and interest rates continue trending lower, we have probably seen the worst. The market can easily have 12-15 per cent earnings growth next year.
In an environment where the economy and earnings are accelerating, with rates coming down, the defensive stability of the consumer stocks will have less appeal. One would expect to see significant sector rotation, with money coming out of these stocks and sectors. Once the rotation begins it is very likely that in a rising market, defensives will actually decline on an absolute basis.
The fact that this rotation has not happened yet indicates investor scepticism around the current rally. Fund managers (especially those on the ground) are still not willing to believe that anything fundamental has changed in India. Some cosmetic changes and announcements, yes, but nothing concrete and structural. If the government does deliver on the National Investment Board, cash-based transfers, credible fiscal consolidation, the goods and services tax, foreign direct investment and so on, then investors will be falling over themselves trying to move money into more cyclical names.
If the government does deliver, and markets turn, they will be pre-emptive — as the on the ground reality will take at least six to nine months to catch up. Investors will have the uncomfortable feeling of markets rising, of having to chase stocks, even as companies initially say nothing has changed and still be sceptical.
Investors in defensive stocks have made their money; they risk overstaying their welcome. If the economy begins to stabilise and then recover, relative earnings momentum will favour cyclicals, and investors will have to adjust their portfolios accordingly. If on the other hand the economy continues to weaken, investors have to ask themselves: how long can these consumer and defensive names earnings hold up? Consumption cannot continue to power ahead, independent of the rest of the economy, indefinitely. And this select set is not priced for any earnings disappointment whatsoever.
One of the simplest trades to implement today is to bet on value once again outperforming growth, and cyclicals versus defensive valuations reverting to the mean, with cyclicals outperforming. Over the coming three years this simple strategy should yield good returns. Buying cyclicals does not mean necessarily buying junk balance sheets and poor promoters, as you can stick with quality even here and still do well.
The author is fund manager and CEO of Amansa Capital