February 2022: Two tiered market

The news over the last few weeks has been all about Ukraine as the US government warned that Russia was planning to invade Ukraine – equity markets were volatile going into the event and fell violently when Russia did actually invade Ukraine. Subsequently there has been some recovery. While the market ostensibly fell because of the Russian invasion, it is quite possible that the real reason for the market weakness is the very high inflation globally, which is something we discussed in our last newsletter as well.

When we analyse the events of the last few years in India we see that growth in India has been sub-par for several years – the economic cycle seems to have peaked out some time in 2012 post which we had all the scams unfolding under the UPA government. Since then there has been the odd year in between when we have seen decent growth, but disruptions like demonetization, GST and the ILFS crisis have kept growth pegged back for several years. To top it all, came covid which has been a huge disruption, particularly for the poorer sections of society. As we have emerged from covid over the last year, corporate numbers have been encouraging but it is perhaps too early to call whether the economic cycle has finally turned around.

Results for the December 2021 quarter continued to be robust. For the non-financials in the BSE500, we find that the 2-year CAGR for revenues is 14.9% for the aggregate and 12.0% for the median company, which is in line with long term historical trends. EBIT has grown at a 24.3% 2-year CAGR and for the median company the number is 13.1%. The material sector is a heavy contributor to these good results because of high commodity prices in the recent past. If we exclude the material sector, the 2-year CAGR of revenues is 13.3% and for EBIT it is 16.6% (median 12.4%). All in all, the corporate results continue to be healthy, though there has been some impact on EBIT margins because of high commodity prices.

The market which was extremely strong till October 2021, has been wobbly ever since – what looked like a gentle correction, has intensified in the last few months into a more severe correction. It is perhaps no coincidence that the fall in the market started after the US Federal Reserve (Fed) started tapering its quantitative easing program and moved from an accommodative stance to a more hawkish one and the Fed is now signaling several interest rate increases in 2022. With US inflation running at 7.5% (Europe and UK are not too far behind and in India too inflation has gone a little beyond RBI’s comfort zone), central banks will likely be forced to raise interest rates to control inflation. As we explained in our last newsletter, interest rates are a key determinant in the valuation of stocks – higher the interest rate, the lower is the multiple that one should attach to earnings.

We are quite conscious that impending interest rate increases could have an impact on valuations of stocks and we have been reducing our positions or completely exiting stocks that have risen to the top end of their valuation range. Our effort is to redeploy these funds in other stocks that are trading at reasonable valuations. Our observation is that we are in a two-tiered market – while a section of the market is trading at expensive valuations, there are others (including several stocks in the portfolio) where stock prices are trading at close to or below their March 2020 lows. So there are opportunities for us on both sides – to sell the stocks that have become expensive and to re-deploy in stocks that are still trading at reasonable valuations.