Investing in equities at stretched valuations:
Everyone wants a piece of the pie in stock markets when the market is going good. When times look challenging, the natural instinct is to shun away from equities.
Let me give you a scenario. Assume you have received a lumpsum corpus of Rs. 1 crore by selling a house. You are confused what to do with this money. For some reason you are no more interested in getting back into real estate. Lately, you have observed a lot of your friends speaking well about the equity markets (Yes, bull market has this effect). You wish to park some money into the stock markets, but are scared of the rally that has already taken place over a period of last 2 years. You end up having 2 fears:
1. Fear of missing out (what if you do not invest and market keeps going up)
2. Fear of losing capital if the market falls after you invest
This is not an easy situation to deal with.
Let me talk a bit about Nifty 50. It is a well-diversified index having 50 stocks. The weightage of each stock in the index is different. The presence of companies from different sectors makes Nifty a relatively safe bet in uncertain times. You have companies from many sectors: Banking & other financials, FMCG, Infrastructure, Insurance, Capital Goods, Automobiles, Manufacturing, Consumer discretionary, Pharma, Information Tech, Chemicals etc. If a particular sector does not perform well, something else generally compensates for it.
On closer observation of the market movement, it is not difficult to note that capital in stock markets often moves from a sector to another. You must have observed that when banking underperforms, many sectors like infrastructure, capital goods, automobiles join the underperformance. This is so because banking and financials is the heart of our capitalistic economic system. Businesses need capital to produce, and so do consumers need capital to purchase. It is safe to say that the economy wouldn’t move without capital.
Having spoken about sectors that will underperform with banking, there are sectors which act as defensives. FMCG, Pharma, IT are classic defensives (atleast in the Indian context). Pharma and IT are export oriented sectors and this puts them in an advantageous position in a country that runs a trade deficit. Similarly, India’s massive population base augurs well for consumption oriented companies. This is precisely the reason why investors start chasing safety in these sectors when the going gets tough.
This brings us to the definition of Beta. In simple terms, beta indicates the correlation of a company with the benchmark. Generally, the benchmark is considered as Nifty 50 by most investors. A beta of 1 means that the company has historically fallen or risen as much as Nifty 50 in a particular period of time. A Beta of 2 means the stock price of the concerned company moves double of what Nifty 50 moves.
Of all the sectors that we have spoken about, we can classify them broadly into 2 buckets: High beta sectors and low beta sectors.
This brings us to the million dollar question: When to allocate money to which sector? The answer is both simple and difficult. Simple because its common sense, and difficult because common sense is not really common.
Let’s begin with simple. If you feel that Nifty 50 is poised to go up, it’s a no-brainer that you must put your money on high beta sectors. Similarly, if you feel that Nifty 50 is likely to go down, you must stay as much away from the high beta sectors and rush towards the safety of defensives or low beta sectors.
Now, the question that arises is how to say with certainty whether Nifty 50 will go up or down. To be honest, if I had the foresight of predicting it with certainty, I wouldn’t spend my time writing this blog article (Maybe I would have migrated to some Carribean island). But, I can surely help you make a strategy without predicting the direction of broader markets.
The movement in Nifty 50 is dependent on multiple factors: domestic economic variables like inflation, GDP growth, export competitiveness of various sectors. These are internal factors. Assume that we as a country are successful in keeping everything in check. However, there are still things that can go wrong. The world today is connected enough to send the ripples of fear from one market to another. An economic disruption in Turkey or a deteriorating political situation between Russia & Ukraine can send chills down the spine of an Indian stock market trader. Not to mention the importance of US monetary policy in this circus called markets!
We can say that predicting the direction of Nifty 50 is not as easy as it seems. Many analysts like to take their chances, however, in my experience, the probability of getting this right is thin over a longer period of time. At this point, I must remind you of your situation. You are sitting with 1 crore rupees waiting to be invested in stock markets. To be honest, you really cannot afford timing the markets. Because, if the market never comes down, you will end up blaming yourself a few years down the line when your friends will showcase their beautiful luxury cars. Similarly, if you invest at once, you might again blame yourself sitting in your second-hand hatchback!
The safest option in such a situation is staggered investment over a period of time. You may decide to make the investment at periodic intervals like daily, weekly, monthly (called as systematic investment plan); or you may decide to invest on the basis of levels of Nifty 50.
I have designed a strategy that has the potential of getting you invested in the stock markets with relatively lower risk. At this point, I have to give my view about the Nifty 50. I believe the market is over-valued and some correction is necessary to get the comfort before investing. I would be very comfortable with a level of 14000-14500 on the index. Should I wait for this level? But what if it never comes?
Understanding of how capital moves from a sector to another comes in handy at such point. When I expect the Nifty 50 to go down, it’s quite obvious that I would like to stay away from high beta sectors. So, I start my investment by putting some amount into the defensives. At the current level of 17500, I invest some part of the corpus into a mutual fund that has majority exposure to Indian IT sector.
As the market moves down to 17000, I again invest a chunk of my corpus into a different defensive. Pharma sector this time.
If the index moves down to 16500, I invest some part of my corpus into a mutual fund having exposure to the FMCG sector.
This completes my allocation to the defensives. If the index keeps moving down, I can be fairly assured that my portfolio allocated at 17500, 17000 and 16500 levels wouldn’t move down as much as the index (remember beta and the concept of safety of capital?)
Let’s assume the index moves down to 16000. Now is a time I start feeling comfortable about the valuations of manufacturing companies. So, I find a mutual fund that has majority exposure to manufacturing companies.
Come down to 15500. I start getting comfort in automobile sector. So, I find an auto-oriented mutual fund and park a part of my funds there.
15000 comes and I am comfortable with the infrastructure sector. I do the obvious on lines with what I did earlier.
Come 14500 and the entire market is frenzied. By the time 14500 comes, banking stocks would have moved significantly down (yes, banks are extremely high beta companies).
At 14500, I decide to invest the last part of my corpus into a banking oriented mutual fund.
The question that arises now is what if the market does not come down. Let me answer that. If I were in your situation, I would have parked the entire 1 crores rupees in a fund category called Equity Savings Scheme (ESS). ESS is a hybrid mutual fund having majority exposure to equities. However, they also have exposure to derivatives by way of which they hedge their portfolio. When the market keeps going up, the ESS funds do not go as much as the market. This is because hedging has a cost associated with it. There is a benefit of ESS funds. You got it right: If the market keeps coming down, ESS funds do not fall as much. Typically, a well-managed ESS fund would fall only half of what Nifty 50 would fall.
If the market goes up 15% in the next year, I will make about 7.5% on my ESS investments. However, if it falls, I end up buying the high beta sectors at much lucrative valuations. By the time the index reaches 14500, my portfolio would start looking like Nifty 50. However, my average cost of acquisition would be very favourable compared to Nifty 50. This is how this strategy has the potential of beating Nifty 50 without being very adventurous and investing all your money at once. Similarly, it doesn’t ask you to become an astrologer and predict the markets.
This brings us to the last question: Who will monitor all these levels? Because it is a time consuming affair! The answer is simple in two bullet points:
Systematic transfer plan (STP)
Trigger based transfer: Our mutual funds portal allows investors to transfer funds from one fund to another when the Sensex/ Nifty reach a particular level. In simple words, I can set a rule saying- if Nifty falls to 16500, transfer funds from my ESS fund to the desired FMCG fund.
What can go wrong?
If the market keeps rising, this strategy will surely underperform. However, it will surely get your more returns that a FD or insurance policy.
If the markets fall and the sectoral movement does not happen as envisaged. This is a genuine risk, however the probability of this happening is low. Even if there are some variations between how we saw sectors and how it turned out, the results wouldn’t be catastrophic. Very likely that this strategy still earns as much as the broader markets.
If the market does not fall to the desired level, the desired investment in target sectors will not be triggered. I acknowledge this risk and the game plan here is to wait and watch. We may have to get the target levels of Nifty up if the market keeps moving up. However, by then, the now existing fears like Fed, COVID, inflation, Ukraine etc. would have cooled off a bit, and that cooling off will give the confidence to raise the levels of Nifty higher.
After all the transfers are triggered, the market may just continue the free fall. This is a risk that cannot be mitigated. It is inherent to equity markets, and one must be comfortable with it before thinking about the potential rewards of equity. At this point, I wish to remind you that we live in an extreme capitalistic society where money is increasingly becoming important for one-and-all. In such a scenario, equity markets collapsing to catastrophic levels and staying there for a very long time is a low probability event.
The below screenshots are from out partner portal that lets you set up the level based triggers.
Disclaimer: We are SEBI registered investment advisors. At the same time, we run a mutual fund distribution business. SEBI allows us to run both at the same time, provided clients from both the segments do not overlap. If you like the strategy mentioned in the above article, we can help you get it implemented in our partner portal. Contact us for more details.