Carnelian Update – What next?
Updated: Jul 2
Greetings from Carnelian.
Who would have imagined in March 2020 when the world was hit by a once in a century kind of pandemic, that markets will hit a new high in less than one year?
In our last three newsletters, we have shared our views on the evolving situation and how this crisis has been creating a lollapalooza impact for Indian equities and many other emerging markets.
Most investors are grappling with questions like – should we allocate more to equities or not? Is it overdone in the short run? What if we allocate money and markets correct? Is there more upside left after such a sharp run?
If one were to make this decision with a rear-view mirror and reference prices of March, the answer most likely will be a No. But if we were to do a fact check and look forward, you are likely to find different answers.
This month, we are attempting to answer some of these questions and our view.
It is important to understand the impact of the crisis on various macro aspects after considering all the measures being undertaken.
Without doubt, COVID-19 negatively impacted several sectors such as Travel & Tourism, Retail, etc., but at the same time it created a positive impact on certain sectors too - IT, Pharma, Healthcare, and Manufacturing. Some sectors such as Auto and BFSI have rebounded. Global liquidity, sharp drop in interest rates, China +1 strategy (shift from China), initiatives to localize manufacturing and local credit support are big structural positives that have emerged post COVID.
Going forward, we see the environment very conducive for Equities as an asset class.
Easy liquidity and low interest rates not only feed into asset prices but also improve earnings growth of corporates thereby creating a positive circular loop.
Mild inflation – a mild inflationary environment is very good for equities as it allows companies to grow both in revenue and margins. We see mild inflation persisting over the next 3-4 years.
Robust corporate earnings growth - wider its span, better it is.
Let’s examine each of these factors –
Easy liquidity – It is a well-articulated policy by both Fed and RBI that they will keep the liquidity conditions benign over the medium term. In previous crisis, this condition helped gain back growth and should do the same this time as well. Another interesting aspect to keep in mind is – In India, historically the risk to easy liquidity & lower interest rates has always been caused by a deteriorating Current Account and its resulting impact on forex reserves. This time around robust FDI & FPI flows coupled with a strong focus on reducing Current Account Deficit (CAD), led to lifetime high forex reserves. We derive huge comfort from tangible efforts being undertaken by the Government to promote local manufacturing and reducing dependence on imports.
Interest rates - Again, this is the condition India has long waited for! RBI has clearly stated its intent to keep it low unless inflation goes out of hand. Low interest rates feed in multiple ways. It reduces the EMI burden of borrowers, reduces the threshold IRR needed for projects and also channelizes more money towards equities as an asset class. Both liquidity and interest rates usually tend to move in the same direction.
Mild Inflation – We see a mild inflationary environment for two reasons – 1) Easy monetary policies always bring about a bit of inflation due to the sudden rise in demand and supply side taking some time to build. 2. Protectionist measures undertaken for the local industries is likely to increase the cost of inputs across the board. Protectionist measures might be good for CAD, but it will have inflationary implications and hence a right balance will be necessary. We believe the government’ focus to build the supply side and competitive set up of the Indian industry will keep high inflation under check.
Corporate Earnings growth - We see a robust earnings growth environment which will be spread across unlike in the past where it was concentrated to few sectors. Indian corporate earnings growth over the past 10 years has just been ~3% for the BSE 500 index (~6% ex-Covid impact), with growth concentrated on a few sectors like FMCG, select private banks, Chemicals, Consumer durables and Retail. We see a big change in this set up as we move forward. Historical laggards such as IT and healthcare have found accelerated growth post Covid. Financials & Auto are coming out of a long consolidation period and will do well over next 3-4 years. Commodities & real estate will also contribute positively to the growth. Manufacturing across the board is a new growth driver. We see a very robust and well diversified corporate earnings growth over next 3-4 years.
If all these factors turn out to be true (to which we assign a very high probability), Indian equities will do very well. We estimate Nifty earnings growth at 20% CAGR over the next 3 years.
What are the risks
The practical difference between risk and uncertainty…. is that in the former the distribution of the outcome in a group of instances is known... while in the case of uncertainty, this is not true because the situation dealt with is in high degree unique” – Frank H Knight
“Covid” kind of uncertainty always exists and can happen anytime. No one can manage this and one has to go through it, be it in life, business or investing.
One should always be watching out for risks but risks need to be managed not avoided. We are almost out of an uncertain environment and even if the second waive comes, world is by and large prepared to handle it without similar implications of past.
How do I time the allocation?
Peter Lynch once said “more money is lost in waiting for correction than correction”
We believe that we are in a structural bull market over the next 3-5 years and this will offer significant wealth creation opportunities. We foresee a golden opportunity for long term investors, hence advise investors to systematically allocate to equity but only with money which they can spare for long term.
However, every bull market has volatility and several intermittent corrections. Timing markets is an impossible task. Our advice to investors is allocate to equities with a view to hold for next 5 years and be prepared for 10-15% drawdown.
How is our portfolio positioned?
Our portfolio is split into 60:40 between Magic and Compounder Baskets. Magic baskets stocks are expected to see both re-rating and earnings growth. Compounder stocks will give steady ~18-20% return in line with their earnings growth. To add another dimension, our portfolio is well diversified with a fair mix of Bank Credit; non-credit (insurance, Capital Markets), Auto, IT and Pharma. The current mix of our portfolio can result in short-term underperformance when high beta stocks are going up, however it is well positioned to capture the aforesaid opportunity over long term.
All the companies in our portfolio have demonstrated superior leadership and execution capabilities amidst the above crisis and emerged much stronger to participate in future growth tail winds. This quarter most of our companies have beaten expectations and have shown a fine recovery. Overall, the portfolio has delivered 7.5% revenue growth YoY and 16% PAT growth YoY.
We expect earnings for our portfolio companies to grow at a CAGR of 19.5% over the next 3 years with average ROE of 20.6%. Most of the companies in our portfolio will continue to gain market share and hence we expect growth to be better than industry.
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