Divergence in stock prices between growth and value is rising
Mon, 17 Jun 2013 23:25:46 -0600
Investor focus should be not on what causes foreign money to flow in or out of our market, but on fundamentals
The fall in the rupee has an adverse impact on inflation and also increases fiscal pressures due to subsidies. These changes in the economy and key macro variables certainly have an impact on the stock market.

Our currency is vulnerable due to our dependence on foreign capital inflows. This round of weakness in most emerging market currencies, including surplus economies, will no doubt end at some point. But the point is that we need to address the fundamental issues holding back the competitiveness of our economy and heal the self-inflicted wounds on the supply side of the economy.

From a balance sheet perspective, the fall in the rupee is negative for corporate India because many of the companies with large forex debt do not have a natural hedge in their revenues. From a profit perspective, the situation is more nuanced. The IT, pharmaceutical sectors have large dollar denominated revenues and several commodity companies also sell at prices that move in sync with exchange rates.

Companies in the manufacturing sector with significant exports will also benefit from the fall in the currency and some manufacturers who have been facing price competition from imports would face some relief. But these are the broad trends- we prefer to focus on the bottoms-up fundamentals than be guided merely by the change in the forex rate.

We are an outlier among emerging markets in having seen strong net inflows into Indian equities even when other economies have not been so lucky. This remains an overhang for the market. But our focus is not on what causes foreign money to flow in or out. If our fundamentals improve there is no reason that capital would not flow into equities-from both local and foreign investors. The economy is healing but there is no dramatic recovery in sight. There is no option but to be patient.

The stock market is certainly vulnerable as the inflows have been dominated by foreigners. But this also means that domestic institutions have liquidity. In the longer term flows follow the markets and not the other way around.

Our view on the market and the economy has been one of caution. The currency weakness adds a new dimension to our challenges, but valuations remain in the comfort zone. Our investment strategy continues to be guided by a bottoms-up focus and we see no reason to eschew that approach.

The biggest challenge in portfolio construction today lies in the divergence in valuations between the cyclical components of the market and the non-cyclical areas. Even within some cyclical areas there is now wide divergence in valuations between companies.

In layman's terms – the market is now paying high valuations for earnings growth and low valuations for businesses with poor earnings visibility. This reflects in part a strong growth bias in the market.

Economic data have been mixed and while there is some stabilisation and the recovery is modest at best. Leading indicators and high-frequency indicators such as auto, cement sales, credit growth etc are sluggish. Long-term consumption trends in India are supported by demographic trends, but obviously job growth and income growth must be supportive.

With the investment cycle having turned weak the growth and income trends are under pressure and inflationary pressures have also eaten into consumer budgets. The policy issues that are being addressed now involve reduction in subsidies and market pricing of goods-this transfers money from consumer wallets to producers. But this is the need of the hour as we need to stabilize the fiscal deficit and incentive investment.

The divergence in stock price behaviour between growth and value has accelerated - the benchmark Growth index (MSCI growth) has accelerated sharply in performance relative to the value index (MSCI Value) over the past few months. This is of course a continuation of a trend that has persisted since 2010. These gains are being driven not just by earnings growth but also by P/E multiple expansion.

Our attempt has been to find a balance between two risks - the risk of overpaying for quality businesses and the risk of being early in buying good businesses albeit with poor visibility at attractive valuations. Our strategy continues to emphasize bottoms-up stock selection. Our focus is not so much on when a growth revival is likely but on being invested in those companies that will benefit the most from a growth revival as and when it happens.

(Excerpted from an interview)

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