Equities – Simple, But Not Easy

In this
simple and easy article, the author shares his perspective on equity and funds.
The article walks you through many data points and tables to make a point about
equity markets. The author is the chief investment officer and fund manager of
a leading fund house. An IIT and IIM graduate and a CFA, Prashant talks about
taking a long view of equity markets. Prashant has been in the markets for more
than 25 years and manages several thousand crores of assets under various funds
under him.

Nature
of Equities

Equities are
remarkably simple. An equity share is simply volatile in the short run, but in
the long run, its returns are close to the growth of the underlying business.
This implies that for a diversified portfolio, the long term returns will be
close to the nominal GDP growth of the country (real growth + inflation). This
is so because all businesses together make the economy and thus the average
growth of different businesses will be similar to the economy’s growth rate.

The chart
below depicts real decadal GDP growth n and inflation n
for India since 1980

Exhibit 1

Source: World Bank
data

It is
interesting to note that the decadal average growth in India’s nominal GDP has
been fairly constant. This is despite the changing headlines over the decades –
different governments, several global and local crises like Gulf crisis, ASEAN
crisis, 9/11, global financial crisis post Lehman, European debt issues etc.,
periods of high and low interest rates, periods of high and low oil prices etc.
etc. 

The persistent
real growth in India is explained by:

–   Excellent demographics – rising population,
even faster growth in number of families

–   Falling dependency ratio and a healthy
savings rate

–   Ample availability of  natural resources

–   Large availability of skilled, young, English
speaking and competitive manpower

–   Low penetration of consumer goods and
improving affordability

It is
interesting to note that these drivers of real growth are not affected by
change in governments, global developments etc., and this is what explains the
remarkably steady growth in India. Further, in periods of high inflation i.e.
1991-00, as interest rates move higher, EMI’s increase thus reducing
affordability and hence real growth; and vice versa. This is why the nominal
growth rates (real growth plus inflation) has remained more or less constant.

The
When, Where and How Much of equities?

Someone with
an interest in equities typically asks the following three questions:

When should I
invest?

Where (which
funds / stocks) should I invest?

How much
should I invest?

When
should I invest?

The table
below depicts Sensex rolling returns for 1, 5, 10 and 15 years since its
inception in 1979 :

Exhibit 2

Source: Bloomberg

Sensex
returns are computed for 1,5,10 &15 years from the date of investment.
Returns for 1 year are absolute and above 1 year CAGR.

CAGR: The
rate at which an investment grows annually over a specified period of time.

Column 2:
shows the value of BSE index at the end of month of the respective year.
Probability of gains is the number of times the investor would have made
positive returns.

Column 3 to
6: Represents the return earned on the investment for the referred period. For
e.g. If you invested in Mar-79 when SENSEX Index was 100, then 1 year returns
(in Mar-80) would have been 29%, 5 years returns (in Mar-84) would have been
20%, 10 year returns (in Mar-89) would have been 22% and 15 year returns (in
Mar-94) would have been 27%.

As the column
of 1 year return shows, returns in short run are simply volatile. Since there
is no pattern of one year returns, it is evident that it is futile to time
the markets in the short run. This is also why equities are considered risky in
the short run and are only recommended for long time horizons. Interestingly,
long term returns are less volatile and as holding period increases, returns
converge close to nominal GDP growth rate of 14-15% (S&P BSE SENSEX has
returned close to 16% since its inception in 1979 till June 2018). Further,
chances of losses reduce as holding period increases, thus reducing risk in
equities.

Interestingly,
not only is it difficult to time the markets in the short run, timing hardly
matters over the long term. For example, whether someone invested at a Sensex
of 510 in Mar 87 or at 398 in Mar 88 hardly made a difference ten years later
when the index was 4000 in 1998!

The key to
successful investing is actually not in timing but in something that is
becoming increasingly rare in times of whatsapp and e-commerce – and that is
patience. As India is a growing economy, the size and value of businesses
also keeps on growing. This implies that the longer one remains invested – the
more the wealth is likely to be created. Invariably, successful investors are
also the most patient investors. Afterall, if someone had simply remained
invested in the Sensex for last 39 years – through good and bad times, through
bullish and bearish times would have made his wealth 350 times –  which is hard to match by the traders and
timers !

Finally, while
short term timing is very difficult, it is possible to take a medium to long
term view of the market based on the past returns of the markets vs. nominal
GDP growth. As explained earlier, over the long term, stock market indices in
India are growing around the same rate as the nominal GDP (GDP Growth +
Inflation) of India. This implies that when in any extended period of, say
10 years, indices grow significantly less than nominal GDP (i.e. 1992-2002),
they tend to make up in the future by delivering higher returns and vice versa.

Where
should I invest?

Each business
has specific risks. These risks are increasing by the day due to rapid changes
in technology and due to several disruptive business models that are emerging.
To reduce business specific risks, it is strongly recommended to maintain
effective diversification when investing in equities, irrespective of whether
one is investing directly or through mutual funds. To discuss more than this
about security selection here is neither desirable nor feasible. Suffice to say
that security selection deals with the future, with uncertainty and even
professionals make several mistakes. It is best to leave this to experts
therefore unless one really understands equities i.e., prefer mutual funds over
direct investments. In my experience, the majority of direct investors have not
done well – the most popular stocks in 1992 were in cement; in 1999 it was the
turn of IT stocks; in 2007 it was the turn of the infrastructure related
stocks, similarly pharma companies were in favour around 2015. On each
occasion, these popular investments did not perform as expected. These
observations give us an insight to a common mistake that investors tend to make
in equity investments. It has been experienced that many investors simply
invest based on past trends i.e. when a sector or a group of stocks does well
for few years these become increasingly popular and attract higher
participation and vice versa. In reality, high returns of the past (especially
when they are disproportionate to business growth) could indicate over
valuation and vice versa. In view of the above, such investors who do not have
proper understanding of equities are probably better off with mutual funds.

Choosing
a right Fund

John C.
Bogle, founder of the
Vanguard group has suggested in his book “Common Sense on Mutual Funds”
that three to five mutual fund schemes that have done well across market cycles
are all that an investor needs for one’s equity portfolio.

With a
tailwind of ~15% p.a. economic and Sensex growth highlighted earlier, it is no
surprise therefore that around 74% of equity and hybrid equity funds with more
than 15 year history have delivered more than 15% CAGR and around 88% of equity
and hybrid equity funds have delivered more than 12% CAGR over last 15 years.
The better ones have delivered returns close to 20% CAGR over this period. (Source:
NAV India)

Interestingly,
while funds proudly display long term returns of 15 – 20%, only a small
minority of investors have experienced similar wealth creation. This is so
because, the vast majority of investors moved in and out of equity funds
several times in this period, from equity funds to liquid and back, from lower
rated funds to higher rated only to witness role reversal of funds in some
time, from large cap to mid cap or vice versa etc. etc. In other words, the
majority frequently churned their funds and refused to stay put. Only a small
minority that simply remained invested in a few carefully chosen funds for
these entire period reaped immense benefits.

To take an
analogy from the game of cricket, the good batsman is not the one who scored
the highest in the last game but is the one who has the best batting average in
say, last 10 or 20 matches.

Just as one
match cannot be used to judge a good batsman, similarly one year’s performance
is too short a time to judge equity funds. Instead, there is merit in assessing
equity funds’ over 3-5 year or longer periods

Funds that
have a good track record across market cycles are likely to be investor’s best
bets and 3-5 such funds is all that an investor needs in my opinion.

How much
should I invest in equities?  The
Importance of Asset Allocation in Equities

Equities are a
great compounding machine (as mentioned earlier, Sensex itself is up 350 times
since 1979) and India has good growth prospects. However, while equities hold
promise over long term, in the short to medium term, equities almost invariably
carry significant risks as the past has repeatedly reminded us.

This suggests
that an investor should assess and allocate one’s risk capital only (that
portion of capital which can be kept aside for few years and on which
volatility can be tolerated) to equities. This simply put, is asset allocation.

Asset
Allocation is critical to successful investing. Unfortunately, it is often
neglected, as more attention is given to timing, security selection, moving
across funds etc.

After
optimal asset allocation, all that an investor needs is patience and discipline: Patience to remain invested for long
periods in equities / equity mutual funds to allow compounding to work and the
discipline of not panicking and on the contrary increasing allocation to
equities when the returns over the past few years have been disappointing or in
simple words when the P/Es are low.

The
illustration below highlights the significant impact asset allocation has on
wealth creation over longer time periods:

Exhibit 3

For
illustration purposes only.  For
calculation purpose CAGR returns has been taken as 15% CAGR for equities and 8%
CAGR for debt. Returns are not assured / guaranteed.

Economic
Prospects of India

As explained
earlier, India is a secular growth economy. Interestingly, other macro
parameters also like fiscal deficit, current account deficit, FDI, inflation
etc. have witnessed significant improvement over last 5 years as can be seen
from the table below.

Slowdown in
GDP growth in FY17 and FY18 is due to adverse short term impact of
demonetisation and GST. Going forward as this effect neutralises, GDP growth
should accelerate. The table below summarises the key macro-economic indicators
and forecasts for India: 

Exhibit 4

Source: CEIC, Macquarie Macro Strategy;
Economic Survey, E-Estimates

Some of the
macro parameters are likely to witness some deterioration in FY19 primarily as
a result of higher oil prices. These are nevertheless expected to remain at
healthy / reasonable levels. GDP growth should however accelerate with improvement
in capex in housing, urban infrastructure and industrial capex led by oil &
gas, metals, fertilizers etc.  Capex in
roads, railways, power T&D has already seen material improvement. RBI has
estimated GDP growth of 7.4% and 7.7% in FY19 and FY20 respectively vs. 6.7% in
FY18.

Equity
Markets Outlook

Equity markets
in India have lagged nominal GDP growth for several years now. As a result,
Market cap to GDP ratio at 70% is below long term average. Market cap to GDP
ratio for CY20 at 62% which will become relevant one year from now looks
particularly attractive. Market cap to GDP ratio is a better tool to analyse
markets instead of P/E in current environment as corporate profitability is
below long term averages.

Exhibit 5

India market cap to
GDP ratio, calendar year-ends 2005-18 (%)

Source: Kotak Institutional Equities, updated till 30^th
June, 2018

Note:

a) From
2005-17, S&P BSE SENSEX PE is based on 12 month forward estimated EPS.

b) For 2018 and
2019, Kotak has calculated S&P BSE SENSEX PE based on estimates as of Mar
19 and Mar 20 end and used market cap as of June 30, 2018.

In the last
seven years, corporate profits as % to GDP have fallen from 5.6% in FY10 to
3.0% in FY17 (chart below).  As a result,
despite improving macro as seen in Exhibit 4 earlier, NIFTY profit growth has
been weak at 7.7% CAGR between FY10 and FY18. This phase of weak earnings
growth now appears to be ending. Driven by improving fundamentals of key
sectors like corporate banks, capital goods, metals etc., the profit growth
should improve in future.

Exhibit 6

Source: Morgan Stanley Research, year is
Fiscal Year

A recent
development in equity markets has been the underperformance of small caps and
midcaps. This underperformance has to be viewed in the backdrop of sharp
outperformance in last 3 and 5 years as seen in the table below:

Exhibit 7

 Source: Bloomberg

At this
juncture, given the large outperformance of midcaps / smallcaps in last 3, 5
years and expected revival of NIFTY profit growth as can be seen from the table
below, risk-reward ratio appears to be more in favor of largecaps.

Exhibit 8

Source: Kotak Institutional Equities

Markets are
trading near 18x CY18 (e) and 15x CY19 (e) (Source: Bloomberg Consensus as
on June 30, 2018). These are reasonable multiples especially in view of
improving profit growth outlook. Markets thus hold promise over the medium to
long term in our opinion. Adverse global events, sharp moderation in equity
oriented mutual funds flows and delays in NPA resolution under NCLT are key
risks in the near term. 

Conclusion:

In conclusion,
equities are a simple asset class. However, getting the best from equities is
not easy. That needs clear understanding of equities, lots of patience and
faith in difficult times. The prospects of equities are closely tied to the
long term prospects of the economy which are promising for India. To benefit
from equities investors should estimate their risk capital and invest the same
in a few carefully selected funds and then hold these for long periods.
Remember that the successful equity investors also tend to be the ones who
think and hold equities / funds for the longest.

Note: The views expressed are of Prashant
Jain, Executive Director and Chief Investment Officer, HDFC Asset Management
Company Limited as on 23^rd July, 2018 and not necessarily those of
HDFC Asset Management Company Limited (HDFC AMC). Neither HDFC Asset Management
Company Limited and HDFC Mutual Fund (the Fund) nor any person connected with
them, accepts any liability arising from the use of this document. Past
performance may or may not be sustained in the future. Readers before acting on
any information herein should make their own investigation and seek appropriate
professional advice and shall alone be fully responsible / liable for any
decision taken on the basis of information contained herein.

Mutual Fund
investments are subject to market risks, read all scheme related documents
carefully.