The Year has ended, this too shall pass
March 2020 saw one of the worst falls in the markets. Nifty 50 fell from a high of 12,000 to 7,500 in a matter of just two weeks.
As a popular saying in the market “this time it is different”. The markets collapsed not due to economic fundamentals but due to healthcare problem. There was no investing template to refer to.
In a situation of crisis, the central bank lowers the interest rate. With the reduction of interest rates, people tend to buy homes, cars, electronics etc. All this leads to growth.
Last year, this economic template was followed globally and in India. RBI lowered the rates and the government planned massive infrastructure spending.
Interestingly, in just a few months, the markets went up and touched the peak.
The year 2020 has been one of the most challenging years for investment professionals. On one side, there was a massive opportunity after the fall and on the other side, extreme uncertainty.
There was a mix of people post the lockdown. One group wanted to participate because of cheap values and the other wanted to sit out due to lack of clarity.
What would have been a reasonable investor’s choice and what should be done now?
Let’s understand from both wealth allocation and equity selection perspective.
India was already facing problems due to IL&FS, Vodafone, Yes Bank etc. These problems were more linked with the bond market and less with the equity market. The massive fall in March 2020 just accentuated the whole issue.
A reasonable investor should have moved all the debt related allocation to Government Securities. This could have been done in the form of mutual funds with 90%+ exposure to RBI bonds and/or tax-free bonds. The objective of debt allocation is safety first and not so much growth. The decision to move to government securities would have checked the safety box.
Equities had already fallen, creating a massive opportunity for large and mega-large cap companies. Well, what happens in a period of crisis? A lot of businesses shut down. When businesses shut down, especially the smaller ones, the value of debt and equity becomes zero. A wise decision would have been to invest in equities of large size businesses.
Since February 2018, small and mid-cap had already seen a massive correction. It was bizarre to see the fall in small and mid-cap similar to large-cap. The small-cap should have fallen much steeper than large caps. Due to the correction that had already happened since 2018, small and mid-caps fell but not so steep.
Given the uncertainty, a reasonable investor would have still sold small and mid-cap companies and allocated the cash to high-quality large-cap companies.
Risk management is a critical aspect of portfolio management. Even small and mid-cap allocations in sound companies in a crisis may give surprises. A reasonable investor would have followed a conservative path and invested in high-quality large caps.
Where are we now?
We are back to normalcy even though we might be facing a second wave. At a portfolio level, you should stick to long-term asset allocation.
If you invest in equities directly, share price performance will follow fundamental performance growth. A basket of high-quality companies across large, mid and small-cap should be fine from a long-term perspective. This is a strategy that pays off well irrespective of the sentiments in the market.
As we are moving up the credit cycle, a lot of cyclical sectors such as auto, financials, commodity etc. will do well. A reasonable investor may still prefer to stay away from these sectors.
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six per cent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six per cent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen per cent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result. - Charlie Munger
This statement has become the backbone of sound investment strategies globally. The market may entice you to look at low-quality cyclical businesses, but you should be more aware of the consequences if you hold these stocks for long.
My concern and way forward
Post-RBI reduction in the interest rates, the cost of sourcing funds called cost of capital fell. The difference between returns and cost increased, leading to more value, hence the jump in the stock market. Now with the increasing pressure of inflation, interest rates may increase, hence the nervousness in the market.
There is a possibility that interest rates may rise sooner than anticipated. The increase in interest rates hurts both equity and debt.
Often behavioural biases operate heavily during these times. When the market falls, people feel it will continue to fall and when the market rise, people feel it will touch the sky. It doesn’t work like that.
A reasonable investor would be aware of these behaviours and will always act with caution.