Feb 4, 2019
Objective factors do play a part in cycles, of course, but it’s the application of psychology to these things that causes investors to under or over react, and thus determines the amplitude of cyclical fluctuations – Howard Marks
Factor investing chooses securities on attributes that are associated with higher returns. We focus on style factors in this study, and ignore macro factors, with the intent of confirming factors that continue to have predictive value for equity returns, using five years of NSE 500 data, and share key findings below.
3 Year PAT Growth
The first factor is 3 year PAT growth. We segregate the data by quadrant with quadrant 1 being companies with the lowest 3 year PAT growth and Quadrant 5 being highest, and list the annual returns in the table below for each quadrant.
Quadrant 5 (high PAT growth companies) delivered a 20.5% CAGR return over the past five years, double the index return. The higher PAT quadrant returns were consistently higher than lower PAT quadrants. Clearly, profits drive price. Further, the high PAT growth quadrant consistently and meaningfully outperforms over all years except FY19. Clearly, consistent profits growth is a factor that contributes meaningful alpha. This factor is a fundamental input in our in-house portfolio construction process.
Consistent High 3 Year PAT Growth Companies Delivered 20.5% CAGR over the Past 5 Years…
…Far in Excess of the Nifty’s 10.4% CAGR
Year-over-Year Sales Growth
Next, we consider year-over-year sales growth as a factor. The high sales growth quadrant delivers consistent, stable returns in comparison to other quadrants, and is less prone to sell-offs. For investors interested in high quality, low beta portfolios, high sales growth is a factor to consider.
High Sales Growth Companies Deliver Consistent Returns…
…With Lower Volatility During Downturns…
Return on Capital Employed (ROCE)
Next, we run the data for Return on Capital Employed (ROCE). Somewhat surprisingly, the data suggest that returns are consistently higher for quadrant 3 and companies with healthy ROCE do better than companies with exceptionally high ROCE, while high ROCE companies deliver consistent returns and low volatility.
Middle Quadrant Healthy ROCE Companies Perform Better than the Market…
…and Provide Meaningful Alpha with Low Volatility
Trailing P/E is often used as a proxy for Value and Growth comparisons. The lowest P/E quadrant – Value – outperforms significantly during bull markets, as a rising tide lifts all boats, while the highest P/E – Growth – outperforms more consistently and holds up during sell offs such as FY18.
Growth has outperformed Value in the past two years; however, Value has delivered a long term alpha of almost 8% above the benchmark. While Growth delivers consistent, stable, predictable returns, Value outperforms during bull phases.
While Low P/E Delivers a Higher Long Term CAGR…
…High P/E Delivers More Consistent, Stable Positive Returns with Lower Volatility
In summary, some guiding investment principles emanate from the study:
• Consistent longer term PAT growth, healthy ROCE, low P/E and Capitalization are attractive factors to consider in return enhancement and portfolio construction
• Growth provides consistent performance, while Value is volatile, but Value does well during bull phases
• High P/E or quality growth, holds its value during corrections with lower downside volatility, and provides predictable, consistent returns
• There appears to be an opportunity for significant alpha in small caps
The Sixth Budget is Equity Positive and Credit Negative
We covered the budget last Friday in a note available here. Our key takeaways are that no matter the winner in the election, rural consumption and disposable income appear set to rise. Second, India seems to be firmly heading towards some kind of basic farmer income support. Third, the fiscal math looks murky and will clarify in coming months, particularly if the government consolidates existing schemes into the stimulus package. The Budget is spending positive and credit negative.
The IMA’s Tenth Quarterly Business Confidence and Performance Survey Points to a Mild Distinct Upturn
The highly respected IMA has come out with their quarterly Business Confidence and Performance Index (BCPI) survey in early January. They’ve been running the survey for over 10 years now. Over 150 CEOs and CFOs responded to a short questionnaire, which seeks to ascertain industry’s outlook on its own performance as well as that of the broader macro-economy. The results point to a mild yet distinct upturn in the overall trajectory for business. After dropping to a 2- year low in October, the headline index is now back up to 57, well above the switch-over point of 50 that signals net pessimism.
The IMA Survey Points to A Mild Distinct Up Turn in the Economy
Earnings Performance – Adjusted Earnings Up 19.2% and 17.8%
On to earnings, where there’s good news and bad news. With 33 and 195 companies in the Nifty 50 and CNX 500 reporting respectively, the top line numbers look great for the Nifty 50 and CNX 500, at 24.5% and 21.8% respectively.
Financials as a sector has delivered a large uptick in earnings, up 34.6% for the Nifty 50 and 50.2% for the CNX 500. Additionally, IT has performed well, but the numbers are muted due to the loss reported by Infosys. Ex Infosys, IT sector earnings bump up to 22.3%.
The bad news: Energy has reported large losses and Telecom continues to report losses, so the net earnings number for the Nifty and CNX 500 remain, as usual, a measly 0.1% and 0.8%. Excluding Bharti Airtel and Indian Oil, the PAT numbers on the Nifty become respectable, up 19.2%. On the CNX 500, excluding Bharti, IOC and Bank of India, yields 17.8%.
Adjusted Earnings (ex Bharti, Infosys and Indian Oil) are Up 19.2% for the Nifty…
…and 17.8% for the CNX 500 (ex Bharti Airtel, IOC, Infosys and Bank of India)
While the Unadjusted Sales Growth Is Stellar and Earnings Flat
The Fed Put is Alive & Well and Balance Sheet Contraction Is Close to an End
In key global news, the Wall Street Journal reported last week that “Fed officials are close to deciding they will maintain a larger portfolio of Treasuries than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” The Fed Put is alive and well. Alongside neutral rate policy, that’s a powerful headwind that closer to an end, and particularly positive for EMs and India.
Market Technicals Remain Healthy and Capital Entered the Market Last Week
The market has been knocking on Nifty levels of 10,968 and been rejected 4 times. Today’s market seems similar to February 2014, when investors exited a challenging 2013, with uncertainty around elections. Worries persisted heading into 2014, and the beginning of 2017 was also a time of fear and trepidation. Valuations are far higher today, but decadal low inflation, structural reforms, low inflation adjusted oil prices, moderate interest rates, rising financial flows, strong PMI data and accommodative central bank policy – domestically and in the U.S. – form a favourable backdrop for equities. Good news is being bought by investors, and bad news taken in stride. The market has also demonstrated strong resilience at lower levels, and each dip in the market is being bought.
Credit is A risk to our Forecast
The ongoing emergence and re-emergence of credit related issues remains a risk to the forecast.
Sectorally, we continue to raise our exposure to technology, financials (corporate banks), consumer staples and select consumer discretionary (luggage, movies, quick service restaurants).
Things look a bit murkier in the short term for debt. There are two immediate negatives that the bond markets must contend with. The gross scheduled borrowing of INR 7.1 lakh crores in the budget was higher than market expectations, although bond yields barely nudged up 12-14 bps on Friday.
Second, the revised fiscal deficit for FY20 at 3.40%, is higher than the previous glide path. With next year’s upward revision wholly due to consumption stiumulus, pending cuts in other programs, the math looks difficult. The bond market may have to contend with greater supply amidst a tapering off in the RBI’s OMO operations.
Rate Cut Looks Unlikely
In the face of strong PMI manufacturing data, with the fastest rise in factory orders since Dec 2017, and marked growth in hiring and new orders, the RBI MPC is likely to take a wait and see approach and will be unwilling to cut rates at the current month meeting this week, noting that the economy is likely to receive a fiscal stimulus and inflation risks have risen.
However, Credit Issues Continue to Persist and are a Concern
After coming through a harrowing period last quarter on IL&FS, the system has come through one of the harsher credit environments and we expect that every bank and NBFC went through their exposures with a fine-tooth comb. Recent news, however, continues to raise questions on re-emergence of credit risk at the periphery and associated inter-linkages.
Globally, the Fed’s being closer to done on liquidity withdrawal as well as rate increases is great news for EM debt. Our preference remains a diversified portfolio of short to medium duration, credit risk and corporate bonds. We continue to prefer short to medium duration AAA oriented strategies. We’d look to deploy capital tactically on spikes in interest rates. Longer end duration bonds could now likely be more volatile given higher supply ahead, especially once the pace of OMOs subsides. For risk averse investors, ultra-short term and liquid funds would be a safe choice to park funds until clarity emerges.
A Golden Cross
Gold in dollar terms has engineered a breakout and a cross over above $1300. Moreover, the 50 day has crossed over above the 200 day, referred to in technical parlance as the golden cross. Gold had a similar up move in 2017 and then rolled over. It’s arguably been stuck in a trading range since 2014. Clearly, momentum does appear to have shifted. A break above $1375 would constitute a mulit year breakout and would clearly have investors attention.
Gold Has Experienced a Golden Crossover…
A Further Break Above $1375 Levels Would be a Multi-Year Breakout
Source: Stock Charts
Equity markets witnessed volatile session of trade on Friday with Nifty witnessing wild swing during the session. Nifty finally settled at 10894 levels up by 0.58% for the day and 1.05% for the week. Index has formed bullish hammer on weekly chart indicating buy at lower, but on daily chart formed shooting star kind candlestick with long upper indicating selling at higher levels. Thus, still no clarity on direction of the market index and continues to be in a range. On the upside Nifty again tested 11000 levels and selling emerged keeping the index within the range. Hence, 11000 needs to be crossed on sustainable basis for market to higher towards 11090 and 11170 levels. On downside immediate support is at 10813 levels which is Friday’s low, moving below it market can see likely to test 10630-10585 levels. In Nifty options, maximum open interest for Puts is seen at strike price 10800 followed by 10400; while for Calls it is seen at strike price 11000 followed by 11200. Call writing was seen in 11200 and 11100 along with unwinding in 10800. Put writing in 10800 and 10900. Thus, suggesting supports are shifting higher. India VIX closed at 15.72 levels down by 11.14% for the week. VIX needs to move below 15 levels for markets to see sustainable breakout on the upside, otherwise index is likely to continue in range or head lower.