MARKET REVIEW AND OUTLOOK
The year 2021 started with a sense of
hope with an expectation of end game for pandemic & related economic woes
with the proliferation of the vaccines. Little did we know that 2021 had in
store for us a bigger Covid-19 wave (or perhaps Tsunami is a better word). April-21,
May-21 & June-21 again saw lock downs & restrictions on mobility albeit
less severe than the previous one in 2020. Post the month of June, restrictions
were eased & economic activity picked up again. The fag end of the year has again increased
anxieties about a possible third wave due to the ‘Omicron’ variant. Overall,
from an economical perspective, the year started with low demand, low inflation
& low-interest-rate environment & is ending with a supply constraint
& high inflation environment with expectations of the global interest rate
rising in 2022.
Amidst all this ‘gloom, boom &
doom’ the S&P CNX Sensex has given a return of 20.6% YTD as on_30th
Nov 2021. The broader markets have performed even better with BSE Midcap &
Small Cap returning 39.1% & 55.6% respectively as on 30th Nov
2021. From a sectoral performance perspective power, metal & real estate
sectors were the leaders this year & FMCG, Pharma & Auto were the laggards.
There have been tectonic shifts in the
global macro environment in the last 18-20 months (post the first wave of the
pandemic & the related economic dislocation) the impact of which will get
more & more pronounced and will impact different sectors differently. Even
for astute bottom-up stock pickers, these rumbling can be heard from an ear on
the ground.
One of the shifts is, pricing power
coming back to primary producers. First time in close to a decade input price
inflation for businesses have surpassed end consumer price inflation as is
reflected in the given chart which compares core WPI & core CPI inflation.
This indicates primary producers (commodity,
energy & food producers) have regained their purchasing power which they
enjoyed in the pre-GFC era or to an extent between 2010-14. In this environment,
non-integrated businesses will be in a disadvantageous position compared to
integrated ones. Similarly, FMCG & second or third order chemical derivative
companies who have benefitted from benign input costs since 2014 will face
higher margin pressure going forward. It will also test the ‘high quality
therefore high valuation’ hypothesis of some of the market
participants.
The question then arises, about the sustainability
of this pricing power of primary producers. Is it driven by short term supply
chain challenges or there is a structural story to it? The answer is ‘both’. While some of the supply constraints are due
to global supply chain dislocations, there has been clear underinvestment in
capacity creation in these businesses. The prices have been unremunerative for
the past few years & the focus of global capital has moved towards ESG compliant
businesses (most of the commodity production does not pass the strict
definition of clean & green). A good example is global upstream CAPEX in
Oil & Gas which fell from ~$800bn in 2014 to ~$350bn in 2020 and is
expected to grow marginally in 2021. Further, disruption in people & goods
movement due to Covid-19 in the last 2 years has resulted in further delays in
under-construction capacities impacting supply.
Even in the Indian context, there has
been clearly under-investment in capacity creation in some of the core industries
at a time when demand for some of these products is expected to grow at a multiplier
to real GDP growth for many years to come.
|
|
India Capacity
|
CAGR
|
|
|
2011
|
2021
|
|
|
Cement ( MMTPA)
|
287
|
521
|
6%
|
|
Refining ( MMTPA)
|
193
|
250
|
3%
|
|
Major Pet Chem (MMTPA)
|
15
|
19
|
2%
|
|
Urea (MMTPA
|
22
|
28
|
2%
|
|
Steel (MMTPA)
|
78
|
144
|
6%
|
Source: CMIE, World Steel Association, FAI,
Ultratech Annual Report
The second
tectonic shift is the increase in the cost of money. We can retire the term
‘Transitory Inflation’’. This recent statement by U.S Federal Reserve
hastens up the road map for a reversal of easy liquidity environment, in place
for the last eighteen months This is perhaps the first time in close to a
decade when the U.S federal Reserve has acknowledged inflation as a concern. While there could be different views
on timing on when interest rates move up but there is a near-unanimous move
that it will move up. This will have a bearing on equity
globally. As
the world of easy liquidity goes away, and risk-free rates go up across
spreadsheet models, return expectation (discounting rates) will also go through
a reset.
As with bonds with higher duration, stocks trading at elevated
valuations are more sensitive to interest rate changes because they discount cash
flows further out in the future. A reasonably valued portfolio of stocks is
expected to outperform vs. an expensive portfolio in this environment. The
following illustration will help understand the concept better.
|
|
Company A
|
Company B
|
|
Year 1 Cash Flow
|
10
|
10
|
|
Growth Rate
|
10%
|
5%
|
|
No of Years Future Cashflows is discounted (P.E)
|
10
|
5
|
|
Intrinsic Value at 12% discounting rate
|
82
|
39
|
|
Intrinsic Value at 14% discounting rate
|
75
|
37
|
|
Fall in Intrinsic Value due to increase in
interest rate
|
-9%
|
-5%
|
Company A grows at 10% every year for 10 years & is valued at
10x PE & company B grows at 5% for the same period & is valued at 5x
P.E. For a 2% increase in interest rates the drawdown in value of Company A is
almost double compared to company B.
Finally, going into 2022 Investors
should also be cautious about popular & hot themes like Electric Vehicles, Consumer
Tech & FinTech. While all these are expected to play out well over the long
term, some of the underlying stocks are factoring in too much good news &
are at bubble territory valuations with no positive cashflows insight for the next
few years. On the contrary, it would be wise to look for stocks and portfolios with
a contrarian approach.
Quantum Long Equity Value Fund’s portfolio
has been built through a bottom-up research process & is tilted towards
cyclicals. It is valued at 12.9x FY24E earnings vs the S&P BSE Sensex
valuations of 18.8x FY24E earnings. The portfolio is stress-tested periodically
to ensure the investee companies have the wherewithal to survive the down
cycle.
Summing up, Investors should not be
unnerved by the near-term volatility steadily move towards their optimum equity
allocation as per the long-term financial goals through systematic investment
plans. Any sharp correction due to near-term headwinds can offer additional
valuation comfort and should be used to allocate more to equities with a
long-term perspective. Our 12--20-80 (12 x monthly expense in a liquid fund,
20% of the remaining allocation in gold & rest 80% in equities) approach
towards asset allocation is best suited to navigate near term volatility in
different asset classes and achieve the best possible result for achieving long
term financial goals
Disclaimer,
Statutory Details & Risk Factors:
The views expressed here in this article / video
are for general information and reading purpose only and do not constitute any
guidelines and recommendations on any course of action to be followed by the
reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering /
communicating any indicative yield on investments made in the scheme(s). The
views are not meant to serve as a professional guide / investment advice /
intended to be an offer or solicitation for the purchase or sale of any
financial product or instrument or mutual fund units for the reader. The
article has been prepared on the basis of publicly available information,
internally developed data and other sources believed to be reliable. Whilst no
action has been solicited based upon the information provided herein, due care
has been taken to ensure that the facts are accurate and views given are fair
and reasonable as on date. Readers of this article should rely on information/data
arising out of their own investigations and advised to seek independent
professional advice and arrive at an informed decision before making any
investments.
Risk Factors: Mutual Fund
investments are subject to market risks, read all scheme related documents
carefully.
