A combination of various factors help investors meet or exceed their objectives by following a disciplined investment strategy.
Wealth creation should be viewed as a long-term journey and not a destination. To ensure that the journey is comfortable and eventually leads to the destination, one must be aptly prepared and adopt a disciplined approach. The foundation for this approach should begin with a suitability analysis, ascertaining risk & return requirements and arriving at a suitable time horizon to achieve the investment objectives. The key lies in adhering to the discipline of the investment philosophy despite market vagaries and intermittent noises.
A well-defined investment philosophy should provide for reasonable deviations from strategic allocations on a periodic basis in response to changing macro and market environment through tactical changes. These changes should not be seen as zero sum. Instead, they should be treated as additions or deletions to the larger strategic allocations. Over and above this, emerging markets like India offer reasonable fund manager alpha over the underlying representative asset class benchmarks. Further, a selection of investment avenues brings in a certain amount of tax and scale efficiencies. A combination of these factors should help investors meet or exceed their objectives by following a disciplined investment strategy.
Basis our five factor relative attractiveness proprietary model, we see five to six investment avenues or opportunities in the market place currently for long-term wealth creation:
1. Mid & Small Cap stocks
The recent sell-off in the markets has significantly eroded the valuation premium that mid and small caps enjoyed over large cap stocks from 40% to the current 6%. Now that midcap stocks are trading at reasonable valuations, they present a compelling buying opportunity. Midcaps are currently trading at a reasonable earnings multiple of 16x versus 5-Year and 10-Year averages of 17.8x and 14.8x, respectively, on a 12-month forward basis with an expected two year earnings CAGR of 22%.
Earnings outlook for this space is improving with earnings quality reflective in better operating and financial leverage. The SEBI’s recent fund categorisation mandate and stipulations over fund allocations have ensured homogeneity and confined the risks within the expected range of the respective fund categories. As uncertainties recede and the business outlook improves, we expect mid and small caps to outperform in the medium term.
2. High Quality Credits in Fixed Income
A spurt in oil prices coupled with rising global cost of capital led to a flight in portfolio capital from the beginning of the year. The fixed income segment has suffered severely with the FPI sell off. A depreciation in the Indian rupee and RBI interventions have further exacerbated the situation leading to tighter liquidity. A conflation of these factors has led to risk aversion in the debt markets, with investors now gravitating towards overnight market instruments. Hence, we are seeing high quality credit bond yields move upwards of 9%.
Given the current average inflation of 4%, medium term inflation expectations of the RBI at 5% and policy rates at 6.5%, currently high quality bond yields are trading at 200-250 basis points above the policy rates. This is a fairly steep discount to historical averages of 100-150 bps. While this suggests excessive risk aversion, we think any improvement in the risk and liquidity environment should soften yields, thus providing investors with the additional kicker in fixed income returns over and above the traditional accrual returns.
3. Private Bank Stocks
Credit growth has improved towards the longer term averages of 14% while deposit growth continues to trail the same. Banks have been resorting to wholesale borrowing due to a lack of pricing power owing to stiff competition from NBFCs, so far. Consequently, NBFCs have grown rapidly at the cost of PSUs over the past five years. Now that liquidity is getting tighter and a severe trust deficit is seeping into the sector, we are seeing a jump in the borrowing rates of NBFCs as well. This offers a great opportunity for private banks, which do not have the capital constraints of PSU banks and liability franchise limitations of NBFCs. We think that private banks are likely to outpace the financial segment at an overall level, while players with a quality franchise and robust liability base are likely to be key beneficiaries among them. Valuations of these banks have also corrected from their earlier peaks and hence provide a compelling investment opportunity.
4. Auto OEMs Stocks
Rising cost of vehicle ownership and the absence of any major new launches has slowed the sales of two and four wheeler automobile vehicles over the past three months. We believe that the policy thrust on improving rural incomes and the ongoing economic expansion will continue to give a fillip to broader consumption and perpetuate a structural shift in patterns of consumption. These factors should lend the necessary support to auto sales over the medium term. In line with the wider market sell off, auto stocks have come under selling pressure as well. Additionally, there has also been increasing competitive intensity in the two-wheeler segment which has led to a sharp correction in the valuations of these stocks. We see this as a good entry opportunity given the medium term healthy demand outlook.
5. Global Asset Allocation
Rising aspirations, an upwardly mobile population and rapidly-changing consumer trends have increased the need for foreign currency. Growing preference for a global education as early as immediately after under graduation, foreign vacation plans further evolving to destination family reunions etc. are all contributing to a dramatic increase in the demand for foreign currency.
Concurrently, the domestic currency has been losing its sheen in part due to the inherent nature of emerging markets. Apart from consumption needs, basic investment portfolios need a hedge from periodic currency depreciation as well. For this, investors could consider global investment allocations. These allocations could be in two ways. One, through the feeder funds route offered by domestic mutual funds without any restrictions and two, through direct allocations to external assets up to regulatory permitted limits of USD 2.5 lakh per annum per individual. These asset classes tend to offer have two sources of gains. One is the gain made through the performance of the respective asset class at constant currency terms and the other is currency translation performance.
6. Emerging Market (EM) Stocks
While global asset allocation itself offers an investment avenue, a granular, bottom-up analysis of the space suggests that emerging market equities are relatively more attractive than developed markets. Owing to the risk aversion and flight of capital, emerging market assets have fallen out of favour and hence valuations are relatively cheap. Along with the markets, EM currencies have depreciated as well. Earnings outlook in these markets appears to have bottomed and is now showing signs of improvement. This combined with an inversion in the global bond yield curve suggests that monetary tightening is likely to halt in the months to come. This could ease concerns of rising cost of capital and risk environment. As the business environment and corporate profitability improve, we expect to see emerging markets become the destination of choice for global investments. Hence, we think that the risk reward will lean in favour of emerging markets from a medium-term perspective.
(By Rajesh Cheruvu, Chief Investment Officer, WGC Wealth)