by SANDEEP TALWAR
Director, Banyan Tree Advisors
December 20, 2011
There is compelling evidence to suggest that this market is near its bottom.
ONE OF my uncles called me the other day, seeking advice on his investment strategy. Although he is quite astute in his line of business, he has generally depended on me for investment advice. So, he calls on me off and on. I launched into my usual harangue about how stocks were very cheap and a great investment. At which point he moaned: “My investments in equity mutual funds have depreciated 60 per cent. Hence, I have now decided to invest only in debt funds. At least, my money will be safe.”
It seemed like sound logic. Principal protection is one of the things that should be uppermost in the mind of any investor. A wise man once wrote: “The best way to make money in the stock market is not to lose any.” My uncle also quoted to me
the fairly fancy returns that debt funds had averaged over the past couple of years. I was left with no answer to this line of argument.
As I mulled over these thoughts and went to bed that night, it finally hit me like a hammer on the head. Debt funds have done so well in the past two years because interest rates have declined substantially during this period. As industrial
growth has slowed down to a dribbling pace, the need for funds has dried up significantly. Even the huge borrowings by the government (which despite all promises, continues to bloat like Obelix) have not been able to keep interest rates
at historical levels. Add to that low inflation, due to lower commodity prices and a deflationary environment, interest rates in India are now at their all-time low. Debt funds that bought bonds at higher interest rates find these bonds trading at a premium, which has significantly boosted their NAVs (net asset values).
Equities have traditionally had an inverse relationship with interest rates. There are two reasons for this. High interest rates raise the cost of loans, and depress corporate profits. The other, more significant factor is that the PE (price to
earnings) ratio — the rate at which earnings are discounted by the market — has an inverse relationship with interest rates. In fact, many experts argue that the floor PE for a stock market is the inverse of the interest rate.
This implies that at the current interest rate of 10 per cent, the floor PE should be 10, while back in 1996-97, when IDBI and ICICI floated bonds offering 16 per cent interest, the floor PE should have been 6. Why is this so? The major difference
between debt and equity is that while the former guarantees a fixed cash flow every year, the cash flows in the latter are uncertain. Over long periods of time, equity returns should beat rates of interest. Otherwise, the company will not be
able to pay interest to its debt holders either. So, equity should be priced at a PE that allows for some growth in cash flows — and therefore at some premium to the inverse of the interest rate.
When investors were offered a return of 16 per cent for a period of five to 20 years by IDBI and ICICI in 1996-97, they jumped at the offer. However, at today’s low rates of interest, few investors are excited by the return. They are shifting to
debt more out of a fear psychosis rather than as a rational investment decision. The reasons for fear are not hard to find. We have just had a major collapse in the stock market. There is a war going on, and the prevailing theme in the market is
that of protection of capital.
I would like to propose a contrary thesis. This is the first time in the past 10-12 years that dividend yields of many top-notch corporates are trading at above the rate of interest. This means that the returns you would get in the form of dividend at the end of the year by buying shares of these companies would be higher than what you would get by investing in bonds of these very companies. ICICI is an obvious example. Besides, unlike interest income, dividends are tax-free in the hands of the investor.
Yes, problems exist. Industry continues to founder. The slowdown, which began in 1997-98 and was then foreseen by many as a temporary one, has now stretched for five years. A typical economic cycle lasts seven to nine years at worst. What that indicates is that the worst is perhaps behind us, or close to being so. Surprisingly enough, despite the industrial slowdown, the GDP (gross domestic product) has continued to chug along at 5 per cent plus rates, largely due to the
robust growth in services.
Can we say that we are at the bottom of the cycle? I believe that it is foolish to try and predict the bottom. Not even the most astute economist can predict that. What we can say with a fair degree of certainty, given the data before us, is that
the probability that the next three years will be better than the past three from an economic standpoint is quite high. There is also some sign of improvement in the agricultural sector, which had suffered from two successive bad monsoons. Given India’s dependence on this sector, this should provide welcome relief. The latest round of cuts in the bank rate (the rate at which RBI lends funds to banks) and the cash reserve ratio, or the CRR (the percentage of deposits banks have to
maintain with the RBI) could perhaps provide the trigger that agriculture and industry need.
The truth is that it is darkest before dawn. While it is too early to say whether dawn is near, one can say with a reasonable degree of certainty that the economy is not near dusk. The external fallout of the war being waged in Afghanistan and the US (bio-terrorism) is very difficult to predict. The current rally in software stocks seems more because they were oversold and had reached ridiculous valuations, than any improvement in the external environment.
Selling your shares now and buying bonds could prove to be as much of a mistake as buying technology stocks in January 2000 was. For the market, looks ahead! And from the depths of a bear market emerges the first seed of a bull market. While that seed may need water and sunshine in the form of sensible government policies and forward-looking regulation to really blossom, selling out in fear now could be a blunder that you may live to regret.