Sep 26, 2016
“Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own judgement, they respond to market forces not with blind emotion but calculated reason.” – Seth Klarman
This month we look at earnings revisions in the Nifty 50 and broader market, global factors and review our investment strategy in a liquidity driven world.
Earnings Revisions for the Nifty 50 and the CNX 500 Are Trending Lower
This week, we start by looking at earnings revisions for the Nifty 50 and the broader market. While wehave always maintained a strong dose of scepticism with respect to analyst earnings forecasts, short term revisions driven by earnings announcements can often provide insight into the current state of the economy.
In the Nifty 50, Energy reported the largest increase in forward expectations over the past month, while Financials have witnessed the highest revisions over the last 3 months. Reeling from increasing competitive intensity, Telecom expectations declined the most in the past month, while Utilities saw the worst penalisation on earnings expectations over the past 3 months.
Financials Have Witnessed the Best Upward Earnings Revisions Over the Past Three Months
Somewhat worryingly, most sectors witnessed negative earnings revisions; however, we would attribute this to the revision of overly optimistic analyst expectations being reset to reality.
Earnings Revisions for the Nifty 50
A deeper look into revisions by company is instructive. In what we hope is not a classic case of confirmation bias, we see trends in this data that confirm our sector preferences and views. For the Nifty 50, both Telecom majors are amongst the top downward revisions. It is a sector we have thankfully avoided.
Next, it has been getting increasingly evident that the IT majors are going through at best, a rough patch, and more likely, a re-definition of their prevailing business model. To us, the IT majors are the disrupted, not the disruptors anymore. In a world where Whatsapp created the dominant chat platform with 8 employees, the body shop model looks increasingly passé and it is a toss of the coin whether these companies can migrate to digital effectively with a labour driven business model that’s looking increasingly bloated.
Finally, the other sector we have consistently shied away from is PSU banks. We would add private banks with large NPAs to that same bucket, and you can add PSE entities to the list as well.
Telecom, the IT Majors and Banks with NPA Issues Are the Biggest Drags on Nifty Earnings
Looking at the positive revisions for the Nifty 50, two key trends emerge. One, automobiles are on a roll. Four companies with upward revisions are in automobiles (Eicher Motors is categorised as Machinery, but is clearly in the two wheeler space).
The other trend is Energy. It is becoming increasingly likely that Crude Oil will stay around the current range for the foreseeable future. The implications are clear for these companies, not to mention the profit potential. We believe we are entering a time where Energy stocks will be consistent outperformers.
Looking at the data on the broader market, Financials are the standout and within Financials, the Consumer Finance sector companies. The earnings revisions data reinforce our view that we are witnessing a bifurcated market, with automobiles, financials and consumer driven sectors performing healthier than stocks in the telecom, IT and PSU space. IT was actually in a sweet spot but the coming elections, Brexit and Europe, not to mention the business model structure, have cast a pall over the sector that is unlikely to alleviate before the end of the year.
The yield on new 10-year benchmark 6.97% closed at 6.81% as the Fed took a dovish stance and kept rates unchanged in its monetary policy meeting on September 21st. We have been forecasting a decline in rates since the Brexit event in late June saw a surge in inflows into Indian debt.
Additional measures such as SEBI allowing select categories of foreign portfolio investors (FPIs) to directly trade in the debt segment of the market, bypassing brokers also served to raise the confidence of foreign investors.
As We have Forecast in Recent Months, the 10 Year Continues to Move Lower…
Fed and Domestic Inflation Suggest a Continued Downward Trend in Rates
CPI for August-16 came in at 5.0%, a 5-month low and below the high of 6.1% in July-16. The Current Account Deficit declined to -0.1% of GDP (vs. expectations of surplus).
The decline in inflation in coming months suggests that inflation expectations will remain muted, yet again a positive contributor to the declining rates scenario.
Flat US PPI in August coupled with a decline of -0.3% in US Retail sales vindicate the Fed’s stand of maintaining status quo as these indicate signs that the underlying economy is actually yet to improve.
The US FOMC meet resulted in yet another status quo on rates. While prognosticators continue to buy the rhetoric that the Fed will raise rates this year, wehave been solidly in the camp all year that the Fed would not be raising rates this year.
Bank of Japan Adopts Inflation Targeting
Bank of Japan’s move to switch to targeting interest rates while keeping asset purchases at Y80tr indicates a continued infusion of liquidity into the global markets.
Key indicators in focus for the coming week: India’s NIKKEI PMI and US Markit Mfg. PMI, US ISM Mfg. PMI.
The Nifty index closed at 8832 levels up by 0.6% for the week. After the gap down opening couple of weeks back, index took support at 8700 where medium term rising trend line offered support to the market. Nifty has slowly moved along this trend line and filled the gap area resistance zone. FIIs continue to hold onto their long positions in derivative segment with in flows in cash of Rs. 2680cr (provisional) for last week.
Momentum indicators on weekly chart are flattening out, suggesting market could remain sideways unless major support levels are broken. The immediate support level for index is 8690 levels, breaking below this next support for the market is at 8500 odd levels. In Nifty put options, 8500 strike has the highest open interest indicating this major support level for the market. Sustaining above 8900 levels, 8970 and then 9080 will be the levels for the market.
The stock market is a device for transferring wealth from the impatient to the patient – Warren Buffett.
Two Keys to Investing Success
From time to time, we think it has been beneficial to look at the larger investment picture.
Life expectancy is rising globally. It has risen by five years in the past 15 years. Another way to state this is that for every year we live, expect to add an additional four months to your life. Further expect this trend to accelerate given the massive wave of innovation headed our way.
What does this have to do with investing? Well, as the chart below demonstrates, investing success is a back-loaded affair. In other words, the first five years may only see your investment double, while the tenth through fifteenth year will see your $1 investment rise 8 times.
Since compounding is back-loaded the only way to get benefited from it is to live a long and healthy life. So a primary conclusion is that the largest benefits will accrue to the patient, and in particular the patient that live their lives well.
The second chart also shows how important it is to not have crippling losses along the way. An investor that manages to avoid a 50% loss in one of the years, will make 2.3 times more money than one that suffers through the loss. In monetary terms, the $1 that would grow to $16.4 in 20 years at 15% p.a., will only grow to $7.1, a significant difference.
Were the investor to suffer two 40% losses over the twenty year period, then his or her CAGR would drop to 7.8%. It is critical to avoid crippling losses.
To summarise, the key to investing is to stay in the game for a very long time without losing a lot of capital.
We have been on the record stating we do not expect the Fed to raise rates this year. So far, that forecast looks solid. As liquidity finds its way into emerging markets, one cannot help but ask how sustainable is this rally?
Despite its stated intentions to the contrary, it is difficult for the U.S. to raise rates other than a token 25 bps. So the punchbowl will remain. If the punchbowl remains, global liquidity will remain.
In this, we think the Japanese model remains a possible glide path for the U.S. One glaring advantage the U.S. has is its reserve currency status, which allows it to address all manner of problems with the creation of money at the touch of a button.
Trump remains another glaring risk.
But the cavalry rides to the rescue here as well. The broader CNX 500, ex PSUs and ex Telecom, has done well, delivering roughly 14.8% earnings growth in the recent quarter.
The strong performance of the auto sector lends credence to the panning out of a consumer-led demand growth story. The Indian consumer is confidently spending and is becoming aspirational and stepping up discretionary spending.
The much talked about 7th Pay Commission and probable imminent GST implementation are an additional fillip to consumption, and will continue to be drivers for economic growth.
Finally, we could easily envision the 10 year headed to a 6% number, and lower if global flows keep coming to India. This again bodes well for the Indian consumer, valuations and earnings. What it does not bode well for is debt investors in future years, and savers, who will see their income and purchasing power be decimated.
The Indian consumer is healthy and we continue to believe that the economy is doing fine. The global punchbowl remains full. While these factors remain, we view corrections in the market as a buying opportunity.