Greetings from Team Carnelian!
Wishing you a very happy and prosperous new year!
Peter Lynch -
“Corrections are unpredictable. By selling stocks to avoid pain, you can miss the next gain.”
Facing mark-to-market drawdowns is a tough reality in investing, though Indian markets almost lost sense of it in recent times. Long-term wealth creation has rarely been a smooth, straight line. To achieve significant gains, investors should be emotionally resilient enough to withstand cyclical downturns. Those who can differentiate between structural and cyclical factors gain a distinct advantage.
October proved to be an eventful month for the Indian markets, with Foreign Institutional Investors (FIIs) pulling out around USD 13.5 bn. The Nifty index dropped by ~9% from its highs and select mid-cap and small-cap stocks (SMID) declined by ~20-50%. In the Nifty 500, ~67 stocks have now fallen over >30% from their all-time highs. We are glad to report that all our portfolios (as highlighted in the table above) have outperformed the Benchmark despite being SMID heavy, displaying the resilience of our investing approach and philosophy.
Understanding whether the current downturn is driven by temporary (cyclical) or more profound (structural) factors is crucial. Our analysis indicate that the current market volatility largely stems from temporary reasons, creating an opportunity for long-term investors.
Currently the markets are contending with short-term headwinds, but the structural fundamentals continue to remain strong. History shows that such temporary factors often create ideal buying opportunities for those focused on long-term gains.
Temporary headwinds
Capital Flows
In October 2024, Foreign Institutional Investors (FIIs) withdrew ~USD 13.5 bn from Indian equities, marking the largest monthly outflow since the onset of pandemic. This significant capital movement was influenced by several factors:
China's Economic Stimulus: China introduced a series of economic reforms, including interest rate cuts, reduction in reserve requirement ratios and liquidity support for both property and financial markets. These measures enhanced the attractiveness of Chinese equities, prompting FIIs to reallocate funds from India to China.
Valuation Disparities: Indian equities were perceived as overvalued compared to their Chinese counterparts. The Shanghai Index, for instance, traded at a price-to-earning (P/E) ratio of nearly 10.9x CY24E (as on 10th Sep 2024 – i.e. before the rise in Chinese markets), whereas the Nifty50 index had a P/E ratio of around 23.8x FY25E (as on 26th Sep 2024 – i.e. before the fall in Indian markets). This valuation gap made Chinese stocks more appealing to investors seeking better value. The valuation disparity has now narrowed to Shanghai being 13.4x CY24E vs Nifty being 22.5x FY25E.
Cyclical downturn in selected sectors ---- driven by short-term challenges
Consumer-facing sectors are experiencing cyclical challenges. FMCG, consumer durables, and auto OEM sectors witnessed slowdown during the quarter, while banking stocks with exposure to unsecured credit are beginning to show signs of stress. While some sectors face these short-term hurdles and overall profitability growth has decelerated over the past year, large financial institutions like SBI, ICICI Bank, and PSU Banks continue to report strong numbers with robust asset quality.
The consumption downturn is primarily driven by a slowdown in urban spending, while rural spending is showing encouraging signs of recovery. With a good monsoon season and increased rural expenditure, rural demand is expected to remain strong. Across various sectors, we are also seeing a rise in capital expenditures, and credit growth remaining robust.
On the positive side, the festive season demand has been stronger than expected, particularly for auto OEMs, while GST collections reached INR 1.87 lakh crore, marking the second-highest monthly collection till date. Corporate tax revenues also continued to show strength.
Geopolitical risks
The Middle East remains a region of heightened tension, with ongoing conflicts involving Israel, Hamas, Lebanon, and Iran. Over the past 8-10 months, there have been frequent missile exchanges and military engagements. Historically wars have created volatility in markets due to its impact on oil prices, which this time has been muted. With Trump winning the US elections, there is a possibility of an early settlement of this risk.
Maintaining a long-term investment perspective and focusing on the underlying strengths of the economy can help navigate periods of volatility influenced by geopolitical events.
Structural tailwinds
A decade ago, India was classified amongst the "Fragile Five" economies, a term coined in 2013 to describe emerging markets with significant economic vulnerabilities. At that time, India was not among the world's ten largest economies. However, through a series of progressive reforms and the establishment of a pro-business regulatory environment, India has ascended to the fifth position globally, surpassing countries like the United Kingdom.
Corporate profit to GDP inching up
In March 2024, corporate profit to GDP ratio reached the highest ever in last 15 years. This ratio which pertains to the BSE 500 universe (which accounts for ~91% of India's market cap) stood at 4.8% (last high was 5.3% in FY08). Sectors such as technology, BFSI, healthcare and capital goods are picking up well. Formalization of the Indian economy continues at a much faster pace thereby acting as a structural tailwind for the rising corporate profit to GDP ratio. Reforms such as GST, RERA, demonetization and a robust digital infrastructure have been key enablers towards this formalization. We see this ratio inching up to ~9-10% on the back of structural reforms.
Low leverage in the system
All the 4 balance sheets – corporate, banks, government and households are well under control right now. Corporate debt to GDP has come down across the board. When we look at the 2008 Global Financial Crisis, significant systemic leverage within global financial institutions, banks, and investment funds, was the single biggest factor leading to the crisis. Today as we look, things are much different for India - the system is far less leveraged, thanks to robust regulations and cautious financial practices in place.
NPA in the banking system is under control
The Reserve Bank of India (RBI) has proactively managed systemic risks thereby strengthening the financial stability and asset quality of the banking sector. RBI's forward-thinking regulatory measures have enhanced resilience, which is evident in improved metrices like decadal low NPA ratios, better capital adequacy, and robust credit growth.
Source: RBI
Unsecured and MFI credit is seeing stress over the last 3-6 months – however both the books put together account only for ~7-8% of the total banking credit. RBI has been proactively taking measures to manage the same.
Inflation under tight control in the last decade
India's inflation has relatively remained stable in 2023, thanks to the policy interventions by the RBI and favorable economic conditions. While global inflation surged, India's Consumer Price Index (CPI) remained steady on account of proactive interest rate adjustments and strategic efforts to stabilize food prices without significant impact on growth. These measures along with a diversified supply base, have helped maintain lower inflation in India.
India’s fiscal deficit trending downwards
Despite the dependence on global commodities, underlying subsidies given in the ongoing geopolitical scenario, India’s fiscal deficit have been well managed under control.
For FY 2023-24, the government achieved a fiscal deficit of 5.6% which was lower than the revised estimates of 5.8%. It plans to reduce it further to 4.5% by FY 2025-26, reflecting its commitment to fiscal consolidation. This achievement stems from structural reforms, steady growth, and reduced debt reliance.
Additionally, the RBI’s management of capital flows and foreign reserves has helped stabilize the current account deficit amidst global uncertainties.
Outlook
We finished Samvat 2080 with a stellar market performance; valuations too have advanced making it imperative for every investor to temper down their return expectations in Samvat 2081. With a recency bias, it is very natural for investors to have high return expectations but wisdom says otherwise. In every good market, fads get built and many underserving companies get money and attention.
At this stage three things are most important from a wealth creation perspective:
Temper down expectations in the short term – this will help avoid taking excessive risks
Stay away from FOMO – FOMO is one of the biggest reasons why investors at large fall into the trap fads with basic principles of investing getting compromised due to greed. AVOID this at any cost. It is very tough but very very relevant.
Stick to the basic fundamentals of investing. There is no alternate to common sense.
Our view is while the broader markets might give single digit to mid-teens kind of returns in Samvat 2081, selective, stock-specific opportunity will always be there. In the last month, all our portfolios have outperformed the Benchmark despite being SMID heavy, displaying the resilience of our investing approach and philosophy.
Investors should focus on sectors with strong fundamentals and reasonable valuations, while exercising caution in areas where valuations have become stretched. This strategy aligns with the current market dynamics and positions investors to capitalize on opportunities as they arise.
By maintaining a disciplined and informed investment approach, investors can navigate the consolidation phase effectively and position themselves for potential gains as market conditions evolve.
We expect sectors such as Financials, IT, Pharma, Capital Goods, CDMO/CRO to do well. We believe chemicals should start doing well towards the later part of the year. Defence, railways and select capital goods have seen a very sharp run-up – we find risk-reward in these unfavorable for fresh allocations. Samvat 2081 is going to be a very stock specific sector specific approach.
We believe this is the right time for investors to create a high-quality portfolio. Our efforts will remain concentrated towards finding the right company in the right sector with credible management.
A note on US elections
With President Trump's victory, there will be implications on geopolitics, World Trade and US economy. After the initial reaction, markets will settle down as no government actions impact immediately, but markets react quickly.
We think its neutral to positive for India considering his last term and some of the election promises.
China +1 should continue to play. It is only further positive for India from here on.
Geopolitics settling down should reduce freight cost which is again a positive for India.
India-US co-operation gets better, settling down some of the associated risks.
We do not see any negative for the IT sector as the US needs technology support which only Indian companies can provide. Any cost increase due to the visa regime will be passed on to the end-clients.
We are not euphoric but positive.
Once again, wishing all our readers a very prosperous New Samvat and Happy investing!
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