For the investment community, one of the biggest challenges in current environment has been a poor risk reward setup across various asset classes when compared to historical metrices. It is a difficult choice where investment returns from multiple assets are likely to be muted over the medium term and expectations need to get reset. Global institutions are having to relook at their traditional asset allocation policies in favour of riskier bonds and allocations to private and public equities in search of higher yields. In India, a similar scenario is playing out across asset classes and they pose a tough challenge for investors.
So, what do different investment options offer in terms of risk and return for us, and how should one build an investment portfolio?
Debt: Fixed income yields have clearly compressed and while the future is unknown, one may not favour locking in money at these rates for a longer duration. 10 year Gsec yields have compressed to 5.8% from a peak of 9%+ in July’13 and 8% in Sep’18. They are now close to the 2009 Lehman crisis low of 5.3% and 5.2% in 2004. Developed markets are close to 0% or even at negative yields in Europe, making it difficult to take a long term investment call in bonds. A rise in yields (probably at some point in the future) will knock off gains and the risk reward seems unremunerative at this stage.
Real estate: With its high-ticket size, high transaction cost and illiquidity coupled with lack of value (low yields), real estate needs a reset to generate interest with investors. Commercial REITS also face a challenge, given work-from-home potential and a slow economy. Lease rentals are getting renegotiated downwards and yields are getting meaningfully compressed.
That leaves Equities, Gold (and Crypto) and of course Cash. They have been the default choice given lack of alternatives.
Globally, Gold has rallied on the back of liquidity injection in the US. It is increasingly been seen as store of value against fiat currency system and has also become a pretty crowded trade amongst investors as well as institutions. It has served well as a hedge against uncontrolled fiat currency expansion and inflationary expectation. However, in the short to medium term, given a deflationary environment, it is a small allocation for investors searching returns. Note that while Gold has been seen a 50% jump in USD (much more in INR) in last 4 years, it had also witnessed a sharp correction of almost 40% from its peak in 2011 until 2015. The INR depreciation mitigated the extent of the fall for investors in India.
I have labelled Crypto currency alongside Gold as it serves a similar objective of providing an alternative system/hedge against Fiat currency. It is still early in the evolution and there is significant competition amongst alternatives vying to be the Amazon of the Crypto world. We do not know how it will play out and it can be a moonshot. Given uncertainties, Crypto still remains an option value for investors then for any serious share in asset allocation.
Equities after a massive correction, have rallied sharply in the June quarter in an apparent disconnect from the real economy. The fact is that almost all major market sell-offs are followed by big bounces, and this one is no different. The question remains about near-term sustainability of the recent move.
Equity Investors are betting around two key assumptions: (1) the hope trade of recovery from the pandemic and life as usual in 6-12 months. (2) a continuous liquidity injection in the US.
This significant liquidity injection (in absence of inflation) has effectively reduced cost of equity leading to willingness to pay higher and accepting lower returns. It is indeed leading to an asset bubble in equities across the world including India. FII inflows in India were USD 4.3bn in May and June as against a sell off of USD 8.4bn in March and April of this year. However, the challenging state of the economy and uncertainty on the recovery show a significant disconnect to the liquidity and hope driven markets.
Given these uncertainties, investors are facing a tough choice on asset allocation/investing. While holding Cash is always an option, I believe, equities will likely emerge as the preferred asset class when investors perceive a better risk-reward. This may happen by way of market correction or higher confidence in economic recovery.
Note that at this point of the business cycle when equities are not cheap but of interest, one would need to develop their own playbook to play the investment game.
In my view, the key ingredients that are critical for successful equity investing in these times would include:
1) The courage to invest during equity market dislocations (going against the herd). (Think of the suggestion to invest during peak of the crisis)
2) Thoughtful thematic overlays to identify secular winners. Refer to this article for top trends and secular winners (e.g., digitalization, healthcare/ wellness, platforms, ESG etc.
3) Fundamental bottom up approach to identify companies with strong balance sheets and capable management that can survive a tough economic environment for quite some time. There is no substitute to good management and strong companies.
4) Patient capital that can stay rational and thoughtful in an irrational environment. Investing is a long game and short term euphoria or dysphoria are noises best ignored.
Remember, investing is as much an understanding of business fundamentals of the company and capabilities of its management as it is an understanding the interplay of various external macro factors (Fx, Commodities, Interest rates, sentiment etc.) that shape the business environment and psychology of business leaders. This means keeping an open mind as many of our investment hypothesis and assumptions will need to get altered along the way
Can there be a Bull market in troubled times?
While the environment looks weak, there is no reason why one may not see a bull market in troubled times. It will indeed be a selective bull market where companies that have the balance sheet strength while operating in crowded markets will benefit at the cost of weaker competitors and gain market share. It is likely that a narrow set of companies will significantly outperform the broader economy, industry and benchmarks.
This is what makes equity investment interesting and investors should heed the advice to keep the noise aside and attempt to seek out businesses with strong balance sheet, low fixed costs and durable pricing power; and long-term thematic opportunities that could thrive in the post-crisis world. Markets have always rewarded industry leaders that generate strong cashflows and high return on capital employed. While markets dislocations are inevitable, these companies bounce back much faster and stronger. A crisis is the only opportunity one get to invest in these companies.
Remember the biggest lesson from the last 6 months:
Whatever your view of the future is, it’s probably wrong. Things change in ways people can’t imagine at times they never considered.