The top quartile: Wealth destruction
January 2018 was a good month for small and midcap investors. The NSE Smallcap 100 index hit a lifetime high of 9656 in January 2018. Subsequently, the index started crashing in February and made a low of 5669 in October 2018. (Wait, do not pull out your calculator app. I have already done that and the percentage fall comes to approx 41%). There are several reasons that people attribute to this crash, however, in my opinion, the root cause was overvaluation. In January 2018, the index was trading at a Price: Earnings ratio of more than 100. What this essentially means is you pay Rs. 100 to buy a company which earns Re. 1 per share in a year. Insane right? And mind you, we are talking about a whole index of 100 stocks here and not a single stock. This means many stocks in the index would have traded at PEs greater than 100 as well. Nothing, but Euphoria!
Earlier, I mentioned that the root cause of the crash was over-valuation. Some of the readers must have noticed that and registered in their minds that the author is perhaps wrong. Yes, now I am talking about the corporate governance lapses which started escaping out slowly from the closed doors of a board room nexus. Friendships between promoters and auditors started getting sour, and why not, Business comes first, followed immediately by Reputation. Here, in this article, I intend to cover some of the mightiest falls we encountered since 2008.
Ah, please wait! This isn't the list that most CAT participants wait for. Yeah, we aren't talking about the admission list of any top Indian Institute of Management. We are talking about the percentage wealth eroded through some listed companies in India (Many of these companies are run by Alumni from top-notch B-Schools globally). Peak prices of some of these stocks are the pre-2008 high. For some, the peak came in January 2018. This is a serious fall and enough for wiping off trading accounts of novice retail investors. Leave aside retail investors, many professional portfolio managers are stuck with illiquid stocks. Clients of such PMS schemes are stuck with an asset which nobody wants to buy.
Why did we land up in this situation in the first place? Well, there are many reasons, some of which are mentioned below:
Mounting debt: Post 2008 crises, Central Banks across the globe were in a phase of Dovish Monetary policy. Banks had to cut interest rates to move the wheels of global economies back to motion. In some cases, these wheels were so jammed that interest rates had to be cut significantly. India was no exception to this global phenomenon and interest rates were cut in India too. Few ambitious promoters leveraged their balance sheets much more than their servicing abilities. The market participants, as always happens in a liquidity-driven rally, ignored the deteriorating fundamentals and kept feeding the hungry promoters with nutrients in the form of surplus liquidity. Deterioration of fundamentals could not be ignored beyond a point and one by one, the pack of cards started collapsing as if a storm had approached.
Corporate Governance lapses: The Rs. 11000 crores Nirav Modi scam that broke out in February 2018 was a genesis of a new stock market fall. This came slightly after the news that long-term capital gains through equity to be taxed at 10 percent in India. Confused investors, could not attribute the fall to a particular reason. After 3-4 months of peace, the IL&FS issue came to the limelight. It isn't a case that market was unaware of mounting debt in IL&FS. Many market leaders were expecting the Government to bail out the Infra giant, after all, the Government and Government institutions have a big holding in IL&FS. In the aftermath of this event, we witnessed a series of defaults in the NBFC space. Some companies like DHFL and Indiabulls Housing Finance came in limelight. The contagion kept on spreading as many corporates and mutual funds had exposure to these papers. During this time, we also saw the default on payouts by some mutual funds in the fixed monthly plans (FMP) schemes.
These are the broad reason why we ended here. I can elaborate on these issues in detail by giving more statistics, however, I intend to keep it simple, more readable and less scary for non-finance-savvy readers.
Let me end this piece of article by sharing my learnings from this fallout:
Boom and bust phase is a reality in the market. Yes, it is the skill that one develops over a period of time to stay away from areas of bubbles. Many times, this tendency of staying away from bubbles may cost you a big opportunity. It is you, who has to judge the sustainable size of a bubble.
Corporate Governance is paramount. You may not always know everything that happens inside a board room, however, you should always try your best in staying away from the worst of the lot. They say 'Something is better than nothing', here in the world of Equities, it goes like this: 'Small issues are better than full-blown crisis'
Know your risk appetite before investing. As a Financial Advisor, I cover a wide socio-economic spectrum. A big problem according to me is: Most people misjudge their risk appetite. Some over-estimate it and some under-estimate it. There are individuals making hefty sums every month, but they do not spread their wings beyond fixed income (extreme conservatism), and on the other side of the spectrum, there are individuals who make meager sums per year but keep betting on small caps. It is important to strike a balance between the estimation of risk and expectation of returns.
Compounding over a longer time is better than multi-baggers. The obsession of multi-baggers is a big business opportunity for many advisers. If you check Google Adwords for the word multi-bagger, you will understand the quantum of obsession that I am talking about. I don't say spotting multi-baggers is futile, but it is certainly overrated. I stand by my thought of allocating a majority of corpus to stable, consistent businesses. It is good to allocate a small percentage of corpus to potential multi-baggers, but yeah, only a small proportion!
After all, Exponential success comes after a prolonged period of Linear efforts!