Indian markets have been very resilient over the past few months. After getting clobbered in January, they have held their ground, absorbing a huge amount of bad news but refusing to break below 5200 on the Nifty. We seem to be stuck stubbornly in a trading range of 5200 to 5700 on the Nifty and have stood broadly at these levels for almost 18 months now. What this range-trading type of behaviour disguises is the huge divergence in performance between sectors and stocks over this time period. While the broad market is close to where it was 18 months ago, many sectors and stocks are at an all-time high. However, many others are still down 80 per cent from their peaks. The market’s breadth has been quite narrow this year with only about 60 stocks in the CNX 500 index up for the year.
The sectors that have done well are those that have anything to do with consumers, consumption and rural India and one or two other defensives like pharmaceuticals, and to a certain extent, technology. The sectors that have been in a continuous free fall are those related to capital investment and asset creation, whether they are capital goods, infrastructure developers, construction or real estate.
A second related theme is the triumph of quality. Companies with good long-term track records, low leverage, high return on capital and reputed management are being bid up to all-time highs, while companies that are leveraged or have a dubious track record seem to be untouchable at any price. Given the business environment and stock-specific pain already experienced, no one has any tolerance for corporate governance risks.
Rising interest rates and a shortage of equity capital have also raised the cost of capital dramatically for many firms. Thus, companies with negative cash flows or long-duration cash flows are being re-priced with significant haircuts in valuation multiples. A rising cost of capital has once again focused people’s mind on rates of return on capital.
Thus, we have a whole bunch of stocks like Hindustan Unilever, Nestle and HDFC Bank hitting an all-time high, while the real estate and infrastructure names continue to languish 80 per cent below their 2007 peaks.
What are the implications of such a sectoral differential in market performance?
First of all, from an economy perspective it is a clear negative, since the sectors and companies that need to raise equity capital are simply unable to get it. Investors are chasing those companies that do not need to raise equity capital. Any announcement of fund raising immediately causes companies’ stock prices to correct. If one talks to investment bankers, one will hear stories of huge deal pipelines, but an inability to execute the transactions. Investors do not want to write a cheque for a company that needs their money. Sectors like real estate and infrastructure are crying out for equity capital but lack access. How can we build infrastructure if no company in the space has access to new sources of equity capital? How much finance can private equity provide? At what cost? I wrote about the lack of equity capital in a previous article pointing out that our infrastructure developers lack the market capitalisation required to support the huge build-out needed, but things have only worsened. Business models that need equity capital to grow are being given the lowest valuations and have the least investor interest.
This state of affairs should worry a government relying on the private sector to fund nearly half of its trillion-dollar infrastructure capex over the coming five years.
The market is also making a clear statement that the transition in growth drivers for the economy from consumption to capital spend is just not happening. Investors prefer to hide in consumption plays despite their valuation multiples, since there is some sense of visibility and growth here. The market seems to have no faith in the possibility of an imminent revival in the investment environment. Markets are a discounting mechanism, and today they are discounting no investment revival for the foreseeable future.
For investors, this is a very difficult market in which to make money. First, mid-cap indices have significantly underperformed compared to their large-cap peers. Investors have to decide what is riskier — continuing to chase consumer stocks trading at 30 to 35 multiples, and where everyone is hiding, or starting to look at some of the bombed out sectors, hoping to find some specific higher-quality companies that have been beaten down with the sector.
The old mantra of investing in high-quality companies at a reasonable price is very difficult to implement today since quality has been really bid up. So investors have to either pay up for quality, move down the quality curve to get better valuations or increase concentration in existing stocks (unable to find anything new). All involve increasing risk, but in different ways.
This also explains why for many fundamental investors, India is still not cheap, despite the markets having not moved much in the past 18 months. Fundamental investors prefer to buy quality companies with strong, credible managements (especially in emerging markets) and these valuations have gone through the roof in India over the past year. The valuation gap between quality (defined in terms of leverage, return on equity, management etc) and other companies has rarely been higher. So, one hears constant complaints about how misleading the market PE statistics are. While the market may be trading at 15 times March 2012 earnings for the BSE-30, the best companies in India (of size) are at a 20-time plus. That is not the definition of a cheap market.
When the next bull market takes off, it is inconceivable that it will be led by the current market darlings of consumers, like pharmaceuticals. Their starting point in terms of valuation makes that highly unlikely. No matter how much we may hate moving there, but the real money in the next market move-up will come from the beneficiaries of capital investment. For, the hard truth is that for the long-term India story to play out, capital spending has to come back. We can only go so far as an economy if we continue to rely on government spending and consumption. Like it or not, investors will have to eventually position for this change in market behaviour and decide how to play it.
The author is fund manager and CEO of Amansa Capital