If we draw parallels from history, such economic slowdowns in the past would have seen a larger price and time correction. This time, however, we have low interest rates globally for very long and central bank support which is giving base to asset prices in spite of slowing earnings and weak economic growth.
By Urvashi Valecha and Malini Bhupta
Investors should look for ‘margin of safety’ in the new normal, says Kalpen Parekh, president, DSP Mutual Fund. In an interview with Urvashi Valecha and Malini Bhupta, he explains why investors should reset their expectation on returns from equities. Excerpts:
What should investors do given that markets have recovered from March lows, but the economy continues to face challenges because of the pandemic?
From a risk reward perspective, these are times to defend and not to attack as we are facing a different magnitude of uncertainty. If we draw parallels from history, such economic slowdowns in the past would have seen a larger price and time correction. This time, however, we have low interest rates globally for very long and central bank support which is giving base to asset prices in spite of slowing earnings and weak economic growth. In past slowdowns, valuation multiples would be much lower unlike today where we are at peak multiples for many companies which are a large part of investor portfolios. Investors should ‘look for a margin of safety.’ Since most companies are trading at their premium valuations and lower growth than the past, it means that future returns can be muted and hence investors must have reasonable return expectations, diversify across asset classes and increase investment horizons.
A lot of investors are pulling money out of MFs as there is a disconnect between markets and economy. Your view.
Markets are rarely in equilibrium, more so today, when more money at low interest rates drives asset prices. From a traditional lens, stock prices look overvalued, yet the other school of thought is when interest rates are so low, these prices can remain high for long. Investors are not exiting due to disconnect between markets and the economy alone. Many investors have seen changes in their cash flows, salaries, careers and businesses and thus adjusted their investments and cash flows accordingly.
Historically, from peak Nifty valuations, future returns of equity and debt are not too different and hence I would advise investors to choose hybrid funds which not only reduces market fluctuations but also can be deployed in stocks if they come down. In 2008, confidence in the economy was highest, profits were growing at 20%, credit growth was strong, capex was rising – perfect picture and all that we would expect today too. Yet, returns on Nifty since then to now is close to 7%. Thus, rosy present doesn’t guarantee a rosy future and likewise a weak current environment doesn’t necessarily mean bleak future returns.
What kind of returns expectations should investors have?
Investors must bring down return expectations, unless data changes and we see strong profit growth across sectors. When the 10-year bond used to be 8-9%, equity returns were 13-14%. If the 10-year bond is at 5.8%, our expectations of 13-14% from equity has to change. Since 2013, RBI set a strong inflation targeting mechanism, we have brought down inflation which will also have an impact on equity returns. The world over if bond yields are close to zero. Everything is at a lower base as the value of money is worth much lower and hence returns expectations should be lower.
How can you build a portfolio in this environment?
In an environment like this when interest rates on bonds are at an all-time low, stocks of good businesses are at an all-time high and when alternate assets like gold are also at annual highs, what do you do with money? At such times, it is wiser to not chase past returns but understand risk and design a safer portfolio. Invert and seek answers to where I can lose money or risk is understated and the margin of safety is low. Based on these questions, build a diversified portfolio across equities, bonds, global companies and gold. My asset allocation is 45% in equity funds, 40% in debt funds and 13% in international as well as gold mining funds and 2% in hedge funds.
Do you see the threat of a second wave-led lockdown in India?
We should wait and watch for November- December which is the festive season. Typically, as people mix around, that will be the real test of progress or decline in Covid-19 cases. Hence, the risk of another lockdown always remains and we should remain cautious with respect to our health as well as our money. On the other hand, there is pent-up demand coming back. India never has a demand problem.